Chapter 3. Other Betas

Portfolio theory worthy of the name in 1951 was conspicuous by its absence. Over the next fourteen years, a bold attempt at filling the void by explaining how markets work unfolded in a series of published academic papers. Collectively, this research lays out the theoretical basis for the modern age of portfolio management and delivers context for thinking about the design and management of asset allocation. Among the highlights:

  • Markowitz's portfolio optimization theory quantifies the investment instinct for maximizing return and minimizing risk.

  • Tobin's separation theorem formalizes the concept of asset allocation.

  • Sharpe and company explain that the market portfolio is the optimal portfolio.

  • Research on the efficient market hypothesis counsels that it is difficult, if not impossible to outguess the market over time and that market prices are likely to be a robust estimate of asset value as a general rule.

As financial revolutions go, the 1952–1965 burst of inquiry and analysis arrived with lightening speed, which is all the more impressive if you consider the dramatic changes in the study and practice of managing money that was unleashed by these papers. Investing isn't close to being "solved" by these theoretical innovations, nor do these papers have a monopoly on the reordering of finance that unfolded in the second half of the twentieth century. But as a group, the ideas in these papers have been front and center in reinventing the framework for analyzing ...

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