A year after Robert Merton won the Nobel prize for economics came the low point of his career, when the hedge fund he co-founded imploded
are, as everybody knows, unworldly people who can scarcely tie their shoelaces, still less change a car tyre. Robert Merton confounds this stereotype. As he talks amiably at the London office of Dimensional Fund Advisors , you sense that here is a man who could fix a flat in no time. He would probably deliver a cheerful lecture on the importance of the correct tyre pressure while he was tightening the wheel nuts.
To start to understand the paper’s importance, go back more than half a century to the birth of modern portfolio theory. Finance theory had been mostly a collection of stories and rules of thumb. Some was useful . Little was rigorous. A new generation of scholars changed this. Their first step was to assume that investors seek the highest returns for a given amount of risk. Stocks are riskier than bonds. The issue for portfolio choice is how much of this risk to bear. That will vary.
In two papers published in August 1969, Mr Merton and his mentor, Paul Samuelson, showed that time horizon should make no difference to portfolio choice. But the result holds only if risk appetite is unchanging and stock prices are unpredictable. Alter these assumptions, as future researchers would, and the results change. Mr Merton’s use of continuous-time mathematics created a valuable template.
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