Chapter 7: Bill Sharpe: “It is Dangerous to Think of Risk as a Number”

Ø Sharpe now sees CAPM from a different perspective; he has transformed himself from a Nobel Laureate theoretician into a pioneering financial engineer.

Ø Sharpe is looking for ways to help individual investors get from here to there, from a miasma of self-defeating decisions into an environment where they know how to analyze the investment problem and where to seek solutions to it.

Ø Sharpe’s contributions:

n CAPM has become a standard for the valuation of risky assets and for calibrating investment performance.

n Alpha and beta are the starting points for many portfolio strategies, both complex and simple.

Ø As a practical matter, nobody today considers the estimates derived from the model as anywhere near the last word in evaluating assets or making judgments about the performance of a portfolio.

Ø Nevertheless, beta serves wisely as a measure of systematic risk, and alpha has become the holy grail of investment management – the excess return after adjustment for risk that can be earned over and above what the market returns.

Ø Sharpe: “I still think it is good to assume that you have to take higher risks if you are seeking higher returns. If you take risks other than the risk of being in the market itself, you probably will not be rewarded, because stock picking seldom pays off. So why do it?”

Ø The historical data on which we all depend so heavily may be useless for asset pricing: As we never know with certainty what the future holds, all we have to rely on is a sense of the probabilities of future events.

Ø Sharpe: “I have been around long enough to see empirical results that seem to be really solid until you try a different country or different statistical method or different time period. May be that’s why Fisher Black said you should put your trust only in logic and theory and forget about statistical empirical results.”

Ø Sharpe sums it up, “It’s dangerous, at least in general, to think of risk as a number… The problem we all face is that there are many scenarios that can unfold in the future…”

Ø The issue is: Do you have similar outcomes in various scenarios, or do you have diverse outcomes? Ultimately, that depends on your preferences (i.e., your utility function).

Ø In the process, as with Behavioral Finance and institutionalism, financial engineers like Sharpe, Markowitz, and Shiller improve neoclassical finance by toughening it and by improving the business payoffs with new and better techniques.