Great. So good evening, everyone, and welcome to the London School of Economics for this public event hosted by the Financial Markets Group. I am Christopher Polk, a professor of finance here at LSE.
First, a few words about the London School of Economics. words about the Financial Markets Group, or FMG. On the third weekend of October 1987, three important events occurred. A hurricane hit London that Thursday evening. Global markets crashed that following Monday.
Monday morning, and the FMG was established by Charles Goodhart and Lord Mervyn King. The first two events are certainly memorable, but the third is also quite important, as the FMG laid the foundation for the creation of what is now a world-leading Department of Finance here at the LSE. Indeed, the FMG has become a leading center for research on financial markets, as well as a focal point for the department's interaction with policy and practice like tonight's event.
Speaking of which, as a proud... proud former director of the FMG. It goes without saying that I'm delighted to chair this exciting event this evening. Tonight we have the pleasure of having Victor Hoganis speak to us on why I stopped picking stocks, the risk matters hypothesis.
Now Victor's going to speak to us about 35, maybe 40 minutes on ideas from his book as well as his broader experience working in finance, after which we'll be taking questions from the floor. Before I introduce Victor, a few administrative points. One, for those of you who are new Those in the audience on social media, the hashtag for tonight's event is LCHegani. Two, we have a photographer present and the lecture is also being filmed. Both photos and that video will be on the FMG website, subject to no technical issues.
If for any reason you do not want to be in those photos, please do let us know, but after the event. And then finally, I have it on good word that there is no fire drill scheduled for this evening. Thus, if you hear a fire alarm, please do leave the building via the mark. All right, for those of you in the know, Victor needs no introduction.
He's an LSE alum, receiving his B.Sc. in economics back in 1984, and then going on to have a quite remarkable career in finance. After graduation, he started at Salomon Brothers in New York as part of their bond arbitrage desk, famously depicted in Michael Lewis's book, Liar's Poker.
In 1993, Victor co-founded the legendary hedge fund, Long-Term Capital Management, and co-headed their London office. More recently, in 2011, he founded Elm Wealth to help clients, including his own family, manage and preserve their wealth through a novel approach he calls dynamic index investing. Now, Victor came back to the LSE in the early 2000s, joining the FMG as a senior research associate, and talking before the event, he said it was there and then when he put together many of his ideas underpinning Elm Wealth. He has been a prolific contributor to the finance movement.
literature, most recently co-authoring the book The Missing Billionaires, A Guide to Better Financial Decisions, which was named by The Economist as one of the best books of last year. Now, I don't want to steal Victor's thunder, but I do want to emphasize the importance of his talk tonight. For various reasons, there could be large gaps between what finance theory prescribes and what investors, even professional ones, actually do.
Tonight, as part of closing those gaps, Victor will delve into the hidden risks of a cost-free market and highlight that while investors may have... won on fees, they're losing on risk. Back in 1932, Keynes wrote that he looked forward to a distant future when economists would be, quote, thought of as humble, competent people on a level with dentists. Tonight is a big step in that direction, with Victor's ideas guiding all of us to make better financial decisions, humbly improving our financial hygiene.
Please join me in giving a warm welcome to Victor Hagané. All right, well, it's great to be here. It's a great honor. I never thought I would be coming back to give a talk after graduating from the LSE, but with a little bit of practice, here I am.
So what I want to talk about this evening is basically a conversation that I've had over a number of years with this person. This is my mom, Lucille. This is a picture of her on her 90th birthday back in May.
My mom is very active. She lives in the States in New Jersey. She's still driving and going to the opera and playing bridge. But, uh, She also has become a stock day trader.
She starts her day off. by putting in different orders into her brokerage account app. And then again, later in the day, she puts in more orders.
And she's trading. She's doing maybe 20 trades a day, which is 5,000 trades per year in her brokerage account. And what I want to talk about this evening is my conversations, more or less, with my mom as I've tried to dissuade her.
from doing that. And I should say, you know, my mom is very good with numbers. She's, you know, yeah, she was actually trained as an opera singer, but, yeah, she's got a good business head, but still, you know, I've been trying to dissuade her.
So, you know, the first thing that I tried to... Convince her of and to talk to her about is what's known as the cost matters hypothesis, an idea formulated by the founder of the Vanguard Index Fund Group, John Bogle. And it's basically this idea that if you take all actively managed stock portfolios and you combine them into one big portfolio, that by definition, that needs to be a portfolio of stock.
equal the market portfolio, right? That there's no other thing that that could equal than the broad market cap weighted index of stocks. And so therefore, if you take all of the active stock picking investors and put them all together, that the return on the average dollar in that portfolio is going to be the market return minus the costs of active investing.
This idea was kind of a riff or development on an earlier paper by William Sharp, where he termed it the arithmetic of active management in 1991. And, you know, this is a really simple idea that I tried to convey to my mom, and I think she totally got it. But, you know, and I even showed her a little bit of data where you can see that and Even if we take a subset of the entire stock market, so this is just U.S. mutual funds, then it turns out that over the last 10 or 20 years, the difference between the returns on actively managed mutual funds has been about 1% lower than the return of the index. This is a really well-known result and backs up that even though these mutual funds are not all of the active investors in the marketplace, that there are a broad enough group of them where you get this result.
So, you know, I told this to my mom, and she said, yes, I get it, I agree, but the costs matter, but my costs are zero. Don't you know that? I'm trading with zero commissions at my brokerage app. I was like, okay.
And, you know, here's a chart of the standard. stock and ETF commission rates from Schwab that show that right around when my mom started to do this day trading was right when Commissions went to zero and in fact what happened was my mom never day traded before that but sometime around 2019 her full service stock broker told her that she could open a Separate account with that broker that would have zero commissions and she could do all the trading that she liked so That's how that whole thing got started. So, you know, it really got me thinking about this question more broadly about what's been going on. I mean, we know that there's been a huge move, a huge increase in low-cost index funds that are used by investors.
But at the same time, you know, we've really seen a tremendous growth of... of retail trading activity. It's hard to pick up the paper without hearing about, you know, some corner of the market where people are going crazy with their activity. And it kind of became clear that, you know, what's happening is that there's a certain desire out there for people to punt things around. There's a certain kind of speculative, you know, emotion that goes through.
a lot of people. And it's so strong that people actually get up and go to places like Las Vegas, and they go into these casinos, and they know that the odds in the casino are against them. That most people that play a slot machine, or play blackjack, or whatever it is, they know that the odds of them winning are... that the odds are against them and that they're expected if they play long enough that they'll lose. But they still just enjoy it so much, the overall experience, that they get up, they go there, they lose money, they come home, and then they go back again.
Well, here what we've got with zero commissions is what appears to be a positive edge gambling opportunity that you can do from the comfort of your own home. And so it's kind of clear why... This has really taken off how things have really changed since we've gotten into this zero commission zero fee world that that and a lot of people have been talking about I mean imagine you know how attractive and addictive these these these these opportunities are and then you sort of say okay actually you can do them and expect to make money I mean it's like you're just you know pulling my mom out of her chair When she's doing her day trading, it's impossible.
She's locked in there until her trades have been executed and she can enjoy her day and then put the trades in at the end of the day. And, you know, this is like on the left here, we have a this is what a brokerage account homepage looks like on the left. And on the right, we have a sports betting app.
I mean, you can see that they're really sort of channeling the. very same types of ideas between them. It's kind of something that we know that some of the crazier excesses in this, like the confetti at Robin Hood has been toned down, but still, this is a shot of Robin Hood from just a month or two ago.
It still has that same sort of look, doesn't it? So what we're seeing is that even though you might expect that with index funds getting bigger and bigger and so much money moving towards indexing, shouldn't we have thought that trading volumes might go down as more people become index investors? But no, what we see is that trading volumes have continued to just monotonically pretty much go up. And when we look at options trading volumes, that's even a stronger picture where where options trading volume has more than doubled in the last five years. It's more than quadrupled in the last 10 or so years.
And what are people trading single stock options for? What are they trading calls and puts on all these different single stocks for other than, you know, it's a really, really big bang for your buck and again, zero commissions. And so, you know, I think that in this zero fee this zero-cost trading world that we live in, we're getting all of these things that we haven't really seen before. You know, the meme stock craze, single-stock ETFs, leveraged single-stock ETFs, zero-day-to-expiration options absolutely exploding, structured notes getting bigger, you know, just all of these different things, the SPAC craze that came and went. I think all of it is kind of related to...
is somehow a manifestation of this zero-fee world that we live in. So I go back to my mom and I'm like, okay, so the cost matters hypothesis, you got me on that one. I think the insight there that all active portfolios aggregate to the market portfolio is something that's important, but okay, your costs are zero, fair enough. But mom... Who's on the other side of your trades?
It still is, you're still engaged in a zero-sum activity, right? That whatever trades you're doing, somebody has to do the market portfolio minus those trades. Somebody has to have the mirror of your trades.
Do you think that you're going to do better than the person or the people that are on the other side of you? And, you know, it's kind of like saying... Do you think that on the other side of you might be somebody like this, or it might be guys like these that are on the other side of your trades?
Do you think that you're going to profit relative to these highly capitalized, highly organized pools of capital or not? And of course, you know... The picture of those guys is kind of the tip of the iceberg when it comes to the smart money out there that we hear about. I mean, probably some of these names are unknown to you in the audience, although other ones have become more current.
I mean, just in this table alone of about 50 names, you know, I would come up with a rough estimate that this represents about $500 billion of trading capital. capital and from what we hear this trading capital is taking out something like a 25% return per annum that's 125 billion dollars that really adds up to a lot of money that is being being sucked out of the non-professional day trading or stock picking community. But my mom says to me, OK, what do you mean? OK, they can make money and I can make money.
I own NVIDIA on Monday. Somebody else owns NVIDIA on Tuesday. Somebody else owns it on Wednesday. We can all make money. I'm like, yes, but you're not making as much money as you should when the market goes up.
But she's like, no, I'm making money. What's the problem with that if I'm making money? So I'm still not quite getting there, but I'm making some progress.
So I say, OK, mom, let me show you something else. Have you ever thought about this? You're a day trader.
So generally, you're buying. at the beginning of the day some stocks, and at the end of the day, you're putting in your orders to take your profits and sell. I said, are you aware that over the last 30 years or so, that almost all of the return of the U.S. stock market has occurred from the closing bell of the day to the opening of the next day? And that if you just own the stock market from the opening bell at 9.15 a.m. until 4 p.m.
when the market closes, that over these 30 years, you would have basically made no money at all. And actually, if you had owned an index of smaller cap stocks, which a lot of retail investors trade in, you would have actually lost 86%. And this is over the last 20 years, you would have lost 86% of your money from the open to the close in that kind of day trading relative to what was made in the overnight, that you would have made 42 times your money in the overnight, but you actually lost 86%. 6% of your money in the daytime as a day trader.
And here's a couple of other pictures that it's not just that, obviously, it's not just at the index level. To the extent that it's at the index level, it's even stronger at the individual stock level. So NVIDIA, for instance, in the last 25 years, you would be down 44%.
You would have lost 44% of your investment. Could you imagine saying, I bought NVIDIA, and without transactions, because I bought NVIDIA every morning, I sold it at every... closed. I was long it for the last 20 odd years. Guess what?
I'm down 44%. And the guy who owned it in the overnight was up 450 times his money, right? I mean, it's just, it just is, it's insane.
You know, the same with Apple, even stronger with some of these other stocks. So, you know, I'm working on my mom. I'm trying to get her to kind of see the light and say, here's some more evidence, mom. Here's a study that was done that was looking at people that had accounts at a discount broker.
This was actually... at Schwab. These two professors, Barbara and Odin, looked at about 70,000 accounts there and analyzed how they were doing trading-wise, and they found that the most active traders were underperforming the market by 70,000.
6% a year. I mean, that's a huge number. And we also have other research. I mean, there's a ton of this research out here.
This is just two pieces. Morningstar publishes, every year they publish a report that's called Mind the Gap, which talks about the difference between fund returns and investor returns. It looks at if you put a dollar into a particular fund, how would that have grown if you just left it in there?
That's the fund return. And then the investor return is looking at all the cash flows going into the fund. fund coming out and looking at the IRR of those flows.
And it finds that if you look at all the mutual funds out there, that for the last 10 years, investor returns were over 1% lower than fund returns. And in some cases, it's unbelievable. Like, I don't know if you've heard of ARK, the ARK, Cathie Wood's ARK investment vehicle. If you invested in that, the fund return from inception over 10 years ago, the fund is up. up like 8x, but investors have net lost several billion dollars because some people invested at the beginning, but a lot of flows came in after she had made 40% returns for a number of years.
They invested at the top, then things didn't go so well, people pulled their money out, and et cetera. So investors have actually had a negative IRR in her vehicle. It's not saying it's her fault, but this is the difference between fund returns and an investor. investor returns that we get from active investing.
Well, you know, starting to be a pattern here with my... mom, but I don't know, maybe I'm kind of softening her up a little bit, I don't know, but I'm kind of getting a little bit exhausted at this point, and there's like a gap in the action as I try to catch my breath again. I'm feeling pretty exasperated by the whole process, and meanwhile, you know, she's actually telling me, she's asking me how am I doing on my investments, and she loves to tell me that her return is higher than my return, and it's going on.
And I'm talking about, talking to people about, you know, I'm telling people about this, you know, and they're saying, geez, you know, I have an aunt who does this, or yeah, my mom does this too. And I just want to try to find a way of convincing her that it doesn't make sense. And so a lot of people are thinking about this.
And I guess at some point, you know, I was really thinking about it a lot. And I was like, okay, you know what, what's missing from all this conversation from the cost matters hypothesis from thinking about who's on the other side of of your trades, is what's missing from all of this is a discussion of risk. So the question is, you know, like, how does risk factor into all of this?
Well, we know that in general, people should be risk averse in that the more wealth that we have, each extra dollar is making us happier, but at a decreasing pace. The decreasing marginal utility of wealth is a pretty standard idea. You know, you can think about it in terms of, you know, what would you prefer? A a 10% guaranteed return or just a 50-50 chance of minus 20 plus 40 that has the same expectation as 10%. You know, I think most people, maybe everybody in this room, would prefer the 10% guaranteed return, in which case risk matters to you as it should.
And so for a given amount of risk, we should want to get the highest return that we can get. Or stated in another way, we want to maximize... are expected risk-adjusted returns. And hopefully this is where I'm going to get my mom eventually.
But I talked to her about it, and she's like, yeah, it kind of sounds good, but, you know, tell me more. So I say, okay, let me give you an example. Let me give you a toy example of this to think about. So I say, okay, imagine, well, in my mom's case, it was a million dollars, but for the audience here, we're going to pounds. I say, imagine you've retired, and you have a million pounds of...
savings. And you invest it in a portfolio that you feel really good about. It just happens to be a relatively high risk portfolio.
So it has a 5% annual expected return, but it's got 30% risk. So it goes up and down by 30%. Either one year it goes up 35%, the next year it goes down 25%. So it's averaging 5%, but it's pretty risky. But you know that you're going to make this 5% average over time just with these fluctuations.
And so you decide, okay, well, if I'm going to make 5% on my million pounds, I should be able to spend 40 pounds a year, and all of this is adjusted for inflation. So the return is 5% after inflation, and the 40,000 pounds, I'm going to grow that with inflation too. So I should be able to just spend 40,000 pounds a year, right, if I'm making 5% on average.
So the question is, if I do that, what is the most... most likely amount of wealth that I'll have after 25 years. Is it about 1.3 million pounds, which would be basically I'm making 5%, but I'm spending 4%. So if I grow a million pounds for 25 years, it compounds up to 1.28 million pounds.
Is that the answer? No. The answer is zero, that after 23 years, I'm bust.
And why is that, right? So we can see it here. Here, you can look at the table on the right. What's happening is basically this volatility is dragging me down.
To go up 35% and then down 25% doesn't leave me with 10% more wealth. It doesn't leave me with 5% and 5%. I'm actually pretty close to zero.
My compound return under that case is more like 1% a year. So I can't eat as... I can't eat my expected return. I have to eat my compound return effectively. My compound return is much lower.
And you can see that there's an acceleration here where I'm getting to zero capital really, really quickly. But if I had that same 5% expected return, but the risk was much lower, say it was just plus or minus 10% a year relative to the 5%, so one year I go down 5%, the next year I go up 15%, and that averages out also to 5% a year. year.
In that case, I'm fine spending the 40,000 pounds adjusted for inflation over time, as you can see there. So, you know, I showed this to my mom and, you know, started to soften her up a little bit. But what it really did is it kind of led me and my co-researchers to come up with an idea of the risk matters hypothesis. And basically, we went back to to the Bogle cost matters hypothesis and realized that, again, if we take all of the stock picking concentrated portfolios and we put them all together into a big bucket, they're going to equal the market portfolio in composition, right? That's just an identity.
So the question is... Is it possible that the risk, that the average risk of all of these portfolios could be lower than the risk of the market portfolio? And here's where we realize that we've never seen that result calculated before, but it kind of intuitively seemed to us that no.
I mean, any way that you break up that portfolio, that it has to have a higher average risk across all of those subportfolios than the market portfolio itself. So we posited that, we thought about it, I'll show you a simple proof of that in a second, and that is the case, that the average risk across any subdivision of the market portfolio is higher than the risk of the market portfolio. So in that case, we know that the aggregated active portfolios is going to give us a return equal to the market return, but the risk is higher.
So no matter what, the risk is going to be higher, the return is going to be the same. So even if fees and trading costs are zero, we know that the risk-adjusted return, the return that we care about, the risk-adjusted return, on average across all of these active portfolios, is going to be lower than the risk-adjusted return of the market. And I think this is one of those ideas that is so simple that nobody bothered...
to write it down. And I think that Sharp and Bogle kind of felt like all we need is the simple arithmetic on returns in a world where costs of active management were high. And so they didn't come to this corollary of the same idea and write it down. And what's really quite remarkable in this case is that if you think about the fees of active management, right, if there are fees and costs associated with active management, all of that is zero-sum, right?
It's like somebody's paying a fee to somebody else. And so there's no deadweight loss in the system. But here, this is a negative sum. Instead of being a zero-sum activity, when thought of in this way, we have a negative-sum activity, right?
That everybody in aggregate is worse off with nobody else getting a commensurate payment to make them better off. And so... Um... I think it's a really cool idea.
And here's a simple proof of it. You know, if you, if we, my mom thought, my mom also thought that this was not a simple proof. But, you know, here's a pretty simple proof of it where you just think about everybody's portfolio of express, try to express everybody's active portfolio as being the market portfolio plus a portfolio of deviations relative to the market.
So what I mean here by sigma A is the risk of the deviations, is the risk of the portfolio of deviations from the market portfolio. So then we can say, okay, so every active portfolio is going to have risk equal to the market risk plus this active risk that they're taking, this deviation risk, plus the covariance of the... of the active and the market risk, fine.
But now we know that the only way to get back to the market portfolio is if I'm going to have this concentrated portfolio of 100 stocks equally weighted or something like that, that somebody else has to hold a portfolio that combined with mine gives us the market portfolio. So there's a mirror portfolio that's held by somebody or by some bodies out there. And that mirror portfolio has the same kind of risk set up. As my active portfolio, except here the covariance is getting subtracted.
So when I take my portfolio and the mirror portfolio and I put them together, the risk of them has to be higher than the risk of the market portfolio unless these deviations have a correlation of one with the market portfolio, which would be a limiting case but is not. you know, is not something that we would expect to see. And you might say, well, but what about if there's a whole bunch of people, you know, that have, here's my active portfolio, and there's a hundred other active portfolios over here that are summing up to equal my, to be the mirror of my portfolio. And what we can do here is we can just keep taking this down the chain, right?
So now we've established that my portfolio plus... the mirror portfolio has more risk than the market portfolio. So now we can come in.
into this mirror portfolio and do the same thing. We can say, take somebody that has an active set of bets relative to the mirror portfolio, that that person plus everybody else has a higher risk on average in the mirror portfolio, and we can... keep going down the line and get this inequality. We can show it more directly as well, but maybe this is the easiest way to see it.
But I wouldn't say exactly that my mom took that one on board quite the same as the others. So, you know, in the same way that we tested the cost matters hypothesis in one of the early slides, we can also test this hypothesis a little bit just to see whether it's generally consistent with reality. And so here what we can do is we can say, look, let's look at the S&P 500 and look at what its risk has been, say, over the last 10 years. So the S&P 500 had risk of 16.6 percent, measuring it as the annualized. the annualized daily changes as a standard deviation of returns.
And we can look at the risk of two pretty diversified other mutual funds by Vanguard, a growth fund and a value fund, which between them own a little bit more stocks than the S&P 500. They own 542 stocks, but they basically are owning stocks that are the complements of each other. Right? That if you put these two funds together, it basically gives you back the S&P 500. And guess what? One of them has a higher risk. The growth fund has had a higher risk over the last 10 years.
The value fund has had a lower risk, but they average to be over 1%. more risk than the S&P 500. And we can look at another 15 or so of these just somewhat randomly pulled just looking for big, I was looking for some big and low cost and diversified funds. And you can see all of the red here means that their risk is higher than the market portfolio.
And the average of them all together is about 1.2% higher. or 1.3% higher than the S&P 500. We can also look at the mirror portfolios of all of these to really get back to the market portfolio, and the mirror portfolios would have had 17.7% risk, roughly the same. that we've kind of chosen a set of mutual funds that do kind of aggregate back to the market portfolio to some extent.
So, you know, it kind of indicates that... indicates that, yeah, even when we're starting to cut up portfolios into a couple hundred stocks, we're not getting back to the market risk. And so, you know, I would say that even holding 185 or 200 stocks is not necessarily enough diversification to take you back to the market.
And, you know, probably some of you are aware of some research that's come out of, from a professor in Arizona State University, Hendrik Bessenbeiner, where he He's looked at the return on all U.S. stocks that have ever existed in the CRISP database, and he has found that it's just 4% of all public U.S. companies that give us the outperformance of U.S. stocks relative to Treasury bills. And the other 96% of stocks just equal the return of Treasury bills. And so it really kind of makes it apparent why... stock picking is so difficult to match or beat the market when 96% of stocks are not doing that. And of course, John Bogle talked about this with his famous saying of, why look for a needle in the haystack, just buy the haystack.
So with this idea of thinking about risk as a cost or part of the cost equation, we can think of risk, we can convert risk into a fee. So we could ask ourselves, like, okay, we're looking at those mutual funds, and they had about 1.3% higher risk than the market risk. More concentrated portfolios would have a greater amount of active risk relative to that. So we can say, look, We could either, we could have a return without paying any fees at all, but it's a concentrated portfolio. So we have market risk plus a certain amount of extra risk, this active risk.
Let's say that we have a 5% expected market return. The market risk is 16%, and we could have, say, 2% extra risk, which would be roughly what you'd get with just random portfolios of 25 to 30 stocks. And we could say... we could try to re-express that to help people to think about it more directly and tangibly.
We could say it is the same as owning the market portfolio and paying a fee, but having the risk of the market portfolio. So here we can say the equation gives us a half a percent per annum fee is the same as an extra 2% risk, or like 35 basis points of extra fee would be the same. as the extra 1.3% risk that we had when we were looking at all of those diversified mutual funds. So, you know, I felt that by trying to reimagine risk in terms of being a fee-equivalent amount of risk, that that would get my mom thinking a little bit more.
Here's just the formula that you would get if you solved the equation above, that the fee is higher the higher the return of the market is. And the fee is, and of course the fee is, this risk equivalent fee is higher the more active risk that you're taking. So how much does all this matter? You know, like, is it a big deal? You know, how should we think about this?
Well, you know, we're kind of saying that active investors having concentrated portfolios, I don't know, maybe on average we're... we would say that the fee equivalent of that is a half a percent a year. If on average investors were holding stocks, maybe 25 stocks, on average sometimes owning more diversified portfolios, very often we read about people owning one or two stocks in their portfolio and having a lot more. Going back to our slide on the professional traders and how much money they're taking out of the market each year, maybe there's a half a percent expected cost from the other side. So, you know, trying to come up with a number, maybe active stock picking investors are spending or are getting 1% lower returns than they should from these two components.
And that could be a really big number. I mean, in the U.S. market, this could be a couple hundred billion dollars per annum that is being left on the table with all of this active trading that people are doing. That's like. you know, close to $2,000, $3,000 per household.
Maybe it's $5,000 even per household that's invested in the stock market. And, you know, maybe 1% doesn't seem like that much, but if you think about just what is the risk-adjusted return of owning stocks to begin with, that, you know, that's probably only a couple of percent a year. So people are losing half of the benefit of being invested in stocks on average. by not thinking about risk and all of the costs of active investing.
So let me close with just a few ideas or thoughts or discussion on what we can do to try to help with this situation, try to help people to get better outcomes. The first is that we need to increase awareness. We need to get people to be aware of how much risk matters in their investing.
Risk is not, you know, I mean, as I showed with the slide of spending 40,000 pounds a year, risk has a really tangible impact on our outcomes. And managing risk and keeping risk or trying to get the highest return you can for a given amount of risk is really important. So getting people to think about not just return, but risk and is really important.
Getting people to Think about their outcomes as risk-adjusted returns is very, very important as well. So my mom is basically looking at her brokerage account, and she keeps telling me, look at my brokerage account, Victor. I'm making money, right?
They're not showing her her risk-adjusted return. They're not doing anything like that. They're just saying, here's your... And they're not even really telling her true P&L because what she's looking at is her realized profit.
So she has some unrealized losses over there. She's like, I'm not going to look at those. This is how much money I've made this year already.
So they're making it really tough for users of these brokerage accounts to see how they're doing. And then finally, I think... I think also just nudging people in the right direction where possible is also very effective. Other people might think that there are other solutions in terms of regulation or a Tobin tax on transactions and so on.
I actually think that these three responses to the situation, if really taken seriously, will do the trick. And, you know, in terms of awareness, right, there's books, there's podcasts, there's all kinds of ways of just making, of trying to help with financial literacy. And, but in terms of the metrics, I think the metrics is really where we can help people. That it's, you know, you go to Vegas, and I'm sure a lot of you have walked into a casino, and there's these slot machines, and the lights are flashing, and it's going crazy, and you really want to...
have a little flutter at the slot machine. And you can look, everywhere you can look on that slot machine, the one thing you will not find on that slot machine is what are the odds of you losing money or making money when you put a dollar into that slot machine. You put a dollar in that slot machine, it costs you 7 cents on average, 7% from every time that you pull the lever.
Why is that not required to be on the slot machine? Well, I can tell you why that's the case. It's because Nevada basically views its job as taking money from the other 49 states in America.
You know, that's what they're, you know, I mean, obviously, you know, this is good for Nevada. The more people that come and play the slot machines, it's good for Nevada, but it's unacceptable. It's unacceptable to not disclose to people what they're getting into. And just as it's, in my opinion, just as it's unacceptable to not be disclosing the odds on these games of chance, why is it that you go, I mean, imagine if when you went onto the sports betting site, it said to you, by the way, the only people that we allow to bet at this site are people who lose money, right? Like, that's what it should say as soon as you go there, right?
Because if you are a user of a sports betting site and you make money, you know what they do? They shut your account or they limit you to a de minimis amount of betting. Why don't they just come right out and say it like, hey, you know, you want to bet here? Well, we only accept losers.
So you're welcome. I mean, why are we not requiring this kind of disclosure to help people make better financial decisions? So here's just a tiny mock up of something that that that that brokers could be required to disclose.
So let's say that, you know, you were. You know, you could have invested in Tesla or Meta or the S&P 500. Well, over the last 10 years, Tesla and Meta have done great, making 25% or so returns, double the return of the S&P 500. And if you invested in Tesla, you would have grown your money 10x and Meta 7x and the S&P 3x, right? But the risk of these different investments was really tremendously different.
The Tesla bounced around. by almost 4% a day. 56% was the annual standard deviation of returns. Meta was over two times as risky as the S&P 500. So we have to have a way of showing people their results after the cost of risk. We need to be able to show people the risk-adjusted returns of their investments.
Well, here's a simple formula for the cost of risk. There's ways that the brokers could easily do this. And you can see that the cost of risk of Tesla would have been huge if you had all this is assuming that you had all your money invested in one of these three investments.
And so the risk adjusted return of Tesla was actually negative over that time, whereas the S&P 500 was higher than than both of them or even it was higher than even 50 50 and Tesla and Meta. So I think there's so much more that we can do to help people. to get to better decision-making, taking risk into account.
And, of course, nudges have been really successful. There's a lot of nudging that goes on in defined contribution pension and savings plans. And so we have seen, I think this is really encouraging, that we have seen market cap weighted and index funds, low-cost index funds in general, actually overtake the amount that's in actively managed mutual funds in the US and that's a trend that's going on. Everywhere.
So in sum, what I have to say to my mom is obviously as costs matter, the other side of your trades matters a lot, and risk matters a lot. And so what I've come to sort of... is that I've got these two moms. I've got the bull market day trading mom on the right, and I've got the market cap indexing mom on the left.
And I think that what I'm really hoping for, and I think that my mom has accepted, is that the market cap indexing mom has become the... the predominant part of her portfolio. So anyway, happy birthday, Mom. And I'll stop here, and we'll have questions.
Thank you. Thank you very much. It's been really fun. Thank you.
You'll let my mom have a little more air time. Absolutely. Wow, that was fantastic. Thank you so much, Victor.
And so we'll take some questions from the floor. We have plenty of time for several questions. I know there must be a lot of those out there. So what we'll do is we'll collect them in threes. when I recognize you, please wait for the mic to come to you.
We want to make sure we can hear you. Certainly before you begin your question, state your name and affiliation so we know who you are. And then, of course, try to keep your question brief and a question.
So let's begin. Yes, gentlemen, the person with the hand up there. Thank you. Stefan Güter, alum and visiting fellow.
Victor, very convincing. How do you deal with global asset allocation and asset allocation between different asset classes, for instance alternatives or bonds versus stocks in this paradigm? Okay, great.
Maybe we have another. Yes, the person, one, two, three, four. With the grey coat on, the person, yes.
Right there, excellent. Thank you so much, Victor, for this insightful lecture. I'm a history student at King's. So I had a small question about Thomas Phelps'books by a hundred baggers top.
and whether you thought it had something consistent with what your theory is. You're talking about the relationship between risk and returns of investments. Okay, and maybe one more. Yes, the person in the grey coat. there.
Excellent. Thank you. Hi. Thank you very much.
Ildar Davletian from Hidden Valley Gems newsletter, private investor. Actually, if I may too, but you can pick one. So there is talk that the S&P is much more concentrated today than 10 years ago.
So how do you take this into account when you deal with risk concentration of the index? And then secondly, you mentioned, I think, Warren Buffett as well. Would you not say that volatility is the price that investors have to pay?
So you If you don't have to sell tomorrow or in three years, but you can hold a highly volatile stock for like 10 years, you actually can achieve better returns if you have patience and long-term view. Thank you. Okay, great. Victor?
Okay. So, yeah, the first question from Stefan, that's a great question, is, you know, okay, we need to define the market portfolio in some way. And, you know, actually in Bill Sharp's paper, he says, okay. this arithmetic holds given a reasonable definition of the market portfolio. But I think that there are some real challenges with defining the market portfolio.
There's lots of things that are either uninvestable or very difficult for people to invest in. And my feeling is that as an individual investor, I want to invest in things that are liquid, that are low cost to invest in. and that represent really, really big asset classes. So for me, I'm pretty comfortable limiting my family's investments to the global public stock market and maybe skewing it a little bit to also try to be a little bit representative.
of the private equity markets as well. Have a little bit of exposure, realizing that commercial real estate is a huge asset class as well, but is mostly privately owned. So having a little bit of extra exposure. for commercial real estate in there.
And then, you know, kind of being willing to miss out on a lot of, you know, pretty big asset classes. But I think that the, you know, the idea is, you know, choose your market portfolio, depending on what kind of an investor you are. If you're an institutional investor, you might be able to encompass more asset classes in what you're doing. But once you define what your market portfolio is, then, you know, invest. accordingly from that point onwards.
And yes, there is segmentation between different markets. I think that it's reasonable to think about the expected return and risk of the U.S. market as one thing that you could invest in and think about European equities and their expected return and risk as another market. Maybe emerging markets and Asia-developed markets could be others, where it's a broad enough swath of companies and there's enough segmentation. in terms of home buyers, that you could actually have a reasonable expectation that returns, expected returns, could be different looking forward on those.
But I think also if you just treat the whole global market portfolio as one big asset class, you're getting well over 90% of the way to a really efficient, good portfolio. Oh, I have two other questions, right. So the King's History student, I didn't quite get the question fully, that you were asking about stocks that go up 100x. Yeah, so look, I mean, so, you know, I think what's interesting in these Bessem binder results that, you know, where I was saying that 4% of stocks have represented all of the... outperformance of US equities versus Treasury bills.
Is there something like deep, subtle, or you know that needs a lot of explanation there? Or is it simply the case that any stock can go to zero or it can go up a hundred X? It can't go down 100x. It can only go down 1x, right?
So we know that stock prices are what we call log-normally distributed. So if stocks on average have a volatility per annum of around 30 or 40%, which is roughly what individual stocks on average have, we should see exactly what Bessem-Binder found, which is that most stocks, because of that volatility, because they can go up infinitely much, but they can only go down to zero. that we're going to see each individual stock having a distribution where most of the probability of returns is low and is bad.
And the higher the volatility of the stock, the more is the median or most likely return going to be poor and offset by a small probability of 100x return. So it's all very natural with regard, what we see is actually very natural. naturally explained simply by the log normality of stock price distributions. But, you know, one of the things that we also talk about in the book is that, and this comes to, this is going to tie into the third question that was asked, is that there are different kinds of risk, right?
So if I am a long-term investor and what I care about is the long-term income stream that my... my wealth can generate because that's what I'm going to spend. You know, I don't care how much is the present value of my wealth. I care about how much can my wealth be converted into as a long-term cost of living adjusted annuity over my life, my kids'lives, or whatever the horizon might be.
And so if I have this long-term horizon, I really don't care about changes in the discount rate, right? I don't really care about changes in how future earnings of stocks or future future coupons on bonds are discounted back to today. I just want those coupons or those earnings or those dividends. And with individual stocks, so much of the risk is real risk, is the risk of the company doing great or the company doing poorly. Whereas when I invest in the overall stock market and I diversify away a lot of each company's idiosyncratic risk, what I'm left with is a larger fraction of the risk that I'm taking in stocks.
is actually coming about from changes in the discount rate, which I actually don't really care about that much. So there's also that between individual stocks having these huge risks and huge potential returns versus investing in the market index. And then, Ilda, your question was about concentration. Well, you had two questions.
One about concentration, and the other was about volatility. being the price that we pay for the expected return of investing in the stock market. So let me start with the second part of your question exactly, that it is stock market risk. It's the risk of our economy. It's the risk of financial crises, et cetera, that are the risks that we care about as investors, the risks that we care about as people that are trying to turn our wealth into future consumption.
consumption. So this is the risk, this is the fundamental risk in our economy, which gives us a higher expected return for taking on those risks. If we just think about a very simple, you know, in the simplest depiction of an economy with agents who are risk averse, and with an economy that is expected to grow but has risk, the assets that we're going to turn into consumption, the risk of them that that we can't diversify away from is is that which gives us this higher expected return for bearing that risk. But it's important to realize that that risk is real risk, and you can make your horizon as long as you want. If you have that fundamental consumption risk, that taking it for longer periods of time, even though your probability of coming out on top gets higher and higher, that the...
that the cost of that risk to you is not changing sort of per annum as you go out, that the cost of the risk is proportional to the variance of the riskiness of that outcome. And so it's also going up with time in the same way as the return is going up with time. So I think there's a lot of misunderstanding in the investor community that says, well, if I have a 100-year horizon... Owning equities is a no-brainer.
I want to own equities because to a 100-year horizon, I have a 99% chance of making more money than on bonds. But no, in a simple framework, that risk is aggregating with time linearly, and the amount that we want to invest in stocks should be invariant. with Horizon in a simple model like that, in the simplest kind of model. But again, the risk that we care about is this real underlying economic risk that would hit our consumption, that would put us out of a job, that would make our home prices go down, et cetera.
And then on your other question about concentration, it's true that the biggest companies today are bigger relative to the average. to other companies than they were in the last 10 or 20 years. Actually, there was a time not that long ago, I think it was in the 70s, when the amount of concentration in the indexes was similar to what it is today.
But the only thing that we can all own is the market portfolio. So to say that these companies, that the S&P 500 is too concentrated and I don't want that concentration and so I just want to have an equal weight investment in the S&P 500 is forcing somebody to... to be on the other side of that bet? And why do we think that the person on the other side of that bet is making a bad bet and that I'm making a good bet? So we have to live with that concentration.
It's just the manifestation of these companies having grown really large. You could think of them as being multiple companies all wrapped up into one. But I think that the concentration concern is somewhat misplaced in today's market. And, of course, the concentration of these stocks is half as big. big in a global portfolio.
So yes, the biggest US stocks are a really big component of the S&P 500, but once you look at all 15,000 stocks around the world that you could invest in in a market portfolio, the... concentration of those biggest stocks is a lot smaller as well. Great. Why don't we have another round of questions?
Yes, the person in the black shirt. You were quick with your hand. Right.
Yes, yeah, G, I'm a commodity analyst at a firm. A lovely lecture, by the way. I just want to ask you, have you ever investigated control? So you looked at day trader returns.
Have you ever controlled those returns? for levels of sophistication. So compared to your mother, you would be a more sophisticated trader and be more, I think as others mentioned, be more willing to trade more exotic assets like commodities compared to your mother.
your mother and have you incorporated that analysis in in your analysis i guess okay thank you um yes the person there with the pink shirt uh hi habib subjali uh class of 86 i guess um thank you that was fascinating as a practitioner i do find this really interesting uh but and i can see we've seen the rise of passive and people just buying the market you and that trend is increasing. But as that continues, what about efficiency of pricing of individual businesses in capital markets? It would be fascinating to hear thoughts on that. Thank you.
Thank you. Let's see. Why not? Let's take that one. Great.
The man with the white lettering on his shirt. Thank you, it was terrific to hear about your mum. I went to university with lots of young people. I was interested to know what advice you would have for young people starting out on their careers and their saving strategies for their lifetime. Okay, great.
Okay, I got them. So the first question was whether, I don't know, maybe the question was, you know, what if my mum were... more diversified with her day trading, you know, what would that look like?
And, you know, I think that the, you know, at the end of the day, if my mom is swimming around with those mostly bald-headed guys, that we're in that picture, she's going to do worse than she should do. She's not getting the returns that she should get commensurate with her risk. So I think that, you know, until she's in the market portfolio and until she stops being... an active investor in that way, that her risk-adjusted returns will be a little bit lower, maybe a little bit lower if the day trading mom stays nice and small relative to the index mom. But it's kind of inescapable.
You know, it's inescapable that there's this deadweight loss from not being as diversified as she could be and also from swimming around, even if her costs are zero, from swimming around from some people that are awful. good at consistently extracting a lot of money from the marketplace. And then Charlie's question was about the rise of indexing and market efficiency and there's been so much talk about this question and you know people love to say you know what if we get to a point where indexers own all of all of stocks completely what's going to who's going to make prices anymore and and but And by the way, the chart that I showed of index funds versus actively managed mutual funds is really, is not even the whole picture. That there's a lot, there's some recent research papers that is indicating that if we look at who owns different stocks in the U.S., let's say, you know, we see Vanguard, we see BlackRock, we see State Street. And we add those up and we're like, wow, look at that.
You know, in general, the market is like 18 percent owned by index funds or indexers. But actually, you know, there's there's reason to believe that indexing is much bigger than that. We could be close to maybe just under 40 percent of stocks are owned by by pretty diligent, diligent index trackers and index funds.
You know, in the extreme, if stocks were fully owned by by index funds, I think that we would still have plenty. of price setting by active investors who can run long and short portfolios. They bet long on this stock, short on that stock.
We're still... really far away from it. But I think there's this question out there that gets asked and answered a lot. Is the growth of indexing making the market less efficient? And Cliff Asness at AQR recently wrote a paper where he says that, look, you know, I started, I don't know, he started in the early 90s, I think, in the industry.
And he said he thinks that the markets are less efficient today than they were when he started. And he puts some of it down to indexing. But He has this interesting definition of market efficiency. How should we measure market efficiency? The way that Cliff likes to analyze it is Cliff says that...
To what extent do prices represent or reflect reality or fundamentals? Well, gosh, how does anybody know what those prices are? Well, Cliff says, you know, Cliff has valuation models for all the different stocks out there.
And he says the stocks are further away from Cliff's reality than they were, you know, earlier on. But from... I would have a different definition of market efficiency. To me, market efficiency would be how hard is it to beat the market?
How hard is it to generate alpha? And, you know, in my experience and from what I see out there, I think it's become harder to beat the market today than it was when I got started coming out of the LSE in the mid-'80s. I think it's harder today. I think the ante is much, much bigger.
I think it's more difficult to beat the market today than... it was back then, I think. So I kind of feel like markets are more efficient.
And if you think about indexing, you know, what Cliff says is like, well, who's moving to indexing? If people are moving to that we're making the market less efficient, then them moving to indexing would make the market more efficient? Or is it the other way around? You know, is it that he was kind of saying, imagine we have sharks and minnows.
Is it the sharks that are moving to indexing or is it the minnows? If the sharks are moving to indexing, then the market becomes less efficient. If it's the minnows that are moving to indexing, the market becomes more efficient. I mean, isn't it almost abundantly clear? that it's the minnows that are moving to indexing.
The sharks are doing well. They're out there munching up a storm. The minnows are the ones that are seeking asylum in index funds.
They're like, get me out of here. Get me out of all this active stuff. Put me into the index fund where there's not much going on and be safe there.
So I think that index funds are probably making the market somewhat more efficient, but the craziness that we see in the market is coming from the stuff that I was talking about, all this zero fee trading, all these new ways. I mean it's kind of like whack-a-mole when fees went down we thought oh you know there's going to be less less flesh taken out of retail investors, but no we found other ways to to do that. And then Jonathan you were asking about advice for young people. or financial decision-making advice for young people. And I think that the main thing that young people, it depends on how young they are.
So first, the biggest decisions that young people make are education, which in the UK is not as... is not as expensive as a decision as it is in the U.S., where it's a really, really big financial decision in the U.S., but here a little bit much less so. But it's your education, career, and housing. Those are kind of the three really big financial decisions that you're making.
The investing part of it, I think, is really easy. You know, the advice to young people is get into the habit of saving and, you know, invest in equities. You know, it's okay to invest in equities. to invest most of your money in equities as a young person.
You have a lot of human capital, and your financial capital is relatively low. So when you look at your overall portfolio, human capital, financial capital, depending on what you're doing, I think if you're working at an investment bank, maybe your human capital is looking a lot like equities anyway. But for most people, their human capital is probably less risky, and they can afford to be more in equities. But I think the really big decisions are around career, education, and housing.
And I think in those decisions, you know, really that risk is so central to those decisions that particularly when it's choosing a career and thinking about what's the risk, you know, you don't want to think about what's my expected compensation, my expected reward in this career going to be, but you really need to think about your risk-adjusted reward. And of course, once you've done that, you can think about what you're attracted to, where your passions are. But I think thinking about career decisions in some risk-adjusted way...
which generally will argue against taking lottery ticket type of career paths, you know, I think is very valuable. And I think with housing, it's like, you know, housing is not your best path to wealth generation. You know, buy your housing, you know, view your housing as a consumption item, not as a wealth generation tool in general. And in terms of education, you know, obviously come to the LSE.
On that note. I think that's a good point to end. I think I speak for everyone that it's been a real pleasure to listen and to learn from you tonight, Victor.
Could everyone please join me in giving him a big round of applause?