Taking big financial risks can, on occasion, produce big financial gains — or hand you your head in a basket. Nobel Laureate William F. Sharpe would rather keep his head.
The theory that broadly diversified investment funds yield better returns in the long run than the riskier targeted funds that may grab headlines is one that Sharpe, Nobel laureate and finance professor emeritus at the Stanford Graduate School of Business, has been writing about for years.
Sharpe reflected on how investors should be wary of financial experts during an Oct. 7 campus lecture as part of a Continuing Education series titled "Stanford Pioneers in Science." In front of a near-capacity crowd at Cubberley Auditorium, he didn't give listeners any new advice about how to weather the current financial crisis and fill the holes in their portfolios. But he did explain again how futile it is to read sure-thing investing books or watch the latest Jim Cramer-like financial guru to find easy answers.
Better, he said, to realize there are no shortcuts to huge gains unless you want to take huge risk — and even then there is no guarantee. "If you take a risk expecting higher returns, you may get higher returns or you may get your head handed to you," he said. Or, in other words, "Don't put all your money into one stock because not everyone else is going to do so."
He explained it this way: If you have a number of investors putting in varying amounts of money — some large amounts and some smaller — that automatically dilutes the possibility one of them is going to come out with a massive return. Your risk has been diversified away because your fellow investors aren't taking a similar risk to yours.
Managers of actively-managed mutual funds study trends, research firms, and invest based on their reading of the market. Some will have good returns, some even better, and some will fall far below the performance of the market at large. Overall their funds will average out to the same return as the market, he said.
In contrast, he described index funds that strive to eliminate volatility by being well-diversified. As an example he described a group of investors each putting 1% of their money into the same cross section of all securities available in China. Each will realize the same return — essentially mimicking the Chinese market over all. Unlike the managed funds that may perform above or below the market, all the index funds will mirror the overall market performance.
With Paul Costello, executive director of communications at the Stanford School of Medicine, asking questions, Sharpe agreed that his warnings about risk vs. returns were ignored in the banking community before the recent meltdown.
He said he agreed with fellow Nobel economist Paul Krugman that much of the current financial crisis was caused by "People who think they can get away with it legally and so will take a lot of risk. On the way up it's a great ride and they become wealthy — and when things go bad, they bail out."
In fact, Sharpe is mentioned in a new book by Time magazine writer Justin Fox, The Myth of the Rational Market, which explores how bankers brought the financial system to disaster. Sharpe shared the Nobel in 1990 with Harry Markowitz, who created a model equating the concept of risk with the mathematical concept of variance.
"Markowitz's model told investors what they should do, rather than predicting what they actually do," Krugman wrote in the New York Times in August. "But by the mid-1960s other theorists had taken the next step, analyzing financial markets on the assumption that investors actually behaved the way Markowitz's model said they should." The result was "an intellectually elegant theory of stock prices," the Capital Asset Pricing Model (CAPM), which grew out of Sharpe's doctoral dissertation written at UCLA.
Sharpe, 75, is still active in the field of personal finance as a board member of Financial Engines, a company he cofounded in 1996 that manages assets of 401(k) investors in large corporations. In response to an audience question about what he had learned from that experience, he wryly said, "I learned people do foolish things," quickly adding that after studying markets for many years, investing is, "Not as simple as I thought it was."
If you're going to put retirement money in 401(k)s, he said, you base your decision by looking forward, not backward. "People take the easy way out, figuring what happened in the past is similar to what is going to happen in the future."
From his home in Carmel, Calif., shared with his artist wife, Kathryn, Sharpe continues to write and blog, especially about markets and equilibrium.
That was in evidence when he answered a question about global warming — whether we have enough information to halt climate change. Sharpe answered that taxes should be levied on polluters.
He said climate change involves externalities — an impact on a party that is not directly involved in the transaction. He said the issue could be seen as a case of poorly defined property rights — the air around the coal plant isn't owned by the coal company, so is the coal company responsible?
Property rights are necessary to create reasonable equilibrium. "You need to get the property rights established so you can say whether this will cost you if you continue," he said, and come up with a tax [on the source of the negative externality — carbon] high enough so that burning stops.