William Sharpe could relax. He has a Nobel Prize in economics, a ratio named after him, and billions of dollars invested every day around his theory -- the Capital Asset Pricing Model (CAPM). Index funds owe their existence to CAPM, and finance students everywhere chant his language of alpha and beta. Yet Sharpe has written a new book, Investors and Markets, published by Princeton University Press, which may cause a revolution -- or, at least, a coup in finance.

CAPM loosens up at 43
The CAPM theory has its 43rd birthday this year. CAPM is based on the first principle of finance: Extra returns mean taking extra risks. But the theory became revolutionary for its contention that investors only earn returns for taking market risk, measured by beta. Other equity risks -- individual stock, investment style, and manager risks -- are diversifiable, and hence not rewarded. Sharpe concluded that the most efficient portfolio was the entire market. As a result, the CAPM investor is a monochromatic character, thinking only of expected return, standard deviation, and how much market risk lurks inside a particular stock.

Investors get diverse
Post-CAPM investors, portrayed in Investors and Markets, are more diverse than their beta-obsessed predecessors. Sharpe now recognizes that investors start with different amounts of wealth, have individual preferences, and hold diverse predictions about the future.

Sharpe defines investors according to three "P"s. First, there is position. Investors differ in where they live, real assets owned, and sources of income outside the financial markets. Sensibly, he predicts that people with different positions will want different portfolios. In a shift from CAPM, he allows investors with significant non-investment sources of income to take on non-market risk, if it diversifies other assets. Salary is a good example of non-investment income. Looking at the total risk faced by an investor, including investment and salary income, Sharpe points out that it is unwise to buy stock in one's own company. Instead, he recommends holding a portfolio underweighted in the stock of your employer, and overweighted in stocks of other companies -- including your employer's competitors. For example, if you work for Best Buy (NYSE:BBY), hold some Circuit City (NYSE:CC) stock.

The second "P" stands for preferences. Investors vary in their feelings about risk and spending vs. saving, and different investors prefer different investment outcomes. For example, an investor may have a strong preference for modest but stable returns in the future, rather than high but bumpy returns. Different preferences lead investors to different portfolios. Preferences have a profound effect on both asset prices and portfolio choices. As Sharpe comments: "Prices are affected more by the average of investors' preferences than by their variation, while portfolios are affected more by the variation in investors' preferences than by their averages."

The final "P" is predictions. Different investors predict different future outcomes for investments -- called "future states" -- and often assess the chances of alternative future outcomes differently. Sharpe's new emphasis on exploring the multiple possible future states for investments means he had to change the math technique used in CAPM.

Thinking in simulations
CAPM is built around the mean/variance approach, which assumes that investors' returns are based on a normal distribution curve. It led to a whole way of thinking about risk in terms of standard deviation, which works well most of the time -- but badly when extreme events occur. Sharpe now recommends a state/preference approach. On a first reading, this change seems unlikely to provoke rioting in the business schools or chino-burning at the hedge funds. But it is a radical shift.

With the mean/variance approach, you need lots of data and calculations. For starters, you need data for market returns and individual stock returns, and you'd better enjoy calculating regressions and co-variances. The state/preference world means less data, more straightforward calculations, and plenty of thinking. Investors should analyze their investment and consumption decisions by simulating their investment payoffs across the alternative future states of the world. Risk is captured by assigning probabilities to the different investment outcomes that the future may produce.

Modeling the many future alternative states and their outcomes and probabilities requires a simulation program. So Sharpe has built one, called APSIM, which stands for Asset Pricing and Portfolio Choice Simulator. It's available as an Excel spreadsheet on his website.

Investment science integrates
Investors and Markets brings the subjects of portfolio choice and asset pricing together into a single, integrated view of investment science. Portfolio choice refers to the ways in which investors do, or more often should, make saving and investment decisions. Asset pricing describes how securities prices are set in the capital markets. Post-CAPM, the return on a security depends on its price and its payoff, and the payoff depends on the future state.

For investors to make the best decisions, or receive the most appropriate advice, portfolio choice and asset pricing must be integrated and treated as a single decision. Sharpe states, "To determine the best investment program requires that information about investor positions, preferences, and wealth be brought together with information about security prices, payoffs, and probabilities (in conventional terms, security risks and expected returns)." Without a well-thought-out model to price assets, investors do not know whether they are investing or betting.

Advice for investors
Sharpe offers four pieces of advice to investors:
  • Diversify. Market risk is still the biggest driver of expected returns, and investors should only take non-market risk to offset risks outside the capital markets. In both cases, diversification remains critical.

  • Economize. As the intellectual godfather of index funds, Sharpe sticks to his advice to economize on unnecessary investment fees and transaction costs.

  • Personalize. Sharpe's post-CAPM investor needs an investment portfolio, which takes account of positions outside the financial markets, as well as the investor's human capital.

  • Contextualize. Returns from assets will vary with different outcomes, or states, of the world. In Sharpe's view, it is impossible to choose an appropriate portfolio in a vacuum, without a coherent theory of how assets are priced.
Messages for the investment industry
Investors and Markets has messages for many in the investment industry. Among them:
  • Investment advisors. The best investment advisors will already follow most of Sharpe's new approach, except they'll likely use a mean/variance approach, rather than a state/preference approach. Sharpe explains how investors face several decisions which must be addressed together, including the choice of an investment portfolio, a pre-retirement saving plan, and a post-retirement spending plan.

  • Active investment managers. Here, Sharpe has several messages. First, to invest rather than bet, managers need to work from a rigorous asset pricing model. Second, he warns fee-paying clients: "Few of us are as smart as all of us, it is hard to identify them in advance, and they may charge more than they are worth." Finally, Sharpe criticizes the constant-mix asset allocation strategy, where an investor periodically rebalances to fixed percentages of total portfolio value. He argues that investors should rebalance based on new forecasts, rather than unchanging percentages -- otherwise, they are back to betting.

  • Passive investment managers. Sharpe remains fond of index funds, reiterating that "the return after costs on the average actively managed dollar must be less than the return after costs on the average passively managed dollar." This is good news for leading indexing-based investment managers such as State Street (NYSE:STT) and Barclays Capital, part of Barclays Bank (NYSE:BCS).

As pointed out in another fine book, Capital Ideas by Peter Bernstein, the investment industry was slow to recognize the full effects of CAPM, with Wells Fargo & Co (NYSE:WFC) being a pioneer. The impact of Investors and Markets, though more a coup than a revolution, deserves to occur more quickly.

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Fool contributor John Finneran writes and advises on increasing the financial value of technology. He is ranked 18 out of 19,779 in CAPS, and he does not own any of the shares mentioned. The Fool has a disclosure policy.