On October 17, William F. Sharpe, Nobel Laureate in Economics and Stanford professor, was a keynote speaker and participant in the School's conference "The '87 Stock Crash Ten Years Later: Causes and Consequences of Market Volatility." He took a few minutes away from the conference to talk to GSM Dean Robert Smiley about the stock market, the Nobel Prize and life in general. 

Sharpe: Yes, and the level of the market after the crash of 1987 made me nervous. And if the market fell 30 percent tomorrow, the level tomorrow night would make me nervous. The market always makes me nervous. But let me answer that operationally. Have I done anything, have I sold any stocks, mutual funds? No. 

Smiley: My daughter's about to graduate from law school. What investment advice would you give someone in their late 20s? 

Sharpe: Buy and hold no load index funds. 

Smiley: Why index funds rather than something else? 

Sharpe: They're cheaper and you get the asset allocation that you think you're getting. I have no problem with putting some money in actively managed funds, but index funds are very attractive and certainly dominate the average actively managed fund in terms of net performance, risk, etc. 

Smiley: If, however, one wanted to invest in an actively managed fund, is the past any guide to the future? 

Sharpe: It's always important to think in terms of performance relative to a reasonable benchmark. In general, the best single predictor is the expense ratio. Followed by turnover, then past performance. 

Smiley: Could you expand on the expense ratio as a predictor? A high expense ratio or a low expense ratio? 

Sharpe: Funds with high expense ratios are likely to have lower net returns (that is, net of expenses). Academic studies have shown that for the average fund, each added dollar of expenses lowers performance net of expenses by about a dollar. 

Smiley: The investment strategies that people might take over their life span--I wonder if there is a general rule in your opinion for how people ought to change strategies as they get older and approach retirement? 

Sharpe: The perceived wisdom in the financial planning community is that you should diminish your risk gradually up to retirement and through retirement. A simple rule of thumb is to have the same amount of assets in bonds equal to your age. So, if you're 60, you should have 60 percent in bonds. For years academics thought that there's really no reason why this kind of rule makes sense. But if you think more broadly about one's wealth, at least until retirement, it consists of financial capital and human capital. When you're young, it's mostly human capital: what you're going to earn until you retire. As you get towards retirement, most of your wealth (hopefully) consists of financial capital. As long as you have a job or the ability to get a job, your human capital is likely to be less risk than the stock market. This line of argument holds that when you are very young, your overall portfolio consists of mostly fairly conservative human capital, therefore the small amount in financial capital can then be quite risky. But as you get older and more and more of your portfolio is in financial assets, it makes sense to lower the risk of financial assets. I think academics are beginning to come around to the view that lowering financial risk as one ages might not be a bad rule after all. 
 
Smiley: Why is the word of Alan Greenspan quite so important in the market? Or is it? 

Sharpe: I don't know if it is. The press has a wonderful time explaining everything that happens, no matter how trivial the purported causes. It's very hard to tell what causes the market to move. We tend to have selective recall--Greenspan said something, then the market moved, so he must have moved it. But we forget all the cases where he said something and nothing happened. The honest answer is that I don't know the extent to which his statements move markets. Obviously, he has the ability to do things that can affect the real economy. If people think he can affect the real economy by saying he's going to do something positive or negative, it makes sense for the market to move. But there's so much mumbo jumbo in the descriptions of the process that I'm cautious about taking a position. 
 
Smiley: The Nobel Prize in 1990 must have had some impact on your life. What were the more interesting ways in which it changed? 

Sharpe: I've had a rash of people over the years asking my opinion on subjects of which I know nothing and about which I have no expertise. That continues to a minor extent today. And, I have more requests for speaking engagements than I can accommodate. 

Smiley: You left Stanford University a year before you received the Nobel Prize. Can you explain why you left and why you returned. 

Sharpe: I went on leave in 1986 to found a consulting firm. I wanted to see if I could bring together the existing financial material that was out there (mine and others) to help pension fund managers make investment decisions. I founded a firm and hired some employees to do research and try to apply new and old research in practice. At first I took an academic leave. Later, I went back to the university and tried to both teach and consult for the firm. That didn't work very well, so when I became 55 I took emeritus status in order to run the firm full time. After a few years, the firm was doing well and we were making money and, I believe, helping our clients make better decisions, but it was a very labor intensive operation. I couldn't distance myself enough from the day-to-day operation to do the amount of research and writing I wanted to do. I decided that research and writing were more important, so we declared a victory, gave everybody one year's notice and closed down the firm. I still do a little consulting, but strictly by myself. 
 
Smiley: The future for you--what are you going to do for the next five or ten years? 

Sharpe: Well, I am involved in another firm, but in a very different role. I am a founder, an investor and chairman of the board of a start-up firm which is developing software for electronic advice to 401K participants. In this case, I have nothing to do with the day-to-day operation. I function as a research advisor. It's an incredible operation and very exciting, so that's one of my favorite things at the moment. I'm still doing research, writing and teaching. I don't expect to change any of that. I'm having a great time.