William F. Sharpe is chairman of Financial Engines Inc., Palo Alto, Calif. One of the originators of the Capital Asset Pricing Model, which related stock risks to returns of the market as a whole, he shared the 1990 Nobel Memorial Prize for economics with his former mentor, Harry Markowitz. He also developed the Sharpe ratio, a tool for analyzing investment performance, and developed a returns-based style analysis for evaluating investment funds. In 1996, he co-founded Financial Engines, which advises 401(k) plan participants and other individuals on investing their retirement assets.
P&I: It's been about 25 years since the big advances in modern finance were put forward: CAPM, options pricing theory, arbitrage pricing theory. Is there going to be another big wave of discoveries in financial economics? What's the new, new thing?
Mr. Sharpe: That's a hard question. I'm tempted to agree with your premise, that those were the big ones, since I was around at the time and I had a role in some of them. But I think probably that's overstating. Is there something big coming? I have no notion. It's sort of like efficient markets: if you knew something big was coming and if you knew what it was going to be, why not do it already?
P&I: We have seen tremendous investment sophistication among defined benefit plans. Now, we are seeing a new evolution on the part of individual investors. How will placing these investment tools in the hands of individual investors change the shape of capital markets?
Mr. Sharpe: It's a much, much greater challenge (than dealing with institutional investors). With individuals, they don't have the time or interest or the background. So it's more a matter of providing them with the tools and allowing them to do what they need to do and to understand what they have to understand to get there. What we find is that individuals care about the ultimate outcomes: "How likely am I to live (well) in retirement and how much do I need to save?" They're not so interested - nor should they be - in the nuances of the particular investment vehicle they might want to choose.
(The other key difference is) that individuals die and pension funds aren't supposed to. For an individual, you've got the lifecycle issue. How should you save and invest over your life?
So, all of a sudden, the number of decisions (an individual) could make becomes very large. That means very, very complex computational issues, but that also means almost death-defying decision issues. How could (an individual) possibly make decisions about all these variables?
P&I: Are individuals aware of the risks of investing?
Mr. Sharpe: I really want to get people to understand what a probability distribution is. Over and over and over again, we are finding that's really a stretch for some of our people. So we generally go to the things they are (used) to: "What's the chance of (attaining) a certain standard of living in retirement? How much could I lose if things get ugly?" So what we're doing is showing the attributes of the distribution rather than the whole thing.
We work very hard to show people what the risk is. I think what's really important is that we show them the risk in the context of their lives. Yes, we show them what will happen in one year to their balances if things get ugly because we know that if we don't show them that and things do get ugly in one year, they very well may panic.
P&I: There's a small but vocal group suggesting we could be facing a negative or flat equity risk premium over coming years. What's your view on that issue?
Mr. Sharpe: I just don't think markets are that out to lunch. If in fact that's the best estimate of the equity risk premium, you've got to ask yourself, why are people holding equity? You can come up with some subtle stories as to why they might hold equity anyway, but I just find that a very tough story to tell.
From a company viewpoint, we do think risk is lower than it was in the very long run. We do think that markets are better able to allocate risk because (some) investors are wealthier and able to bear risk.
P&I: An important outgrowth of CAPM has been the development of index strategies. But can you reach a point where the level of indexation in the market becomes too high, that is, it creates inefficient markets?
Mr. Sharpe: Yes. If you get to the point where everyone is indexing, you absolutely have to buy everything that is publicly available. I would immediately incorporate Bill Sharpe Inc. at an incredibly high price, and go to market with it. And you'd all have to buy it for your index funds at whatever price I set. And that's a reductio ad absurdum.
The whole premise of indexing is that market prices are set reasonably efficiently and reflect reasonable estimates of the admittedly uncertain future. And that requires somebody doing security analysis and trying to exploit mispricing, so there has to be a balance. What we don't know is where that imbalance point is. I've continued to say that it doesn't feel to me that we're near it yet.
P&I: To what extent has the Internet revolutionized finance?
Mr. Sharpe: Almost all finance is just moving bits around. The fundamental financial functions increasingly are computerized. When you buy a mutual fund, bits move from your bank to the mutual fund. When you sell it, bits are moved from the mutual fund to your bank. Almost nothing physical is going on except little electrons are traveling on fiber optic cables.
Maybe two or three or four years ago, there were some who thought that people would just change all of their financial habits quickly, so they would make a lot of decisions sitting at home in front of their screens. And I think we're seeing less of that than certainly some might have anticipated.
Plus, I think you're going to have the ability to have much more customization of financial products. One of the things we find is that people really are different in ever so many ways. There's one argument that all you need is one off-the-shelf huge index fund for everybody. That's obviously naive and not right. As we find out more about individual differences, we'll be able to produce much more personalized investment strategies than we can even now.
Financial services is a very complex industry and, by its nature, it's a slow-moving industry. You don't get radical overnight changes. We didn't know four, five years ago how rapidly this dramatic change in technology and costs were affecting industry. I think we now know that the effect will be profound, but it's not going to happen overnight.
P&I: Is Financial Engines going to go public? Are you going to sell the company?
Mr. Sharpe: At some point in the evolution, it would be good for us to be a public company. When that point will come, I can't tell you. It depends on us, it depends on the markets. I just don't know when that is. That's not our objective. Our objective is to build a business and do the best job we can. That's something we would do at some point. This is not a get-rich-quick scheme. If it is, it's failed miserably.