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Scheduled air date: Aug. 23, 2002
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William Sharpe
Chairman, Financial Engines
1990 Nobel Laureate
William Sharpe

Sharpe, who shared the 1990 Nobel Prize for economics, founded Financial Engines in 1996. More than 800 organizations spanning 3 million workers currently use Financial Engines' technology platform to offer investment advice tailored for each individual user. Sharpe is also the STANCO 25 Professor of Finance, Emeritus, at Stanford University' s Graduate School of Business.

His work in the 1960s produced the Capital Asset Pricing Model (CAPM), which was the primary reason for his Nobel Prize. CAPM was a key building block in what became efficient markets theory, which basically asserts that over the long run, it is impossible to outperform the market. That, in turn, led to now-widely accepted investment practices such as portfolio diversification and index investing, although wildly successful investment managers such as Warren Buffett consider efficient markets theory (EMT) -- and, in general, the application of higher-order math to the markets -- just so much hogwash.

"The disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of (Benjamin) Graham," Buffett wrote in the 1988 annual report of his investment firm, Berkshire Hathaway. "Its an enormous advantage to have opponents who have been taught that its useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT."

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» 1990 Nobel citation for William Sharpe

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Buffett and his peers notwithstanding, studies have consistently shown that most investors do, in fact, fail to beat the market. Meanwhile, since CAPM, Sharpe went on to develop the Sharpe Ratio for investment performance analysis, the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns-based style analysis for evaluating the style and performance of investment funds.

All that research into asset pricing and valuation prepared Sharpe well for his private career. In some ways, his company's services became especially popular with the market downturn.

"The fact that the market fell should have helped us in the sense that were the 'risk people,' " Sharpe said during an interview earlier this year for Financial Advisor magazine. "During the glory days, we were out there crying in the wilderness saying, 'Watch out. If you take more risk you could lose more money.' So in some sense having that 'correction' should have helped us as people said, 'They were right, it is important to focus on risk.' "

However, financial services firms -- Financial Engines' main constituency -- also have been hit hard during the bear market, and many development projects have been delayed, slowed or scaled down. There are some signs that financial services is starting to turn around, Sharpe said.

Meanwhile, he and his company continue to highlight investment risks. Sharpe sees three reasons for annual investment returns to be lower in the future, as low as the 5.5 percent to 6.5 percent range.

"Its plausible to believe that there is less risk associated with investing than there was during the 20s and 30s," Sharpe told Financial Advisor. "With less risk, people require and get lower risk premiums. Second, were better at sharing the risk. ... This makes it possible to bear risk more efficiently, so the premium doesnt have to be as high. The third reason is that investors are richer than they were 20, 30, 40 or 50 years ago. People who are richer are generally willing to bear risk for a lower reward."

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