Competitive Advantage in Investing. Steven Abrahams

Competitive Advantage in Investing - Steven Abrahams


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it would have to wait at least another 10 years.

      William Sharpe at Stanford and later John Lintner at Harvard separately came along more than a decade later and built on Markowitz's approach (Sharpe, 1964; Lintner, 1965). They developed a method that not only had something to say about the best way to combine all the items on the infinite investment list and choose a single best portfolio but also had something to say about how much each investment was worth. Known today as the capital asset pricing model, or CAPM, it probably has become the most broadly taught framework for building a portfolio and for valuing the assets that go into it. It has also led to important tools for measuring the important costs of running a company and for gauging the performance of asset managers. And, like all good theories, it was beautifully simple. Perhaps too beautiful.

      To Markowitz's framework, Sharpe added the assumption that all investors agree on the most important features of asset returns over a given investment horizon: their likely mean, variance, and correlation. Investors see the same security cash flows, the same risk attributes driving those cash flows, and the same future path for those risks. All investors see the same world of possible investments. Most important, all investors see the same efficient frontier. He might have argued that investors can all have different opinions about given investments, but they can't have their own facts. Common facts prevail.

      Sharpe adapted an idea originally described by James Tobin at Yale and assumed that all investors could borrow or lend money at a single, common riskless rate (Tobin, 1958). Individuals, corporations, and even the US Treasury would pay the same rate of interest. This is not as unrealistic as it might sound at first. Once individuals or corporations put up valuable property or other collateral to secure a loan, interest rates can vary by only a small amount at least over short periods.

      Sharpe knew he would be challenged. “These are highly restrictive and undoubtedly unrealistic assumptions,” he noted. But he argued that the implications of his approach fit beautifully with some of the key predictions of classical finance. Beauty in theory would win over beauty in practice.

      The immediate implication of holding cash or lending at a common riskless rate along with a common view of risky assets would be that an investor could hold a mix of cash and risky assets. If the investor held only cash, the portfolio would spin off a riskless return. If the investor held only efficient risky assets, the portfolio would spin off a return somewhere along the efficient frontier. If the investor held a mix of cash and risky assets, returns would fall somewhere along a line between a riskless return and a single point on the efficient frontier.

Image described by caption.

      Sharpe's capital market line reduced the complexity of Markowitz's approach. With a common view of asset performance, investors all should buy the same market portfolio of risky assets and individually either blend it with a relatively riskless investment or borrow and buy more of the portfolio to suit preferences for risk and return.

      The complexity of the infinite investment menu had moved from the search for the single best investment through Markowitz to the efficient frontier and now through Sharpe to the capital market line. Investing had been reduced to a simple decision about the best mix of cash, borrowing, and a single efficient risk portfolio.

      Sharpe's approach also led to another powerful conclusion about the value of available investable assets, a conclusion that ever since has broadly set the terms for evaluating assets and investment managers.

      Sharpe then made the case that the value of any investment depends only on the amount of risk the asset shares with portfolios along the capital market line. Think of that as the risk of overall economic growth or decline. The remaining risk in an asset was unique or idiosyncratic. It could reflect the unpredictable effects of personnel or reputation or local markets or other factors. By combining investments, a portfolio could balance bad luck on one investment with good luck on another, just like the effect of flipping multiple coins can balance out into a smooth set of outcomes. But the core, systematic risk in an investment an investor cannot diversify away. And if the investor cannot eliminate the risk, then the investor needs fair compensation.