IndexUniverse.com chats with the Nobel Prize winner about his latest book, asset allocation, how to prepare for retirement, and more.
Recently IndexUniverse.com Assistant Editor Heather Bell spoke with William Sharpe, the recipient of the 1990 Nobel Memorial Prize in Economics for the development of the Capital Asset Pricing Model (CAPM). Dr. Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University and the founder of Financial Engines, Inc., a provider of investment advice and managed accounts to defined contribution plans. He is also the creator of the Sharpe Ratio.
Index Universe (IU): Can you tell us a little bit about your recently published book Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice?
William F. Sharpe (Sharpe): I was invited to give some lectures at Princeton University and turn that into a book. I decided this would be a good opportunity to think about equilibrium and capital markets and what that means for investors and investment strategy and policy. What did I think I had learned, not only in the mean variance days of the capital asset pricing model and Markowitz, but also from all the things that people have done since then? I wanted to bring it all together. That seemed like a great undertaking; little did I realize where it was leading.
In the course of working on the lectures, I leaned more and more toward writing a simulator and just going back to first principles. The premise was that you had people coming together and trading with each other until they didn't want to trade anymore. What could you say about the outcome and prices and risk and return? I started writing this simulator, and it became a lot of fun but a lot of work.
In the old days, we made a lot of simplifying assumptions. Harry Markowitz decided to assume people care only about the mean and the variance of portfolio returns. And I thought if that were true, we should figure out what we could say about equilibrium, risk and return, and the CAPM.
In this setting, I asked if people care about something other than the mean and variance of portfolio returns, and what if return distributions could be anything? What's left? What can we say about how prices are determined? And more importantly, once you've got prices determined in a competitive market, what does that imply for what we ought to do with our money when we invest?
I also wanted to make it accessible, and I wanted to try to show academics in particular that this in many ways was a better way of teaching finance than the traditional way—in some ways simpler and certainly more general and potentially more fun—and push the notion of simulation as opposed to analytic closed-form mathematical models as an interesting way to look at things and make them seem more plausible.
IU: How should investors approach asset allocation?
Sharpe: The first thing you have to do is figure out what your objectives are. This isn't trivial: What are you trying to accomplish? What are your preferences for risk and return? What are your needs for things like liquidity?
Second, you have to figure out what your pre-existing sources of risk and return are. Do you own a house? If so, where is it and what risks are likely to impact its value? What about your job and other assets that are not in the portfolio?
One of my favorite diatribes is, "How can you possibly do your asset allocation without looking at the market values of the asset classes out there today?" That's probably the most valuable information you can get as to the future prospects of those asset classes, and what astounds me is the fact that many people—many of them very sophisticated—do asset allocation without even checking to see what the relative values of the outstanding shares in, say, European securities, U.S. securities, emerging markets, etc., are.
IU: Should investors index?