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The Wright Education Station- brings youthe fathers and sons of Modern Portfolio Theory (MPT).
A Series of interviews sponsored by Index Funds Advisors. Mark Hebner is the founder and President of Index Funds Advisors, Inc., author of the
ifa.com and indexfunds.com web sites, and the book, Index Funds: The 12-Step Program for Active Investors. Learning Modern Portfolo
Theory is time consuming and often intimidating as you stare at your first 400 page Investment text book of which 265 pages are mathematical
equations. Relax these educational videosare twice the fun and half the pain. We promise no equations, just plain English, with less jargon to
help you learn the basic concepts. Window To Wall Street is not endorsing IFA. We seek to bring you access to commercial free quality education.
 

The Father of Efficient Markets Hypothesis is Eugene F. Fama. His son Fama Jr. explains 

 

 

 

 

 

 

 

 

 

 

 

Modern Portfolio Theory

Innovations in financial markets research over the last fifty years are the keystone of a belief system that guides Dimensional's & IFA's approach to investing. Today, the investment industry takes for granted the calculation of rates of return and the availability of comparative universes for professionally managed funds. But before the mid 1960s, there was neither a generally accepted way to calculate a total return nor a way to compare the returns of different funds.

This all changed with the advent of computers and the collection of data for mutual funds as well as for individual stocks and bonds. Rigorous testing by financial economists of that seminal era led to the development of asset pricing models to evaluate the risk/return characteristics of securities and portfolios, and also led to a theory of market efficiency that suggested excess returns were only achievable by taking on above-market risk.

Studies documenting the failure of active managers to outperform market indexes gave rise in the early 1970s to passively managed index funds that relied on capital markets as the source of investment returns. Further research and data compilation over several decades led to the identification of the multiple equity asset classes and risk dimensions that form the basis of Dimensional's & IFA's strategies.


The Evolution of Modern Portfolio Theory

1950

"Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points."

Gerald M. Loeb
The Battle for Investment Survival, 1935

Analyze securities one by one. Focus on picking winners. Concentrate holdings to maximize returns.

Broad diversification is considered undesirable.

1958

The Role of Stocks

James Tobin
Nobel Prize in Economics, 1981

Separation Theorem:
1. Form portfolio of risky assets.
2. Temper risk by lending and borrowing.

Shifts focus from security selection to portfolio structure.

"Liquidity Preference as Behavior Toward Risk," Review of Economic Studies,
February 1958.

1950

1952

Diversification and Portfolio Risk

Harry Markowitz
Nobel Prize in Economics, 1990

Diversification reduces risk.

Assets evaluated not by individual characteristics but by their effect on a portfolio. An optimal portfolio can be constructed to maximize return for a given standard deviation.

1961

Investments and Capital Structure

Merton Miller and Franco Modigliani
Nobel Prizes in Economics, 1985 and 1990

Theorem relating corporate finance to returns.

A firm's value is unrelated to its dividend policy.

Dividend policy is an unreliable guide for stock selection.

1965

Behavior of Securities Prices

Paul Samuelson, MIT
Nobel Prize in Economics, 1970

Market prices are the best estimates of value.

Price changes follow random patterns. Future share prices are unpredictable.

"Proof that Properly Anticipated Prices Fluctuate Randomly,"
Industrial Management Review,
Spring 1965

1968

First Major Study of Manager Performance

Michael Jensen, 1965;
A.G. Becker Corporation, 1968

First studies of mutual funds (Jensen) and of institutional plans (A.G. Becker Corp.) indicate active managers underperform indexes.

Becker Corp. gives rise to consulting industry with creation of "Green Book" performance tables comparing results to benchmarks.

1960

1964

Single-Factor Asset Pricing Risk/Return Model

William Sharpe
Nobel Prize in Economics, 1990

Capital Asset Pricing Model:

Theoretical model defines risk as volatility relative to market.

A stock's cost of capital (the investor's expected return) is proportional to the stock's risk relative to the entire stock universe.

Theoretical model for evaluating the risk and expected return of securities and portfolios.

1966

Efficient Markets Hypothesis

Eugene F. Fama,
University of Chicago

Extensive research on stock price patterns.

Develops Efficient Markets Hypothesis, which asserts that prices reflect values and information accurately and quickly. It is difficult if not impossible to capture returns in excess of market returns without taking greater than market levels of risk.

Investors cannot identify superior stocks using fundamental information or price patterns.

1971

The Birth of Index Funds

John McQuown,
Wells Fargo Bank, 1971;
Rex Sinquefield,
American National Bank,

1973

Banks develop the first passive S&P 500 Index funds. Years later, Sinquefield co-chairs Dimensional, and McQuown sits on its Board.

1975

A Major Plan First Commits to Indexing

New York Telephone Company invests $40 million in an S&P 500 Index fund.

The first major plan to index.

Helps launch the era of indexed investing.

"Fund spokesmen are quick to point out you can't buy the market averages. It's time the public could."

Burton G. Malkiel,
A Random Walk Down Wall Street, 1973 ed.







1970

1972

Options Pricing Model

Fischer Black,
University of Chicago;
Myron Scholes
University of Chicago;
Robert Merton
Harvard University;
Nobel Prize in Economics,

1997

The development of the Options Pricing Model allows new ways to segment, quantify, and manage risk.

The model spurs the development of a market for alternative investments.

1977

Database of Securities Prices since 1926

Roger Ibbotson and Rex Sinquefield,
Stocks, Bonds, Bills, and Inflation

An extensive returns database for multiple asset classes is first developed and will become one of the most widely used investment databases.

The first extensive, empirical basis for making asset allocation decisions changes the way investors build portfolios.

1981

The Size Effect

Rolf Banz,
University of Chicago

Analyzed NYSE stocks, 1926-1975.

Finds that, in the long term, small companies have higher expected returns than large companies and behave differently.

Dimensional Fund Advisors is founded in 1981 and launches the first passive small cap strategy (the US Micro Cap Portfolio).

1986

International Size Effect

Dimensional Fund Advisors
International Small Cap Strategies

Dimensional Investing vs. Indexing:

With no index, Dimensional creates international small cap strategies modeled after the US research.

Dimensional's live returns become the index used in Ibbotson Associates' database.

Dimensional investing is based on a rational risk dimension, and does not slavishly follow indexes or investing conventions.

1980

1983

Variable Maturity Strategy Implemented

Dimensional Fund Advisors
One-Year Fixed Income Strategy

With no prediction of interest rates, Eugene Fama develops a method of shifting maturities that identifies optimal positions on the fixed income yield curve.

1990

Nobel Prize Recognizes Modern Finance

Economists who shaped the way we invest are recognized, emphasizing the role of science in finance.

William Sharpe for the Capital Asset Pricing Model.

Harry Markowitz for portfolio theory.

Merton Miller for work on the effect of firms' capital structure and dividend policy on their prices.

 

1999

Tax Management

Dimensional tax-managed strategies implemented to maximize after-tax returns by offsetting gains and minimizing dividends.

Based on Fama/French research and Dimensional's "portfolio decision system" trading technology.



1990

1992

Multifactor Asset Pricing Model and Value Effect

Eugene Fama and
Kenneth French
University of Chicago

Improves on the single-factor asset pricing model (CAPM).

Identifies market, size, and "value" factors in returns.

Develops the three-factor asset pricing model, an invaluable asset allocation and portfolio analysis tool.

Dimensional introduces value strategies based on the research.

Lends to similar findings internationally.

2004

Applied Core Equity

Dimensional portfolio construction methodology weights securities by size and value characteristics instead of market capitalization.

Total market strategies launched to provide efficient, diversified risk factor exposure while limiting turnover and transaction costs.

Core equity portfolios move beyond traditional, component-based asset allocation via vast diversification and cost-efficient market coverage.

2000