September 05, 2009
William F. Sharpe ('61) Earned Nobel Prize for Capital Asset Pricing Model
Principles of the CAPM were present in his UCLA dissertation
William F. Sharpe (Ph.D. '61) is one of the leading figures in Financial Economics. His dissertation at UCLA contained concepts that he would later develop into the highly-influential Capital Asset Pricing Model (CAPM). For this contribution to his field, Sharpe shared the 1990 Nobel Prize in Economic Sciences.
As an undergraduate and master's student at UCLA, Sharpe was a research assistant for the late Fred Weston. He continued to take courses from Weston and work closely with him until completing his Ph.D. in Economics in 1961. "He was a major influence in my life and a great contributor to the field of Finance. It was a privilege and an honor to have known him, learned from him and worked with him over many, many years," Sharpe says.
When Sharpe was choosing a topic for his dissertation, Weston suggested he talk with Harry Markowitz who was doing research at the RAND Corporation. Markowitz provided some direction and served as his unofficial dissertation advisor. Markowitz also shared the 1990 Nobel Prize in Economic Sciences for his work in portfolio theory.
After graduating from UCLA, Sharpe had a distinguished career at the University of Washington, the University of California at Irvine and Stanford University. He also spent time at the National Bureau of Economic Research (NBER) and the RAND Corporation. He has authored a number of influential books including the textbook Investments, which is now in its sixth edition. Sharpe also served as a consultant to top investment firms before launching his own firm, Financial Engines, Inc., which specializes in online investment advice and management.
Sharpe introduced the Capital Asset Pricing Model (CAPM) in his 1964 paper, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. In finance, the CAPM is used to determine a theoretically appropriate required rate of return of an asset, given that asset's non-diversifiable risk.
Sharpe Describes the Capital Asset Pricing Model
Sharpe says an investor might think of the CAPM this way. "First, I would say to you, ‘what do you think you should pay to get a dollar in bad times? Should you pay more than to get a dollar in good times?' And you would probably say, ‘Yes, I think so.' If you said, ‘No,' I'd say, ‘Well there aren't as many dollars available in bad times so don't you think the price of scarcer goods should be higher than more plentiful goods?' And hopefully you'd see that this makes sense. So I'd try to convince you that, all things being equal, the price of a dollar in bad times should be higher so, therefore, the return on what you pay for it should be worse. You pay more to get the dollar so the return on your investment is going to be worse."
"If I can get you to that point, I'd say, ‘Well, then it pretty much follows that if you put your money in something that will do really badly in bad times, you should expect not only to get more in good times, but you should expect to get more over the very long run. Markets should be such, and prices should be such and investors' behavior should be such that the expected return on an asset is greater if it does badly in bad times - than if it doesn't do so badly in bad times."
"And if you agree so far," he continues, "I'd say, ‘Well, we have this measure which is sort of a short cut for indicating how badly an investment is likely to do in bad times and it's called beta (β). High beta investments are ones that do particularly badly in bad times and low beta investments are ones that don't do so badly in bad times.'"
"So, hopefully I've gotten you to the point where you agree that an investment with a high beta should have a higher expected return than an investment with a low beta. At that point, I might say, ‘Well, over the long run, don't you expect that you'd do better with stocks - because terrible things could happen to you in the short run - than with bonds?'" According to Sharpe, this is the key message for investors from the Capital Asset Pricing Model.
Sharpe Ratio Combines Risk and Return
Sharpe is also known for creating the Sharpe Ratio, which is a risk-adjusted measure of investment performance. This continues to be one of the most widely-used performance measures for investment managers.
Sharpe originally called the Sharpe Ratio the Reward to Variability Ratio but other scholars insisted on naming the idea for its founder. Sharpe explains that, "It originally was intended to answer the question, if you had to rate the prospects for a portfolio with a single number, what might that number be? The idea was you don't want to just use the expected return because that doesn't include anything about risk. So the question was - How might you create a number that reflects both expected return and risk?"
"My answer was to take the expected return over and above safe investments, like a Treasury bill or money in the bank, put that in the numerator and, in the denominator, put a measure of risk (the standard deviation of the differences in these returns). The idea was that the reward is in the top. Bigger is better. Variability is in the bottom. Bigger is worse."
"The ratio produces useful numbers," he says, "but now you can do better by putting more data into a computer and letting it analyze your overall risk and return."
Putting Theory into Practice
In 1996, Sharpe and two partners founded a firm to apply principles from the field of Financial Economics to investment management. The firm, Financial Engines, Inc. now employs over 200 people and manages portfolios for employees at many Fortune 500 companies. Sharpe holds the title Director Emeritus and continues to be involved with research.
"I realized there was a sea change going on in the way people finance their retirement," he says. "It used to be that after you retired you would receive checks. When you died, your spouse would receive smaller checks. Then when your spouse died, the checks would stop. Today, we are in a brave new world of 401Ks and 403Bs in which you have to manage your retirement funds, yet many people have not learned how to plan and manage their finances for the future."
Financial Engines applies concepts such as style analysis, optimization and equilibrium theory to help clients manage their portfolios. "Style analysis is a way of building and calibrating a model of all the diverse investments that you usually find in a portfolio," Sharpe explains. "It came directly out of my research"
"The computer engines in our firm were built very much on my view of how you ought to do these things," he continues. "Since it began, the firm has done huge amounts of empirical and theoretical research and algorithm development. Now there are many techniques that go well beyond what I helped set up initially. But my legacy and philosophy are still there."
Financial Engines typically works with large firms. They provide each employee with a detailed analysis of their retirement portfolio at least once a year. "We say, ‘Here's what you've got, here's how you're exposed to the markets and, if you keep doing what you're doing, here's the chance you'll have a retirement at level X or above. Here's the chance it will be at level Y or below. And, by the way, you might consider saving this much more because if you do so your prospects in retirement could be this much better.'"
The firm offers both online decision tools, and individually managed accounts for those who prefer not to make all their own investment decisions.
Sharpe's View of the Future of Financial Economics
In his recent book, Investors and Markets, Sharpe called for a new approach to the teaching and practice of Finance. "It's time to move beyond the simplifying assumption that probability distributions of economic events are normal or log-normal and that people only need to consider the mean and the standard deviation of a distribution," he says.
"I think, increasingly, we need to go beyond that - and there's no reason that we can't. You can have distributions that are as complex as you like and you can have characterizations of people's preferences that are reasonably complex. So I think practitioners should go beyond simple paradigms and I have been calling for academics teaching in business schools to do so."
Sharpe pauses when asked what area of Financial Economics he would study if he were starting his career today. "My gut reaction," he says, "is that maybe one should concentrate on some of the really tough institutional issues associated with banking and shadow banking rather than just how to create some new derivative."
"Also, I think there's a huge need to help people make financial choices," he continues. "It's what I broadly call ‘lifetime finance.' How do we finance an individual's lifetime? You can approach this from a social standpoint, dealing with the design of a social security system or the design of healthcare systems. Or you can approach it from an individual standpoint. How should individuals make decisions if they have to do so? You can approach it from an education and communication standpoint. How can we help individuals make decisions either by collective education or individual counseling?"
"Then there are the behavioral aspects. How do we find out what a person's preferences really are? Right now we are beginning to learn from work in an area called neural economics, which is really fascinating. I would probably tilt my work somewhat toward the area of behavioral economics - trying to understand how people really make decisions. Then there's the much harder question - How do you help people make decisions that are truly in their best interests? You can become very philosophical about those issues."
"I think there's much to be done in the field of Financial Economics if it's regarded in a very broad sense," he says. "It's a very exciting time. There are revolutions and paradigm shifts underway. ‘Would I go into the field again?' Yes, I think I would. I view Financial Economics as dealing with resources, time and uncertainty. Would I still choose to do work dealing with resource allocation, time and uncertainty? I think so."
Please click here to watch Bill Sharpe's interview at the First Meeting of Laureates in Economic Sciences at Lindau, Germany, September 1-2, 2004.Contact Information
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