Balancing Risk and Reward

William Sharpe’s Capital Asset Pricing Model

Dr. William Sharpe at work in his UW office, about 1964 - he says that his “time at the UW was fabulous.” (Foster School of Business, UW)

William Sharpe’s work is the bedrock of modern finance

Rocky HigginsFoster School of Business, UW

William Sharpe was an assistant professor of finance in the UW College of Business Administration when he published his innovative 1964 article “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” The Capital Asset Pricing Model (CAPM) expressed the mathematical relationship between risk and return in capital markets, and suggested a strategy for portfolio diversification.

Sharpe’s 1964 “Capital Asset Prices” presented this graph to establish that in an equilibrium model, all assets will lie on a line relating beta to expected return. (“Capital Asset Pricing: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance Vol. 19 No. 3 September 1964)

Professor Sharpe in his UW office in about 1964, the year his CAPM paper was published. (Foster School of Business, UW)

As a graduate student, Sharpe had been disappointed to discover that financial practice was governed by rule of thumb rather than by theory. Investors confidently believed that paying high fees to investment advisors guaranteed success in the market. So Sharpe decided to apply recently developed computer programs and to innovate new mathematical models to analyze and quantify market processes.

The result was an elegantly simple insight: exposure to greater risk earns greater returns, exposure to lesser risk earns lesser returns. Sharpe’s equation became basic to modern finance, proving that holding a portfolio of equities balanced across market risk is the wisest investment strategy. Sharpe’s paper was rejected twice before publication, but its groundbreaking ideas have informed generations of scholarship. CAPM supplied the economic argument for modern low-cost, low-risk, broadly diversified index funds-and it made Sharpe a winner of the 1990 Nobel Prize in Economics.