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Stanford Business magazine


Nobel Laureate Sharpe on Retirement Economics

By Bill Snyder

With millions of baby boomers closing in on retirement age, saving money for a comfortable old age is nearly as popular a conversation topic as sex. There’s no shortage of advice, good or otherwise, as legions of pricey financial advisors, money managers, and columnists weigh in, and no shortage of financial products claiming to solve the problem.

But much less attention is focused on managing those hard-won assets once the aging boomer has cleared his or her desk for the last time. With the nest egg finally hatched, retirees are faced with a new set of critical questions: How much can I safely spend every year; should I buy an annuity; what about long-term care insurance; and is selling my house a better idea than a reverse mortgage?

SharpeWilliam Sharpe, the Nobel Prize-winning economist whose groundbreaking work on the dynamics of the stock market has guided generations of professional portfolio managers, says, “In the old days, you got a pension or Social Security check and your choices were pretty clear cut. Now they’re not, and people with money are begging for answers.”

Sharpe, an emeritus professor of finance, is addressing these questions as he turns his attention to a nascent field he calls “retirement economics.” His goal: Lay some of the theoretical and practical groundwork that will help financial advisors, including a company he founded, do a better job guiding retirees and possibly lead to a new generation of commercially available retirement tools.

Although Sharpe has shifted his focus in recent years, retirement economics is by no means a break with his earlier work. The theoretical underpinnings are similar, and the researcher’s four basic rules, or “pillars,” for investors and their advisors—diversify, economize, personalize, and contextualize—apply to the retiree and to the younger employee in the midst of building a portfolio.

Sharpe’s prize-winning work changed the way professional investors think about stocks. While much of it is rather technical, his capital asset pricing model, or CAPM, focuses on the relationship between risk and reward in the context of the entire market. As Sharpe puts it: “Some investments have higher expected returns than others. And they are the ones that will do the worst in bad times.” In other words, if you want higher returns, you’ve got to take some of the market’s overall risk.

In theory, an investor would be assured of a return that equaled that of the market as a whole if he or she owned a portfolio that encompassed all traded stocks. In fact, low-cost index funds allow investors to come close to that ideal state, and are an excellent alternative to traditionally managed portfolios for many investors, Sharpe says.

It’s important to remember that investments have costs such as management and brokerage fees that reduce profits. And here’s where Sharpe takes sharp issue with the conventional “stock-picking” approach to investing. “A lot of people have a strong vested financial interest in saying ‘I know how to beat an index fund,’ and if you torture a body of data long enough it will confess to anything you want. I’d be skeptical of anyone who assumes there is a simple formula to get something for nothing.”

Now 73 and still working a 50-hour week, Sharpe jokes that he wants to act “in loco parentis to my potentially deranged older self.” Humor aside, Sharpe has a serious point: Older people may be less able to make intelligent decisions about complicated financial matters. So having a plan mapped out in advance “while I can still think clearly” is essential, he says.

And while many financial advisors tend to separate plans for spending and investing, Sharpe maintains that integrating the two is key to achieving the right balance and the best results.

Sharpe calls his solution to the spending/investing conundrum “a lockbox.” Rather than using a rule of thumb that encourages a retiree to spend a certain percentage of saved assets each year, he suggests making discrete plans for investing and spending during each year of retirement. The money in each year’s lockbox is invested independently from other lockboxes, and, barring emergencies, the retiree spends only the funds in that year’s box.

At some point, it’s possible that Financial Engines, the investment advisory firm founded by Sharpe, will sell a product built around the lockbox theory, but not in the next few years, says a spokesman for the Palo Alto, Calif.-based company.

Meanwhile, Financial Engines already manages about $11 billion of the assets of more than 150,000 401(k) participants in some 100 companies. Sharpe, who stepped down as chairman of Financial Engines in 2003, remains on the board but is not active in day-to-day management of the firm.

The company’s clients are firms that offer 401(k) plans. It provides personalized advice, typically paid for by the employer, and fund management, paid for by employees who opt for it. For a fee ranging from 0.2 percent to 0.6 percent of the money managed, Financial Engines will choose a desirable combination of mutual funds available through their employer for each employee.

How does Sharpe explain the possible contradiction between founding an investment management and advisory firm and his advocacy of passive investment, index funds, and the like?

Sharpe replies that fees charged by Financial Engines combined with the fees charged by the funds the company recommends are substantially lower than the typical combination of fees investors pay if they hire independent financial planners who claim they can help them beat the market. “We are not trying to help people beat the market, but by using the tools of financial economic theory and empirical research we find efficient strategies that provide diversification at low cost,” he says.

In conversation, Sharpe is disarmingly affable and takes time out to good-naturedly shoo Henry, his new Bichon Frise puppy, from his home office in Carmel, Calif. But don’t think he’s always Mr. Nice Guy. Sharpe can be very tough minded, offering scathing criticisms of conventional money managers. He once called financial planning “a fantasyland.”

Sharpe’s view of risk and reward underlies retirement economics as well as general market theory. He maintains that in general there are two types of risk: market risk and nonmarket risk. Market risks are conditions that all stocks are subjected to, such as major changes in the economy, war, or disaster. Since all stocks are affected, this type of risk pays a significant premium. But nonmarket risk, the kind that affects a single stock or sector, does not.

In practice, much nonmarket risk can be diversified away. The risk of holding a stock in an exotic new technology, say hydrogen fuel cells, could be offset by an investment in a conventional energy company. And it’s worth noting that although the fuel cell company is probably a very risky bet, its stock price is not likely to be affected substantially by the risk that is specific to the company or its technology.

Sharpe’s CAPM theory offers investors a way to quantify risk; it’s called beta, a concept that has become a standard financial tool. Beta measures a stock’s relative volatility—that is, it shows how much the price of a particular stock is likely to jump up and down when the stock market as a whole moves. On average a stock with a beta of 1 would move in harmony with the market, while a stock with a beta of 1.5 would likely rise by 15 percent if the market rose by 10 percent, and fall by 15 percent if the market fell by 10 percent.

While all of this sounds complex, and it is, Sharpe maintains that his investment philosophy can be summed up with four verbs explained in his most recent book, Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice. In it, and during an interview with Stanford Business, he explained his four-verb mantra:

  • Diversify.  This is pretty simple. “For many investors a few highly diversified low-cost index funds may suffice,” he writes.
  • Economize.  If an index fund is right for you, as it is for many investors, why spend a lot of money on management fees in a likely vain attempt to beat the market? In financial argot, index funds are “passively managed”—which means your advisor doesn’t do much and can’t charge very much. Active management, which includes stock-picking, costs a lot more. Of course, investors willing to bear additional risk may want to earmark part of their portfolios to potentially market-topping ideas.
  • Personalize.  This may seem obvious, but there’s more to it than you might think. As an example, Sharpe talks about an investor who works and owns a home in Silicon Valley. Personalizing her portfolio might well mean underweighting technology stocks, since a downturn in the Valley could cost her job and knock a big percentage off the value of her home. So why risk having the retirement portfolio going down as much with the other ships?
  • Contextualize.  Here Sharpe departs a bit in his focus and is speaking more to the advisor and money manager when he says: “Asset prices are not set in a vacuum.  … It is impossible to choose an appropriate portfolio without a coherent view of the determinants of asset prices.” In other words, consider the underlying factors, whether it be CAPM or other theories, that move markets.

Because the 1990 Nobel Prize made him something of a celebrity in the academic community, Sharpe’s words get a lot of attention. A comment here and there to a journalist has led to speculation that he has abandoned much of his earlier thinking. Does he really believe that beta is dead? “Not in my house,” he says wryly.

But Sharpe is quick to add that “when I first published in 1964 I built a very simple model. Since then I and 10,000 other researchers have thought more about these issues and have much more empirical data to work with. We’ve added a bit more reality.”