Sharpe v. Markowitz - Is the Capital Asset Pricing Model washed up?
William F. Sharpe, who won a Nobel Prize in economics in 1990 along with Harry Markowitz is saying in his new book that his prize-winning Capital Asset Pricing Model may no longer be all that gol-darned cool.
Kind of tough to argue with what his allies, like Santa Clara Prof. Meir Statman, are saying about the concept of risk:
"We've come to thinking about risk as standard deviation," Mr. Statman said. "What people want is protection when the economy tanks."
though it's also kind of hard to acquaint my tiny mind with Sharpe's new best friend "state-preference theory":
"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.
Guess I should put the book on my Christmas wish-list, squint real hard, and commence to cipherin'.
Meanwhile, Harry Markowitz isn't too terribly impressed, according to the same Investment News item:
"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.