American Finance Association

Efficient Capital Markets: A Review of Theory and Empirical Work: Discussion Author(s): William F. Sharpe Source: The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 418-420 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2325487 . Accessed: 19/07/2011 17:21
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DISCUSSION
praise forthis excelconsiderable Fama deserves WILLIAM F. SHARPE: * Professor have providedmuch of the key work in the He lent summary. and his students and to thathe shouldbe the first bringthe materialtogether area; it is thusfitting of to showso clearlythe relationships the variousparts to the overallsubject. thissubjecteverynow and then,to see just to it I find worthwhile stepback from market, put,the thesisis this: in a well-functioning Simply whatis beingconsidered. based on all relevant predictions the pricesof capital assets (securities)will reflect to self-evident most profesThis seems almosttrivially and available information. seems rathersilly.On the otherhand, sional economists-somuchso, that testing analyst.Only the most security to theidea seemstrulyrevolutionary the traditional of practitioners the merits could possiblyconvincesome die-hard testing exhaustive appear to thinkmorehighly economists professional of the approach.Interestingly, investors. thando otherprofessional investors of professional modelwith the more appealingmartingale of The replacement the random-walk schemeappealing, And I findthe proposedclassification modelseemsverydesirable. is martingale clearlyopen to dispute(when of the although definition a semi-strong are publiclyavailable?whichinvestors in the public? how soon must is information be the information available? at what price?). it, As is The idea of a weak martingale moreclear-cut. I understand the concept Since return beingpredicted. the assumesthe fulluse of past data concerning factor should of formulation theweak martingale a interest, careful is theobjectof primary not just on prices.In fact,this (i.e. pricesand dividends), be based on past returns is oftendone via "prices adjusted for dividends".But I would hope that in the and willbe moretalk of returns less of pricesper se. there future thesisrequiresmuch more than Fama indicates,the random-walk As Professor it alone. Moreover, is often conditions one would expectfrommarketequilibrium process). Let (as and/ormisinterpreted is the more generalmartingale misstated prices.Then, in reflected current Assumethat past data are properly me illustrate. But tells everything. in anothersense, it tells in a sense, the price of a security one In nothing. a worldin whichthereis risk-aversion, should somehowfindout return), highexpected a are whichsecurities morerisky(and thuspromise relatively low expectedreturn).If and whichare less risky (and thus promisea relatively stable over time,past data can be used to are characteristics reasonably security fromone anotherin this respect.One could estimaterisk securities differentiate consince equilibrium return, expected to be but directly, it might simpler estimate senfor thatit is a good surrogate risk.An obvious,and apparently ditionssuggest duringsome past period.This is sible,procedure to simplyuse the average return although that the orderof the past data (returns)may not be important, suggests will be. Thus it hardlyfollows(as some assert) thatone should the data themselves to are not look at past data at all. Only in a worldin whichinvestors indifferent wouldthenhave the same expected riskwouldthisbe thecase (since everysecurity in world; but some statements the literature return).This is not a veryinteresting . make littlesense in any otherenvironment
*

of at of University California Irvine Professor Economics,

418

Discussion

419

ex The idea of usingpast data to represent ante predictions raisessomeinteresting questions.Two interpretations be offered. One holds that predictions remain may relatively constant over time,and that the data represent unbiasedsamplesof those predictions. other The hold interpretations thatinvestors in fact,makepredictions do, of by simply extrapolating data. If so, past data provideestimates the predicpast tionscurrently beingmade by investors. Both interpretations a crucialquestion.What,if any, reasondoes a corporaraise tionhave to keep its securities from changing over significantly time?The empirical evidencesuggests considerable risk (the Pj term stability-most notablyin security in Professor Fama's paper). Why might thisbe so? I suspectthat it arises because corporate officers know that significant changesin securitycharacteristics impose There is the cost of not realizing that a changehas occurred, costson investors. as well as the cost associatedwiththe set of transactions to one's required re-establish preferred positionregarding risk vis-a-visexpectedreturn. The true extentof this and the reasonsfor it clearlydeserveadditionalinvestigation, do the stability as for implications the fieldof corporate finance. The roleof thespecialist and his possiblereplacement a computer-cum-algorithm by raisesomeinteresting (and essentially unanswered) questions. The current procedure leads to certain typesof investor Most notably, large majority orders behavior. a of are placed "at market". a computer If werein charge, theremight a largerproporbe tionof limitorders.Moreover, the "book" were public knowledge, number if the of limitordersmight further be since the submission such an orderwould of affected, have two effects, of which (conveying one information to directly many otherinvestors)is nowabsent.It is thusverydifficult predict fullimplications any to the of scheme(computer particular proposed let algorithm), alone suggest bestprocedure. the This is not the place to enterinto the controversy concerning distributions of One potentially return. bothersome implication requirescomment, however.In his dissertation, Blumesuggests that the residualsarounda security's characteristic line (i.e. the tj term the "market in model"described Professor by Fama) may follow a witha characteristic stableParetiandistribution less than 2. This suggests exponent that least-squaresproceduresmay give poor estimatesof securityor portfolio one mightfit a line that minimizes As volatility. an alternative, the sum of the This is relatively absolutedeviations. simple,but the resulting estimates lack some attributed the model (in particular, slope parameter to of thekey characteristics the of a portfolio may not equal the appropriately-weighted averageof the slope parametersof its component we securities). Clearly, could use a healthydose of empirical in research thisarea. Fama differentiates Professor tests" fromtests involving "single security interAs I security comparisons. an economist, findthe latterfarmoreinteresting. there If should be correlated is risk-aversion, with risk. The key question expectedreturn measure of risk. As indicated,there is only one wellconcernsthe appropriate to I developedtheory cope withthis problem. am beginning thinkof it as the to since it is usually titledby connecting two to fivenames with hyphenated theory, Professor Fama has used Sharpeand Lintner, others but have added (quite hyphens. the rightfully) names of Treynorand Mossin, as well as those of Markowitzand Tobin. In any event,the theory proposesa simpleyet convincing measureof risk. I call it volatility, following Treynor; otherscall it simplybeta; whateverit is of called,it measuresthe responsiveness a security portfolio's or returnto changes in thereturn the market a whole. on as The crucialquestionis not what to name risk,but how to measureit. Since the

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The Journalof Finance

interest rate does, in fact,changefromtime to time,it may be preferable riskless to regress excessreturn the excessreturn the market, on on thus: where: Rit= = RMt Pt =
bi=

et =

(Rit- pt) =bi(Rmt- pt) + et or i the return security portfolio at timet on the return the market timet on at theriskless pureinterest or rate at timet of the volatility security portfolio or i termwith (in theory)a mean value of zero a residualor error

But this is only one of a numberof possibledecisionsone can make. Here are someothers: than Are ones moreimportant 1. How shouldobservations weighted? morerecent be important? long period How a should considered? be lessrecent ones?Howmuch more monthly, interval 2. How often shouldobservations taken?Is the best differencing be annually? quarterly, 3. Shouldone use return the logarithm the value relative? the appropriate Is of or rate of compounded differencing interval infinitely small? If so, a continuously return The of (to may be mostappropriate. logarithm the value relative base e) provides sucha value. 4. Shouldone use before-tax after-tax at values,and if the latter, whattax rate? or none of the theoretical empirical to or workperformed date adequately Virtually of treatment thesetwo for taxes;but differential accounts income and capital-gains if results might obtained taxeswere be components return of suggests different that How for takenintoaccount. tax Can a "representative" rate suffice thispurpose? different theresults will be? 5. Whatindexshouldone use forthe "market"? Industrial The Dow-Jones Average, and the return thesecurities theNewYork Standard Poor's500 stocks, average on on or the Stock Exchange, perhaps return any portfolio 30 or moresecurities on of chosen random? at rate?Treasury rates, "prime" bill the 6. What measure should use forthe"riskless" one or of rate?Should prices used,or ask prices, an average thetwo? bid be deviaLeast-squares mean-absolute or 7. How should characteristic be estimated? lines tion? at Returns excess Should linebe forced the through point which the or returns? bothreturns rate,or shouldit be allowedto go above or equal the pureinterest belowthatpoint? vollimitson estimated 8. How shouldone compute, and interpret, use "confidence" atility? empirical test,not onlyin academe,but also in All thesequestions undergoing are for the investment industry. seem to have leftthe era of testing serial correlaWe tionof security the head-onthe pricesand to have entered era in whichwe confront and level. We have come a long questionof riskat both a theoretical an empirical we for prospects, still way in the last fewyears. But, fortunately our employment have a longway to go.