Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice

233 Pages·2006·1.31 MB·English

by  William F. Sharpe

INVESTORS AND
MARKETS
PRINCETON LECTURES IN FINANCE
Yacine Ait-Sahalia, Series Editor
The Princeton Lectures in Finance, published by arrangement with the
Bendheim Center for Finance of Princeton University, are based on annual
lectures offered at Princeton University. Each year, the Bendheim Center
invites a leading figure in the field of finance to deliver a set of lectures on a
topic of major significance to researchers and professionals around the world.
Stephen A. Ross, Neoclassical Finance
William F. Sharpe, Investors and Markets:
Portfolio Choices, Asset Prices, and Investment Advice
INVESTORS AND
MARKETS
PORTFOLIO CHOICES, ASSET PRICES, AND INVESTMENT ADVICE
William F. Sharpe
This work is published by arrangement with the
Bendheim Center for Finance of Princeton University
princeton university press
princeton and oxford
Copyright © 2007 by Princeton University Press
Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock,
Oxfordshire OX20 1TW
All Rights Reserved
Third printing, and first paperback printing, 2008
Paperback ISBN: 978-0-691-13850-3
The Library of Congress has cataloged the cloth edition of this book as follows
Sharpe, William F.
Investors and markets : portfolio choices, asset prices, and investment advice /
William F. Sharpe.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-0-691-12842-9 (hardcover : alk. paper)
ISBN-10: 0-691-12842-1 (hardcover : alk. paper)
1. Portfolio management. 2. Securities—Prices. 3. Capital asset pricing model.
4. Investment analysis. 5. Investments. I. Title.
HG4529.5.S53 2007
332.6—dc22 2006015387
British Library Cataloging-in-Publication Data is available
This book has been composed in Goudy and Swiss 911 Extra Compressed
by Princeton Editorial Associates, Inc., Scottsdale, Arizona
Printed on acid-free paper. ∞
press.princeton.edu
Printed in the United States of America
3 5 7 9 10 8 6 4
CONTENTS
PREFACE vii
ONE
Introduction 1
TWO
Equilibrium 9
THREE
Preferences 35
FOUR
Prices 63
FIVE
Positions 111
SIX
Predictions 129
SEVEN
Protection 149
EIGHT
Advice 185
REFERENCES 213
INDEX 215

PREFACE
T
HIS BOOK IS based on the Princeton University Lectures in Finance
that I gave in May 2004. The invitation to present these lectures pro-
vided me a chance to address old issues in new ways and to bring to-
gether a number of interrelated topics in financial economics with an emphasis
on individuals’ saving and investment decisions.
I am grateful to Professor Yacine Ait-Sahalia of Princeton, the series editor,
and to Peter Dougherty of Princeton University Press for inviting me to under-
take this project and for giving me valuable advice throughout.
This work follows a tradition with strong Princeton roots. In the first (2001)
Princeton Lectures in Finance, Stephen Ross masterfully addressed the central
issues associated with asset pricing. That work is now available as the first book
in this series: Neoclassical Finance(Ross 2005).
In 2001 Princeton University Press published the first edition of John
Cochrane’s marvelous book, Asset Pricing(Cochrane 2001), which is fast be-
coming a standard text for its target audience—“economics and finance Ph.D.
students, advanced MBA students, and professionals with similar background.”
My goal is to continue down the path set by Ross and Cochrane, using a
somewhat different approach and providing several extensions. However,
this book differs substantially from the work of Ross and Cochrane in both
approach and motivation. I am primarily concerned with helping individual
investors make good saving and investment decisions—usually with the assis-
tance of investment professionals such as financial planners, mutual fund man-
agers, advisory services, and personal asset managers. This requires more than
just an understanding of the determinants of asset prices. But for many other
applications in finance, it suffices to understand asset pricing. For example,
a corporation desiring to maximize the value of its stock can, in principle,
simply consider the pricing of the potential outcomes associated with its ac-
tivities. A financial engineer designing a financial product may need only to
determine a way to replicate the desired outcomes and compute the cost of
doing so.
Appropriately, Ross concentrated on the ability to price assets using only
information about other assets’ prices in his first chapter: “No Arbitrage: The
Fundamental Theorem of Finance.” The title of Cochrane’s book indicates a
similar focus, as does his statement in the preface that “we now go to asset prices
directly. One can then find optimal portfolios, but it is a side issue for the asset
pricing question.”
viii PREFACE
However, to determine the best investment portfolio for an individual, one
needs more than asset prices. To use the standard economic jargon, individuals
should maximize expected utility, not just portfolio value. To do so efficiently
requires an understanding of the ways in which asset prices reflect investors’
diverse situations and views of the future. I thus deal here with both asset pric-
ing and portfolio choice. And, as will be seen, I treat them more as one subject
than as two.
Over the past year and a half I have benefited greatly from comments and
suggestions made by a number of friends and colleagues. Without implicating
any of them in the final results, I wish to thank Yacine Ait-Sahalia, Princeton
University; Geert Bekaert, Columbia University; Phillip Dolan, Macquarie
University; Peter Dougherty, Princeton University Press; Ed Fine, Financial
Engines, Inc.; Steven Grenadier, Stanford University; Christopher Jones,
Financial Engines, Inc.; Haim Levy, Hebrew University; Harry Markowitz,
Harry Markowitz Associates; André Perold, Harvard University; Steven Ross,
Massachusetts Institute of Technology; and Jason Scott, Jim Shearer, John
Watson, and Robert Young, Financial Engines, Inc.
Finally, I express my gratitude to my wife Kathy for her support and encour-
agement. We are proof that a professional artist and a financial economist can
live happily and productively together.
INVESTORS AND
MARKETS