Elroy Dimson: Investing & Optimism | Rational Reminder 408

0:08 This is [music] the Rational Reminder podcast,

0:09 a weekly reality check on sensible

0:11 investing and financial decision-making from two Canadians.

0:13 We're hosted by me, Benjamin Felix, Chief Investment Officer,

0:16 and Braden Warwick, Financial Planning Product Architect at PWL Capital.

0:22 All right.

0:23 Welcome to episode 408.

0:27 Uh this is an episode that I am a man I I loved it.

0:31 I love the conversation that we just had, Braden,

0:34 and it's an episode that I have wanted to do for a long time.

0:38 But Professor Elroy Dimson is uh he's he's a busy man.

0:42 Uh but I I I was I was on another podcast uh in the UK and that person,

0:49 uh Damian, it's the Damian Talks Money podcast,

0:51 had a has a relationship with Elroy, and so he made an introduction uh which

0:56 which uh finally got the got the connection made.

1:00 Uh and yeah, so but it We we would have done this one sooner if we could have.

1:06 Uh I guess that's the point of my long preamble,

1:09 but I'm super excited that we got to talk to uh Elroy Dimson.

1:14 He is a Professor of Finance and Research Director at Cambridge

1:17 Judge Business School and Bye-Fellow of Gonville and Caius College, Cambridge.

1:22 He is also Emeritus Professor of Finance at London Business School.

1:26 Uh listeners will likely know his name.

1:28 He's Elroy Dimson, uh which is the D in the DMS data,

1:34 which we've talked about many times because we use

1:36 it a lot in our own research at PWL.

1:40 We also did an episode, I can't remember the episode number,

1:41 but we did an episode a while ago,

1:43 um something like a uh Lessons from 100 Years of Stock Returns or something,

1:47 where we went through a a bunch of their past reports.

1:51 They they do uh something called the the Global Investment Returns

1:55 Yearbook uh that they've been publishing for many many years now.

1:59 Right now it's sponsored by UBS.

2:02 Formerly it was sponsored by Credit Suisse,

2:04 but it's this just incredible book that they publish annually that details stock

2:09 bond and bill returns for a whole bunch of countries all around the world.

2:13 Uh they also publish indices which we PWL subscribe to.

2:17 We we purchase them every year, purchase a license to to use them.

2:21 Uh and in their yearbooks in the global investment return yearbooks,

2:25 they also and and he mentions this during the conversation,

2:28 they also do a couple of essays where they take

2:31 a topic and they use their historical data to analyze it.

2:36 So, an example would be what

2:38 is the historical relationship between economic growth

2:41 in a country and its stock returns or industry growth and stock returns.

2:45 Uh but they've got just tons of these different

2:48 essays over the the many many years that that they've been doing this and it is

2:52 it is a wealth of incredible analysis and information.

2:56 Uh they've also got a very famous book called Triumph of the Optimists

2:59 which we also discussed and that that book was the culmination

3:03 of their work using historical data to reconstruct indexes for a whole bunch

3:08 of different countries that really and we

3:10 talked about this during the conversation too,

3:11 it really changed our our knowledge of what is the equity risk premium,

3:17 how much should you expect in stock returns

3:19 relative to bond returns which prior to their work

3:22 had been heavily influenced by the US historical record

3:26 which we all know has been uh incredible, exceptional.

3:30 And so their expansion to international markets really

3:33 gave us more knowledge about what what it might

3:36 be reasonable to expect as an equity risk

3:37 premium going forward which was uh which was great.

3:41 Anyway, so we're super fortunate and grateful to be able to talk to Elroy.

3:47 Uh we talked for about 90 minutes.

3:49 Braden, any any comments?

3:51 What what did you think of the conversation?

3:54 Well, I think it was just so cool from my perspective

3:56 as someone who's used the DMS data for years now.

4:00 I use it all the time.

4:02 Um to just hear the origin story about why he need

4:05 he decided to collect the data and all that went into it

4:09 over the course of time and then it just really brought

4:12 the data to life to me to hear his perspective on it.

4:15 Um yeah, it was just such a cool conversation.

4:17 Really a pleasure to to talk to Elroy.

4:20 He's got he's got his academic experience,

4:22 but he's also done lots of interesting investment

4:23 committee work uh including with Norway's sovereign wealth fund.

4:28 Which is like, you know,

4:28 it's the it's the biggest single investor in in the world.

4:33 Um and he helps to form their their whole setup

4:37 um and and investment policies and all that kind of stuff.

4:40 So, he's not just an academic,

4:41 he's got real-world experience dealing with people and he talks

4:45 about some of those types of issues during our conversation,

4:48 people in committees and and just making like real investment decisions.

4:51 Um yeah, so just an incredible wealth of wisdom uh that comes

4:57 from both tons of time with the data and doing analysis,

4:59 but also tons of time working with real humans trying to make

5:03 investment decisions uh based on the data and other and other inputs.

5:10 All right, I think that's a good

5:11 that's a good introduction for Professor Elroy Dimson.

5:14 Let's go [music] ahead to our conversation.

5:19 Elroy [music] Dimson, welcome to the Rational Reminder podcast.

5:24 Well, thank you for having me.

5:25 Uh it's a very pleasant afternoon here,

5:28 but I hope the people who are tuning in will be all over the world.

5:32 Uh weather may be different where you are.

5:35 It's it's actually a very nice day where I am as well.

5:37 Uh so, that's good.

5:39 Uh just real quick, Elroy.

5:40 Super excited to be talking to you on the podcast.

5:42 This is something that I've wanted to do for We've

5:44 been running the podcast for 8 years now and uh yeah,

5:47 you're someone I've always wanted to have on and yeah,

5:51 just super super excited that we're talking to you.

5:54 Well, I think it's so exciting so that one.

5:57 That's good that's good.

5:58 All right, so to start with the first question here,

6:01 can you talk to us about why it's important

6:03 to study financial market history when thinking about the future?

6:09 It's actually difficult to think about

6:11 the future without knowing where you've come from.

6:13 So it's an integral part of a journey.

6:17 If you don't know where the journey started,

6:19 you can't start thinking about where you're going to end up.

6:25 [clears throat] So what was the process like to assemble

6:28 your the data for your 2002 book Triumph of the Optimists?

6:32 Well, that's an interesting story because when Paul Marsh and I

6:36 also we all did our PhDs at London Business School.

6:40 And early on in our academic lives,

6:44 textbooks all made very heavy use of American data.

6:50 And a little bit of British and a tiny bit of Canadian data.

6:54 But basically if you had what then was a standard

6:59 textbook of William Myers and another couple of co-authors.

7:05 You would see some indications to what returns you might expect but there was

7:10 very little choice other than to recite what had happened in the United States.

7:16 So there was heavy reliance on the long-term data

7:19 which had come out of the University of Chicago.

7:23 Uh Paul Marsh and I had done a bit on looking

7:26 at the long-term for the UK and there'd been one or two

7:30 snippets of not very satisfactory research on the UK but that was

7:34 about it and even Canada didn't really play a part.

7:40 Uh we at that time distributed our research when we

7:46 began at the very end of the uh 19 1999,

7:51 uh we distributed it uh through uh a firm which has sort of changed hands a bit.

7:57 We've not changed sponsors much except when

8:01 there's been uh corporate events amongst the sponsors.

8:05 Um but it became clear there was demand to go

8:09 beyond the American and British states that we had.

8:12 Uh we were moving into a period of an internationalization.

8:18 Uh uh My money was kind of free at the end of 1999 expecting 2000 to come along.

8:26 And the global head was our own knowledge of the research

8:30 that others were doing and the other practitioner who was thinking globally.

8:35 Uh we liked that idea and we worked through the run-up

8:39 to New Year 2000 on producing a book which was privately published.

8:45 Uh and at first we had a number of countries, but as we reached the end of 1999,

8:52 uh we found that it was creeping up towards 10.

8:56 The 10th was actually at quite a late stage.

8:59 10 countries for which we had accumulated 100

9:02 years and we thought that's a millennium of data.

9:06 And so the millennium year came along.

9:09 Um it that our work got a great deal of publicity.

9:13 Uh but one of the things which uh nobody had noticed

9:17 at the time was uh when do you celebrate a birthday?

9:21 So people were talking about the new millennium as the thousandth birthday.

9:25 Actually, uh you have a birthday,

9:27 you are 1 year old when you are into your next year.

9:33 So birthdays actually are calculated differently.

9:36 And so people pointed this out,

9:38 and by that time we discovered data for lots of other countries.

9:41 Uh and the suggestion was well, we should have Millennium book two.

9:44 So, the real Millennium the real Millennium was

9:49 uh once there were a thousand years behind us,

9:52 we were in the thousand and one for 2001 year.

9:56 So, the story was one of evolution.

9:57 That was a big success, Millennium book two.

10:00 Uh then was uh an idea that uh Princeton University

10:05 Press thought would be uh something worth bringing to people.

10:09 Uh and uh the book that you know, Triumph of the Optimists,

10:14 a fairly expensive book uh which produced by us uh

10:19 building on something which we'd already done in a private publication.

10:23 There's still a few people around who got

10:25 the original Millennium book and Millennium book two.

10:28 It pops up on eBay from time to time.

10:31 Um but uh the real beginning was once we

10:34 were into the uh uh the the current century.

10:38 I wish I had 25 years of running with it.

10:40 Uh it's been uh an amazing journey.

10:44 What So, when you're assembling the data,

10:46 like when you say you got the 10 countries and you keep adding countries,

10:49 what are you actually doing?

10:50 Like how how where's the data coming from?

10:53 Uh our data set is primarily a compilation with data.

10:58 So, let me go backwards in time.

11:01 What would we like now?

11:03 Nowadays, we have high quality indices.

11:06 So, if you start particular period, we're going back where there's a good

11:10 quality capital gains index with an income series.

11:14 But, nobody would dream of telling you what

11:17 the return is on Treasury bills excluding income because

11:21 if the dollar the value every year is

11:23 dollar and dollar and dollar and dollar and dollar.

11:26 But, so equities people would uh manage without uh income,

11:31 and that's really strange.

11:33 So, we wanted to data which covers a longer period.

11:37 Uh we presented our data.

11:39 I'll tell you a bit about our very detailed data in a moment.

11:43 Um but uh once we've got that first book done, there was so much interest in it.

11:48 We were presenting it all over the place to academics and practitioners.

11:52 And every so often we'd be in a large room and uh uh question time kind of line,

11:57 and somebody would say, "You know,

11:59 I've been collecting data like this for my country.

12:03 It never occurred to me that anybody would be interested." Mhm.

12:06 And so we grabbed.

12:08 Uh and so uh by the time we had our first 10 countries,

12:12 um uh we we had accumulated some long-term return series,

12:17 but that rapidly went up after that.

12:20 And so we used data which has often been

12:23 assembled by other people in more recent decades commercially,

12:27 and before that uh academics were doing this job.

12:31 And um they've been kind to us, and we've been kind to them.

12:35 We collect it.

12:35 They work in great detail.

12:38 Uh and often we were able to extend it.

12:41 For example, for South Africa,

12:43 uh there was somebody who had done a study like the famous

12:46 Ibbotson and Sinquefield long-term return studies

12:49 for South Africa which started in 1940.

12:53 Mhm.

12:53 Uh but before 1940, uh South African

12:57 shares were traded heavily as well in London.

13:00 And so it was possible to use data to infill missing data.

13:05 And so we've worked in a number of cases with people from other countries

13:09 to extend the data set and produce a series which starts at a common date.

13:15 So, our primary start date is a new year, 1900.

13:19 And um it's uh drawing on contributions from scores

13:25 of academics and scores of commercial data sets.

13:29 Hm.

13:30 Yeah, it's incredible.

13:31 You mentioned excluding income and having just a capital gains index.

13:34 Other than that, what are some of the biases

13:37 and other issues that can affect historical index data?

13:41 Well, when we first launched our research,

13:46 uh we um we we made some remarks about our predecessor's work.

13:53 Um that really necessitated some of the challenges you face.

13:57 So, uh earlier on we reported on the only uh index series for the UK.

14:05 That was uh prepared by uh a predecessor of Barclays Global Investors,

14:12 who you know of only Yeah, they've also changed ownership.

14:17 Um and that started with a um a stock broking firm in the 1950s hiring

14:25 some general economists to run financial economists

14:28 in those days to produce a long-term history.

14:32 And they wanted something which would represent the UK stock market.

14:36 Um the FT, the Financial Times Index, had begun in 1935.

14:43 And they were going to go back further than 1935 to an earlier date.

14:48 They wanted their series to look similar to the standard FT series.

14:56 So, uh what they did was we wanted the pre-1935 data to be reflected uh with uh

15:08 a a reference to the companies which were

15:11 in the Financial Times Index after it launched.

15:15 So, we had companies from 1934, 1933, 1932.

15:21 And as you went back in time,

15:23 what the uh uh Barclays Gilt-edged

15:25 Investors Index or Barclays Capital Index contained

15:31 was a set of companies that had done well enough to be big,

15:36 and left out the companies that had died.

15:39 Mhm.

15:39 Uh that index got replaced sometime after our own series came out.

15:46 But at the time, what we were doing was

15:48 replacing an inadequate index with one that was adequate.

15:53 Now, this is all ancient history,

15:55 and I guess they lost and lived with that, but uh um

16:00 if if you want me to rephrase anything, just tell tell me.

16:04 No, that that that was great on survivorship bias.

16:07 I I I I'd love you to talk also about

16:10 um easy data bias when it comes to country indices.

16:15 Well, the term easy data bias is one that we coined.

16:19 Mhm.

16:20 Now, and the easiest data to collect is data which is readily accessible.

16:27 Uh and uh which is well known.

16:31 And so, the easy data people having data series for the UK

16:37 started after a period in which markets had become like unreliable,

16:43 had had had less information behind them.

16:49 So, for example, the um the the Barclays Index,

16:53 which is still used by some people,

16:55 um it began life uh at the beginning of 1919.

17:02 Why not 1918 or 1917 or 1916?

17:05 There was a war on.

17:06 People could couldn't trust prices.

17:09 So, the series began after the wartime turmoil was out of the way.

17:15 Um and uh that was easier to do.

17:20 The data was more reliable.

17:21 You take a more extreme case,

17:23 there was a Barclays publication of similar nature looking at Germany,

17:29 which waited until after the turmoil of the Second World

17:32 War and the succeeding events were out of the way.

17:36 And so, if you look at Germany

17:39 and you include the recovery period after Germany recovered,

17:43 but uh, leave out what happened in the war,

17:46 uh, you again have a misleading number.

17:49 And so, we discovered that that almost everywhere, almost every country,

17:55 was one where if you used the standard index over a standard period,

17:59 that was easier to do.

18:00 You didn't have so much in the way of data collection,

18:03 but performance was very overstated compared to what happened if you imposed

18:10 a common start date on all of the different markets that you looked at.

18:15 I would say that that is the most important of the biases that we eliminated,

18:20 but there are others as well.

18:23 So, what about stock markets that don't survive or succeed?

18:27 What happens in that case,

18:28 and how does that affect global average stock returns?

18:34 Uh, well, if you take markets which are

18:38 important at the date you're compiling data, uh,

18:42 you're more likely to incorporate ones that have done well,

18:45 and more likely to leave out ones which had started tiny and got smaller still.

18:52 So, there is a a bias there, and that's choosing markets,

18:56 which is similar to the choices you have

18:59 to make within a stock market looking at individual stocks.

19:03 Um, there are relatively few markets that simply didn't succeed,

19:10 leaving out uh, the couple of major geopolitical casualties.

19:17 So uh the demise of the Russian stock market was important.

19:25 Um the uh um acquisition by the state of not only

19:32 Russian but Chinese resources when China moved towards a communist framework.

19:40 Um but mostly the market which start

19:44 up do okay and then just completely disappear.

19:48 I've been one or two and I could give you anecdotes along those lines.

19:53 Um but uh we make sure that we include everything.

19:57 And so our history is now covered significantly over 98%

20:02 of the market capitalization of global equity markets in 1900.

20:08 Uh um they're equally comprehensive today.

20:12 So missing countries doesn't make uh it's not it's not a problem.

20:18 Um what is important is how you do the calculations.

20:24 So if a market um loses some of its assets for example

20:30 um Austria uh lost uh the Hungarian assets but the Austrian market continued.

20:38 We want to make sure that we're using

20:39 the right index to reflect in what went wrong.

20:42 Um if we're looking at uh the world index we need

20:47 to include the Russian or the Chinese stocks that became valueless.

20:52 As in just the same way as if you were looking at a conventional single country

20:56 index you take in those uh companies which

21:02 became valueless and they're part of the index calculation.

21:05 The same is true for the global service.

21:09 It's crazy.

21:09 It's a lot of like really looking at what actually happened

21:13 in that country to figure out what should be included in the calculation.

21:17 Well, back histories I think are tricky and if

21:19 you look at the earlier attempts at back histories, which were typically done uh

21:24 by general business economists or economic historians,

21:29 uh they were perhaps less critical Mhm.

21:34 uh of the data that they were using.

21:36 Nowadays, uh financial history is a big thing

21:40 and uh people are much more aware of the dangers

21:44 of uh finding ways of just losing data

21:50 and inadvertently having misleading results uh in the index history.

21:57 So, so we go from US market data,

22:00 maybe some UK upward biased UK market data um being the norm,

22:04 what everybody knew.

22:06 How did your work on long-term global returns change

22:09 our just like our understanding of expected stock and bond returns?

22:14 Well, let's go back to the book that we were talking about today.

22:17 We called it Triumph of the Optimists.

22:21 So, uh we called that book Triumph of the Optimists

22:24 and we did that because we have a century of data.

22:28 Uh and if you look to the beginning of 1900s

22:32 and you asked who was investing in financial assets,

22:37 there would have been a small number of optimists

22:40 who thought the commercial and industrial complex would do well.

22:44 And a much larger group of people who were cautious.

22:48 If you look at US endowments 100 years before,

22:53 you would find that the endowments were full of bonds.

22:56 So, the 20th century was one in which optimists,

23:00 that's the people who bought common stocks, did well.

23:04 And uh that does mean that you can

23:08 now look at out-of-sample data because you know,

23:11 we put into the market uh data for the last complete century,

23:16 for the 20th century.

23:18 We've now got a quarter of a century out-of-sample uh rolling forward,

23:24 which has been quite good, but not as good as the 20th century.

23:27 We can also go back in time and so some

23:29 people have been looking at uh evidence that predates 1900.

23:36 Um and uh there there's a papers by a number of individuals.

23:42 Financial Analysts Journal has become a popular

23:45 location for talking about these historical issues.

23:49 Uh and it's clear that if you start in 1900 and you go back in time,

23:54 uh performance of equities wasn't quite so good either.

23:57 So, our data changed the way people

24:00 think about the rewards for risky investment, for the equity risk premium.

24:05 Um and it's still changing because people are now saying,

24:10 "Well, it was a good century, but uh um it wasn't quite so good before

24:15 that." Uh it's it's difficult going back in time.

24:20 Uh we've done that uh using British data, which goes back further.

24:26 The attempts at doing the same comparisons through the United States are more

24:29 difficult because if you want to cover up the 90 with the 1800s,

24:35 um then you can't find a history for government bonds but but that century.

24:41 You can't find government bonds apart from it.

24:43 That's because there were no government bonds and uh you

24:46 would have to settle for uh corporates or uh state securities.

24:53 So, interpreting history also gets to be more difficult

24:57 the further back you go and requires more and more care.

25:01 I've got a question.

25:03 So in in 1900, the the optimist end end

25:07 up triumphing as the title of your book suggests.

25:10 Do you think and I'm asking this question just thinking

25:13 about how people feel today about the state of the world?

25:16 Do you think people in 1900 thought that stock returns

25:20 would be as positive as they were in the future?

25:23 No, I think um they had a pleasant surprise.

25:26 It was really in the second half of the 20th century.

25:30 And uh people would have expected I think extrapolating

25:37 from uh their experience before and in the early years

25:43 of uh the 20th century uh they would have extrapolated

25:49 from a world in which companies did business, generated income.

25:54 The income was paid out as dividends.

25:57 And so pretty much everything was income driven.

26:01 Mhm.

26:02 Uh we then moved into the 20th century proper.

26:06 And at that point people were making capital gains and in part

26:11 they were making those capital gains because expectations for the future

26:15 look rosy and what you would get from investing in common

26:18 stocks was more than just the dividend that were paid out.

26:22 But you had rising valuations.

26:24 And that must be something which you talk

26:26 about and write about in your own business.

26:30 Absolutely.

26:31 Comes up all the time,

26:32 especially today where the US stock market has obviously had lots

26:36 of capital appreciation on presumably very

26:39 very rosy expectations for the future.

26:43 Well, yeah.

26:44 The the role of the United States in all of this is greatly

26:47 achieved having one of the foremost

26:49 survivorship biases in the global equity markets,

26:52 although America was one of several large markets back in 1900,

26:57 fairly rapidly it became the biggest one in the world.

27:00 And it stayed that way with the exception of a very brief

27:03 period where the Japanese equity market was bigger than any other market.

27:09 Um and so the US has had this amazing history.

27:14 And uh people who are um psychologically attuned to uh the United

27:22 States have often said that they think that can only continue.

27:28 Our expectation was that with a hundred very good years from the US,

27:33 you couldn't expect it to continue.

27:36 And Paul and Mike and I were wrong.

27:38 It did continue.

27:39 It continued till about a year and a half ago.

27:43 Yeah.

27:43 I I've been saying the same thing for for a long

27:46 time now with the US valuations being so high, just saying that, you know,

27:51 the expected return of the US market

27:52 must be lower based on where valuations are,

27:54 but as you said, returns up until recently

27:57 continued to be higher than expectations would have suggested.

28:02 I mean I mean, once you've got a market

28:05 which represent more than all the others put together,

28:08 I mean, you can't imagine anything else which is as big.

28:12 Yeah.

28:12 So uh extrapolating to the history that was

28:17 uh going to be used for the future, well,

28:22 that's a a very difficult extrapolation and yet we really must

28:27 look at long-term stock market histories in a variety of different

28:31 circumstances so we can learn by looking at the differing experiences

28:36 of markets around the world and not just relying on the US.

28:40 Mhm.

28:43 So, at the beginning of the status series back in 1900,

28:47 can you describe what the composition of the country weights look like back then

28:52 and then how did that evolve over time to get where we're at today?

28:57 Well, the biggest market in the world by market cap in 1900 was Britain.

29:04 And there were others that were large, Germany, France, and so forth.

29:13 What what did those top markets valuations reflect?

29:19 Well, parts of it was the growing network for communications,

29:24 physical communications in different countries.

29:27 So, the majority of all of US common stocks majority

29:33 of all British common stocks by value was railroad stocks.

29:42 We had previously had a canal frenzy.

29:46 Canals did very well.

29:49 But they found themselves cutting quite a niche saying it's underwater.

29:56 They within a few decades railways had come along.

30:01 And although canals were very efficient compared

30:05 to lousy ground transports being pulled by a horse

30:10 and cart you had the same sort of thing

30:13 where trains were much better when traveling on canals.

30:19 And trains were very important.

30:24 I don't think it would have been obvious at the time once we saw it as a railway

30:27 boom that there would be alternatives like trucking

30:32 where or road transport might be alternatives like flying.

30:41 But nevertheless, um there was a longer period of succession

30:45 for China and India and they should stuck with it.

30:48 Railways did quite well but they went through some very

30:51 very difficult periods in the middle of the 20th century.

30:56 That that you you have that in in one

30:57 of the one of the yearbooks comparing the performance of railway

31:01 stocks for my I want to say 1900 to uh

31:05 I don't know I don't remember the timeline now, but it was railway stocks

31:08 you you're doing well.

31:09 Uh let let me give you the verbal picture of a chart you could you

31:13 you could put on uh if you're not choosing the people who want to watch Nvidia.

31:20 Uh we look at railway stocks from 1900 going forward.

31:25 And then as soon as there is an industry sector

31:28 for road transport which is not as early as 1900,

31:33 but as soon as that's available, we take that sector index and we start it

31:38 at the same level on the start date as railways had.

31:43 And we do the same thing once there's a listed

31:46 sector on the stock market for flying for for airplanes.

31:51 So, we can have another series and what you find is

31:54 that railways did much better than

31:57 the alternatives even though I don't Nowadays,

32:02 nobody would think of railway stocks as a growth stock in any sense.

32:06 Yeah, that's or that's that's what you you show in the in the yearbook

32:09 that the the market capitalization of railway

32:12 stocks decreased from being massive to being tiny,

32:14 but the returns outpaced all of those other sectors and the market as a whole.

32:18 That that that's just mind-blowing stuff.

32:20 I Yeah, I love that one.

32:22 It's fun.

32:23 And so, we we periodically update that work.

32:27 So, typically what happens over a year, we write these books and we we produce

32:31 them and an essay or two on particular topics.

32:35 Some of those you have acquired because they found their way onto the internet.

32:40 Um but we also bring in the long-lived pieces of research.

32:46 And so, the the book is now

32:49 the the the this is what the the latest book looks like.

32:54 It weighs nearly a kilo.

32:56 So, when people ask for it to be posted, uh we we will we send it back courier.

33:01 It's too heavy to put in in that letter post.

33:06 Uh and it would increasingly grow to having more and more topics.

33:13 We never realized that if we had this long-term

33:16 history where we could simply ask the history,

33:19 "What was the equity risk premium?" But instead,

33:22 we could look at all sorts of other questions over time.

33:25 Uh and it's the richness of that data.

33:29 It's uh data which we license you to use in your own research as well.

33:35 Um uh it it can answer a whole variety of different questions,

33:40 whether you are focused on inflation,

33:43 the emerging markets, uh and sometimes more esoteric esoteric investments,

33:50 uh precious metals, artworks, and so forth.

33:54 Yeah.

33:54 The So, has the railway analysis held up since you first did it?

33:59 Yes, the story has remained the same.

34:02 You know, when you see these graphs of different

34:05 asset classes or indices moving up over time.

34:09 So, we've got a horizontal axis, which is sort of years,

34:13 and the vertical axis is sort of the value.

34:14 But that vertical axis is always plotted in a logarithmic form.

34:19 So, if you move 1 in up the vertical axis on the page,

34:24 and let's suppose that over that your good inch on the page,

34:28 you've got values going up tenfold,

34:31 then the next inch on the pad edge will be the 10 becoming 10 times as big,

34:37 it's a hundredfold and so forth.

34:39 So, when you see uh a series and you're asking me about one particular series,

34:44 and you see one is winning a great deal compared to others,

34:48 it needs quite a lot Mhm.

34:50 to uh send them to the the back of the queue.

34:54 Right.

34:55 W- So, real quick on on emerging markets,

34:58 and actually it's kind of related to the next question

35:00 what I want to what I want to ask you, but you you had another chart in in one

35:03 of your books comparing developed market returns to emerging market returns.

35:08 Um and the fact that emerging markets underperformed,

35:11 to me was just like mind-blowing the first time that I that I read the analysis.

35:16 Um yeah, that was I I I If you have any Well,

35:18 actually I'll I'll I'll ask the question.

35:20 So, that the reason that I think it's related to this question

35:23 is because emerging markets tend to have high economic growth.

35:27 Can you talk about the historical relationship between

35:29 a country's economic growth and its stock returns?

35:33 Absolutely.

35:34 Uh if you know in advance that a country is going to have high economic growth,

35:41 that if you've got a a crystal ball, if you can foresee these things accurately,

35:46 it would be a good case for buying the stocks.

35:50 But, unfortunately, we don't have a reliable crystal ball.

35:54 We typically extrapolate from the past.

35:57 And so, when we first started to look

36:00 at emerging markets and comparing them to developed markets,

36:04 there was a wave of interest uh in emerging markets as being the future,

36:10 the growth opportunity.

36:12 Um and we don't really argue with that.

36:15 The question is whether as a shareholder, you will benefit from that.

36:19 And as a shareholder, stock holder, investor,

36:22 if you know that that uh there has been a lot of growth in the past.

36:28 Everybody else knows.

36:29 It'll be in the price.

36:31 And so you will pay more for a growth opportunity.

36:33 And so people who buy into an emerging market

36:37 which has done well are coming along too late.

36:41 So the long-term record of emerging markets is surprisingly disappointing.

36:49 Um they got left behind.

36:51 Oh, what were the big disappointments?

36:54 Um Uh if you lose a global war that can wipe a great deal off your stock market.

37:05 So the history of Japan for example is one in which

37:11 a huge amount of financial value disappeared during the Second World War.

37:17 Um So if we step back from that, we ask

37:22 what happens if we begin our index series not in 1900, not in 1940, but in 1960,

37:31 some point in the '60s emerging markets

37:34 have broadly moved in line with developed markets.

37:37 But they've actually done a little bit better.

37:40 But if you look at the entire series uh there were some very substantial losses.

37:46 And it's a warning really that there's

37:50 no guarantee particularly based on extrapolating

37:53 from the past that the investment strategy will pay off going forward.

37:59 We we talked a lot about that analysis and about Japan

38:03 and and and all that kind of stuff in a in a past episode.

38:06 And and one of the comments that I made was that it's kind

38:07 of like a reverse lottery where you

38:09 you might expect higher returns from emerging markets,

38:11 but you have these occasional big events

38:14 where one country just gets completely wiped out.

38:17 Uh and and that causes the the long-term record for emerging markets not to be

38:20 so great even if the expected return based on something like valuations is high.

38:26 I think there's there's a another twist on this.

38:29 Um and that says that you focus on the individual investor.

38:37 And you focus on people who are using institutional products.

38:43 So, you might want to ask yourself, which is entirely hypothetical,

38:47 what would happen if you were uh selling

38:51 a global fund and let's suppose it's imagine 48.

38:57 And you say, we think Germany looks really good.

39:01 We suggest you stick a quarter of your assets into Germany.

39:06 Uh and uh they would have been phoning up

39:09 for men in white coats to take you out.

39:11 Uh so uh it Afterwards, we see that if you bought into an emerging

39:20 market like that, you would have done very well,

39:21 but you would have to be ever so brave.

39:24 It would not have been a saleable proposition to retail investors.

39:28 It would not have been something which if you were managing a pension

39:32 fund or some other scheme institutionally that uh you you could have pursued.

39:38 So, being counter-cyclical,

39:42 focusing on uh ca- cases where there is scope for a very substantial recovery,

39:52 you just got to be awfully brave.

39:54 Uh so, I think that's that's part of the dilemma.

39:57 We have looked at the impact of strategies where you systematically buy

40:05 into stock markets that have done poorly or sectors that have done poorly.

40:09 And uh the outcome afterwards is two things.

40:14 First of all, uh if you've done poorly in the past,

40:19 it's a more volatile market, so you're more likely to do very badly.

40:22 You're also more likely to do very well.

40:24 Mhm.

40:25 So, in the long term, if you buy into markets that have collapsed,

40:29 you will be ahead of the game.

40:31 But, typically, what most investors will do is they'll lose their nerve.

40:34 They they might let They might like that story.

40:37 Uh so, but they're going to stick with it for a long time.

40:40 And so, that's mostly uh it's beyond our patience.

40:46 Mhm.

40:48 That's super interesting.

40:49 Uh we talked about railways already, but more generally,

40:53 what's the historical relationship between industry growth and stock returns?

41:00 Well, it it's a similar story to what I was talking about earlier,

41:04 but uh uh if you've got good economic conditions in a country,

41:09 and you know in advance that's a good idea, the same is true for an industry.

41:15 But, um historically, I'm going to caveat this in a this in a moment,

41:20 but historically, um if you bought uh into industries that were cheap,

41:26 cheap defined, for example, with uh a put an aggregate price to book,

41:33 or cheap in relation to dividend yields,

41:37 historically, um buying into cheap markets

41:40 or cheap industries uh outperformed a little bit.

41:45 But, we've just been through a period where

41:48 um that's been a difficult strategy to sustain.

41:51 So, if you have been convinced that buying into sectors

41:55 that are cheap and avoiding or even shorting ones that are expensive,

42:01 that's not something which would have done very much good for your business.

42:06 Nope.

42:07 Definitely a tough period.

42:08 We we we do have a bit of a a value tilt in our portfolios,

42:12 which has been a yep not not as good as a growth

42:15 tilt over the last I don't know 10 or so years.

42:18 Although recently a little better.

42:20 We lost We lost you a little second there.

42:22 Yeah.

42:22 Yeah.

42:23 And in traders.

42:24 So okay, the the evidence on country

42:27 economic growth and industry economic growth

42:29 with respect to stock returns it it seems like it's just like kind of noisy.

42:33 Like there's maybe even a negative

42:34 relationship but it's just seems really messy.

42:37 What why is that?

42:38 What why doesn't economic growth translate into higher stock returns?

42:43 Well, it's because uh economic growth

42:46 benefits all sorts of categories of people.

42:48 So if you think back to people who were buying into China for example,

42:53 there were people who were a couple of decades ago quick

42:56 clear mindedly could see that China was going to do well.

43:00 But that does not mean that you necessarily do well buying listed stocks.

43:04 Those listed stocks will already have a price that reflects what's going on.

43:08 So the big beneficiaries will be the equity partners in joint

43:12 ventures or maybe individuals who start up their own business.

43:18 So economic growth can help the country

43:21 of the constraints will bind and sectors and so forth.

43:24 Um and the benefits get spread around.

43:27 And uh everybody to to some extent benefit except those who go into the stock

43:34 market where prices will already reflect

43:36 the consensus as to what the future holds.

43:39 Right.

43:41 Yeah, that's super interesting.

43:42 Makes a lot of sense.

43:44 Um what impact has global diversification had on long-term risk and returns?

43:50 I think that's been very important.

43:53 Um again, if you go back a long way,

43:56 uh almost every country had uh a small number of sectors which were important.

44:05 And had a very small number of that were important.

44:08 Uh and so, uh it was difficult to get a broad portfolio.

44:16 Uh over the years, uh two things were happening.

44:21 One is that uh there were more and more industry sectors.

44:25 So, if you were to look within one large market, such as the United States,

44:29 there was much more opportunity to create a diversified portfolio

44:33 because businesses that used to be private by then were listed.

44:39 Um and if we think about uh investing globally, then you could spread the risks

44:47 that are associated with particular countries or are

44:50 associated with the resources that particular countries

44:53 have and diversify those much more effectively.

44:58 So, there's a lot of risk which you

45:01 might have thought uh is inherent to investing.

45:07 And it turned out a lot of that could be diversified away.

45:10 So, uh you uh can spread your money

45:14 around in a way in which eliminates many elements

45:18 of risk which you would not recognized as diversifiable

45:22 uh in the middle of the last century.

45:26 So, uh diversification has been important and it's been important

45:31 as there's been a growth in and varied investment opportunities.

45:37 Some people would say that now, because of the 20 largest companies,

45:43 uh there's a little bit less opportunity to diversify.

45:47 So, uh about 1/4 of the global

45:50 equity markets is represented by just 10 companies.

45:55 10 of those 10 are neither in one country,

45:59 the United States, um and one uh is uh uh in Taiwan.

46:08 So, basically, uh you would like to diversify,

46:14 but there are some sort of diversifications

46:17 which are a little bit more difficult.

46:19 Uh I you've got though to be brave in the way I was describing it

46:24 earlier if you were going to move

46:25 away from having exposure to those both companies.

46:30 We really don't know whether we are in the middle of uh an upward

46:34 momentum or whether those stocks will become

46:38 so expensive that uh there'll be a collapse.

46:41 We don't know whether we are in uh early

46:45 year 2000s confronting a collapse sort of three uh

46:50 technology companies of that era or whether we're uh

46:55 in the middle of uh continued ascent by technology companies.

47:03 Yeah, it's one of the one of the hard

47:05 parts of hard parts about being an investor.

47:07 Can't can't know the future.

47:09 Uh so, we can look like in in your data, for example,

47:13 we can look and see that there has

47:14 historically been a quantitative diversification benefit to global stocks.

47:21 I I and I picked this question up from reading I don't remember which one,

47:24 but one of your yearbooks.

47:25 What effect could frictions like foreign markets

47:28 being less accessible to investors historically than they

47:31 are today have on the perceived quantitative benefits

47:34 that we see in the data of diversification?

47:38 Well, trading costs can impair performance.

47:42 Um and uh performance over the long history

47:47 that we examine has been helped by trading being cheaper.

47:53 So, uh cost drag became something people talked about.

48:00 Although the lower the costs are, the more people are willing to trade.

48:07 So, while I don't have numbers to share with you,

48:10 my hunch is that if we looked at the aggregate of cost drag, that is,

48:15 what it costs to make to do a transaction

48:18 and the frequency with which they happen amongst investors as a whole,

48:23 then uh, I I think um, I think jury for me may may still be out.

48:30 Uh, it's much, much cheaper to uh, invest globally.

48:36 Well, but so many people are doing it that the aggregate across all

48:40 investors there may be less of a benefit than than you might have anticipated.

48:46 Mhm.

48:48 So, on that note, how have

48:49 the benefits of international diversification evolved over time?

48:55 Well, international diversification involves spreading your money across uh,

49:01 different markets, different jurisdictions, and so forth.

49:05 Uh, there's a lot of resistance amongst American investors to investing in uh,

49:12 uh, markets which are less promising than the US in the eyes of individuals.

49:19 Um, but on the other hand,

49:21 it can't be the case that for everyone it makes sense for them to uh,

49:27 avoid diversifying out of that home market.

49:31 And so, what we can see is that if you

49:33 had moved into a market which turned out to do well,

49:38 you prospered, and uh, vice versa.

49:42 But, people who were in the United States

49:44 who bought foreign stocks may have been persuaded uh,

49:49 by people like me and my co-authors that risk reduction was worth having

49:54 and therefore they would be better off

49:57 if they spread their money into other countries.

50:03 People did do that from the United States.

50:05 And it was a little bit more difficult to do from Canada,

50:08 but those impediments were lifted because people

50:12 were convinced that global diversification was worthwhile.

50:17 So there were opportunities just like that.

50:21 But it cannot be the case that there

50:22 is a strategy which makes money for everyone.

50:26 So in other words, when Americans put their money outside [snorts]

50:30 the US they were buying stocks

50:33 which were destined to underperform American stocks.

50:38 What that means also is that if Europeans or Asians had

50:44 moved out of their home markets and bought more in the US,

50:47 they would have bought more.

50:48 The average return experience across all of them has to be zero.

50:54 That you can't create returns out of out of nowhere.

50:58 So the role of international diversification is risk reduction.

51:04 And that you can kind of promise.

51:08 On on that, on on international diversification,

51:11 why do you think and and I will note that we

51:13 we do have a home country bias in our portfolios.

51:16 We we weight more than the Canadian market capitalization.

51:21 We we have about a third of our portfolios in Canadian stocks.

51:24 And we have reasons for that which we can talk about if you want,

51:26 but why do you think investors And actually one more

51:29 note on that our home country bias in our portfolios,

51:32 which we think is reasonable,

51:34 is much less than a typical Canadian investor's home country

51:37 bias who might have 60% of their portfolio in Canadian stocks.

51:41 Why do you think investors continue to exhibit home country bias when

51:43 the benefits of international diversification that you

51:45 just described are so well known.

51:49 So, some of it may of course be not rational, just warm feelings.

51:55 Um but uh it may also be uh other attributes to that.

52:01 So, my my answer to some extent is

52:04 colored by taking um an institutional investor perspective.

52:08 So, I'm I'm uh employed by uh one of the wealthier universities in Europe,

52:14 which is uh Cambridge.

52:17 Um and Cambridge, when it hires people,

52:20 has a mix of uh paying salaries which are

52:24 the going rate locally and will stay that way.

52:28 And some where the going rate is essentially determined globally.

52:33 So, the decision as to how much you want uh

52:36 exposure to foreign markets compared to to local markets, it uh [clears throat]

52:43 it it is something where there isn't a a a a rule that applies to everyone.

52:49 I think there are individual circumstances which will

52:53 uh finish what you ought to be doing.

52:57 So, um I do understand home bias.

53:00 For those who have a heavy bond component,

53:02 I think the uh story is more compelling.

53:06 Mhm.

53:07 as is uh um being able to diversify out of your home bond market

53:14 into foreign bond markets is taking a view

53:18 on how exchange rates are going change.

53:22 Um and uh I'm in favor of diversification, however it comes,

53:28 but I can see how for fixed income investors, it's uh uh it's a little bit

53:33 more important because you can hedge more effectively.

53:37 Uh when it comes to the stock market,

53:39 I still I some sympathy with people who wants to stay at home.

53:44 But, uh I think the proportions you describe are not high enough.

53:51 I think back to the time when I

53:53 was more heavily involved with the Norwegian sovereign funds.

53:56 I chaired the uh strategy council for Norway for about a decade.

54:03 Um and early on when I was working with the Norwegians,

54:07 they had a strong Nordic tilts because they were buying

54:12 and selling goods and services uh in Scandinavia and nearby.

54:18 Uh and then over time,

54:20 they came to appreciate that if they bought something which

54:25 uh came out of Scandinavia came out of an IKEA store,

54:30 uh they weren't really too exposed to the Swedish currency

54:36 because some of that would have been made in China.

54:39 Mhm.

54:40 And if you looked through that, uh China

54:43 was quite heavily linked to the US dollar.

54:46 Mhm.

54:47 And there was a gradual realization

54:49 that having strong geographic tilts is not uh

54:53 in the interests of the Norwegian people

54:55 compared to to being well diversified globally.

54:59 Mhm.

55:00 And I would be saying the same thing from Canada.

55:04 Mhm.

55:05 But there are these geopolitical issues which uh are being wrestled with now.

55:09 How much do you want to be self-aligned uh within a particular country?

55:15 And the world is so complex now,

55:18 you could probably run a another session like this focusing

55:21 on geopolitical risk and uh you'll get a lot of solutions.

55:28 That's one of the things that uh we had Gene

55:30 Fama on this podcast years ago and we we have,

55:33 you know, that there's a tax efficiency, cost efficiency,

55:36 local currency argument for home country bias, uh which I think are fine,

55:40 uh but Fama brought up that's more geopolitical expropriation risk of investing

55:46 in foreign stocks that I I just haven't thought about before,

55:49 but when he described it it was uh yeah, that that well,

55:52 gave me another another reason for a bit of home country bias, I guess.

55:57 In early in my career, um when hedging currency was happening in its infancy,

56:05 um we used to uh focus on back-to-back loans.

56:10 In other words, a business, rather than uh taking exposure through

56:16 setting up a subsidiary in another country,

56:19 would borrow in that country and then invest the money.

56:23 Um and it was for exactly those sorts of reasons that uh it

56:27 you you could end up with expropriation of assets you thought you had.

56:32 My um uh my wife's family come from Germany.

56:36 They were refugees um at the uh outbreak of the Second World War.

56:43 Uh and uh my late mother-in-law remembered that the first bit of savings

56:49 that they had uh were that they they they uh um took to uh Switzerland.

56:58 And they took a small amount in a bank

57:02 and she wrote uh a number to the account number.

57:08 Uh and in her final years, I always my mother was keen to get the the savings.

57:16 And so people put that they would run run

57:19 to money in case they they had to run again.

57:23 And um he went from uh bank to bank.

57:26 None of them recognized the number as it had been inadvertently expropriated.

57:32 We went to the uh um banking ombudsman in Switzerland.

57:37 Um several years later you wrote that they

57:40 had identified uh this deposit uh and there was

57:45 no explanation as to quite what had happened

57:48 to it explanation as to how they got the money,

57:51 but this money which the young couple who had

57:53 left the state from Germany uh at the end

57:57 of the 1930s was eventually available uh um

58:02 uh thing much more than half a century later.

58:07 So, this expropriation risk it's it's a real dilemma

58:12 and it's one which as a family we would see it.

58:15 Hm.

58:16 That's a fascinating story.

58:18 Uh crazy.

58:20 Um how important would you say

58:21 that industry diversification is relative to country diversification?

58:27 I'd say it has become more important.

58:30 Um that's because uh companies find somewhere to list their shares.

58:39 And so, you end up with a uh listing in locations

58:44 which are not naturally where where they do their profit creation.

58:50 So, we had quite a number of years

58:53 of resource companies being listed on the London Stock Exchange.

58:56 It's they're not making the way of resources

58:59 that comes out of the ground and and and Britain.

59:02 Hm.

59:03 Uh So, when you diversify across markets

59:08 um you're diversifying different sorts of statements.

59:12 And I I I think the the uh reality

59:14 of diversifying across industries now is more compelling than it was.

59:21 Hm.

59:22 Interesting.

59:23 What do people say to you?

59:24 You know, that must be something which you talk about.

59:27 Well, it's a tough one.

59:28 I mean, we we we look at different papers

59:30 and writings including including yours and some of the yearbooks.

59:34 And it's a tough one.

59:35 It seems like it changes over time,

59:36 which I guess you're you're kind of just describing.

59:39 So, it's that really comes back to that big

59:41 question of of how important is international diversification.

59:45 I think it comes up a lot for US-focused

59:48 investors and investors in the US who look at Well,

59:51 look how diversified our industrial base is in in the United States.

59:55 We don't need to diversify outside of the country.

59:58 And that's really one of the main reasons that I've looked at this is

1:00:01 is is a well-diversified market sufficient

1:00:05 diversification relative to being diversified across countries.

1:00:09 And it's you know, I I I I

1:00:10 think I've landed on international diversification is still important.

1:00:14 But it's not a super easy question to answer.

1:00:18 Yeah, I mean, it's it is much cheaper to invest globally than it was.

1:00:24 So, in a way, you less important, but it can also be a great deal less costly.

1:00:30 The the the uh um the burden in terms of costs

1:00:35 to investing in a passive global fund is remarkably low.

1:00:41 It's just amazingly low.

1:00:44 Um and uh the burden therefore for active investors

1:00:49 to compete with that it's it is really difficult.

1:00:54 Yeah.

1:00:56 Uh so, we've mentioned Dimensional briefly.

1:00:58 Can Can you you've looked at longer-term historical data than

1:01:03 even Dimensional would have had when they started their business?

1:01:06 Can you talk about how pervasive the size and value

1:01:08 effects have been in historical data around the world?

1:01:12 Yeah, it's it's kind of curious that because um uh when Dimensional was quite

1:01:19 young in the London market Um they

1:01:24 supported us collecting uh value and size data.

1:01:29 Value data had previously not existed.

1:01:32 And so uh I coordinated several uh PhD students to do that.

1:01:40 The work largely was done by year 1, year 2,

1:01:45 year 3 PhDs collecting data manually and coordinated by year zero PhD.

1:01:52 You might also wonder what a year zero PhD is.

1:01:55 Somebody who we have given a place on the PhD program.

1:01:59 Um and uh he just seemed very well organized.

1:02:03 So um this is a man who subsequently became editor of Journal of Finance.

1:02:09 So he was he was my PhD student.

1:02:11 Um and um it we ended up

1:02:16 collecting data publishing this in Financial Analysts Journal.

1:02:22 I think it probably could have been published somewhere better,

1:02:25 but we were in a hurry to get it out.

1:02:27 And uh that was uh the first attempt at the time time when uh I think

1:02:34 in the early years Dimensional was much more keen

1:02:38 on factor effects within the US and thinking globally.

1:02:41 That that was still to come.

1:02:44 That's the the paper on the value and growth uh

1:02:48 in the UK was complementary to uh to to to other stuff.

1:02:54 We looked at performances.

1:02:57 You know, you you have these checkerboard charts

1:03:00 which are popular in the hedge fund world, but we also look at them year by year

1:03:06 seeing well I don't know each year what the best,

1:03:10 middling, and lowest performers was uh for different factors.

1:03:15 And we also do this decade by decade because we

1:03:17 got some data which goes back quite a long way.

1:03:20 Some of it a bit further back than the I don't know Fama and French

1:03:26 uh material on which Dimensional Solutions kindly

1:03:29 make available to the search as a whole.

1:03:32 And um the the small firm effect was the premier anomaly.

1:03:39 It ceased to be.

1:03:41 Um value uh became a premier anomaly in stock market performance.

1:03:48 But that's kind of gone away.

1:03:50 Um I would get a bit of a jumping around for the last handful of years.

1:03:55 Value sort of got left behind quite quite a lot.

1:04:00 The one that was most striking uh is momentum.

1:04:04 What's striking about momentum is there's a big

1:04:06 contrast between momentum investing and size and value investing.

1:04:13 For size investing, you buy small caps and you hope that they will outperform.

1:04:18 Um and at the end of the year, you can reformulate your strategy.

1:04:26 Um and if you're really lucky, your strategy won't be messed up because some

1:04:31 of those small companies won't be small any longer.

1:04:34 But basically, you're fairly doomed.

1:04:36 You buy small companies and they'll stay fairly small.

1:04:39 Buy value companies and they'll stay fairly value-ish.

1:04:44 But you can't do that for momentum because for momentum,

1:04:47 you're buying stocks which have trended up

1:04:50 and avoiding or shorting stocks which have trended down.

1:04:53 There's actually no reason why one which has

1:04:55 trended up over time should uh keep doing that.

1:05:00 So, the galaxy would explode would explode.

1:05:03 I mean, it would be that can't be can't happen.

1:05:06 So, it's it's a high-cost strategy.

1:05:10 And uh size and value has been uh

1:05:14 somewhat overwhelmed by momentum returns, but it's high cost.

1:05:18 And so whether you do that effectively, uh if you can control costs very well,

1:05:24 then uh size and value are pushed

1:05:27 down as the as relatively unpopular factors now.

1:05:33 But for a long time and after uh when uh Footsie 500 the first uh small cap

1:05:39 index in the UK which mirrored what Rolf Banz

1:05:43 had done it as Dimensional was being set up, he had done that for the US.

1:05:50 Um the astonishing performance of uh small caps which continued over a very

1:05:56 long period up into about a 2/3 of the way into the 1980s, that all evaporated.

1:06:03 So, uh it's a that's a factor and I

1:06:06 think we now recognize that there are factors and premium.

1:06:10 There are attributes which are associated with differential

1:06:13 performance which may be good or may be bad.

1:06:17 And um attributes which may be associated with a premium

1:06:22 because they are giving you exposure to stock

1:06:25 characteristics that people don't want to be exposed

1:06:29 to and that will make those stocks more cheap.

1:06:35 Do you think the size and value premiums are still worth pursuing today?

1:06:41 Um No, I think they should be monitored.

1:06:44 Um it if you were looking at um institutional active portfolios,

1:06:53 then you'll often find that there are inadvertent factor tilts.

1:06:59 Um for example, some charities uh are constrained to spending income.

1:07:09 What that means is that they run the danger

1:07:14 of um influencing their asset manager to buy high-yielding stocks.

1:07:23 So, if you are aware of the factor effects, you can discover that in my example,

1:07:31 uh a uh a uh a a a fund manager buys too much of the high yielders

1:07:39 because that's the only way that the charity

1:07:43 can actually access the money that that it's making.

1:07:47 Um but there's other similar things.

1:07:50 Peo- people after small caps have done well want to buy small caps.

1:07:55 If they do that through a pooled vehicle, mutual fund, or an ETF.

1:08:02 Uh small caps are expensive to trade.

1:08:05 And so, their strategies can be expensive.

1:08:10 And so, you need to understand some of these subconscious

1:08:14 influences on the way a portfolio gets constructed.

1:08:19 And I I would argue that a an active manager

1:08:22 that is not particularly assuaged by your sort of uh

1:08:29 didn't like the passive management is not persuaded by your interest

1:08:34 in factors should still be looking at these attributes.

1:08:40 Yeah, interesting.

1:08:40 I mean, that that kind of reminds me of like uh Mark Carhartt and Fama

1:08:44 and French both have papers looking at active

1:08:46 mutual fund performance through the lens of factor exposures.

1:08:50 Is that Is that kind of the line of thinking that you're talking about?

1:08:55 Yeah, so you know, what I'm talking about is Uh,

1:09:00 traditional active managers primarily who um,

1:09:04 accidentally end up with factor tilts.

1:09:08 Right.

1:09:08 Yeah.

1:09:08 And those factor tilts are essentially bets being made by the uh,

1:09:15 the owner or or or through the portfolio.

1:09:19 Um, where they didn't actually intend to to make those bets.

1:09:24 They would they would do something which they thought was

1:09:27 more innocuous and more geared towards the objective of the client.

1:09:31 But I've been on a lot

1:09:32 of investment committees for pension funds and endowments,

1:09:36 and I've seen that uh, multiple times over.

1:09:40 Hm, interesting.

1:09:40 Yeah.

1:09:41 I I had a call with a reporter earlier

1:09:42 who wanted to talk about equal weighted index funds.

1:09:46 And this is one of the things I explained is

1:09:47 that you're you're taking you're putting

1:09:50 significant factor exposures into place uh,

1:09:53 by having that uh, that that the equal weights, but it's sort of a naive tilt.

1:09:56 And so I was like, if if somebody wants those factor exposures,

1:09:59 there's probably a lower cost and more efficient way for them to get there.

1:10:04 Yeah, I mean the journalists should be aware that if this is a good idea,

1:10:10 it would have been a good idea 2 years or 6 years ago.

1:10:13 Right.

1:10:13 And then every time uh,

1:10:16 any of the magnificent seven do well, you would reduce your exposure.

1:10:22 Uh, at the end of the decade, you would feel much poorer.

1:10:26 Yeah.

1:10:27 Yeah, I I I alluded sort of that to that too.

1:10:29 I we talked about the the negative momentum exposure

1:10:32 that equal weighting is always going to have, which is Yes.

1:10:34 what you're just talking about.

1:10:37 Uh, okay.

1:10:37 I I I want to move on to the equity risk premium.

1:10:39 Uh, can can you just can you talk about what

1:10:42 history tells us about the size of the equity risk premium?

1:10:47 Uh, the the size of the equity premium uh, risk premium is very important.

1:10:53 If you were trying to build a modern building,

1:10:57 you will have steel pillars that support it.

1:11:01 But if you were trying to do that in such a way

1:11:04 that the ratio of the diameter of those pillars that support a skyscraper,

1:11:09 uh if you were the ratio of the circumference to the diameter,

1:11:14 if you wanted to be anything other than 3.1415965, etc., you can't do it.

1:11:21 And so we have a number in investment which

1:11:24 is just as important to theory as to me.

1:11:27 Uh the trouble is that while we know what the value of pi is,

1:11:32 we have no real idea as to what the equity premium is.

1:11:37 And it's even worse than that because um

1:11:41 there are lots of different estimates that come out.

1:11:43 They seem to vary a lot over time.

1:11:46 Um and uh we think of these as being long-term attributes,

1:11:53 but there are sell-side advisers who are

1:11:57 constantly changing their alive and but they've

1:12:00 got limited opportunity to do their business

1:12:05 if the equity premium never changes.

1:12:09 So, we see lots and lots of calculations.

1:12:12 Uh in the academic world, this has been a source of uh discussion for 20 years.

1:12:18 So, it started with Goyal and Welch, Welch being based in the US,

1:12:25 Goyal nowadays being in um Switzerland,

1:12:31 um who looked at what happened if you didn't peek into the future,

1:12:35 but just well, shows as you went through time to make an investment based

1:12:42 on information that at a particular date you've got based on all the past.

1:12:47 So, uh the equity premium that you get if year.

1:12:53 And use long-term data is uh still quite high

1:12:57 as depending on whether you look at the 21st century,

1:12:59 the 20th century, or the 19th century.

1:13:02 Uh but our the sort of numbers that we come up with nowadays

1:13:10 uh are much lower than the spending rules that are followed by many endowments.

1:13:16 So, we typically use 3% as the uh equity premium,

1:13:23 the amount that uh uh equities will throw off relative to uh safe assets.

1:13:30 But, 4% is uh it's very you you have to be quite lucky.

1:13:35 And in many cases, you find that endowments, not the long-term investors,

1:13:40 who think that sustainable spending can run at a level of 5%.

1:13:46 Sustainable spending means money that you

1:13:48 can spend without destroying the future.

1:13:50 Partly, it's not to do with rainforests or climate change.

1:13:54 Yeah.

1:13:55 Uh so, what we're talking about is how much you can take out

1:13:58 of the fund and still leave it in a good good shape for future.

1:14:02 Our equity premium estimates that we have are I think

1:14:05 lower and the consensus is much smaller than it was.

1:14:10 And uh I think there's been gradual movement.

1:14:14 So, even the most optimistic of individuals say my people

1:14:18 generally seek a little This is not optimistic amongst common factors.

1:14:23 have brought down their numbers.

1:14:25 And in other cases, their estimates of the reward for equity

1:14:30 risk compared to uh short-term risk-free

1:14:35 investments or long-term uh risk-free investments.

1:14:40 It's a smaller number than we used to talk about.

1:14:43 Mhm.

1:14:44 Uh so, historically, uh that's the risk premium.

1:14:50 How does that correspond to the real return on equities?

1:14:57 Uh, well, we can look at the equity premium as the difference between the uh,

1:15:02 expected or the realized return uh,

1:15:06 on equities and the and the return on safe assets.

1:15:12 We can do that in real terms or nominal terms.

1:15:15 The number will be exactly the same.

1:15:16 So, if you've got uh, a numerator and denominator which is nominal,

1:15:22 uh, you divide one by the other.

1:15:24 It doesn't matter if the top half of that fraction

1:15:27 and the bottom half of the fraction are scaled, uh, by inflation.

1:15:31 So, the equity premium is fundamental.

1:15:34 And it's fundamental whether you are uh,

1:15:37 an investor that's focusing on real returns,

1:15:41 focusing on the purchasing power of your portfolio,

1:15:45 or whether you uh, are focusing on the nominal

1:15:49 risks and what a nominally straightforward low-risk alternative would be.

1:15:59 Crazy.

1:15:59 So, three or three or four percent equity risk premium.

1:16:02 I you know, I think that's already getting high.

1:16:06 Wow.

1:16:07 Three percent.

1:16:08 I think there was still there is still plenty of institutional

1:16:13 investors in the US who would be talking about five percent.

1:16:19 Well, I think to get to numbers like that, you've got to be, uh,

1:16:23 claiming that you can not only get the equity premium,

1:16:27 but you can identify clever managers who will outperform the pack.

1:16:32 Mhm.

1:16:32 And, um, that's hard.

1:16:37 I So, I just don't I'm trying to think of listeners hearing three three percent,

1:16:42 um, and and, you know,

1:16:44 panicking a little bit because that's a low number if uh if if we switch

1:16:49 from thinking about the equity risk premium

1:16:52 to just real stock returns without adjusting for risk,

1:16:57 what does a 3% equity risk premium look like

1:17:01 in terms of just a real expected stock return?

1:17:04 Not not a risk premium.

1:17:06 I would take the view that over a a 10-year period,

1:17:09 a plausible real return from bonds might be 2%.

1:17:15 And so, uh if if that risk premium is related to bonds,

1:17:21 the equity bond premium of 3% would give rise to a 5% return above inflation.

1:17:30 Okay.

1:17:32 Yeah, that that that's a number that I think makes sense.

1:17:36 And that's Is that pretty close to historical uh real return on stocks?

1:17:40 Right.

1:17:41 Yeah.

1:17:42 It's it's it will leave you a lot

1:17:45 happier than if you'd been asked the same question

1:17:47 4 years ago when the long-term return on bonds

1:17:51 would have been zero in real terms or less.

1:17:56 Right.

1:17:57 So, we're we're we've moved not all the way back to long-term history,

1:18:02 but the sort of numbers that people could plausibly use

1:18:04 now are not quite as discomforting as as they were.

1:18:10 Right.

1:18:12 Well, this is the this is the I'd actually be the heart

1:18:16 of what financial advisors who you're working with uh think about.

1:18:22 And I think there's another way of considering

1:18:26 what individual savers ought to be doing.

1:18:30 So, the traditional way would be to look at how much wealth one has and say,

1:18:34 "Well, this is what you can afford to be spending over years into the future.

1:18:40 There is another way, which is to say um that hypothetically at least,

1:18:47 you could um take out uh a contract which would

1:18:53 cover all of your needs from age 100 to 101.

1:18:57 Let's assume that you're not expected to live beyond that.

1:19:01 Um but that's something which you could price.

1:19:04 It's an annuity.

1:19:06 You could also work out how much would be needed

1:19:09 to help you live from 99 to 100 or 98 to 99.

1:19:13 Uh Bill Sharpe calls this a lock box.

1:19:16 Mhm.

1:19:17 Um it's working back from the end of your life as to how much you need

1:19:22 rather than starting where you are now

1:19:24 and having a plan which will take you forward,

1:19:27 but then when you're say 82 years old, you'll have nothing left.

1:19:33 So um the reason I like that is that it's uh

1:19:38 helps you focus on how long you should be working for.

1:19:41 Some people have a job like mine which they just enjoy.

1:19:45 But other people, um they would quite like to stop working.

1:19:50 And I think the stage at which they will be able

1:19:54 to stop working is something which they could do with guidance.

1:19:59 And financial advisors don't think about it that way around usually.

1:20:04 Mhm.

1:20:05 Yeah, that is a that is a good perspective to take.

1:20:09 So looking at markets today with wars, high valuations,

1:20:12 and the fear of AI and so on, how should investors remain optimistic?

1:20:19 Um well, your listeners will be a range of ages.

1:20:25 If you're young, you'll ask young listeners for those who

1:20:28 ask people who have got quite a lot of wealth.

1:20:32 And so, I think part part of the story

1:20:35 is children to know who they're investing for.

1:20:39 Um and what chances they can take and the the the optimistic ones will

1:20:46 be ones who have the good fortune to be able to invest for their children,

1:20:50 their grandchildren, for charities, or whatever.

1:20:53 In the end, they'll spend their money on.

1:20:56 So, how can they be optimistic?

1:20:59 It is through living modestly and investing

1:21:04 for a future which stretches out a long way

1:21:07 and beyond their lives if they're fortunate enough

1:21:10 to be able to afford to invest that way.

1:21:13 Mhm.

1:21:15 What do you think of the risks of being pessimistic about future stock returns?

1:21:23 Well, if you're pessimistic, you still got to put your money somewhere.

1:21:26 So, that means that you are not

1:21:28 like the optimistic investors in the stock market.

1:21:31 You're going to stick your money in the bank.

1:21:34 And um over any reasonably long period,

1:21:38 um you are likely to lose purchasing power doing that.

1:21:42 So, if this is money you don't need for in the future,

1:21:48 then you should be investing for the long term.

1:21:51 You still need some liquidity.

1:21:54 Uh I came to um New York at one stage

1:21:57 in 1999 at the peak of the data queue bubble.

1:22:01 And at that stage, there were taxi drivers who would uh tell you that uh they

1:22:09 are planning for uh their daughter's wedding

1:22:12 or their son's bar mitzvah or whatever it was.

1:22:14 And uh um they put some money to one side and within 5 or 6 years' time,

1:22:22 they were going to be in a position to spend the money that they needed.

1:22:26 They did not understand that uh the projections in both of the long run,

1:22:34 which uh the Wharton School Professor uh Jeremy Siegel had popularized,

1:22:40 but they're still science there.

1:22:42 And so for people who are not such optimists,

1:22:47 uh they are not going to become as wealthy,

1:22:52 but the downside with uh here is less.

1:22:57 As well, if you didn't need the money, then my world is also in balance.

1:23:01 Mhm.

1:23:02 And so if you look at Oxford and Cambridge colleges,

1:23:07 some are terrifically wealthy and others are not.

1:23:11 If you are worried about whether rain will come through

1:23:13 the roof and ruin the organ in in in your college,

1:23:18 you don't stick the money in the stock market if

1:23:21 you're not likely to need it in a few years time.

1:23:23 So, uh that's the cross-subsidy, if you like,

1:23:27 between long-term investors and shorter-term investors.

1:23:31 Mhm.

1:23:31 Long-term investors will do better

1:23:33 because short-term investors can't afford losses.

1:23:38 That was a great line.

1:23:42 So, we talked about the equity risk

1:23:44 premium and that 3% number being fairly attractive,

1:23:48 especially once you consider the risk-free rate and inflation.

1:23:52 How do you think about the role of bonds in portfolios?

1:23:58 Well, the the extent to which bonds have co-moved with or do

1:24:06 they diversify for equities quite important in all of this.

1:24:10 And we we went through a period for the first two decades

1:24:15 of the current century in which we had become used to uh,

1:24:21 having a a role in the portfolio being a a safe asset.

1:24:27 Um, and then 2022 came along and all all bets are off.

1:24:33 Um, uh, so I think that is at all bonds um,

1:24:41 but I'll give you the personal view as uh,

1:24:45 um, our tastes, I put it personally, are very modest.

1:24:50 Um, and we don't need to spend um, an awful lot.

1:24:56 And so I think that there's a big benefit from being

1:25:01 heavily invested in equities to somebody who thinks that way.

1:25:06 Uh, so so again, people sometimes ask me for advice and I'm

1:25:11 I'm not a financial advisor and I don't like giving advice.

1:25:15 Um, but I think uh, you you need a clear idea of how risk-averse you are,

1:25:22 how much you might need money for an adverse event.

1:25:26 And if you can manage it, if you can invest for the long term,

1:25:30 that is the second best investment you can make.

1:25:34 The very best is investing in yourself.

1:25:38 That's getting an education.

1:25:40 So that would be where I rank bonds.

1:25:43 And after that, I look for long-term financial assets.

1:25:48 I love it.

1:25:49 Make yourself the safe asset and uh, live modestly so you can invest in stocks.

1:25:54 I I I love it.

1:25:56 I share the same philosophy.

1:25:57 So con- confirmation bias, that's why I'm so excited.

1:26:02 Uh, okay.

1:26:04 L- last two questions here.

1:26:06 We've talked about US exceptionalism and how

1:26:10 the US has just had this incredible performance.

1:26:13 How do you think you investors should think about

1:26:15 expected future returns in the context of the US market.

1:26:22 But it it's never a good idea to be a market timer.

1:26:29 People who ask themselves, "What should I be doing now because it looks

1:26:35 as though I could uh uh invest in risky assets now,

1:26:40 but lose a lot, and so I could stay out of the market." That's market timing,

1:26:45 which is not something which any advisor will urge you to do.

1:26:50 Um the reason for that is that it's easy to make a decision

1:26:53 now to sell your common stocks because you think they may fall,

1:26:58 but you may never get the opportunity to buy back.

1:27:01 So, uh you know, I think that what people

1:27:05 should be doing is uh focusing on a long-term strategy.

1:27:10 That long-term strategy should be as diversified as possible.

1:27:15 Costs should be as low as possible.

1:27:19 And uh there are instruments for doing that where

1:27:23 the platform fees and the asset management fees are incredibly low.

1:27:28 So, that should be the the the uh the starting point,

1:27:32 I think, for many investors.

1:27:36 Great answer.

1:27:38 All right.

1:27:38 So, our last question, Elroy, how do you define success in your life?

1:27:46 Uh that's easy for me.

1:27:48 We've got uh um four children, and four children-in-law, and four grandchildren.

1:27:54 I think we've got 10 grandchildren.

1:27:57 And we success is happy people.

1:28:02 That is a great answer.

1:28:03 I've got four children, too,

1:28:04 but no uh no children-in-law, and no no grandchildren yet.

1:28:09 It'll be be for that still.

1:28:12 But, if they're happy, good good with that.

1:28:16 Yeah, no, that's a awesome great answer to the question.

1:28:19 This has been a great conversation, alright.

1:28:21 I I mentioned to you that this is just it flew by for me.

1:28:24 I can't believe we've been talking for for 90 minutes,

1:28:26 but really appreciate you coming on the podcast.

1:28:28 This has been fantastic.

1:28:31 That's great.

1:28:32 Oh, thanks so much.

1:28:33 It's time to stop.

1:28:36 [laughter] Hey everyone, it's producer Matt.

1:28:42 Thank you so much for tuning in to this week's episode.

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