Did a theory define our financial markets?
Of course, the CAPM isn't simply a model to be used in grocery stores; it shows how Sharpe has contributed to the analysis of financial markets, and gives an idea of why the Nobel Committee has called his work “the backbone of financial economics”. Once Sharpe dives into what the CAPM means for financial markets, understanding it can be a true challenge. Even when he's asked to explain it in simple terms, it's not easy to grasp the main ideas, let alone the overarching impact, of his theory.
But Sharpe, in true professor-mode, succeeds in keeping it clear: “In equilibrium there are a set of portfolios that are efficient, better than others. Those portfolios typically involve a combination of what we now call the market portfolio. A broad portfolio including, in principal, all the available securities in proportion to their market values,” Sharpe says, thoughtfully, as he leans back in his chair.
“Then, the best thing to do is to put some or all of your money in that portfolio and the rest or none into something safe like treasury bonds, bills, treasury inflation-protected securities. If you really want to take on risk and get a higher expected return, you might even want to borrow money, and invest all your money, and the money you borrow, in that market portfolio. Another implication is that the trade-off between expected return and risk will be roughly linear, so if you want more expected return, you’re going to have to take more risk.”