Applying Capital Market Theory to Investing

Abstract

In 1970 Wells Fargo Bank began the development of an investment management process utilizing the new insights of Capital Market Theory but retaining workable elements of Classical Financial Theory. Two years later, by the end of 1972, the new system had taken sufficient form to be introduced as the process to manage the $1.58 billion of assets entrusted to the Investment Advisors Division, the money management arm of the Trust Division. At the end of 1977, the sharpened management system calls the shots on the investment of $2.1 billion of institutional assets and another $1.7 billion of personal trust assets, and is subscribed to by nearly 100 other money managers throughout the world. The annual net profit to Wells Fargo is currently about $3.5 million and growing rapidly. A major underpinning of the process comes from a highly systematic approach to understanding the structure of equity prices. Using the oldest available theory, the discounting of future cash flows to present value, in combination with a modern definition of risk, the “Security Market Line” of the Capital Asset Pricing Model is derived. The Security Market Line description of the equity market, along with a similar description of the fixed income market, in combination with the clients' ability to bear risk, are inputs to the asset allocation model which determines the optimal mix of equity and fixed income investments. Within the equity market a quadratic programming model structures a “value added” risk-controlled optimal portfolio. In addition, index funds, pioneered by Wells Fargo, are used in a growing number of accounts. In some cases index funds are used in conjunction with the “value added” strategies.