To quote the introduction, “Nobel prize winning financial economist William Sharpe shows that investment professionals cannot make good portfolio choices unless they understand the determinants of asset prices. Until now asset-price analysis has largely been inaccessible to everyone except PhDs in financial economics. This book aims to fill the gap, by setting out a state of the art approach to asset pricing in a non-mathematical form, bridging the gap between best financial theory and investment choice.”

Does the book succeed? Only to a certain extent. It is a theoretical piece of work – no surprise as it is based on Sharpe’s 2004 Princeton lectures, building on previous work by Ross and Cochrane. The basic approach is readily understandable to any student of economics: determining maximum expected utility by setting up a series of models of portfolio choices that steadily become more complex, for example, by including alternative business scenarios, different investor preferences, or the need for certain levels of wealth protection.

How practical is this advice? The book states that academic researchers will find here a series of useful capital market analyses, which is certainly the case. A major goal is to show how asset-pricing theory and mean general variance analysis can be taught to a range of students. I showed the book to a colleague who had passed the CFA exam, and he considered it a good summary of the course work he studied.

However, the book also hopes that: “Investment advisers will find a set of possible frameworks for making logical decisions”. There will be some, but I fear most would consider this book too removed from the real world. The final chapter on financial advice is a good example. Some good points are made, about the dangers of using historical returns, and how investors must have a sound framework for determining the correct prices of securities before making an investment decision. Even here, though, Sharpe includes detailed material on arbitrage pricing theory and the Fama/French three-factor model which would put off some readers.

Sharpe does admit that there are flaws to his basic approach. The most glaring is the lack of more time periods. None of the scenarios take into account trading costs. Information asymmetries are a common feature of markets, such as directors’ buying and selling. My concern was more that in the real world equilibrium is rarely (if ever) achieved; hence new entrants influence a stock market or new products alter a future profits path. Sharpe is well aware of this, arguing that markets will be heading towards equilibrium and the more efficient the financial system the smaller the discrepancies between market conditions and those of full equilibrium. Readers will have their own thoughts on how small or wide that gap is.

I must not be too negative about this book. There is much that is good: setting out complex issues such as the capital-asset pricing model and market risk/reward theorem in readily understandable terms, showing the importance of trading, time preferences, risk aversion, how individual actions, perhaps irrational on occasion, can still lead to a rational outcome, estimates of the equity risk premium, and the relative value of passive and active investing. Nor should the book be seen in isolation. Sharpe’s analysis is based on a computer programme (APSIM) available on his website www.wsharpe.com. This enables users to create virtual markets populated by individuals, set up the initial starting conditions and then allow trading until an equilibrium is reached and trading stops. Such tools are clearly of potential use to economists in many areas.

Andrew Milligan

Head of Global Strategy, Investment Dept, Standard Life Investments