There have been various pioneers who have contributed greatly to the field of finance over the years. Their works in the field have led to the development of various concepts that are applied in today's financial sectors and markets all over the world reflecting the importance of these ideas. Below is a discussion of three of these pioneers who have made profound effect to the financial field through their novel ideas that are used on a daily basis when carrying out financial decisions.
Benjamin Graham was a British citizen being born in London in the year 1894. His family later moved to America while Benjamin w still young where his family started a business involved in importation. The father died while still he was young and the family got into poverty. He later joined Columbia University where he graduated at the age of twenty as the second highest graduate of his class at the. He was offered a job as an instructor at the university but declined it to take up a job with Newburger, Loeb, and Henderson as chalker on Wall Street. Graham then created an investment firm with Jerome Newman in 1926.
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Graham is credited for his contribution to financial analysis with his notion of value investing which is based on the use of fundamentals to evaluate securities. According to graham, value investing involves the purchasing of a part of the capital of a company whose market price at the time is below its real value or what he referred to as the intrinsic value. This purchase is done with an ample margin for safety. This theory was based on the assumption that there are two values that are usually attached to every company.
The first assumption is a market price which is the present worth of the company in the stock market. The second assumption is a business value also referred to as the intrinsic value (Graham 65). The intrinsic value of a company is based on the real time value of the company that would be used in the event that the company was to be taken over or it was to merge with a competitor. The business value could also be considered as the value that the owners of a company would have if they would break up the company and sell all of its assets.
The notion of value investing is one based on the long term as the stocks of a company would reflect its business value in the long term (Whitman, 56). On the short term and the middle term, the prices would mostly either below are above the intrinsic value. So as to invest in a company, one should buy when the market price of the stocks is significantly lesser than its intrinsic value by a margin of 40% to 50% below the intrinsic value. The difference that exists between the intrinsic and market value is referred to as the margin of safety (Graham 104).
When the margin of safety is quite wide, there is a security against loss of the capital invested. Once bought, one is to hold the stocks and sell them when the market price gets near to the intrinsic value of the company. As such, value investors need patience as the stocks may take some tome to get near to their intrinsic value which is the right time to sell. Time has shown that value stocks have lead over the years in performance.
Harry Markowitz is an economist in addition to being a finance professor who is the recipient of the Nobel Memorial Prize as well as the John von Neumann Theory Prize. Born in 1927, he had a good foundation being the only child of his parents. He attended school where he had interests in philosophy, astronomy, and physics. He later joined the University of Chicago where he majored in economics of uncertainty. He had the privilege of being taught by famous economists such as Leonard Savage, Milton Friedman, and Jacob Marschak.
Still a student at the university, he was invited to the Cowles Commission for Research in Economics famous for its Econometric thoughts to become a student member. During his dissertation, he decided to pursue the application of mathematical methods in studying of the stock market. With the support of Jacob Marschak and Marshall Ketchum, he was able to pursue the topic given the financial theory and financial practices present at that time. He received his prizes in 1989 and 1990 for his work in portfolio theory, simulation language programming, and sparse matrix methods.
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His major contribution to the field of finance is his portfolio theory which is an investment theory that attempts to explain the manner in which an investor could minimize risk while at the same time maximize return. The theory is a kind of arithmetical principle that is employed in the notion of diversification when investing. The aim is to select an assortment of investment assets that will have the lowest risk collectively compared to any single asset. The theory makes the assumption that investors are usually risk averse and as a result will always prefer the least risky investment option (Lintner, 26).
As such, investors will always prefer investments that carry the least risk. It then follows that higher risks attract higher risk. From such a stand point, an investor will agree to take an investment that has more risk only if there will be a compensation that offers higher expected returns. The theory models the return from an asset in the form of a random variable while the portfolio that is comprised of several investment options as the weighted combination of the comprising assets. The return from such a portfolio is usually the weighted combination of the combined returns of the constituent assets.
The risk vs. return preference of an investor could be illustrated through the use of a quadratic utility function. This assumption results in the conclusion that the expected return and volatility are important to the investor. Volatility entails the mean return of the asset and the standard deviation (Markowitz, 178). Other characteristics of the return such as the kurtosis or the skewness are not as such important. From the possible number of portfolios that are attainable, the ones that optimally form a balance between the expected return and the risk what Markowitz referred to as an efficient frontier are the ones that an investor should target.
The theory is important in understanding the interaction between risk and return. It has played a great role in the management of institutional portfolios as well s resulting in the adoption of passive techniques for investment management. Through diversification, it is possible to diminish considerably the risk in investing s an investor gets to choose the correct combination of investment vehicles to make up a portfolio.
William Sharpe, born in 1934, is credited for winning the Nobel Memorial Prize for his work in Economic Sciences. He is also an Emeritus at the graduate school of business at Stanford University. As his father was in the National Guard resulted in them moving several times during the Second World War from his initial birth place in Boston, Massachusetts to Riverside, California. Sharpe attended the rest of his pre-college school days at Riverside and then joined the University of California to undertake a medical degree.
A later change from UCLA Berkeley to UCLA Los Angeles resulted in a change from the initial medical degree to business administration majoring in economics. He was to be influenced by two of his professors, Fred Weston, who was a finance professor and introduced Sharpe to the portfolio theory by Markowitz and Armen Alchian, an economics professor. While still an undergraduate student, he became a Phi Beta Kappa Society member. He then joined the RAND Corporation as a researcher in applied economics and learned computer programming. While still at the corporation, he pursued his Ph.D in economics at UCLA carrying out a dissertation in portfolio analysis using the single factor model of the security prices under the guidance of Harry Markowitz who at the time was at the RAND Corporation. Sharpe has taught at various universities including UCLA at Irvine, the university of Washington, and Stanford University.
Sharpe is credited with his work that resulted in the capital asset pricing model that is used in determining the theoretically suitable rate of return of any asset which is to be added to a diversified portfolio given the non diversifiable risk of that asset. The model can be used to price both individual securities and portfolios. When pricing individual securities, the security market line is used to show how the individual securities are to be priced by the market based on their security class of risk (Sharpe, 106).
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According to the model, an asset is properly priced when its observed price is similar to the value derived from calculating using the derived discount rate of the CAPM (Gordon, Jeffrey, & Sharpe 89). Some of the assumptions made by the model concerning investors include: investors are normally risk averse and rational; ever aim at getting the most out of their economic utility; will at all times deal in securities that are divisible into smaller bundles, that they are usually price takers as they are not in apposition to influence prices; and that they will trade without taxation costs.
Other contributions by Sharpe include the Sharpe ratio that is used in the analysis of risk attuned investment performance, the binomial method that is instrumental in the valuation of options, the returns based style study that is used for evaluating both the performance and style of investment funds, and the gradient method that has been widely used in asset allocation optimization.
Due to their noble contributions in the financial field, these three financial pioneers have been able to influence the financial field and winning recognition for their excellent work. Benjamin Graham is credited for the notion of value investing that is used in financial analysis to make sound decisions when investing in securities. Harry Markowitz is credited for his portfolio theory that assists in enabling an investor maximize returns and minimize risk when investing. William Sharpe is credited for his work that resulted in the capital asset pricing model that is very helpful in determining how suitable it is to add an asset to a diversified portfolio.
- Gordon, Alexander., Jeffrey, Bailey., and Sharpe, William. Fundamentals of Investments . New York: Prentice-Hall. 2000.
- Graham, Benjamin. Security Analysis. New York: McGraw Hill. 1934.
- Lintner, John. "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets". The Review of Economics and Statistics 47 (1): 13-39. 1965.
- Markowitz, Harry. Portfolio Selection: Efficient Diversification of Investments. New York: John Wiley & Sons. 1959.
- Sharpe, William. Portfolio Theory and Capital Markets. New York: McGraw-Hill. 2000.
- Whitman, Martin. Value Investing: A Balanced Approach. New York: John Wiley and Sons. 2000.