While working for ADL Treynor worked on valuing a risky stream of future earnings. He wanted to first calculate the market-clearing risk premium on each economic variable in a moment in time and then to trace the evolution of these variables. Treynor used the CAPM model to help explain some of these questions but was unsuccessful in answering all of them. His research led him to find a benchmark on which financial managers could be measured.
The ADL report was produced to develop ways for evaluating performance of Yale's portfolio managers but Treynor was unable to convincing top management the potential of his methods and he had to leave.
A for Hoyt.
ReplyDeleteTreynor didn't realize what he had. He was still focused on where the discount rate comes from, and how that applies to the valuation of uncertain future cash flows. This is roughly Chapter 11 of your text. But to get here, he's already got the core of a CAPM model, which is roughly Chapter 7 of your text.
There's an aphorism that the better is the enemy of the good, and Treynor is clearly in that position. Extra credit to the first person to deliver a handwritten explanation of how that aphorism is related to an earlier extra credit assignment.
His bosses didn't get it either.
Now, at this time, financial professionals really didn't get the idea of an efficient market. So, it was natural to think that some stock pickers could beat the market. Treynor goes in the direction of measuring that ability. We'd now call that positive alpha, and you get it as a byproduct of estimating a CAPM. We also know that a significant positive alpha is very rare. Treynor didn't know that yet. So again, he missed the whole part about betas and diversifiable risk to get at the alphas (which we now know really aren't that important).