Sharpe Rethinks CAPM

InvestmentNews.com: Sharpe rethinks the capital asset pricing model (CAPM).

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.

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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 and president of Gifford Fong Associates, a Lafayette, Calif.-based consultant on fixed income and derivatives.

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.

As I said in my earlier posts, a replacement to CAPM and the mean-variance notion as a way of defining risk and return is definitely long over-due. Although I am skeptical about its usefulness, I will try to find out what this "state preference" theory is all about. The draft version of the afor-mentioned book is available online at this site at Stanford.