The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 23

When Harry Met Bill(y)

Bill Sharpe strode into class with a newspaper under his arm, sat on the edge of the table in front of the blackboard, leg dangling, and launched into an animated monologue on the day’s scams, scandals, and other stories, weaving them seamlessly into the theory of finance.

It was the early 1990s and Sharpe had already shared the Nobel Prize in economics with Harry Markowitz and Merton Miller. I had recently started teaching at Stanford University’s School of Engineering, and Sharpe graciously allowed me to audit his course in the Business School. I had come for the education, but I stayed for the entertainment.

A Simplified Model of the Relationships Among Securities

Sharpe met Markowitz in 1960 in Santa Monica, California, when they were both working at the RAND Corporation, the government think tank for which the term “think tank” was coined. Sharpe had a master’s degree in economics from UCLA and was searching for a PhD thesis topic. His advisor suggested that he brainstorm with Markowitz.

The original formulation of Markowitz’s computer model required the interrelationship between every pair of individual investments. Markowitz and Sharpe realized that most of these interrelationships were not significant but that each stock had a relationship to the stock market as a whole. So, as the Dow Jones went up or down, it dragged other securities with it to varying degrees. They felt that it would not be a bad approximation to ignore the other ...