### Sharpe Rethinks CAPM

This came by email. William Sharpe is rethinking the CAPM model and adopting a state-preference approach instead, something co-Nobel prize winner for work in this area Harry Markowitz disagrees with:

Sharpe rethinks the capital asset pricing model, by Joel Chernoff, InvestmentNews.com: William F. Sharpe says his pioneering work on the capital asset pricing model is ready for a makeover.

The 42-year-old model - which earned Mr. Sharpe a Nobel Memorial Prize in economics in 1990 - is being revamped because Mr. Sharpe says he found a better way for portfolio managers and business-school students to learn about how portfolios are constructed and how securities are priced.

CAPM, along with modern portfolio theory, developed by Mr. Sharpe's mentor and co-Nobel winner Harry Markowitz, is the foundation of every finance program in the country, if not the world.

His latest book, "Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice," may send investors and academics scurrying. Published this month by Princeton University Press, the book eschews mean-variance analysis - the mathematically complex formula that relates rewards to risks of securities or portfolios - in favor of a "state preference" approach that relies on an easy-to-understand simulation. That approach is based on a model closer to that used in financial engineering than in the ivory tower.

"I think of it as 'beyond mean-variance,'" Mr. Sharpe said in an interview. Whether that approach will work in the real world is unknown. Mr. Sharpe says he is just starting work on applying it to asset allocation. If the approach proves successful, it could result in a shift away from the traditional mean-variance optimizer used in establishing asset mixes and managing securities portfolios. ...

CAPM's flaws

There are numerous reasons for finding a substitute for a mean-variance approach. For one thing, it is ill-suited for considering extraordinary economic events such as bubbles, depressions, hyperinflation or terrorist attacks.

These types of "tail risk" are ignored by mean-variance analysis... "We've come to thinking about risk as standard deviation," Mr. Statman said. "What people want is protection when the economy tanks."

Another problem is that mean-variance analysis assumes that all investors have the same beliefs about the market and the relationship among different assets. In addition, mean-variance analysis ignores taxes, transaction costs and illiquidity. The analysis also assumes that all investors can borrow at the risk-free rate - a major flaw, in Mr. Markowitz's view.

CAPM was a revolutionary concept when Mr. Sharpe developed it in 1964. ... In CAPM, Mr. Sharpe found the most efficient portfolio was the entire market. He also related the risk of an individual security to the entire market, which was termed "beta."

Mr. Sharpe concluded that most of a stock's risk stemmed from the market. The idea of an index fund - passively tracking the entire market - came directly out of CAPM and the "efficient market hypothesis" unveiled a year later by Eugene F. Fama in his doctoral dissertation...

By contrast to mean-variance analysis, the state-preference approach doesn't rely on a normal distribution, and the mathematics is far simpler than in mean-variance analysis.

"The elegance of (the state-preference model) is that you can understand the elements of the various moving parts of the optimization," said Gifford Fong, editor of the Journal of Investment Management...

Taken from research done in the 1950s by Nobel Laureate Kenneth Arrow, an economics professor emeritus at Stanford (Calif.) University, and Gerard Debreu, the late economist, state-preference theory said that there are many possible future states of the world but that only one of them actually will occur.

Investors can assign probabilities of any given state occurring. In a complete market, an investor can buy or sell a security for every possible outcome. These contingent claims are like insurance policies. In fact, this methodology is used in pricing options, Mr. Sharpe said.

Many economists don't like state-preference theory, because it isn't provable, instead relying on a simulator. Some experts also note that it involves a massive amount of calculations.

"I find [the state-preference approach uses] a very general set of assumptions out of which very little specific can be deduced," said Mr. Markowitz. He and Mr. Sharpe will debate their differing views Oct. 16 at the Institute for Quantitative Research in Economics' 40th anniversary conference in Santa Barbara, Calif.

Mr. Sharpe's new book shows that a simulator based on the state/preference model can mimic market behavior and can be used where mean-variance analysis won't work. ...

What's more, Mr. Sharpe's simulator works even when markets are "incomplete" - meaning there isn't a contingent claim for every possibility - and when investors have outside sources of income.

Unlike a mean-variance analysis, however, the simulator finds that it does make sense for some investors to take non-market risk. For example, someone living in Silicon Valley might want to underweight technology stocks to reduce risk, Mr. Sharpe said.

Laurence B. Siegel, director of research ... Ford Foundation's investment division in New York, praised Mr. Sharpe's new work for validating classical finance theory. He said some managers are willing to discard CAPM because of its flaws, but Mr. Sharpe's new work shows equilibrium prices can be set without using a mean-variance analysis. ...

Posted by Mark Thoma on Wednesday, October 11, 2006 at 12:06 AM in Environment, Financial System |
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