William F. Sharpe
In 1990 American economists William F. Sharpe, harry markowitz, and merton h. miller shared the Nobel Prize “for their pioneering work in the theory of financial economics.” Their early contributions established financial economics as a separate field of study. In the 1960s Sharpe, taking off from Markowitz’s portfolio theory, developed the Capital Asset Pricing Model (CAPM). One implication of this model is that a single mix of risky assets fits in every investor’s portfolio. Those who want a high return hold a portfolio heavily weighted with the risky asset; those who want a low return hold a portfolio heavily weighted with a riskless asset, such as an insured bank deposit. A measure of the portfolio risk that cannot be diversified away by mixing stocks is “beta.” A portfolio with a beta of 1.5, for example, is likely to rise by 15 percent if the stock market rises by 10 percent and is likely to fall by 15 percent if the market falls by 10 percent.
One implication of Sharpe’s work is that the expected return on a portfolio in excess of a riskless return should be beta times the excess return of the market. Thus, a portfolio with a beta of 2 should have an excess return that is twice as high as the market as a whole. If the market’s expected return is 8 percent and the riskless return is 5 percent, the market’s expected excess return is 3 percent (8 minus 5) and the portfolio’s expected excess return is therefore 6 percent (twice the market’s expected excess return of 3 percent). The portfolio’s expected total return would then be 11 percent (6 plus the riskless return of 5).
Sharpe was a Ph.D. candidate at the University of California at Los Angeles and an employee of the RAND Corporation when he first met Markowitz, who was also employed at RAND. Sharpe chose Markowitz as his dissertation adviser, even though Markowitz was not on the faculty at UCLA. Sharpe taught first at the University of Washington in Seattle and then at the University of California at Irvine. In 1971 he became a professor of finance at Stanford University. In 1986 Sharpe founded William F. Sharpe Associates, a firm that consulted to foundations, endowments, and pension plans. He returned to Stanford as a professor of finance in 1993 and is now a professor emeritus there.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.