How academic debate transformed into Wall Street wealth.

This had long been interpreted to mean that trustees should stick the money in their charge in high-grade bonds and maybe a few blue-chip stocks. That approach was sorely tested in the 1960s, when imprudent investors seemed to be having all the fun and making all the money. It was tested even more in the 1970s, when neither bonds nor blue chips proved safe, leaving a big opening for a new approach to risk, return, and diversification. In this view it wasn't the riskiness of an individual stock or bond that mattered, but the way it fit in to a portfolio. By the mid-1970s, this approach had a name—modern portfolio theory—and was beginning to make slight inroads in the institutional investing world.

Then Washington gave it a huge boost. In the wake of several corporate bankruptcies that left pensions unpaid, Congress passed pension-reform legislation in 1974. The Employee Retirement Security Act has since gone on to have many interesting consequences. The first had to do with the standard of prudence laid down by the law and in subsequent regulations from the Department of Labor. No longer a legal concept based on tradition, prudence was redefined to mean following the scientific dictates of modern portfolio theory.

In this accounting, risk ceased to be a vague, unquantifiable menace that could be tamed only with judgment. It was a number, variance, which could be estimated mainly by looking at past variance. This development was in one way curious: The same finance scholars who claimed that you couldn't predict future stock price movements by looking at past stock price movements were embracing the idea that future stock volatility could be predicted by looking at past stock volatility.

"Estimating variances is orders of magnitude easier than estimating ... expected returns," reasoned Fischer Black, one of the most prominent of the 1970s risk engineers. There was no economic law dictating that financial volatility had to be constant or predictable.

But at least there wasn't any economic law that said it couldn't be. If the direction of stock prices could be predicted, there would be free lunch for all. If the volatility could be predicted, that just meant more work for finance professors.

Also in the early 1970s, Barr Rosenberg of UC-Berkeley looked back through a century of stock market data and found: