Episode #532: Hendrik Bessembinder – Do Stocks Outperform T-Bills?

Guest: Hendrik Bessembinder, a professor at Arizona State University.

Recorded: 4/24/2024  |  Run-Time: 43:38 

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Summary: In today’s episode, Meb and Hank discuss Hank’s research on long-term stock returns and wealth generation. They explore the concept of power laws in the stock market, where a small percentage of stocks generate significant returns, while the majority underperform. They also discuss the implications of Hank’s findings for investors, including the importance of diversification and the challenges of holding onto big winners.

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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.

 

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

 

Links from the Episode: 

• (1:06) – Welcome to our guest, Hendrik Bessembinder
• (1:27) – Do Stocks Outperform Treasury Bills?
• (6:16) – Power laws drive stock market returns
• (13:52) – The importance of holding on to winners in your portfolio
• (15:22) – Shared traits among the best stocks
• (23:10) – Takeaways from his global studies
• (28:21) – Mutual Fund Performance and Long Horizons
• (31:34) – Other topics Hank is interested in researching
• (37:52) – Hendrik’s most memorable investment
• Learn more about Hendrik: SSRN; Lessons from Bessembinder

 

Transcript:

Meb:

Welcome everybody. We got another great episode today. I’m super excited for this one. I’ve been trying to get this professor on the podcast for a while now. Our guest today is Hendrick Hank Bessenbender, a professor at Arizona State University. Done some of my favorite research on long-term stock returns and wealth generation, going all the way back a hundred years almost. I wanted to have him on the show. I can’t wait to talk about his research today. Professor, welcome to the show.

Hendrik:

Well, Meb, thanks very much and I’m happy to be here with you today.

Meb:

We’re going to talk about a lot of stuff today and bounce around. The one thing that we got to talk about and start with is your paper, which I think has made waves in our world. What made you think up this paper?

Hendrik:

The title Do Stocks Outperform Treasury Bills? I freely admit I chose that title strategically, thinking that people have to look to see what this paper’s about, given what we already know about the stock market. Of course, as soon as they look beyond the title to the abstract, they can see I’m talking about individual stocks, and the question is, do individual stocks outperform the market? I was involved in another project with co-authors. We had a fairly large sample of stock returns, and this is a little techie, but we were working in logarithmic returns, continuously compounded returns, and I noticed that we had a negative mean for a large sample of stocks, and it’s in the back of my mind that if a given stock has a negative time series mean of log returns, then it also has a negative holding period return. So anyway, the thought just occurred to me all of a sudden, “Wow, it looks like a lot of the stocks in this sample actually lost money during the time they were in the data.”

Somewhere along the way, I can’t remember the exact thought process, it occurred to me that a buy and hold return, that is just taking the returns that are in the database, which include dividends and compounding them, was not the only way to measure a longer in return, and perhaps even misleading in some cases. So I also started thinking about alternative ways of measuring long-term outcomes, and that’s where I worked out this other measure that’s in the paper that I call shareholder wealth creation. And one of the key differences, well, there’s really two key differences between just compounding the returns to get a buy and hold return versus shareholder wealth creation. One is that shareholder wealth is measured in dollars rather than percent. The second does not assume that dividends are reinvested in the same stock. For that matter, it also takes into account seasoned equity offerings and share repurchases, and it kind of depends on the question you want to ask of the data.

I mean, you can ask the question, “If someone had used a buy and hold strategy with dividends reinvested, how would things have turned out?” Perfectly good question. But if you want to think about things at a more aggregate level, “How did all the shareholders in this company do or how did all the shareholders in the market do?” Then that’s not quite the right way, because you and I, individually, can reinvest dividends. Shareholders as a group, cannot and don’t reinvest dividends. If I’m buying shares to reinvest dividends, somebody else has to sell shares. So this alternative measure, the shareholder wealth creation measures, is a little more true to the facts. It takes into account that shareholders don’t reinvest dividends, that they do fund seasoned equity offerings, that they do receive the proceeds of share repurchases.

Meb:

So the main takeaway, as you think about it in your head, is a decent amount of stocks, if you’re just throwing the darts, don’t do that great. And really that this kind of power law mentality that a small percentage generates these big huge returns is really what drives markets. Is that a reasonable summary?

Hendrik:

So you essentially hit the nail on the head there, Meb. We know that the equity markets, in the long run, generate a very handsome premium. It’s so large that a lot of academics are still using the phrase the equity premium puzzle. Why is the premium for the overall market as high as it is? That’s true. What I brought to the table that maybe people hadn’t recognized before is that it’s not the typical stock that’s generating the equity premium. It’s a relatively few high-performing stocks that are generating the equity premium. I personally haven’t thought in any formal way about whether this exactly fits the power law idea, but it’s certainly consistent with, generally speaking, with the power law idea, that most of the gain is driven by a few. We talked a moment ago about strategically chosen titles. If I had gone with a more descriptive title, I could have called the paper Long run stock returns are positively skewed. That’s what’s really going on. There’s positive skewness in the distribution of returns. That’s a more techie way to describe it, but it is in some ways more precise.

Meb:

Only the nerds would like that one. Most people’s eyes start to glaze over when you say the word skew.

Hendrik:

Which is why I did not choose that title.

Meb:

Who do you have on the hall of fame list of these giant performers? Do you know any of the names offhand? Is it like Amazon? Is it McDonald’s? Is it Monster?

Hendrik:

I have memorized the list and I have updated the paper a few times, and of course with each update, the exact members on the list have changed a little bit. The first time I compiled the list, the company at the top was ExxonMobil. They’ve stumbled some since, but they’re still pretty high on the list, but most of the companies that are high on the list are going to be the household names, Microsoft, Amazon, Apple.

Meb:

There’s a couple books behind me, somewhere on the shelf, that kind of focus on, I think one’s called A Hundred Baggers, one’s called 101 in the stock market, but they’re focused on these investments where you return a hundred times your money, which has happened in stocks. You just mentioned a few, they were probably a hundred baggers. I wonder what the record is. Do you know the record offhand for the numero uno public performing stock?

Hendrik:

This may have changed since I last looked at it, and this is in terms of percentage returns rather than the wealth creation number that I mentioned, but when I last looked, the company with the best compound buy and hold return was Altria Group. And I remember the number when I look at it. I think this was through 2016 at the time I looked at it, and the number was 240,000,000%.

Meb:

I can’t even do the math on that. We’ll figure the math out on a calculator later and come up with what a hundred thousand turns into a zillion, a trillion. That’s the old Philip Morris, right?

Hendrik:

Yeah. I have to admit, when I first saw that the company with the highest compound return was Altria Group, I had to go online and figure out who Altria Group was, but Philip Morris, USA was one of their main holdings.

Meb:

Well, listeners, this may not be the case anymore, but it was last time I looked, because I know tobacco stocks have sort of gone sideways for five, 10 years now, but at one point when you look at the French Fama database, of all the industries, the two best performing industries were tobacco and beer or alcohol, whatever for the last a hundred years. So it was like the human vices speaking to your investment returns. I imagine a lot of that had to do with things like Altria for a hundred years.

Hendrik:

One of the points I like to make with my MBA students is that in our market system, companies produce what society values, where the word value is used in a very specific way, what we’re willing to pay for and whether we like it or not, in a good bad usage of the word value, sin stocks are producing something that society values, and that shows up in stock returns.

Meb:

If I was to blind the title of this paper and just talk about the general takeaways where there’s a lot of investments, most don’t really return anything or have negative returns, but a few big winners determine the returns of the whole portfolio, and you were to say poll, what asset class do you think it is? I think people would say startup or venture capital investing.

Hendrik:

Yes, exactly. And I’ve drawn that analogy before. I phrased it this way, if I just came into an audience and said, I’m going to tell you about an asset class, and some of the key features about this asset class is that most investments are losers. As a matter of fact, the single most common outcome is to lose everything, but there’s a few really big gainers, 10 baggers, 100 baggers, and there’s enough of them that make this asset class desirable, you might reasonably think I was talking about venture capital, but I’m not. I’m talking about the public stock market in the long run. So my takeaway is that these features of the data are not unique to the private markets or early stage. They’re fundamental to investing in an entrepreneurial economy.

Meb:

How does this practically impact my day-to-day investing? And this could be an individual, it could be CalPERS. What’s the main takeaway?

Hendrik:

The main takeaway is somewhat in the eye of the beholder, and I actually don’t think that’s wrong. Let me state that a little bit differently. In the great active versus passive debate, there’s new ammunition for both sides here, and I should preface this a little bit. It depends on who the audience is, who’s the investor we’re talking to. Being trained as an economist, I can’t divorce myself from the economist’s worldview. In my mind, one of the most important ideas from economics is comparative advantage. What are you good at? Core competency might be the way more management gurus come after the same idea. For the vast majority of investors, picking stocks is not your comparative advantage. You got a day job. That is your comparative advantage. If you don’t have a comparative advantage in stock picking, diversification was always great advice for you, and now you’ve got some new ammunition. Because what I’ve shown is that if you just pick a few stocks at random without knowing anything, the odds are heavily skewed towards you’re underperforming the market.

Most stocks underperform not only T-bills, but the market’s a higher hurdle, so even more stocks are going to underperform the market. So if you’re just picking a few stocks at random, the odds are really stacked against you. So everything that favored diversification, that’s already in the text books, plus another important bit of information from the data. On the other hand, I do think comparative advantage is important and some people have the right comparative advantage. It would not have been good if somebody had told Mr. Jokic up in Denver that the odds are against people, any randomly selected person making the NBA. Some people have the right comparative advantage. And the markets need active investors. We can debate or have discussions about how efficient the markets are, but if everybody’s a passive investor, they certainly wouldn’t be efficient, and that wouldn’t be good for the markets or for capital raising and capital allocation. So some people have the right comparative advantage. What my paper shows is that the gains to having the right comparative advantage are potentially bigger than we might have realized.

Meb:

We often tell people it’s good to have a written investing plan. And 99% of people assume that’s because of the losers, right? I invest in something that goes wrong, something hits the fan, and that’s true. I think that’s helpful to think about, because, as you demonstrate, there’s going to be a lot of losers. In fact, the batting average is probably going to have more do-nothing losers than just about anything. So that’s the day to day norm. On the flip side, let’s say you get one of these winners, and I think it’s important to think through how to think about having one of these or holding onto them because every 100 bagger, whatever Altria was, was once a double and then it’s a triple, and a quadruple.

And I think most investors, you buy a stock and it doubles. You’re like, “Hallelujah, I’m going to sell it and go to Cabo.” I don’t know. Are there any takeaways or things you think about as practical ways to think about holding on to these giant winners? I feel like it’s a problem that’s a great problem to have, but in reality, it becomes a giant part of the portfolio, a pretty interesting problem to think about too.

Hendrik:

I’d certainly agree, it’s a rich and interesting problem, and I don’t have any magic bullet here, but if you do have one of these big winners in your portfolio, as you point out, you’re going to tend to lose some of your diversification, as you have a larger amount of your capital tied up. And then of course you hear the phrases like Magnificent Seven and such, this isn’t obviously an interest for the markets as a whole. If there are big winners, you end up with a less diversified portfolio. Whether to let it ride or take your money off the table, I don’t have an answer. It really comes down to fundamental analysis.

Companies had a run-up, has the market fully realized its potential or does it still have room to run, or has it overshot? That’s ultimately a matter of fundamental analysis, and there’s not going to be a one-size-fits-all answer. What we do know is it’s not going to be easy. A simple strategy of, well, let’s just buy the stocks that have had a big run-up because they’re winners. We know there’s some momentum effects in the data, but as an overriding trading strategy to buy into the winners because they’ve been winners is probably not going to be reliable. Got to exercise judgment.

Meb:

That’s a good lead-in to what I imagine is probably your most often asked question for the investors, which is, “All right, Hank, tell me how to go find these.” Did you find anything in the data where you sifted through and are there any secrets to clues to the characteristics of these 100, 1,000, 10,000 baggers before they take off?

Hendrik:

I could jump ahead to an indirect but revealing answer, which is that I’m largely a diversified buy-and-hold investor myself, and if I had discovered some secrets…

Meb:

Good news, you own them, you’re guaranteed to own them.

Hendrik:

Exactly. The one way to be sure that you’re going to have tomorrow’s big winner in your portfolio is to own them all. I should probably mention, in the interest of full disclosure, some of these studies were commissioned by Bailey Gifford. But as you say, everybody wants to know the answer here. I did some studies where I looked at outcomes at the decade horizon, then I looked at a set of variables. I had 20 of them that I looked at, all constructed from the prior returns or from the accounting data, and I posed the question at two levels. One is during the same decade you have stocks that turn out to be big winners or big losers. Avoiding big losers is also desirable. You look at the stocks that are big winners or big losers and then ask, “Well, what was going on with them in the same decade?”

Of course, that’s not what people really want. They want it to be predictive. But we might learn something useful by looking within the same decade. And then I also looked at it at a predictive level. It’s very close to impossible from the data. Now I have 20 variables. I think three of them came in statistically significant in trying to predict who was going to be a big winner in the next decade. So that’s a little bit better than the one in 20 that you’d expect randomly, but it’s not much better. And the R-squared in the predictive regression, how much predictive power does it have? Less than 1%. What did I find? It was sensible. I found that firm age had some predictive power. The big winners tend to be younger firms. And then I also found that higher asset growth in the prior decade, and higher R&D spending in the prior decade had some predictive power.

But as I said, the R-squared is really small and finding three variables with predictive power out of 20 is not an impressive showing. But it shouldn’t be surprising. It’s hard to predict who’s going to be a winner. If I go within the same decade, now we’re no longer predicting, but maybe we can learn something, I did find a few things. That the big winners within a decade tend to be firms with rapid asset growth, rapid cash growth, although the causation may run the other direction there, right? If you’re doing well, you’re accumulating cash. Growth in dividends. And when I did statistical horse race, a net income growth was the most powerful variable for explaining which firms did well within a decade. I found it interesting that when the dust all settled that this came down to something as fundamental as firms with rapid income growth are the ones that tend to generate the best stock market returns.

Meb:

I feel like all this though, that what you’re explaining, is the way that it should be, as if you think about… I’m trying to think of anything in these studies that really conflict in my mind with the way the world should probably work. I don’t think there’s anything. Is there anything in here you’re like, “You know what, this feels at odds with probably the way it should work?” Most of it seems to me like it is no, this is how capitalism and free markets and investing should work.

Hendrik:

I agree with that. Matter of fact, one of the lessons that I draw from this is that we learned something from the fact that my papers initially surprised people. And I have to admit, I was among those that was initially surprised. I was surprised to find that the majority of stocks lost money, and the majority underperformed treasuries. Most of the gains in the market was attributable to a few firms. A few of my colleagues in academics responded, “Well, that’s not surprising. Of course.” I’ve come around to the viewpoint that they were right, we should not have been surprised. And the fact that so many people were surprised, both academics and people in the investment world, to me suggests we’ve had a little bit of tunnel vision. Let me point the criticism mainly at academics here, though I don’t know that it’s exclusively at academics.

Somewhere along the way, we got the impression that what we needed to study was the average monthly return, the arithmetic meaning of monthly returns. And sometimes we get fancy with that. We do things like compute alphas, but alphas are still an arithmetic average. Technically conditional arithmetic average. We do Sharpe ratios, which have the arithmetic average in the numerator. Have tended to focus on describing the arithmetic average of monthly returns, which makes us totally miss the properties of compound returns or other measures of long horizon outcomes. So I think everything I’ve found is sensible. It is what we should have expected. It does tie into fundamentals. And the fact that it was surprising is maybe informative.

Meb:

You mentioned Bailey Gifford, they had some really nice graphics that they did about your work that summarized it, that I thought was interesting. And one of the ones that surprised me was… Well, there’s two things. One that’s not particularly surprising is the path was not smooth for these big winners, and I think the example they gave was Apple, which is now a multi-trillion dollar company in basically every decade except the last one, like a 70% plus drawdown. What investors could sit through that? I know I couldn’t. I would have sold that. It takes nerves of steel. And the second one, I think if you were to ask people, okay, this has got to be all tech stocks, right? That wasn’t really the case, was it?

Hendrik:

Yeah, you’re right. One of the things I documented is that it’s not a smooth ride against studying things at the decade horizon. If I looked at the firms that ended up being top performers within a given decade, and here I looked at the top 200 firms in a given decade, if we go to the prior decade, those firms averaged drawdowns of 51% in the prior decade. And you mentioned Apple three separate times had 70% drawdowns, and Amazon had a 91% drawdown at one point. Can you imagine? Your dollar shrunk to 9 cents before Amazon recovered to be the firm that we recognize high on the leaderboards today? For anybody who is thinking to themselves, “Well, I do have the comparative advantage. I should have a narrow portfolio to find the next Tesla or the next Amazon.” Maybe Tesla is the wrong example to use this week, but for anybody who’s saying to themselves, “I have that comparative advantage.”

Maybe you want to ask yourself whether you also have the fortitude to bear drawdowns like that. You touched on industry, so we can circle back to that for a moment. If you look at the firms that end up near the top of my wealth creation list, there’s a lot of tech stocks there, so it’d be easy to think that the key here is to get invested in tech stocks. What I actually found is that if I looked at both top performing firms, top 200 in a given decade, and bottom performing firms, bottom 200 in a given decade, tech firms, a randomly selected tech firm was actually slightly more likely to end up in the bottom 200 than the top 200. We’ve got some huge winners among tech stocks, but there’s lots and lots of losers whose names we don’t remember among tech stocks as well.

Meb:

You guys have expanded this to global. Are there similar takeaways? Totally different? What’s going on there?

Hendrik:

Very similar, and if anything, even a little stronger. Every punchline from my original US focused study is borne out in the global data, and if anything, a little stronger tendency for the stock market gains to be concentrated in a few firms. I’ve come to the viewpoint, I already alluded to this, came around to the viewpoint that we should not be surprised. Forecasting the future is always perilous, but it makes a difference which forecast you make. So I’m not going to forecast which stocks are going to be at the top of the leaderboard over the next decade, but I feel really confident forecasting that it will be a concentrated distribution over the next decade and the upcoming decades, this outcome where a few big winners, a lot of stocks that lose modest amounts and quite a few stocks that just go belly up and we lose everything. I believe it’s hardwired into the math of the markets. It’s hardwired into compounding of random returns essentially.

Meb:

Before we leave this topic, anything else that’s specific to this discussion that you’re thinking about for future jumping off points or further research?

Hendrik:

I think we should be thinking more about how we measure long-term investment outcomes. I already implicitly criticized the focus on arithmetic averages, including alpha, because they just don’t pick up the dynamics of long-run outcomes. But I don’t think we’ve thought nearly enough about it. So let me give you a motivating example. If you look at the data compiled, say by Jeremy Siegel in stocks for the long run, or Roger Ibbotson has disseminated similar data. It’s often in the textbooks. I don’t mean to denigrate their accomplishments. They’ve both made tremendous contributions to our field and our understanding of the markets. I’m just wondering if it can’t be taken further.

It’s not unusual to see a graph that is something like, “Well, if you had invested $1 in 1926, what would it have grown to by 2022 or 2023 or whatever. And it’s usually a very impressive number. I’m going from memory here. That $1 is turned into thousands of dollars as it’s compounded over almost a hundred years, but they worked with returns that included dividends. So when they compound those, they’re implicitly assuming reinvestment of dividends. I already touched on this. That’s fine for a hypothetical individual investor, but I think it was Jason Zweig, the Wall Street Journal writer who referred to this as the return that no one ever got.

Meb:

Yeah, everybody spends all their dividends on piña coladas.

Hendrik:

Yeah, piña coladas or something. So we know that in aggregate dividends are not reinvested. Firms would have to issue more shares to accommodate reinvestment of dividends. If you just assume that those dividends are instead rolled into Treasury bills, it can make a 20x difference in your statement about what did that $1 grow to. Your multiple could be 20 times lower. That’s a different punchline. And we don’t know what people do with their dividends, but I suspect you’re right, they’re mostly consumed. And I think we have to put our minds to the question of how do we measure long run investment outcomes when we take into account that the goal isn’t really to die with the most money in the bank.

We invest to facilitate other objectives like our own consumption or real investment, or say, if you have an endowment, you’re invested to fund real activities, say research activities at a university, or if you’re running a pension fund, you’re investing to fund pensions. I think we need measures of long run investment performance that take into account why we invest. And I think we have to figure out how to build into it, the use of cash thrown off by our investment for other purposes. So this is one of the things driving me right now. I’ve got a working paper, but it’s incomplete. So I’m thinking more about that. I hope other people will also think more about that.

Meb:

Yeah. Well, speaking of papers, you’ve written a lot, and distribution with power laws, you certainly, the one we talked about today is probably the most downloads and interest, maybe more than all the others combined. I don’t know. That’s probably usually how it goes. But you got some other fun ones. You got one where you’re talking about… And I tweeted about this the other day, not specifically to you, but it’s basically this mystery of you having these zero cost indexes at this point, but particularly in the mutual fund world, there’s people paying one and a half, 2% for essentially closet index funds. And I get if you’re trying to at least be an active manager and you’re going to be really different. But so much of that world today is still just closet index, but a really high fee. And thinking of why that mystery persists, I have some ideas, but you had a paper called Mutual Fund Performance at Long Horizons where you’re trying to calculate the total wealth loss and cost, or said differently, transfer to mutual fund managers, maybe. Tell us a little bit about what was the conclusion there.

Hendrik:

The punchline is that if mutual fund investors had earned SPY returns, the SPY ETF, they had earned SPY returns instead of their actual returns, it amounted to a trillion dollar difference by the end of the sample. A trillion is a sizable number. And of course, that’s a hypothetical benchmark. Obviously not everybody could have been in the SPY, but still the number is illustrative. The same basic principles are at work with mutual funds as with individual stocks, just lower key. Again, the techie term is skewness. But there’s some big winner funds and then there’s a lot of underperforming funds. It’s not so severe that the average fund underperforms T-bills, fortunately, but it is the case that most funds underperform a market benchmark like the SPY.

What lesson do we take from this? Really big question. Active versus passive. Every investor has to make their own decisions there. But we can also think of it from an economic wide level. Is too much money in active? Is too much money in passive? You can find people arguing both sides of that. What I take from the study is that in the past, either too much money was in active or fees were too high. Of course, nowadays, less money is in active, more money is passive, and fees are lower than they used to be. Are we now at the right equilibrium or should fees be lower and the active sector be smaller? I don’t have the answer, but I think the evidence is that in the past, either too much money was active or the fees were too high.

Meb:

It’s even worse in some other countries around the world. The US has certainly seen this big shift to low cost, and a lot of countries, developed as well as emerging, where the offerings, there’s so many intermediaries, where you’re looking at 2% plus for all in costs for just getting some basic exposures is really frustrating. But to me that seems like a one-way street. My thesis is it’s death and divorce and bear markets. So death, divorce and drawdowns, or the three D’s, that money never goes back usually to paying 2% for something you can get for zero or close to zero. But that plays out over really long time periods.

Hendrik:

I’m with you in that… I agree that fund managers who charge a high fee to be closet indexers are not making the world a better place. Maybe they’re making themselves a better place. So my thinking is if you’re going to be active, be active, put your chin out there, and if you’re right, the world will know it. And if you’re wrong, the world will know it too. But I think if you’re going to be active, be active.

Meb:

I hear you. Are there any papers you’ve written where you were like, “Damn, man,” this was a great paper and the world just didn’t really care or something that you’re really… You could answer this slightly differently. Is there anything you’re currently working on you’re really excited about? Is there something you worked on that you either thought should get more recognition or something you’re excited about now that you think will be exciting when it comes out?

Hendrik:

I do have a paper that fits under the description you made there, and I’m going to sound a little bit like a stuck record here, because I’m going to go back to the world pays a lot of attention to Alphas, but the intellectual history of Alpha, I’m old enough to remember you’re probably not, that this was originally called Jensen’s Alpha. Michael Jensen unfortunately passed away two weeks ago, but he’s left an intellectual legacy in many ways. But Alpha was originally Jensen’s Alpha. And if you go back to the paper where Jensen introduced Alpha, he very clearly described that this was a measure of performance that rests on the capital asset pricing model. And the capital asset pricing model, we’ve moved away from it, but it’s a single period model. And I think a lot of what is done, particularly in academic investment studies, still has this single period mindset.

So Alpha is an estimate of an abnormal return, earned, in. If you estimate it for a monthly data, it’s an estimate of the average abnormal return in a month. There’s information there, but what if somebody’s invested for 120 months or 360 months? You cannot just take the monthly Alpha and compound it. So I have a paper where we attempt to estimate Alpha over longer horizons, like a decade, and it’s quite challenging, because the longer the horizon you want to measure returns over the less independent data you have, the [inaudible 00:32:38] data, you mentioned it, there’s a hundred years of data there. It means we have almost 10 independent data points on decade horizon returns. So there’s certainly some challenges, but in any event, I have a paper where we try to take on those challenges and estimate decade horizon Alphas.

Meb:

I saw you make one comment somewhere, I don’t remember where, but it was along the lines of this topic of portfolios and rebalancing. And you said, “I think a decent portion about what’s been written about rebalancing doesn’t make sense.” I love the intro. What do you mean by that?

Hendrik:

So I’m not immediately remembering where I said that or where you might have come across that quote, but I do generally feel that way, that much of what’s been written about rebalancing is overly simplistic. So I won’t point to any particular paper, but there’s some papers that suggest that rebalancing is a way of enhancing your average portfolio return. You get wealthier by rebalancing. That’s far from guaranteed. A rebalancing strategy is essentially the opposite of a momentum strategy. It’s to sell stocks that have gone up and buy stocks that have gone down to get back to previous weights. It’s basically a contrarian strategy, and if there’s momentum in the data at the horizon, you do it.

Rebalancing is not going to make you wealthier on average. If everything was a random walk, then rebalancing would have no effect at all on your expected returns. So there’s no magic there, really. Just understand rebalancing as a contrarian strategy, and whether it improves your average return depends on whether there’s serial dependence in the data. Are there continuations or are there reversals? The one thing I will say about rebalancing is it restores diversification. We touched on this earlier. If you start with a well-diversified portfolio, because there’s a few big winners 10 years later, you don’t have such a well-diversified portfolio. So you can restore diversification by rebalancing. That part’s solid.

Meb:

You reminded me of a quote from Peter Bernstein, which I found recently, and I had not seen before. But he said, “I view diversification not only as a survival strategy, but as an aggressive strategy, because the next windfall might come from a surprising place.” Which I thought was interesting as we’ve seen… For example, I love talking about cocoa going through the roof this past year as my chocolate prices are getting very expensive. But it also applies to really any investment. It could be MLPs, it could be bonds, real estate, commodities, stocks, foreign stocks. Not a totally unique environment, but a somewhat rare environment where the US stock market has really mowed down everything in the rest of the world for the past 15 years, but has been really an exceptional investment. But sometimes the returns come from weird places, and that’s within the stock market too.

Hendrik:

Yeah, I agree. It’s really solid to say that most people should be diversified, unless there’s good reason to think you’re one of the few with the right comparative advantage, or you can find the manager who has that comparative advantage. Most of us should be diversified. But that doesn’t necessarily mean you want a US total market index. So first of all, we should be considering potentially going outside of the stock market. I did, myself, in the wake of the financial crisis. I bought a number of single family homes as investment properties. I was not flipping. It seemed to be a good opportunity. Also, this is partly related to where I am in my lifecycle, but I’ve been tilting towards dividend paying ETFs, still diversified, but something of a defensive strategy and a focus on income.

Meb:

And are you reinvesting those dividends or are you just spending it on piña coladas? Give us a real world example.

Hendrik:

Well, for the moment I’m reinvesting, but the idea is that if and when I retire, which is an open question, at that point, I’ll be looking at the dividends to fund piña coladas. The other thing that your comments reminded me of, I’ve tilted, to a substantial extent, to non-US dividend ETFs. The fact that the US markets have had this incredible 30 or 40 year run, and maybe not everybody realizes the extent to which the US markets, US stock markets have outperformed the rest of the world. That doesn’t guarantee it’s going to happen again. So anyway, I’ve made it a point to buy into some non-US dividend funds. So yeah, definitely diversified, but with some thought to where to diversify, and I think many more people can benefit from that.

Meb:

What’s been your own most memorable investment? Is there anything that stands out? Is it housing? Is it something else?

Hendrik:

As I said, I’m mostly a diversified buy and hold guy. So the downside to being that guy is, well, it’s all kind of boring. For most people, it’s our best investment advice, but it’s boring. Maybe it’s not surprising that people would prefer to hear someone tell them how to be rich by next Friday. So most of my investment stories are pretty boring for that reason. Probably the most interesting thing I’ve done was going into residential real estate as an investment. I did that here in the Phoenix area in 2010, in the wake of the financial crisis. It turned out well. Of course, the same money invested in the stock market in 2010 would have also done well. But I do get a little kick out of telling people with a straight face that I chose to do this several months ahead of the big companies, big investment companies that came in and started buying up foreclosed houses by the thousands, which by the way, then pushed me out of the market once that competition arrived.

Meb:

Hank, what’s the best place to find your writings, your research? Where do they go?

Hendrik:

Ssrn.com. I know you’re familiar with it because some of your papers are there and are among the most highly downloaded papers on the site. Ssrn.com. You can search for the author’s name. Here’s the advantage of having an unusual last name. Makes me easy to find.

Meb:

Hank, thanks so much for joining us today.

Hendrik:

It’s my pleasure, Meb.