Episode Transcript
[00:00:00] Speaker A: Michael, welcome to the show. It's a pleasure to have you here today.
[00:00:03] Speaker B: Thank you. My pleasure too.
[00:00:06] Speaker A: I would like to jump right into it. You wrote two books about investing. Before we get into it, why did you decide to write these books?
[00:00:15] Speaker B: Well, the first one called the Big Investment Lie. What drove me to it was an experience I had and they wanted a mathematician. And one of the two partners in it, well, there were more, slightly more than two partners, had interviewed me, so to speak, and was extremely interested in my mathematical background to the point where he asked me what was in my dissertation. And I don't think I'd ever been asked that before.
He seemed to be very interested. And so I thought, oh, this sounds pretty good.
But they kept saying they were going to come up with an offer and their accountant was working on it, but they never did. And at the time, I really wanted to move.
I wanted to go out of the country, the US And I asked some friends of mine, you know, a couple of friends of mine, I said, you know, you got any idea what's going on here? They keep saying they want to hire me. They having their accountant working on a deal, but somehow they never quite get to saying anything. And the friend said, okay, we got it. They, they really want to hire you, but they don't have any money, so. So I thought, okay, I'll just go any. So I emailed them and I said, I'm coming. They, they did say they would provide an apartment for me. So I thought, okay, fine, I decided to go there. I arrived on July 4th evening in the middle of a raucous alcoholic party they were having.
And the guy that I had interviewed in person took me aside and he said, okay, look, we really want you to work here, but the government of Andalusia owes us a million euros and they haven't paid yet, but they will, and then we can start paying you. I said, okay, fine, let's just, we'll just work on it anyway. They seem to have all kinds of interesting things going on that would require some math. And I thought, gee boys, this is one of the most interesting possibilities for projects.
But after a little while, I realized the whole damn thing was about beating the stock market. And the president, he would go out and he was one of these salesy types, and he would go out and he'd tell people, we're beating the market by 90%.
So finally a more level headed guy who actually the company survived and it's the more level headed guy who has run it ever since. That was like 1819 years ago, 20 years ago.
And he asked me, could you do a kind of an investigation into what the strategy would have done in the last six months? I did. Would have been down 80%.
[00:03:21] Speaker A: Investment strategy.
[00:03:22] Speaker B: Yeah. Yeah. Because of brokerage fees, basically. Yeah.
So. And the market happened to be down, but also there was no. Nothing good about it.
So, you know, I told off the president and he finally, he didn't have the, let's say, the guts to do it in person, but he told this other guy tell me I was going to have to leave. So I had no apartment. And I decided, okay, I'm going to find a place. I feel like I got to write about this. So I'm going to find a place somewhere in the world and I envision some Margaritaville or something. Go be a writer and then go have a margarita. But as it happened, I wound up in the very nice town of Sintra in Portugal for five months and wrote the big investment lie. So it was that that caused me to do it wasn't exactly an inspiration. It was just a reaction to. And I mean, I had seen this kind of thing over and over and over again, you know, BS about being beating the market just incessant. And so let's.
[00:04:34] Speaker A: So let's do two things. One is bring us on board with explaining in simplistic terms what is efficient markets. And is that part of why you. Part of your theory behind, let's say, the hoax behind investing or the investment lie?
[00:04:52] Speaker B: Yes. I mean, there's two things. There's the theory and there's the, I mean, veritable Everest high mountain of empirical evidence for efficient market theory.
The theory basically says, well, let's look at it this way.
A stock price is an estimate of the present value. This is an old theory, as you know, the estimate of the present value of future earnings or future dividends. And in order to calculate that estimate, you need to make a prediction of future earnings for decades into the future. So it is.
The price is a prediction of the future, and it changes over time because the facts known at the time change and they will change your prediction of the earnings and dividends. So trying to predict a future stock price is essentially trying to predict a prediction.
And if the prediction itself is very difficult, predicting a prediction that will be in the future based on information that you don't know now is virtually impossible. And that's why you can't tell which direction the price of a security of a liquid trade.
[00:06:35] Speaker A: Security predictions.
[00:06:36] Speaker B: Yeah, yeah.
There's no reason why you should be able to predict it. And there's particularly no reason why you should be able to predict it based on the past movements of that price. So that, that's the essence of efficient market theory as far as I'm concerned.
[00:07:00] Speaker A: So I'll share with you something that Fama said in one of our classes. Somebody asked him, oh, you know, Professor Fama, what do you think about, you know, artificial intelligence when it comes to day trading?
And Fama said, I think that all day trading is artificial intelligence. And of course, everybody, everybody immediately started laughing. But, but the, the debate that came after that was incredibly interesting because now keep me honest here because I'm going to put a few words in your mouth, okay? In essence, you're saying that it's incredibly difficult to be a successful day trader.
And what makes it kind of worst. And this you didn't say, but I'm adding it on. So please keep me honest. If you add on the commissions of active training trading, then it kind of brings you many times below market on average. So that's the statement I'd like to start with. I want to just make sure that we agree on this. Okay?
So an easy thing to say is, well, okay, let's just get rid of all the day traders because they're not making money. They're just, they're losing money for you. On average, some of them are doing well, some of them are doing poorly. On average, it's kind of market minus commission. So why don't we just get rid of all the day traders? And that was my thought. It's like, well, nobody should invest in this. And then Professor Farmer said something incredibly interesting and he explained how the day traders are actually the police force of the market.
And that just blew me away. I thought that was so interesting.
[00:08:31] Speaker B: Yeah, I don't really agree with that.
I don't think the person that I probably most agree with about these things is John K. I don't know if you know the name and tell us more though.
[00:08:47] Speaker A: Bring the audience with us.
[00:08:49] Speaker B: So, okay, well, John has written several books and we've corresponded, I interviewed him, I wrote We Met in Hong Kong.
And he's just a very, very astute fellow. And he has written some books about, like one, one that I think I reviewed called Other People's Money.
And I love it. I mean, he says, I think in that book he says there's a concept that's just completely overemphasized and that is liquidity. Liquidity is not really important.
And I think he's absolutely right.
You just don't need so many trades if you want to sell.
An individual investor and an institutional investor really should sell only when they need some cash, and they should buy only when they have extra cash that they want to invest in between. You should do no trading.
There's just no reason. That's essentially efficient. Market theory says that.
So what's the problem? If it's time to sell, you'll find somebody who is willing to sell to you. Because there's so many people also at the same time wanting to buy, you'll find somebody who is willing to buy. I mean, you'll have lots of options of people to sell to and you'll come to a reasonable agreement. You don't need all those extra day traders to make that agreement better.
I just don't see that.
[00:10:35] Speaker A: But if everybody, every single American, let's say, would go invest in indexes and nobody would trade at all, that would be a problem. I think that was really his point.
[00:10:44] Speaker B: I don't think it would be a problem.
[00:10:46] Speaker A: So how would the stock prices adjust if we just had an index?
[00:10:50] Speaker B: And by. Well, okay, this is, this is the thing. I mean, now you have to get into the nitty gritty because index funds are run by index fund managers and they do the buying and selling. And so they. I mean, first of all, no index fund is precisely the index and shouldn't be because there's no. This stuff about tracking and tracking error. That's just one of hundreds of bits of nonsense in the field there's no reason to track.
Exactly. And this was an insight of David Booth, none other than David Booth. And part of the reason why DFA did well, because he realized we don't need to track this small stock index so perfectly. We'll just wait until somebody is aggressive about wanting to sell to us and then we'll, we'll say, okay, we'll buy, because we probably will get an advantage that way. And they did. They made more, as David told me once, they made. They made more on this than he expected. They got a better, you know, small increment over the index.
[00:12:10] Speaker A: No, I appreciate it.
[00:12:12] Speaker B: Yeah.
[00:12:12] Speaker A: So in your book, you went through this experience.
What were the key points you basically wanted to bring to your audience?
[00:12:21] Speaker B: So in the book, I say, sauntering through the expensive, glossy outputs of the professional investment field, you may glimpse arcane, sophisticated sounding articles suggesting the discourses of an elite core of exquisitely knowledgeable experts.
Recent issues of Institutional Investor magazine, for example, and others like like it carries stories about portable alpha, separating your alpha from Your beta and other impenetrable themes. And these articles are full of mathematics. Yet in spite of the self serving message trumpeted to both insiders and outsiders by these arcana, quote we insiders are smart and extraordinarily capable. The actual fact is that professional investors do not do better than the random investment picks of a gaggle of monkeys.
[00:13:22] Speaker A: So we need to justify this a little bit. Yeah, tell us a little bit about the research that you were citing before about performance of these basically active investors.
[00:13:37] Speaker B: Well, some of it I've done myself not it wasn't published. I don't think it could be because I had, on two occasions I had access to the largest databases of investment performance. The first time it was institutional investment performance. That is because my first job was with AG Becker which had a. I was in the so called funds evaluation division and it was known for having the largest database of investment returns on pension funds, endowment funds, foundation funds, something called Taft Hartley funds, union funds, Iliam Oceanery funds. It had a huge database of funds. And then that was in the, in the 70s. Then later in the 1990s, I had access for another reason to a very probably the largest database of investment returns of individual investors managed by investment managers.
And one way you can tell, you can validate the random walk hypothesis is to see.
[00:14:55] Speaker A: Wait, hold on, bring us on board. And explain what you mean by random walk hypothesis.
[00:15:00] Speaker B: Yeah, it's simply that the past returns tell you nothing about what future returns will be.
And one way to check that is you say, okay, let's take the returns for the past quarter or year or whatever for a bunch of investment managers and let's divide them into, let's say two groups. The highest, the above, the 50th percentile performers, and the below the 50th percentile performers. And you ask, does that predict which ones will be in the upper 50% in the next period of time or doesn't it? And the answer is it doesn't. So you take the upper 50% of performers and then you see how many of them are in the upper 50% in the next time period and it turns out to be 50% of that 50% are in the upper and 50% in the lower. And the same thing with the poor performers.
There's no way to tell if they're going to be above or below median from whether they were in the past.
[00:16:23] Speaker A: The three simple rules of investing. So that with a title like that we can't ask the following question. What are the three simple rules of investing?
[00:16:31] Speaker B: Oh, the first one was narrow your options because there's so many. There's thousands of different mutual funds to invest in, more mutual funds than stocks, many more mutual funds and stocks. So narrow down your options.
Second is look only forward.
Don't look back at history. Don't look at history. And the third is screen out. Noise. Don't pay attention. All the noise.
It's simple. It comes down to like two or three index funds. And don't look at their performance because what's the point? Tells you nothing about what you're going to do later. And that's all you really care about. So think about what you're going to need in the future and what's going to be likely to fit that.
And then pay no attention to anything else.
[00:17:29] Speaker A: Let's talk about the pay no attention to anything else. What does that mean?
[00:17:34] Speaker B: It means that so much noise about investing that let's say, let's give it a whole lot of nines, 99.9999% of which you should completely ignore because it's completely worthless.
[00:17:56] Speaker A: I wanted to ask you for the younger audience that we have.
They're just working their 9 to 5 job. They're getting their salary. What would be some advice that you might give to the young generation looking to build their nest egg?
[00:18:12] Speaker B: The first thing they should look at, if it's possible, and it should be possible, and I think they should aggressively try to make it possible, is to find out what the fees are that they will be paying in that 401. Because about half of 401 s charge fees that make it more profitable to invest to pay the tax and then invest outside of the 401. You'll actually get a better after tax return doing that because of some of these fee levels. So that's the first thing to find out. If the total fees you pay by Investing through a 401 are more than 1% of your assets, it's probably worth simply except for the match, you should at least contribute up to the match. But beyond that, if the fee is greater than 1%, you might as well just pay the tax, take your money out and invest it in a personal account. It doesn't have to be any kind of tax deferred anything, just invest it.
So that's the first thing.
The second thing is they should invest as much as they can. If they're young.
If they're young, they should invest in the global stock market because they're not going to take the money out. They shouldn't take the money out for decades.
And if, unless economic growth truly stops somehow, which is very unlikely I think, because innovation continues, you can't stop it. And innovation does lead to profits. So it's very likely that the global stock market will increase in the long run. And you got a long run, you're young, so you have decades. So what they should do is simply invest in the global stock market. They can do this with like two index funds or even one, one index fund will do it.
And then they should forget it. They should keep investing like every month.
[00:20:26] Speaker A: Put more money in consistently.
[00:20:28] Speaker B: Yeah, put 1,000, 2,000, whatever they can and then pay no attention to it. And when the time comes they need the money, they will be very surprised because they paid no attention to discover how much they have.
[00:20:42] Speaker A: So I have a question. If times get rough, should I stop putting that money in? Not because I can't put the money in, but because the market is low?
[00:20:50] Speaker B: No, because the market is not necessarily low relative to the future. And you don't care. It might be low relative to the past, but all you care about is whether it's low relative to the future. And you don't know that. All you know is that it's likely to keep rising in the long run for the reason that I said. So you just keep doing, you ignore the market's level and you just keep doing it.
[00:21:18] Speaker A: Yeah, I thought that was incredibly interesting because there's a, there's almost a human psychology where people want to cut their losses and like, oh, if the market is low, I need to sell, I need to get my money out. But that, that could be a terrible mistake by, by doing that knee jerk reaction decision, couldn't it?
[00:21:37] Speaker B: Yeah, it's just wrong. It's completely wrong. They should, they should pay no attention to the market level and just keep investing every periodically when they. And I'm not talking about so called dollar cost average, which is not advantageous. I'm just talking about invest as much as you can.
[00:21:57] Speaker A: Michael, thank you so much for having me on the show today. I appreciate you.
[00:22:01] Speaker B: Okay, thank you very much.
