Wednesday, March 10, 2010

Business Schools do teach Modigliani-Miller and Sharpe Ratios. Why does no one remember them?

The New York Times had a disturbing story about pension fund investments the other day. One paragraph is typical:

Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called “risk parity,” which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

We teach that IRR rules are bad rules because they don't take into account risk. Net present value rules, where one needs to explicitly pick a risk adjusted discount rate, can prevent the sort of woe we have seen over the past few years.

Whenever I meet a senior executive from a company that got in trouble because of too much leverage, I ask (nicely, I hope) whether they know MM, which implies that investment decisions should not be made based on capital structure. Most say no, but they are very interested to hear about it.

This is stuff that has been known for a long time. One would think the most recent crisis would teach pension funds not to go down the same path they and others followed before. Alas this seems not to be the case.


John said...

Very informative post. Do business schools teach this in all states?

Mike C said...

I'm a former student of yours and your post got me thinking about why fundamental learnings about financial risk are often ignored in the commercial world. My short answer is that the incentives promote ignoring them.

Longer answer here: