Who is William F. Sharpe?
William Forsyth Sharpe is an American economist who won the 1990 Nobel Prize in Economic Sciences, along with Harry Markowitz and Merton Miller, for developing models to assist with investment decision making.
Sharpe is well known for developing the capital asset pricing model (CAPM) in the 1960s. The CAPM describes the relationship between systematic risk and expected returns, and states that taking on more risk is necessary to earn a higher return. He is also known for creating the Sharpe ratio, a figure used to measure the risk-to-reward ratio of an investment.
Life of William F. Sharpe
William Forsyth Sharpe was born in Boston on June 6, 1934. He and his family eventually settled in California, and he graduated from Riverside Polytechnic High School in 1951. After several false starts in deciding what to study at college, including abandoned plans to pursue medicine and business administration, Sharpe decided to study economics. He graduated from the University of California at Berkley with a Bachelor of Arts degree in 1955 and a Master of Arts degree in 1956. In 1961, he earned a Ph.D. in economics from the University of California at Los Angeles.
Sharpe has taught at the University of Washington, the University of California at Irvine, and Stanford University. He has also held several positions in his professional career outside of academia. Notably, he was an economist at RAND Corporation, consultant at Merrill Lynch and Wells Fargo, founder of Sharpe-Russell Research in conjunction with Frank Russell Company, and founder of the consulting firm William F. Sharpe Associates. Sharpe received many awards for his contribution to the field of finance and business, including the American Assembly of Collegiate Schools of Business award for outstanding contribution to the field of business education in 1980, and the Financial Analysts Federated Nicholas Molodovsky Award for outstanding contribution to the [finance] profession in 1989. The Nobel Prize award he won in 1990 is the most prestigious achievement.
- William F. Sharpe is an economist credited with developing the CAPM and Sharpe ratio.
- The CAPM is a cornerstone in portfolio management and seeks to find the expected return by looking at the risk-free rate, beta, and the market risk premium.
- The Sharpe ratio helps investors decipher which investments provide the best returns for the risk level.
Contributions to Financial Economics
Sharpe is most well-known for his role in developing CAPM, which has become a foundational concept in financial economics and portfolio management. This theory has origins in his doctoral dissertation. Sharpe submitted a paper summarizing the basis for CAPM to the Journal of Finance in 1962. Although it is now a cornerstone theory in finance, it originally received negative feedback from the publication. It was later published in 1964 following a change in editorship.
The CAPM model theorized that the expected return of a stock should be the risk-free rate of return plus the beta of the investment multiplied by the market risk premium. The risk-free rate of return compensates investors for tying up their money, while the beta and market risk premium compensates the investor for the additional risk they are taking on over and above simply investing in treasuries which provide the risk-free rate.
Sharpe also created the oft-referenced Sharpe ratio. The Sharpe ratio measures the excess return earned over the risk-free rate per unit of volatility. The ratio helps investors determine if higher returns are due to smart investment decisions or taking on too much risk. Two portfolios may have similar returns, but the Sharpe ratio shows which one is taking more risk to attain that return. Higher returns with lower risk is better, and the Sharpe ratio helps investors find that mix.
In addition, Sharpe's 1998 paper, Determining a Fund's Effective Mix, is credited as being the foundation of return-based analysis models, which analyze historical investment returns in order to determine how to classify an investment.
Example of How Investors Use the Sharpe Ratio
Assume an investor wants to add a new stock to their portfolio. They are currently considering two and want to pick the one with the better risk-adjusted return. They will use the Sharpe ratio calculation.
Assume the risk-free rate is 3%.
Stock A has a returned 15% in the past year, with volatility of 10%. The Sharpe ratio is 1.2. Calculated as (15-3)/10.
Stock B has returned 13% in the past year, with volatility of 7%. The Sharpe ratio is 1.43. Calculated as (13-3)/7.
While stock B had a lower return than stock A, the volatility of stock B is also lower. When factoring in the risk of the investments, stock B provides a better mix of returns with lower risk. Even if stock B only returned 12%, it would still be a better buy with a Sharpe ratio of 1.29.
The prudent investor chooses stock B, because the slightly higher return associated with stock A doesn't adequately compensate for the higher risk.
There are a few issues with the calculation, including the limited time frame being looked at and the assumption that prior returns and volatility are representative of futures returns and volatility. This may not always be the case.