Prof. Robert C. Merton: ICAPM, Retirement, and Models in Finance (EP.234)
The Rational Reminder Podcast
Capital Asset Pricing Models - How Do They Work?
In the CAPM, there's an optimal portfolio based on mean and variance. Ed models that I've developed are more complicated. For example, you don't have one consumption good. That your human capital risk changes. And so they're going to invest in a different set of risks. So those are the kinds of risks that enter into the model.
Few people have impacted the way the world works, and today, we have the privilege of speaking to one of them. Professor Robert C. Merton is the Distinguished Professor of Finance at The Massachusetts Institute of Technology (MIT) Sloan School of Management and Professor Emeritus at Harvard University. He has a Ph.D. in Economics from MIT and is currently the Resident Scientist at Dimensional Fund Advisors. Professor Merton was awarded the Alfred Nobel Memorial Prize in Economic Sciences in 1997 for his work establishing a new method to determine the value of derivatives. He also created the Intertemporal Capital Asset Pricing Model (ICAPM), a popular tool to help advisors make informed financial decisions and understand market trends. In our incredible conversation, we cover portfolio theory, moving from Capital Asset Pricing Model (CAPM) to the Intertemporal Capital Asset Pricing Model (ICAPM), and how financial models work. We also discuss the difference between the value of your capital and the value of the cash flow that can come from that capital, why size can't be a factor, what aspects to consider when calculating the worth of an account, and the definition of market efficiency. We also delve into retirement, how to safely invest for it, what pitfalls to avoid, and how retirement funds may change over time. He also shares his opinion about some popular financial advise and what the roles of financial advisors should be. For all this and more, tune in to hear from the man behind the model and Nobel laureate, Professor Robert C. Merton!
Key Points From This Episode:
- We start with Professor Merton describing the concept of market efficiency. (0:04:28)
- He explains the basics of his ICAPM asset pricing model. (0:09:10)
- How portfolio theory changes when moving from single-period to multi-period. (0:10:46)
- Hear a practical example of expected returns changing over time. (0:14:15)
- Why ICAPM is dependent on the sensitivities to risk of an individual investor. (0:22:52)
- Find out how to determine if the correct proxy has been identified for a risk. (0:25:34)
- Learn how home country bias fits into portfolio choice from an ICAPM hedging perspective. (0:31:54)
- The definition of a risk-free asset and how it changes with time. (0:33:24)
- What influence the time horizon should have on the mix between stocks and bonds in an investor’s portfolio. (0:35:33)
- His opinion about young investors using leverage to make investments. (0:41:50)
- What people should be doing to get more accessibility to leverage. (0:47:39)
- Professor Merton tells us who should focus on value stocks and growth stocks. (0:51:34)
- Discover what makes retirement income a difficult problem to solve and tips to ensure your retirement. (0:56:47)
- We discuss using Monte Carlo simulations to estimate how much people can spend in retirement. (1:09:04)
- He provides insight into how to get more from your retirement investment. (1:13:04)
- Whether nominal annuities are considered low-risk assets for retirees. (1:16:48)
- An overview of the impact mathematical models have had on the finance sector. (1:20:12)
- Areas of finance practice that are lagging behind the financial models. (1:27:35)
- Hear what popular financial advice Professor Merton thinks is misguided. (1:33:22)
- Ways his work on option pricing has impacted society. (1:41:26)
- The role he sees for financial advisors. (1:45:42)
- Why he decided to join Dimensional Fund Advisors. (1:48:54)
- Professor Merton unpacks the definition of product design. (1:52:14)
- Stay listening for the extended discussion. (1:57:24)
Participate in our Community Discussion about this Episode: https://community.rationalreminder.ca/t/episode-234-prof-robert-c-merton-icapm-retirement-and-models-in-finance-discussion-thread/20748
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