Capital markets have undergone a dramatic transformation since 1952. That year eventual Nobel laureate Harry Markowitz tossed aside the widely held notion that securities should be evaluated by their individual characteristics. He asserted instead that the rational investor would focus on how a security impacted the overall risk and return of his portfolio. Fifty-four years later, the debate among financial economists is over. Portfolio theory has supplanted fundamental analysis and other approaches that pre-date statistical reasoning as the basis for the study of investing. In the capital markets, where clever marketing can obscure sound science, the battle rages on. But disciples of stock picking and market timing are clearly on the defensive.
Several other eventual Nobel Prize winners built upon Markowitz’s foundation. Tobin furthered the understanding of portfolio structure by introducing lending and borrowing (1958), while Miller and Modigliani (1961) demonstrated that portfolio theory was consistent with corporate capital structure. William Sharpe (1964) developed the Capital Asset Pricing Model (CAPM), which defined investment risk as volatility relative to the market. Samuelson (1965) established that market prices are the best estimates of a firm’s value, and that stock prices change randomly, so that future prices are unpredictable.
Black, Scholes and Merton segmented and better quantified risk by introducing the Options Pricing Model. It was in 1966, however, that Eugene Fama developed the Efficient Market Hypothesis that is now taught almost universally among business schools. His exhaustive research on security price patterns made it clear that it was very difficult if not impossible for an investor to capture returns in excess of market returns without assuming greater than market levels of risk.
Despite the impressive body of empirical evidence to support the wisdom of passive investing, Fama’s work was not warmly embraced by the money management industry. In 1971 the first passive S&P 500 Index fund was established at the Wells Fargo Bank, and in 1976 John Bogle established the Vanguard 500 Index Fund. These funds, which represented the first attempts to simply capture the returns of the U.S. stock market as efficiently as possible, at the time were derided as “guaranteed mediocrity.”
Today index funds represent 15 percent of all equity mutual fund assets, and in 2004 one of every three dollars invested in equity mutual funds was dedicated to an index fund. Notably, these figures do not include the passively managed funds created by Dimensional Fund Advisors (DFA)1 (we find DFA’s approach to be superior to simple indexing).
The future is bright for investors. As investment theory and information technology continue to progress rapidly, asset classes will become better defined and investment vehicles will be made more cost-efficient. We will ensure that our readers remain poised to fully exploit these opportunities as they emerge.
Also in This Issue:
Amaranth and Hedge Funds’ Hidden Risks
Quarterly Review of Investment Policy
Tax Swapping Time
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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