Based on lectures this noted author gave at Princeton University in 2004, this book takes the investment professional through the world of asset pricing and portfolio theory with a nontraditional approach that avoids mean–variance analysis and requires little math.
Investors, investment professionals, and academics are inundated by books on investing and asset pricing. A search of “investments” on Amazon.com yields a mind-numbing 233,604 matches. Searching “asset pricing” produces a large, although more manageable, 3,344. Which books should be read and whose advice should be followed are million-dollar questions.
Returning to our roots in finance is a good way to find the answers. Like much of the readership of the Financial Analysts Journal , I received my first formal exposure to investments through William F. Sharpe’s 1978 classic text Investments (now in its sixth edition). In the ensuing years, Sharpe’s writings have continued to shape the thinking of a generation of investment professionals. Sharpe, perhaps more than any other finance academic, has an uncanny ability to communicate important insights so that they are accessible to nearly all professionals and students in the field. With his simplification of Markowitz’s portfolio theory, his capital asset pricing model, his widely used measure of portfolio performance, and his early realization that option valuation could be simply explained via a decision tree to his strong advocacy of passive index funds, Sharpe has influenced the thinking of financial practitioners for three decades.
Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice , based on three lectures that Sharpe delivered at Princeton University in May 2004, is an effort to continue that tradition. The lectures were part of a series that began with Stephen A. Ross of the Massachusetts Institute of Technology in 2001 and that has included Myron S. Scholes of Stanford University, Douglas W. Diamond of the University of Chicago, and Hayne Leland of the University of California, Berkeley. (Ross’s lecture led to his 2005 book Neoclassical Finance .)
As Sharpe points out in the preface to Investors and Markets , both the Ross book and John Cochrane’s 2001 Asset Pricing are excellent texts for doctoral students and advanced MBA students. Many investment professionals, however, lack the mathematical background to benefit fully from these works. In addition, Sharpe is interested in helping individual investors make sound saving and investment decisions, usually with the help of investment professionals. This objective compels him to expand the discussion beyond the determinants of asset prices.
In Investors and Markets , Sharpe takes the reader through the world of asset pricing and portfolio theory with a nontraditional approach that avoids mean–variance analysis and requires little math. The book’s brevity (barely 200 pages of text) and the absence of equations might initially lead the reader to believe it can easily be tackled in a weekend. The reader will quickly realize, however, that a solid grasp of the author’s concepts requires one’s undivided attention.
Sharpe’s approach is to return to his formal training in economics. He uses Kenneth Arrow and Gerard Debreu’s state/preference technique, together with simulations, to reach the same conclusions about portfolio choice that the mean–variance method produces. By using simulations, Sharpe is able to simplify his explanation through eliminating the need for complex algebraic expressions. The drawback is that his analysis can be somewhat difficult to follow because the reader sees only the results of the simulations. Sharpe has tried to deal with this problem by making the simulation program, known as the Asset Pricing and Portfolio Choice Simulator (APSIM), available for free on his website ( http://www.stanford.edu/~wfsharpe/apsim/index.html ). The source code for this Microsoft Excel program, written in C++, is also available. Although Sharpe does not recommend that the average reader analyze the code, he believes that it serves a function similar to the derivations in traditional algebraic models.
Investors and Markets consists of eight chapters. Following an introduction to the topic, Sharpe proceeds systematically from “Equilibrium” in Chapter 2 to “Advice” in Chapter 8. To illustrate his key concepts, Sharpe leads the reader on a fishing expedition (literally) by creating hypothetical individuals in a simplified economy where investments are limited to equity in fishing companies and bonds.
At the outset, Sharpe introduces Mario and Hue, two individuals who help illustrate the concept of equilibrium. To convey this concept, Sharpe lays out in Chapter 2 the microeconomics of Mario and Hue’s preferences and shows how prices are determined by these preferences. Although Sharpe makes various assumptions about Mario and Hue’s preferences, readers can see how sensitive the results are to those assumptions by using the APSIM program to change the parameters. In later chapters, Sharpe expands the analysis by introducing wealthier siblings and other characters in order to generalize the concepts.
One of the book’s greatest insights appears in the chapter on prediction. Sharpe, a long-time advocate of passive management, uses an unconventional analysis to make a strong case for indexing. Advocates of indexing traditionally argue that the efficiency of the market prevents most managers from outperforming. Active managers, however, continue to claim that their research provides superior predictions that can be exploited to produce excess returns. Using some simple mathematics, Sharpe shows that even a manager who discerns the correct probability distribution may not beat the market, with the result that the index is likely to do nearly as well. 1
Throughout the past 40 years, Sharpe has remained one of the most influential voices in finance for both academics and practitioners. As is true for all of Sharpe’s writings, investment professionals will do well to read Investors and Markets and carefully absorb its insights.
—R.L.M