Episode #530: Professor Kenneth French on Risk, Return, and Rationality

Guest: Kenneth French is the Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College. He is an expert on the behavior of security prices and investment strategies.

Recorded: 4/10/2024  |  Run-Time: 53:45 

Summary: In today’s episode, Ken shares what topic he and Professor Fama disagree on. Then we get into a number of topics: what it means to truly be a long-term investor, the global market portfolio, misconceptions around stock buybacks, and much more.

Sponsor: 10 East is a membership-based investment firm founded by Michael Leffell, former Deputy Executive Managing Member of Davidson Kempner, focused on providing targeted exposure to private markets. Members invest at their discretion in single-investment and niche fund vehicles across private credit, real estate, private equity, and venture capital.

 

 

 

Comments or suggestions? Interested in sponsoring an episode? Email us Feedback@TheMebFaberShow.com

Links from the Episode: 

  • (01:17) – Welcome to our guest, Kenneth French
  • (03:35) – Investing in FAANG Stocks: Should You Expect Unexpected Returns?
  • (07:10) – Deciphering an investors skill vs. luck
  • (15:12) – Having an investment plan
  • (20:24) – The global market portfolio
  • (25:02) – Thoughts on gold and other commodities
  • (26:26) – Incorporating human capital
  • (32:12) – Ken’s thoughts on stock buybacks
  • (35:36) – Improving financial education
  • (40:10) – Disagreement, Taste, and Asset Prices
  • (44:05) – Ken’s most controversial opinion
  • (46:37) – Ken’s most memorable investment

 

Resources

 

Transcript:

Meb:

Professor French, welcome to the show.

Professor Ken French:

Thank you very much. Looking forward to chatting.

Meb:

Well, we had your partner in crime a few months ago and he was a lot of fun. And I thought a fun way to start this was, I imagine over the years, Professor Fama and yourself have had countless papers and projects you’ve worked on. And you had a really beautiful piece you wrote about Professor Fama and some of the things, looking back on the career. But I wanted to ask you a question which is, you guys sit down for coffee or a meal or tennis, I don’t know if you play tennis with him anymore, but what do you guys disagree about?

Professor Ken French:

Simplest answer is his sense of market efficiency is different from mine. I always say there are certainly lots of mistakes in prices. Some are too high, some are too low. Personally, I don’t know which is which, but I suspect there are some people out there that are better at it than I am, and they do have reasonable predictions.

And then I immediately hasten to add that I think they’re the scarce resource, and I don’t see any reason why they have to give their scarce resource away. And what I mean by that is even if I knew who they were and I suspect Jim Simons, for example, is somebody who is truly beating the market. That doesn’t mean Jim Simons is going to allow me to invest and give me a superior rate of return. He doesn’t need my capital. In fact, the only way you can invest with Jim Simons these days, as I understand it, is to get a job at his firm. And that really is telling you he does not need outside capital, he’s got plenty. And even if he did need outside capital, other investors aren’t going to allow me to go in there and get a superior rate of return.

So for pragmatic purposes, at least when we think about the investment side of things, Fama’s view that prices are almost always right, and my view that there’s plenty of mistakes, leads to the same conclusion for most investors.

Meb:

Speaking of pricing things differently, you had a nice piece on the FANG stocks in the last, I can’t even say last cycle, but a few years ago, and now that name has been overtaken with the Magnificent 7. You could go back every few years and there’s a new name. I remember the BRICs, you got the Nifty 50, there’s all these names people love to grant to whatever the hot flying investments are of the day. Do you think there’s a chance we’d be talking about something like Mag 7 when you were just talking about the FANGs a couple of years ago?

Professor Ken French:

First you described it as people talking about the hot stocks that are performing well, that’s the wrong verb tense. What people do is they label groups of stocks that have been performing well and then they project, oh, well, they’re going to continue to do well. That’s a total fallacy. I mean it’s sort of, getting the verb tense right in this case is absolutely critical. Those are stocks that have done well, they may do well, but the fact that they have done well, other than the momentum effect, which we’re all well aware of, it’s not really going to help you forecast what those stocks are doing.

And that’s the whole point of my FANG stock story, is they were shooting the lights out. 2000, if you bought an evaluate portfolio of the FANG stocks, which are Facebook, Apple, Amazon, Netflix, Google, how do you suppose they do when we’re all locked down? Those are exactly the companies, they’re going to benefit from our lockdown. And the fact that their return was astronomical that year doesn’t predict, oh, well, they’re going to continue to do astronomically. Well, no, the huge rate of return was pricing in the current and whatever good news there was about the future for those companies, for precisely the same reason. It gets incorporated in prices as soon as people understand what’s going on. Sometimes it’s too high, sometimes it’s too low. But again, I don’t know which way.

Meb:

In this day and age, 2024, everyone’s attention spans are getting compressed, not just on our ability to focus on a book or a movie, but everything getting crammed down to 15 seconds. But looking at invest-

Professor Ken French:

Is there evidence of that?

Meb:

Yeah, I think not only is there subjective evidence of what people consume, at least on the content we put out as far as the shorter clips versus the longer ones. Would have to dig in for objective evidence, but I love that question, but it feels like just being around my friends in the younger cohort. Could be wrong, of course, but it seems that.

Professor Ken French:

I will acknowledge that five minute videos, people will watch a lot more than they’ll watch 15-minute videos. If you put out a video it’s like, you want to keep it short if you want people to watch it, which is consistent with your hypothesis.

Meb:

And then part of that thinking about, and this has sort of always been the case, where investment time horizons, everyone wants their returns, they want the certainty now, and you have one of my all time favorite quotes, which we use, and hopefully we’ll get it a little bit right, but you said something along the lines of, “People are crazy when they try and draw inferences that they do from 3, 5 or even 10 years of an asset or any actively managed fund.” 10 years. Can you tell us a little bit what you mean by that, and what are some of the consequences?

Professor Ken French:

Let me give you an example, and I do this with people, where I’m trying to get them to recalibrate what they can learn from returns. And the critical issue here is we don’t observe expected returns, we observe realized returns. And for most investors, what they’re trying to do is identify the expected return. Guess what’s going to happen in the future.

So one of the many different ways I try to calibrate is to say, imagine I know that I have the best hedge fund manager in the world. And she delivers after costs, fees, expenses, everything, she delivers an expected alpha of 5% a year. Most of the time it happens, it’s an expected 5%. Sometimes she gets unlucky, negative returns, so there’s randomness in the process. How random, imagine her hedge fund has equity-like volatility, 20% a year. So that’s kind of the level of volatility of the overall market year by year.

So she has equity-like volatility, true 5% alpha after fees and expenses. How many years will it take to say that a woman actually has some skill, able to cover her costs and expenses and fees? We don’t even need to know she’s adding 5%. I just want to know if she has made some positive contribution after fees and expenses. And what I’m looking for here is, critically, I’m looking for a T-statistic of two or an expected T-statistic of two. So I just want to be outside the standard of error in this question. How many years will it take? That I can observe it and say, okay, I’m guessing this woman really does have skill. I won’t embarrass you. If you want, feel free to shoot out a number.

Meb:

I know the answer because I’ve done enough research and listened to you for long enough. Listeners, come up with a number in your head of what you think is a realistic time horizon to judge this hedge fund manager. All right, you got a number? All right, professor, give us the reveal.

Professor Ken French:

Okay, what I actually tell people to do is write a number down. As soon as I tell them the answer, they’re going to say, oh yeah, yeah, that’s what I was thinking. So write the number down.

Meb:

I don’t think anyone’s going to say, yeah, that’s what I was thinking when you give us the answer.

Professor Ken French:

In this particular case, the answer is 64 years.

Meb:

An investment lifetime.

Professor Ken French:

It’s three investment lifetimes, right? I mean, there’s no possibility that this woman is still out there running a hedge fund if it really takes 64 years to figure out, hey, she’s really great, probably the best in the world. No possibility. So this is what I mean. There’s so much randomness in the returns we observe. We’re trying to back out what was the expected return, and mostly what we’re observing is the unexpected return.

It’s not futile. If you have long enough you can learn things, and in some cases you can learn a lot. For example, if you want to know whether an index fund is doing what they’re supposed to do, that’s easy. I give you the index that they’re supposed to be matching, and then you can look and see. What that’s doing is it’s taking all the noise away. You’re able to see what they’re actually doing relative to the index and decide, hey, they’re doing something good, or you’re not really selling me an index fund here. So that’s a case where you can observe it. Most of the time in the interesting cases, it’s mostly noise.

Meb:

I think this is probably, I would love to hear your thoughts on this. One of the biggest mismatches really between investors and not just individuals, so we speak to a lot of professional investors too, and their time horizon almost universally that they look at investments is one to three years.

And we do polls and we love to do Twitter polls, and I don’t want to set you off, but we do Twitter polls where we ask people to say, hey, how long would you give an active manager underperforming their benchmark before you liquidate the investment? And it’s almost the entirety, say one to three years. I said, how long would you be willing to be “wrong” on an investment? Meaning underperforming a benchmark, nothing has changed and the manager didn’t die, there’s no structural shifts, no government regulations, no aliens, no anything. 20% said up to a year, and then 50% said up to five years. So everyone’s focused on this very short period. And again, like you mentioned, it’s just in the short run, a lot of luck and noise.

Professor Ken French:

One of my favorite stories, many, many years ago I was teaching at MIT. I got a call from MIT’s Investment Office. They wanted some advice on, should they fire a manager? And they described the situation. The manager had been working for another firm, shot the lights out, had a really great performance, and left that firm to set up his own firm. And for the first 18 months, things didn’t go well. They had horrible returns, but fundamentally the asset class they were in had horrible returns. The investment group at MIT wanted to know, what should they do? Should they fire this manager? And it was a hedge fund, which is relevant for the answer. And I said, well, the way I think about it, if you liked them when you hired them, you should love them now. And I see you shaking your head. You know exactly what I mean.

But the investment office did not. And what I said was, you’ve learned essentially nothing about that manager’s skill over the last 18 months. All you’ve learned is your fees are lower. Why are they lower? Because there’s a high watermark. They will have to get back to where they started when they invested with the manager once he started his new firm. So they’ve got what it really was down 30 or 40%. They’ve got a huge run before they have to start paying the 20 out of the 2 and 20. So if they liked them at 2 and 20, they should love them at two. They didn’t learn anything else, or very [inaudible 00:12:48]. Granted, you got to learn something, but essentially nothing that would help you make a real decision. And I try to emphasize that over and over again. Most of the consultants in the world aren’t helpful in this conversation because if they didn’t fire somebody after three years, what would they do? Yeah, we’ll bring you in every 30 years and evaluate how you did.

Meb:

There’s so much wrapped in this. I think part of the struggle, going back to even your comment about writing down the number before you revealed it, we also pull investors and say, do you have a written investing plan? And almost no one does, but then we say, do you write down the criteria for why you’re investing in an investment when you make it? Because so many investors are sophisticated on the surface. They’re talking about sharp ratios and all these other types of metrics that they look at, but to me it is, so much of it comes on this process, not performance. And then they make the buy decision, then it just all goes out the window. Do you have a process for how you’re going to think about either selling or adding to this investment when you make it?

Professor Ken French:

There’s another question you might ask them, which is, who’s going to be on the other side of the trade? And if they keep telling you, well, it’s somebody dumber than me, there’s probably a problem with that. Do they really believe all of their active trades, the party on the other side just doesn’t get it? And I’m kind of alluding to an idea of Bill Sharpe’s. He has a wonderful paper called the Arithmetic of Active Management. It was published in the Financial Analyst Journal back in 1991. The Arithmetic of Active Management, an easy way to say it is if you win, somebody else must be losing. So if you put a trade on thinking you are going to win, presumably the party on the other side is similarly confident that they’re going to win. One of you is wrong. And it takes a lot of hubris to think, well, it’s always the other guy that’s wrong.

Meb:

You have another quote where you were talking about… And I think this is, unless you’re Spock, I feel like this is hard for most people where you say, “When I judge the quality of an investing decision I made, I don’t pay much attention to the outcome, I pay attention to, did I make a good decision at the time based on the information I had?” And I feel like that’s a very poker mentality, but it’s easy to get lulled into the sense of, hey, this investment did amazing, I’m so glad I bought NVIDIA, I’m brilliant. I knew I should buy Bitcoin, or vice versa. How do you distance yourself from that? Are you getting suggestions from the investors? I mean, I’m a quant, so look, it speaks to my heart.

Professor Ken French:

I have been blessed with 35 or 40 years of working with Gene Fama. Gene somehow or other managed to adopt that view of the world very early in his life. It just took me longer, but I really have gotten there. It gives me much better investment experience, not in performance, but simply how satisfied am I with the way I invest? Acknowledging that most of what’s going to happen here is just random. It makes it much easier when things go down a lot or things go up a lot. I don’t claim any credit, and I don’t take any blame. If it was stupid, I will acknowledge that, but if it was that stupid, I don’t think I would’ve done the investment straight up. I’m more describing my style, which I’m not out there picking winners. I’m basically saying, what exposure do I want to different factors?

How much do I want stocks in my portfolio? How much do I want bonds in my portfolio? And even there, if I’m thinking about maximizing something, my goal is to be at the top of the hill. The slope at the top of the hill is zero, so I can make small movements to the left, to the right. I can be off a little bit, maybe even more than a little bit, because basically I’m flat at the top of the hill. Well, if you think about how many stocks, how many bonds at the optimal point, wherever it is that maximizes my expected utility. Again, I’m at the top of a hill, and I can be screwed up. If I’m off from the top of the hill, the market is actually going to protect me, in a sense.

What do I mean by that? Okay, suppose I got too many bonds, not enough stock. What that means is I’ve lowered my expected return. I presume the expected return on stocks is higher than bonds, I didn’t take enough stock, so I have a lower expected return. But the markets almost protected me because I also have less risk. Yes, I gave up some expected returns. The benefit of doing that was less risk than I would’ve taken at the top. That trade-off doesn’t protect me entirely, otherwise the whole hill would be flat. It’s not flat. I lose a little bit, but I don’t lose much. If I over-invest in stocks now, great, I get a higher expected return, but at the cost of more risk, and that higher expected return almost compensates me for the additional risk I take. The beauty of that is I just don’t worry. I couldn’t tell you within 10% how much stock and how much bonds I have in my portfolio, and it’ll all work out.

Meb:

You mentioned Professor Sharpe. We had the benefit of getting to chat with him here in Los Angeles a while back, and he was talking about a topic that you’ve mentioned a fair amount and we like to talk about here when you’re talking about portfolios, and that’s the global market portfolio. Could you explain briefly what that is for the listeners who haven’t heard, and then we’ve got a few follow-on questions and derivations from this.

Professor Ken French:

Sure. The global market portfolio, just think in terms of you’ve aggregated up everybody in the world’s investment portfolio. So it’s anything that people think is in their investment portfolio, it’s going to be in that global market portfolio. So it’s all the shares of Eastman Kodak, all the bonds of Ford, it’s all the gold, if people think of gold as a financial asset.

What’s not in there? It’s the best. So that would include futures contracts. For every long, there’s a short. That would include options. Somebody’s writing it, somebody’s buying it. All those things cancel out when you add them up. So they’re not even in my global market portfolio. But to be clear, when I say market, I’m not just talking about stocks. I’m talking more broadly about bonds, precious metals, whatever people think of as financial instruments here. And the beauty of that is it’s a wonderful benchmark. What I know is if I aggregate up everybody’s holding, that’s what it looks like. It’s that portfolio. Just like if I say, what’s the aggregate of all US stocks? It’s the US stock market portfolio. The global market portfolio is just a wonderful benchmark.

Meb:

It’s actually pretty hard to beat too. We did a book where we looked at a lot of the famous investing, buy and hold asset allocation strategies, permanent portfolios, 60-40, risk parity, global market portfolio, and global market portfolio is a pretty impressive benchmark. Why do you think no one has launched a global market portfolio mutual fund or ETF? I know there’s some that are close and there’s some kind of round, you could get away with two Vanguard funds that probably get you 99% of the way there. But how come nobody said, hey, I’m just going to do the one and done this is it, global benchmark?

Professor Ken French:

There’s lots of costs in investing in lots of markets around the world. There’s markets where foreign investors are probably not treated as well as domestic investors. There’s good reasons to tilt away from some foreign markets. Even Australia’s, they’re our buddies, but there’s tax withholding in Australia that domestic investors get compensated for, foreign investors don’t. So we all get the same pre-tax return, Australian investors get a higher post-tax return, so we’re at a disadvantage. There’s one price for everybody.

So what that says is, I’m probably going to get hurt a little bit relative to a domestic investor in Australia. And you see the same thing for different reasons in different markets around the world. So there’s pretty good reasons why I might want to say I’d hold a different portfolio than an Australian. And then there’s just natural home bias having to do with keeping up with the Joneses, for example. There’s a whole literature on why there is this home bias that investors have all around the world, and there’s all sorts of interesting hypotheses to explain the behavior.

Meb:

The Omaha crowd has a quote that’s along the lines of, “It’s not greed and fear that drive markets, envy.” Because there’s no worse feeling than your neighbor buying a bunch of Dogecoin and making a zillion dollars, and you not. So it’s hard when you see Mag 7, whatever it is, whatever is going on in the world, that’s the worst feeling.

Professor Ken French:

As you know, the economists call that keeping up with the Joneses, and that is an explanation people offer. If my neighbors are over-weighting the US and I don’t, well, I may win by having more outside the US, but it hurts a lot more when I lose relative to my neighbor, than when I win relative to my neighbor. So if I just track what my neighbor’s doing, it takes out that element of risk.

Meb:

You mentioned Australia, they must be having a moment. My friends down in Aus, they’re one of the few markets historically for the past 100, 120 years that have had stock market returns kind of in line with the US. The US is one of the best, and I think tiny South Africa, according to the Dimson Marsh database, was one of the better ones. But they’re big gold people, gold’s at all time highs. How does that fit into the global market portfolio?

Professor Ken French:

Precious metals can play a role for some people just as a hedge, or if you’re really, really worried about global stability. I’m not sure exactly what I would do with gold, but people do think of gold as a hedge against all sorts of instability in the world. The price of gold does go up, but in that horrible state of the world where dollars don’t count, and I don’t understand how gold’s actually going to count, especially if I have it in a futures contract rather than in a precious metal.

Meb:

Well, Costco just revealed they’ve been selling $200 million a month of little gold ounce bars to retail customers, so somebody’s buying it.

Professor Ken French:

The beauty there is that they are at least small enough to keep with you as you’re fleeing.

Meb:

Exactly. By the way, the question that I asked Professor Sharpe when we were chatting about the global market portfolio, and I said to a lot of people here, the younger crowd, what do you think about crypto? Does crypto play a role in the global market portfolio? He took a long pause and smiled and he said, “Yes, but unfortunately not a positive one.” And I thought that was the funniest.

Professor Ken French:

What a great answer.

Meb:

You talk a lot about how investors should think about investing relative to their own situation, what you call human capital. Can you maybe talk a little bit about that?

Professor Ken French:

I start by asking the question, why do people invest? People invest because they’re trying to move resources into the future. And what they really want is to move consumption into the future. So you can either spend all of your money today, consume it however you choose to consume it, and I mean when I say consume, I mean broadly defined. Yes, it’s what you eat, it’s the cars you buy, but it’s also the contribution you make to your local church, or it’s donations you make to some politician, or it’s the money you give to your kids, or whatever else you want to do with your resources.

So we invest because we’re trying to defer some of our consumption into the future. What I’ve done now is I’ve said, okay, this is not about dollars, this is about consumption. And when I think about risk, if I define risk as the variance of my dollar wealth, there’s a big gap there. I should be thinking about the uncertainty I have about my consumption in the future, and so I can give you a bunch of examples.

My favorite is Enron. Most of the senior management at Enron had all of their retirement wealth tied up in Enron stock. So the day Enron fails, they have to go home and tell their spouse, honey, I just lost my job and we lost all our retirement savings. That’s a really bad idea, so don’t double down. A better example for most of us is, if you think about homeowners insurance, that’s a horrible investment. Why? Well, it almost certainly has a negative expected return. Unless you’re an arsonist, you can pretty much count on your homeowners insurance as a negative expected return. Why? Because the insurance company wouldn’t sell it to you if they didn’t think they were going to make money, but people buy it. It looks like a lottery ticket to me. I put money up, most of the time I lose it, once in a while I get a really good draw and make a pile of money on my insurance. Unfortunately, that really good draw meant my house just burned down. That’s the payoff.

Why do people take this negative expected return lottery ticket? They get it. They’re hedging their consumption. I often joke that the way I have managed to eliminate lots of risk for my portfolio is by buying my house. And the reason I’m joking about this is because I always say, and it’s my kid’s problem. After I die, they have to worry about what the price is. What I know is I’ve locked down a bunch of consumption for the rest of my life. There’s no randomness about what the price is going to be. Or there’s a little bit, I don’t know what my taxes are going to be each year, but hold that aside, I pretty much have eliminated a lot of randomness from my consumption.

When you think about your investment portfolio, what you should be doing, financial advisors should be helping their clients do, is tilt their portfolio in a way that minimizes, at least reduces the uncertainty about their client’s lifetime consumption. And there’s lots and lots of different ways to approach that.

Meb:

One of the strange things that we’ll see consistently though is investors who make a lot of money, it may not even be market related and they sell a business, they have a lot of money, they fund their life goals. So whatever it may be, it could be paying for your kid’s college, paying for your house, covered. And then you see the mistake where people still continue to take on a huge amount of concentration risk or even in some cases a lot of leverage risk.

And there’s a great William Bernstein quote where he is like something along the lines of, “once you’ve won the game, you don’t have to keep playing if you’ve built up this nest egg.” And we had fun. I don’t know if people really understand TIPS, but I did a poll on Twitter where I asked people, I said, at what TIPS real yield do you sell your stocks and buy TIPS? And most people said either never or 7%. I said, man, if you’re getting a 7% real yield on TIPS, which I don’t think has ever happened before. In the late 90s, it was like 4.

Professor Ken French:

There was a period where the yield was high, but it didn’t last long, and every finance professor was telling other finance professors, did you see the yield on these TIPS? They really were very attractive.

Meb:

I feel like TIPS have bad marketing. They need a different phrase to market these better so people can understand them. Speaking of bad marketing, I have an entire website page dedicated to a topic that might be the number one topic that our politicians, journalists, even market prognosticators and commentators consistently get wrong. And you have one of my all time favorite quotes, and so you’ll probably know what I’m talking about as soon as I say it where you said, “Buybacks are divisive. They divide people who understand finance from those who don’t.” And that was a pretty clean way of saying it. But what do you mean by this? Why do buybacks cause people’s brains to malfunction and misfire and shut down?

Professor Ken French:

I don’t actually know the answer to your question. Let me explain why I think buybacks are not destructive, why it’s incredibly stupid for the government to say companies shouldn’t be allowed to buy back their stock. There’s lots of reasons why companies are buying back their stock. Most of them are pretty neutral. I mean the easy one is, sometimes companies might buy back their stock, they think it’s undervalued. Okay, fine. All that’s happening there is a transfer from some shareholders to other shareholders. We’re not destroying any wealth. There is some value created in having a more accurate stock price and in essence, that’s what’s happening when they buy back their shares. For that reason they kind of are going to push the price up.

Presumably they know better than the market what the price should be and they’re saying, ah, this price is too low, let’s buy some shares. And individuals who happen to sell, they lose relative to the individuals who didn’t sell because it’s going to push the price up. But that’s just a red herring. That’s just a neutral effect in terms of, did we destroy anything? Did we create anything? We created a little more accuracy in stock prices, which is a good thing, but that’s about it.

The bigger issue is I have a company that just looks out there and says, you know what? Right now we don’t have anything really useful to do with our shareholders’ wealth. We’re sitting on this pot of money, created all of this by all the good things we’ve done in the past. We don’t have anything useful to do with it. Let’s just give it back to the shareholders. Our alternative is to destroy wealth. Normally companies are charged with, okay, what we’d like you to do is take 90 cents of resources and turn them into something society values at a dollar.

That’s great. We’ve made the world better off by 10 cents every time we turn that crank. The share repurchase issue, if you say, okay, I have something society values at a dollar, I’m going to turn it over to my shareholders and say, here’s a dollar, spend it wisely. And you say, no, no, you’re not allowed to do that. What you got to do is invest it in something that society values at 90 cents. That’s the antithesis of what we want corporations doing. Take something society values at a dollar and turn it into 90 cents. And this is what our government is sitting there saying, we don’t like it. We want you to turn that dollar into 90 cents. It drives me nuts, as you can tell.

Meb:

You’ve been teaching for a long time and have written a lot of works. What do you think about, we don’t really teach personal finance, money, investing, any of that in schools, high schools. It’s moving in the right direction, up to maybe 25% of schools teach it at some point. Now, do you think this is a worthwhile endeavor? And if not, why? But if so, are there any kind of suggestions? If Biden called you up today and said, professor, I really want to focus on teaching people about money as they go through school, what would you suggest?

Professor Ken French:

It’s hard for me to talk about how one would go about doing it, so let me focus on what I would like to communicate. The first thing that would be helpful would be for people to understand the fancy term time value of money. An easier way to think about it is that a dollar today is worth more than a dollar 10 years from now.

And my parents, if I think back to my own childhood, my parents were forever adding up dollars 10 years from now, 9 years from now, 8 years from now with no discount whatsoever, and just adding them up, and so things like life insurance. They were stunned by the fact that a life insurance sales guy could have them getting more 20 or 30 years from now than they put in over the last 20 or 30 years. It was just a phenomenal concept to them, like it was just free money.

And so getting people to understand you can’t add dollars 10 years from now to dollars today without some adjustment. And it would help people, you’re trying to decide you want to replace your furnace. You don’t want to just think about the incremental cost of putting a new furnace in compared to the incremental cost of the fuel that you’ll have to pay under the old furnace for the next 20 years. Those two numbers don’t compute unless you make some adjustment for the fact that interest rates are positive. So getting people to understand that would be a huge step.

And then if I got one more presentation, I would spend it trying to get people to understand that for most of us, there’s no free lunch in the market. That most of us ought to act as though prices are right. And the arguments are pretty compelling when you look at the data. And if we look at mutual funds for example, nobody can argue with this. If I add up, build a valuate market portfolio of all active US mutual funds, it looks very much like the market minus the valuate average fees and expenses. It’s as simple as that. So what does that tell us?

I mean, again, I’m coming back to Bill Sharpe’s Arithmetic of Active Management. That is the arithmetic of active management. Somebody wins, somebody loses, and they both pay to play the game. So is that a game I want to play? No, I know in a much easier way to generate a higher rate of return, just buy the global market portfolio, the one we were talking about earlier, or put together the weights you want to reflect your personal circumstances, but don’t try to beat the market. Recognize that most of us are going to lose when we try to beat the market.

Notice I didn’t say everybody’s going to lose, even in a true expectational sense, I think there really are people out there who can beat the market, but I don’t think they’re intending to share their expertise with anybody. Yes, they’ll take your money if you’ll give it to them, but why would they pay you more than they have to to get your money? And it appears by the behavior of other investors, investors are so overconfident about their ability to pick winners, they’re willing to systematically lose.

Meb:

First of all, I want to say thank you. A month does not go by where I don’t go to your website and download all sorts of very large Excel files to use in various articles and Excel spreadsheets. And listeners, we’ll put a bunch of show note links, the professor’s work, and a lot of the things we talked about today, Sharpe’s article, etc.

As you look back at all these papers, you obviously have the most famous ones. Everyone loves to talk about the factor papers. Are there any that either you have written or you could even say that in your mind currently that you feel like didn’t get enough interest? You’re like, oh man, this is just a killer paper, or this is something that I was working on that the rest of the world is just like, ah, not as interesting.

Professor Ken French:

One paper I really like is a paper I did with Gene Fama published in 2007. It’s called Disagreements, Tastes and Asset Pricing. And there’s nothing in there that any of my colleagues would find controversial these days, particularly insightful. But so much of the world is so confused about ESG investing, environmental, sustainable, governance investing. It thinks somehow or other that if they tilt their portfolio towards sustainability, for example, by tilting their portfolio, they’re going to increase their expected return because other people are also tilting their portfolio. They have the sign exactly wrong.

The whole point is, imagine 60% of investors decide they want more than their pro rata share of sustainable companies. Where did they get them from? The only way they can get more than their fair share is to buy them from the other 40%. What do they do when that 60% tries to buy shares from the 40% that have to sell them in order for the 60% to be happy?

They must bid up the prices. People were happy with their original portfolios; to get them to sell the sustainable companies they’re going to have to raise the price. Well, the process of raising the price lowers the expected return. Now people get confused because while they’re pushing the price up, the realized return is going to be higher. So if we’re surprised by the amount of sustainable investing, we’ll get higher realized return. It’s just we’re pushing prices so we get a higher realized return, but that doesn’t tell me then I should expect higher future returns. It tells me the exact opposite.

It’s as you push prices up, unless somehow or other you’re changing expected cash flows, you’re going to have to have lower expected return going forward. And the act of pushing prices up is not changing expected cash flows. So it’s as simple as that. And that’s fundamentally the point we make in that paper. It seems pretty straightforward.

Meb:

Before your time. I feel like the world is slowly coming around to that, maybe not. It seems like the narrative has shifted a little bit, hard to say.

Professor Ken French:

Well, yes, perhaps in the last year, but if you talk to any European consultant two or three years ago, they would tell you, you can do well by doing good. That was the mantra.

Meb:

Yeah, sounds good.

Professor Ken French:

It sounds good, but it makes no sense.

Meb:

If you use your data set, and I don’t know if this is true, I haven’t looked at this in a few years, but one of my favorite statistics was when you broke out to the industries, and I don’t remember the exact number, the two best performing over the last 100 years were like beer and tobacco. I always say that to people. I was like, human nature, if you want to perform well, it’s catered to what people want.

Professor Ken French:

I’m not sure that’s exactly the inference you should be drawing from that.

Meb:

If you sit down with a group of your peers, so it could be professors in the faculty room, it could be professional consultants, investors, what’s something that you believe, or if you said out loud that 75% of them would shake their head and be like, “No, I totally disagree with that.”

Professor Ken French:

Let me just focus on the investment side, because it’s not as though we’re monolithic in the academic community, but it’s hard for me to think of anything I believe that 75% of the people I’m having lunch with would say, “Boy, that’s a dumb idea.” I mean, what we do is we’re constantly honing our ideas by arguing with each other. And if we’re intellectually honest, you have to converge unless you’ve just started with fundamentally different premises that don’t make sense.

But on the other hand, if I were to talk about active investors, my view of the way the world works is totally inconsistent with the way most active investors think about how the world works. So that’s the easy call for me. I’m often out there speaking with active investors and I’m more than happy to acknowledge that some of them truly do have positive expected alpha, but far fewer than imagined, they do.

And again, the example I often point to is Jim Simons, as somebody who actually does beat the market. And when I talk about him in my investments class, I’ll say in the past, it doesn’t happen anymore. But in the past, it couldn’t possibly be my current students. It’s the guys in the back row who plan to go be successful active managers. They look at Jim Simons’ success and say, “Aha, this is evidence that I too should be out there beating the market.” I interpret it in exactly the opposite way. I interpret it as this is evidence that I should not open my wallet. If Jim Simons has taken $5 billion out of the market this year, that’s $5 billion that other investors must be putting in. Over and above all of the summations that we’ve been talking about earlier. Whatever he’s taking out, somebody else is putting in plus costs.

Meb:

And also the big challenge with Rentech is their Medallion Fund isn’t necessarily scalable because like you mentioned, they don’t take outside money, and a lot of the institutional stuff they do-

Professor Ken French:

They’ve had some brand extensions.

Meb:

Yeah. None of them look like medallions.

Professor Ken French:

Exactly. Those don’t look quite so good.

Meb:

Last question, what’s your most memorable investment? Could be good, bad, in between, as you look back at your career. Anything come to mind?

Professor Ken French:

I have two different answers. I’ll give you the more interesting one, and then I’ll give you the more philosophical one. The interesting one was I had written a couple of papers with Brad Cornell, who at the time was on the faculty at UCLA, and I’ve forgotten where Brad’s at right now, maybe Caltech. We had formulas for pricing stock index futures, which today every MBA student knows how to price stock index futures, but somebody has to write it down the first time. We were fortunate enough to be in a position where we happened to write it down the first time, and it was just before they started trading stock index futures. So when they did start trading, we looked at the prices and discovered they were all screwed up, and we put together a little partnership and started trading stock index futures, basically doing index arbitrage before anybody else was doing index arbitrage.

And we made serious money. Like the first few trades, I was making my annual salary. And our profits went like that through time, just down, down, down. And eventually it just wasn’t worth our time anymore. I happened to go to Wall Street to visit some friends and discovered what Bear Stearns had understood, had figured out how to do index arbitrage, they could just do it way more efficiently than we could. So, it’s what you would expect. Prices got right, but we happened to be there at the right time in the right place, and we were able to take advantage of the fact that people had to figure out what they were doing before prices got right. So that’s sort of an interesting trade.

Almost all of the trades I make are highly uninteresting. And I think for most of us, that’s what investing should be like. It should be, we’re just buying broad portfolios. We’re not trying to beat the market. We’re trying to take the investment opportunities that are there, and just hoping to have a good investment experience over our lifetimes. And when I think of it that way, I’m pleased that I only have one more story to tell you. It’s good that the rest of my investment life has been pretty passive, pretty quiet, no more drama than any that I want.

Meb:

That sounds nice. We got enough drama everywhere else. We wrote a piece that said, what is the cost of your personal Alpha quest where it quantifies, it says, how much money do you make? How much time do you spend on your investments every week? And how much alpha would you have to generate for that to be a worthwhile endeavor?

Professor Ken French:

What a great experiment. I like that.

Meb:

I think the title was basically called, The Best Way to Add Yield to Your Portfolio is Stop Spending Time on It. Now for those of us who love the investing world and it’s a hobby or a career, good for you, spend time on it, it’s fun. But for the people who are actually just like me, I think I’m going to improve my returns, you’re probably better spent time getting a raise, finding a better job, not doing this, which is also not guaranteed.

Professor Ken French:

I always say I’d rather earn my money with my brain than my stomach.

Meb:

That is a perfect ending to this, because it’s almost lunchtime here in California.

Professor Ken French:

Oh, good.

Meb:

Professor, I want to say a huge thanks. You’ve been a huge inspiration to everyone here. Also, the amount that you’ve shared over the years has been very kind, and I think we have probably half a dozen of y’all’s former students and family tree on this podcast over the years. So I’ve enjoyed it, and thanks so much for joining us today.

Professor Ken French:

Well, thank you for having me, and thank you for those very kind words. I sincerely appreciate it.

 

 

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