Bogleheads® on Investing Podcast 059: Dr. William F. Sharpe, host Jon Luskin
00:00:00.000 | John Luskin: Welcome to the 59th edition of the Bogleheads on Investing podcast.
00:00:14.780 | Today our special guest is Dr. William Sharpe.
00:00:18.100 | I'm John Luskin and I normally host our Bogleheads live show for the folks of Twitter.
00:00:23.860 | I'll be taking over for the normal host, Rick Ferry, while he takes a summer sabbatical.
00:00:37.260 | Please allow me to introduce Dr. William Sharpe.
00:00:40.060 | He was one of the originators of the capital asset pricing model, developed the Sharpe
00:00:45.020 | ratio for investment performance analysis, and developed other methods for the evaluation
00:00:49.980 | of options, asset allocation optimization, and investment return analysis for evaluating
00:00:56.260 | the style and performance of investment funds.
00:00:59.260 | Dr. Sharpe has published articles in a number of professional journals and is a past president
00:01:05.940 | of the American Finance Association.
00:01:08.860 | In 1990, he received the Nobel Prize in Economic Sciences for his work on the capital asset
00:01:14.500 | pricing model.
00:01:15.980 | You can learn more about Dr. Sharpe at wsharpe.com.
00:01:20.700 | Some announcements before we get started on today's episode with Dr. Bill Sharpe.
00:01:25.820 | This episode of the Bogleheads on Investing podcast, as with all episodes, is brought
00:01:30.620 | to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is
00:01:36.420 | building a world of well-informed, capable, and empowered investors.
00:01:41.180 | Visit boglecenter.net where you'll find valuable information, including transcripts
00:01:46.140 | of podcast episodes.
00:01:48.380 | Another announcement, registration is currently open for the 2023 Bogleheads Conference.
00:01:53.700 | This year's conference is on October 13th through the 15th in Maryland.
00:01:58.560 | We have some phenomenal personal finance and investing rock stars who will be attending
00:02:03.180 | as speakers, including Charles Ellis, Paul Merriman, Clark Howard, Jonathan Clements,
00:02:11.180 | Michelle Singletary, Barry Ritholz, Wade Pfau, and more.
00:02:16.660 | And of course, Bogleheads favorites, host of this show, Rick Ferry, Christine Benz,
00:02:22.060 | Dr. Bill Bernstein, Mike Piper, Alan Roth, and much more.
00:02:27.280 | Go to boglecenter.net/2023conference to see the full lineup and to register.
00:02:33.740 | Also, you still have time to take advantage of the discounted room rate.
00:02:38.060 | Again, that's boglecenter.net/2023conference.
00:02:44.180 | And finally, a disclaimer, the following is for informational and entertainment purposes
00:02:49.740 | only, and should not be relied upon as investment advice.
00:02:54.620 | And with that, let's get started on our interview with Dr. William Sharp.
00:02:59.460 | Bill, welcome to the 59th Bogleheads on Investing Podcast.
00:03:05.120 | Thank you for joining us.
00:03:06.120 | My pleasure.
00:03:07.120 | In 1990, you jointly received the Nobel Memorial Prize in Economics with Harry Markowitz and
00:03:15.380 | Martin Miller for your work on the capital asset pricing model.
00:03:20.460 | Tell us about the capital asset pricing model.
00:03:24.160 | The idea is that the more securities you have in a portfolio, the less important is the
00:03:31.600 | risk that's specific to a given stock, whether it be from the company's activities or from
00:03:38.620 | the industry it's in.
00:03:40.660 | So as you put more and more securities in a portfolio, what we call idiosyncratic risk,
00:03:46.880 | the risk that's attributable to the fact that General Motors or the fact that it's in the
00:03:51.400 | auto industry, that risk tends to be diversified away.
00:03:56.800 | And as you diversify more, the risk in your portfolio becomes predominantly due to what's
00:04:03.280 | going on in the broader market.
00:04:05.800 | So certainly Bogleheads are fully subscribed to this.
00:04:09.360 | We love diversification and we love those low cost index funds.
00:04:13.680 | We want the return of the market.
00:04:16.560 | We're not necessarily putting all our money into just one individual stock and that helps
00:04:21.960 | manage risk.
00:04:23.880 | Let's jump to one of our questions that we got from Twitter.
00:04:28.040 | This question is from a user named Levi who writes, "Do you still fully subscribe to the
00:04:32.360 | capital asset price model?"
00:04:34.000 | Well, it's a model and models abstract from reality in various ways and get results based
00:04:42.920 | on what goes into the model, what you assume in the model.
00:04:46.720 | The CAPM, the original version in the dissertation assumed that all stocks had risk that came
00:04:54.760 | from "the market" and then idiosyncratic risk that was unique to them and not correlated
00:05:02.600 | with anything else going on.
00:05:05.000 | So in that sense, it assumed, it was not perhaps surprising I got the result that expected
00:05:11.280 | returns would be related to beta values, that is sensitivity to the market.
00:05:16.880 | The broader model used just the idea that the more diversified your portfolio, the greater
00:05:24.820 | would be the component of risk in that portfolio that was attributable to the market as a whole.
00:05:31.440 | And so in a sense it did not assume that the market was the only source of returns.
00:05:38.280 | It in some sense got bad results that the market portfolio was predominantly, I should
00:05:43.840 | say to be careful, the risk for which there would be rewards and higher expected returns.
00:05:50.000 | There was a radical difference between the two.
00:05:53.000 | And some people who knew the first were, had thought that the second result, the CAPM resulted
00:05:59.840 | from assuming the "single index model," that is that only market risk was the correlated
00:06:06.260 | risk in securities, it did not.
00:06:08.400 | Again, if you have enough stocks that will diversify away and be of much less importance
00:06:15.560 | and therefore not rewarded, the non-market part would not be rewarded in higher expected
00:06:21.720 | returns.
00:06:23.840 | This question is from David from Twitter who writes, "It would be great if Dr. Sharpe
00:06:27.960 | could comment on CAPM assumptions and the degree to which the model's value has changed
00:06:33.320 | as markets have evolved."
00:06:35.640 | It's hard to describe to somebody in today's world how irrelevant the stock market was
00:06:42.360 | for most human beings back in the 50s and 60s.
00:06:47.820 | Relatively few people had individual stocks, there were not 401k plans, and there certainly
00:06:54.280 | weren't as many securities as there are now, or as many different exchanges, et cetera.
00:07:00.280 | At the time, the idea was that the market as a whole could be sufficiently dominant
00:07:08.880 | in expected returns that it would be a high, high, high percentage of the influence on
00:07:17.120 | expected returns.
00:07:18.320 | Now there was the idea that only the beta of a security would have an impact on its
00:07:24.420 | expected returns.
00:07:25.880 | That was a pretty far out assumption.
00:07:29.560 | Now there are so many securities, so many markets for that matter, and so many people
00:07:35.840 | who own securities that nowhere else in their 401ks or 3Bs, I think it's to me at least
00:07:43.480 | a more comfortable assumption.
00:07:46.720 | Let's jump to measuring risk next.
00:07:51.160 | This question comes from username 95 suited from the Bill Bled's forums who writes, "Should
00:07:56.380 | investors consider volatility to be the primary measure of risk when constructing financial
00:08:02.800 | portfolios?"
00:08:04.640 | I would say yes, if they have a bunch of securities or a mutual fund that has a bunch of securities
00:08:10.720 | or multiple mutual funds.
00:08:13.000 | Obviously, if they have an investment portfolio of three stocks, there's a lot of non-market
00:08:18.760 | risk in that portfolio.
00:08:20.760 | But if they do what bobbleheads might, by and large, I would assume do, yes.
00:08:26.340 | Yes, certainly.
00:08:27.340 | I wonder if 95 suited is referring to some other risks that long-term investors might
00:08:32.820 | face, such as inflation risk.
00:08:35.900 | That's to say, if you don't want to take volatility as a risk, the risk that your investments
00:08:40.620 | decrease in value, then you're not necessarily getting rid of all risk so much as you're
00:08:46.060 | trading that one risk, volatility, for another risk, which is inflation.
00:08:52.620 | If you're not going to invest in assets like stocks that have historically grown more than
00:08:57.060 | inflation, then you might be looking at your wealth decreasing over the long term.
00:09:01.980 | Well, I think there's a very strong argument that for most people, the returns that matter
00:09:07.920 | are real returns, inflation adjusts.
00:09:10.340 | Now, you know, we can talk about how important is inflation for old people versus young people,
00:09:16.500 | but in a sense, I would favor thinking of returns not as nominal returns, but as real
00:09:23.420 | returns.
00:09:24.420 | Pick your country and time period.
00:09:26.460 | Inflation may be dominant.
00:09:27.460 | It may, if you're lucky, for a short period in some countries be sort of minimal, as we
00:09:32.980 | well know and as we're experiencing.
00:09:35.340 | In most countries, in many times, inflation is important.
00:09:39.660 | So in some sense, it's easy to just do everything in real returns.
00:09:43.580 | When I'm doing projections, Monte Carlo, what have you, I tend to like to do it all in real
00:09:50.340 | returns.
00:09:51.340 | Then the literature, there's an argument that for retired people, inflation may not be quite
00:09:57.660 | as formidable a factor, depending on if they've bought their house and they paid off their
00:10:03.420 | mortgage, et cetera.
00:10:05.540 | Retiree taxes in some places in California, for example, there's a limit on how much they
00:10:11.420 | can be increased once you bought the house, et cetera.
00:10:15.200 | My inflation may be different than your inflation.
00:10:18.820 | There's some research by David Blanchett that talks about the spending smile of retirees,
00:10:24.660 | showing how retiree spending might not actually keep up with inflation.
00:10:29.740 | I will link to that in the show notes for our podcast listeners.
00:10:33.860 | David Blanchett, by the way, was our guest on episode 14 of the Bogleheads Live show.
00:10:41.060 | I'll also link to that in the show notes.
00:10:44.220 | Let's talk more about measuring risk.
00:10:46.660 | This question is from the White Coat Investor from the Bogleheads forums, who writes, "Risk
00:10:53.940 | adjusted return calculators, such as the Sharpe ratio, use volatility as a measurement risk.
00:11:01.180 | Volatility is the change in price of your investment."
00:11:05.980 | The White Coat Investor goes on to say, "A long-term investor really shouldn't care much
00:11:10.780 | about volatility.
00:11:12.660 | Does that mean that they shouldn't care about the Sharpe, Treynor, or Sortino ratios?"
00:11:17.700 | And before we answer that question, perhaps you can tell us what those ratios are.
00:11:23.580 | I can probably answer that part, what the Sharpe ratio is.
00:11:27.280 | And let me say, by the way, I didn't call it that.
00:11:29.620 | I called it the reward to variability ratio, and I think it was Gene Fama started calling
00:11:34.420 | it the Sharpe ratio.
00:11:36.060 | The idea of the Sharpe ratio is to at least take two things into account, you know, an
00:11:43.540 | average returns and a standard deviation.
00:11:48.100 | Standard deviation, for those who aren't investing nerds, is just a way that we can measure risk.
00:11:55.160 | How much our portfolio changes in value.
00:11:59.360 | This is the same thing as the volatility that we just mentioned.
00:12:03.480 | Standard deviation, volatility, and risk are often all used interchangeably.
00:12:09.760 | The T statistic or the Sharpe ratio, it gives you credit for higher average returns.
00:12:16.520 | That's on the top and it gives you a discredit or demotes your number or lowers your number
00:12:21.780 | for more risk, more variation.
00:12:24.520 | That's the number on the bottom.
00:12:26.460 | And so this has in the numerator an average and on the denominator a standard deviation.
00:12:33.000 | So you get a better number if you do better on average and you get a better number of
00:12:37.940 | the things equal if you have less variability.
00:12:41.880 | It's not unlike a statistical measure called the T statistic, which again is saying, well,
00:12:48.400 | here's how you did on average, but how much variation was there?
00:12:52.240 | If you did this on average and it was almost the same every single period, then using that
00:12:57.660 | number as a prediction makes me more comfortable than if it was that on average, but it was
00:13:02.820 | very all over the place.
00:13:05.180 | The original idea, as you know, it takes into account the risk-free rate.
00:13:10.780 | So it's not just the average return on the top.
00:13:13.540 | It's average over and above the risk-free rate.
00:13:16.500 | That's because it assumes that you can borrow and lend at that rate.
00:13:20.660 | And so you could take that portfolio and lever it up or down at that rate.
00:13:26.060 | That's the economics behind it.
00:13:28.180 | The Sharpe ratio, it's a useful number.
00:13:30.900 | I would not refuse to look at it if somebody offered it to me for an investment.
00:13:36.520 | And again, it's particularly important to understand that for a piece of a portfolio,
00:13:42.960 | the risk of that piece may or may not be important depending on how correlated it is with what's
00:13:49.080 | going on with the other securities in the portfolio.
00:13:52.080 | I sometimes say when people ask about the Sharpe ratio, they say, look, folks, we have
00:13:57.440 | computers now.
00:13:58.500 | We don't need to put everything in one number.
00:14:01.620 | We can look at more than one number, you know, what was the average return and what was the
00:14:06.040 | risk and what was the beta, et cetera.
00:14:09.540 | We can do things that are more sophisticated.
00:14:12.220 | I serve on nonprofit investment committees.
00:14:15.900 | Very often the consultant or the manager will show you Sharpe ratios for every investment
00:14:21.560 | in the portfolio, this fund, that fund, et cetera.
00:14:25.220 | That doesn't really help you much with what it was originally intended for.
00:14:29.660 | It does help you in the sense it's like a T statistic.
00:14:33.140 | It is interesting if a manager did not only well, but did it with quite some consistency.
00:14:38.420 | You have more reason to believe that you'll might get some good results in the future.
00:14:43.860 | Like some manager who is touting a Sharpe ratio, I don't know, it was five or something,
00:14:50.420 | you know, this humongous Sharpe ratio and looked at it and said, it was based on, I
00:14:56.260 | think it was 14 monthly returns for private equity for which there was no market value.
00:15:04.740 | It was just an estimate.
00:15:06.300 | And they'd put down these 15 estimates and sure enough, there wasn't much variation and
00:15:11.900 | they've done all right, according to the estimates.
00:15:14.440 | So sometimes there are uses that I would not endorse.
00:15:17.580 | For those folks who aren't investment nerds, why that is hilarious for two reasons.
00:15:23.220 | Number one, a 14 month investment return is pretty much random.
00:15:27.660 | And then also if it's a private investment, the manager can pretty much make up whatever
00:15:32.720 | price, whatever investment return.
00:15:35.380 | What do you want?
00:15:36.380 | What would you like it to be worth?
00:15:38.340 | All that's to say how they use the Sharpe ratio in that situation is quite silly.
00:15:43.460 | And then for me, the Sharpe ratio is very special because I looked at how endowments
00:15:47.540 | did next to index fund portfolios for a master's thesis.
00:15:51.900 | Hey, what happens with $600 million to invest?
00:15:55.140 | Well, the data already exists to show that those endowments would have been better off
00:16:00.620 | with low cost index funds.
00:16:02.520 | But what about risk?
00:16:03.880 | What is the risk adjusted return?
00:16:06.140 | So I use a Sharpe ratio and the Sortino ratio to show even on a risk adjusted basis, considering
00:16:11.720 | how much risk you are taking, that the amount of return you're getting compared to that
00:16:16.860 | index fund portfolio is not that great.
00:16:20.580 | And of course, if you're comparing portfolios and you can borrow and lend at the riskless
00:16:25.380 | rate, then the portfolio with the highest Sharpe ratio is golden because with leverage
00:16:31.920 | up or down, that can beat anything below it.
00:16:37.580 | Let's jump to the second part of the White Coat Investors question who asks, "How can
00:16:41.620 | we adjust for the deep risks discussed by Dr. Bill Bernstein, such as inflation, deflation,
00:16:48.020 | confiscation, and devastation?"
00:16:50.780 | Let me maybe twist the question a little to a broader question, to what extent is it useful
00:16:57.060 | to look at historic returns on a security portfolio, the market, whatever, as a predictor
00:17:05.500 | of future returns and risks?
00:17:10.220 | And that's a very serious question you have to ask yourself.
00:17:14.060 | I would say, I think it's incumbent upon you or your advisor to look at history to see
00:17:21.960 | how that particular portfolio would have done in the past.
00:17:26.520 | I don't think you should say past is not a predictor of the future, so don't look at
00:17:31.640 | all.
00:17:33.140 | On the other hand, if a portfolio did well in the past, how likely is it that it's going
00:17:39.120 | to do well in the future?
00:17:40.980 | And I would say generally not very likely.
00:17:44.340 | Risk is a somewhat different matter.
00:17:46.160 | Past risk is probably a better predictor of future risk.
00:17:49.700 | In an efficient market, past expected returns that are abnormally high are unlikely to be
00:17:57.120 | repeated as are terrible returns.
00:18:00.440 | If it's done really well in the past, the market knows that, and the price reflects
00:18:06.400 | that to the extent that it's predictive of the future.
00:18:10.060 | So don't expect, with any kind of certainty, abnormally high returns in the future.
00:18:16.860 | Let's talk a little bit more about the risk-adjusted metrics that are out there.
00:18:22.780 | Username Chiggy from Twitter writes, "I should ask him if the Sharpe Ratio is the best risk-adjusted
00:18:28.320 | return metric to compare index funds versus mutual funds."
00:18:32.620 | In principle, the Sharpe Ratio should be used for your whole portfolio.
00:18:35.700 | In many cases, it's used for pieces of the portfolio.
00:18:39.880 | It's useful, but in a different sense.
00:18:42.140 | And if you're using it for pieces of a portfolio, then it's more in the sense of the T-statistic.
00:18:49.320 | How did that piece do on average, and how much risk variation was there getting to that
00:18:56.300 | average?
00:18:57.300 | If you got that average return almost every single month, then that's a very different
00:19:02.820 | story than if you got it ranging all over the place.
00:19:06.660 | For a whole portfolio, don't just use the standard deviation.
00:19:11.300 | Look at the whole distribution.
00:19:13.120 | How many months, let's say, over the last 20 years, did it lose 20%, did it lose 19%?
00:19:20.280 | Show the range of things that happened and how frequently they happened.
00:19:24.340 | That's for the whole portfolio.
00:19:26.100 | For pieces of the portfolio, even standard deviation, the typical risk measure, standard
00:19:32.340 | deviation of a portfolio of X plus Y is not just the average of those two standard deviations.
00:19:39.980 | It depends on how they move together, so it gets more complicated.
00:19:45.140 | Thoughts on the Sortino ratio?
00:19:48.100 | My recollection is that for the Sortino ratio, for the risk side, uses downside risk on the
00:19:55.420 | grounds that the risk of that you'll do better than expected doesn't seem to be something
00:19:59.940 | you should worry about.
00:20:01.340 | And Sortino is certainly right.
00:20:03.340 | When you're looking at a whole portfolio, what you care about is downside.
00:20:08.700 | Outside risk is fine, you know, the more the merrier.
00:20:11.860 | And there's the issue, if the distribution is symmetric around a middle point, you know,
00:20:17.380 | when you plot it, it looks sort of the same on the downside as on the upside, then it
00:20:22.440 | kind of doesn't matter whether you use standard deviation or the standard deviation of the
00:20:27.580 | downside.
00:20:28.580 | Bill, I mentioned earlier that I used the Sharpe ratio to compare index fund portfolios
00:20:33.620 | to the very high fee portfolios of endowments to compare their performance on a risk-adjusted
00:20:39.420 | basis.
00:20:40.420 | I also used the Sortino ratio and the results were very similar.
00:20:45.300 | That's kind of my expectation.
00:20:47.460 | The probability distributions aren't symmetric, but they're typically of a similar enough
00:20:53.020 | form.
00:20:54.020 | Probably if you rank on one, probably rank on the other.
00:20:57.500 | This question is from username Derrick Tinnin from Twitter, who writes, "Are the persistent
00:21:04.300 | flows to index funds changing the market structure?"
00:21:08.260 | I guess there are two ways of looking at that question.
00:21:12.780 | One is, were there not those funds, how different would things be?
00:21:18.380 | The other is, given there are those now and there were not back in my early days, how
00:21:23.780 | different are things, and I'll skip the latter one because the world is so different
00:21:28.220 | in general.
00:21:29.220 | I don't even know how to start on that one.
00:21:31.700 | I guess one difference if people generally stop using index funds would be they'd be
00:21:37.780 | poorer because they'd be paying higher fees.
00:21:40.900 | And as Jack Vogel has wrote about and talked about many times, that's not a trivial difference.
00:21:47.700 | That's a major difference.
00:21:49.680 | Some of the ironies of efficient market theory broadly construed is there's a sort of a contradiction.
00:21:56.160 | We assume that people are really working hard to figure out exactly how much more General
00:22:00.960 | Motors is worth than General Electric, and that all those prices take into account information
00:22:08.240 | in very efficient ways.
00:22:11.140 | And yet we encourage investors to pay no attention to any of that and just call them all.
00:22:18.660 | And there has to be a point at which there aren't enough active managers, people doing
00:22:23.840 | research on securities to keep the market prices right, as it were, to incorporate the
00:22:30.600 | information that's extant into security prices.
00:22:35.100 | That's a really interesting thing to worry about.
00:22:37.820 | And over the many years since we all started in this field, question is how much indexing
00:22:43.760 | is too much?
00:22:45.560 | My hope at least is that if and when we got to that point, enough people will peel off
00:22:51.080 | and start doing security research and become active managers.
00:22:56.000 | Where that point is, I don't know, but it is a dilemma.
00:23:01.280 | So you don't want to convince too many people to index.
00:23:05.320 | Unfortunately, the people who don't index are paying the price for that research through
00:23:11.020 | higher fees.
00:23:12.380 | It's a very strange kind of equilibrium.
00:23:15.780 | Do I worry about it now?
00:23:17.740 | No.
00:23:18.740 | Do I index now?
00:23:20.880 | Yes.
00:23:21.880 | When I started teaching the investments course at Stanford, and this would have been 1970
00:23:27.380 | or thereafter, I would start the course by going into the classroom and writing on the
00:23:32.120 | board a phone number.
00:23:34.000 | And I would say, this is the most important information you're going to get in this course.
00:23:39.120 | And I'd wait for somebody to say, well, what is that?
00:23:41.960 | And I said, that's the new customer line at Vanguard.
00:23:45.560 | This is true.
00:23:46.560 | And I'm making this up just to please the Bogleheads because they were at that time
00:23:51.320 | the only place you could get an index fund.
00:23:54.300 | It's an issue to think about, if not worry about, is there too much indexing?
00:24:00.680 | The answer is no, but I can't prove it.
00:24:03.920 | Certainly to your point, if too many index fund investors means an opportunity to make
00:24:08.600 | some money, someone's going to try and do just that.
00:24:11.640 | Of course.
00:24:12.640 | And the question is, how much, if any of that, will the managers pass through to the shareholders
00:24:18.200 | of the fund?
00:24:19.760 | To quote Rick Ferry, if there is any alpha, it goes to the managers.
00:24:25.200 | Let's move on to another question on index investing.
00:24:28.940 | This one is from username SB1234 from the Bogleheads forums who writes, are buy and
00:24:34.840 | hold index fund investors free riding in the sense that they do not contribute to price
00:24:39.920 | discovery?
00:24:40.920 | I think so.
00:24:43.000 | There are certainly managers who get rich by being in some sense superior in getting
00:24:49.480 | information and acting on it.
00:24:52.760 | I have a general audience teaching the investments course at Stanford and I will divide them
00:24:58.600 | into two halves, left side of the room, right side.
00:25:02.160 | They're all money managers in this market and they collectively are the market.
00:25:07.160 | I would assign half of them to be index fund managers and tell them what they did.
00:25:12.480 | They had to figure out how many shares were outstanding of each and by exactly proportional
00:25:17.280 | amounts and the people on this side were active managers and I would describe this one does
00:25:23.720 | research on this and that one does this and, you know, give them a sense of what active
00:25:28.060 | managers do.
00:25:29.680 | So I'd say these folks own half the market and those folks collectively own half the
00:25:35.120 | market and the index managers, of course, each of them owns the same portfolio, but
00:25:39.760 | the active managers are all over the place.
00:25:42.560 | And then I would say, okay, before costs, the market is down 12%, okay, before costs,
00:25:48.720 | what did this passive manager earn and they've said 12%, what did that one earn, yeah, 12%.
00:25:56.040 | Now over here on the active side, what did this one earn, 30%, brilliant, what did this
00:26:01.120 | one earn, minus 12, what did the average dollar earn on the passive side before costs and
00:26:07.240 | they think a bit, 12%.
00:26:09.720 | What did the average dollar earn on the active side, it takes a little while, it gotta be
00:26:15.440 | 12%.
00:26:16.440 | Okay.
00:26:17.440 | Then we take costs into account.
00:26:19.420 | In general audiences, when you play that little game, they say, wait a minute, what did he
00:26:25.400 | do?
00:26:26.400 | Wait, that can't be right.
00:26:27.400 | I mean, forget datas and standard deviations and equilibrium and all that, just that argument
00:26:34.480 | from pure arithmetic.
00:26:36.520 | And the money managers hate to hear that because they don't want to have to have that discussion
00:26:41.680 | with their clients.
00:26:42.680 | It's a paper, I published a two-page paper on the arithmetic of active management.
00:26:48.600 | Sharpe's math, I'll link to that in the show notes for our podcast listeners, they can
00:26:53.680 | check out that paper by Bill.
00:26:55.880 | There have been attempts by many managers writing articles to say, well, but there are
00:26:59.900 | new issues.
00:27:00.900 | We get them, the good ones first, and there's this and there's that.
00:27:04.400 | Those are minor perturbations, realistically.
00:27:08.040 | And that argument for indexing, I mean, it's so self-evident, virtually everybody in the
00:27:13.680 | Boglehead group knows it.
00:27:16.360 | Let's move on to some questions on model portfolios next.
00:27:19.500 | This one is from username Exodusing from the Bogleheads forums who writes, a general principle
00:27:25.640 | is that people who are much different from the average investor, as weighted by portfolio
00:27:30.200 | size or trading activity, those people should deviate from the market cap weighting to take
00:27:35.640 | into account their special differences.
00:27:38.300 | Does Bill agree?
00:27:39.460 | And then we had a similar question from username Tom76.
00:27:43.400 | Let me break that into two pieces.
00:27:45.440 | One is less risk, more risk.
00:27:49.760 | And in the theory, you can do that by borrowing and lending.
00:27:55.120 | And in the theory, you can borrow and lend at the same rate, but those are very strong
00:27:59.460 | assumptions.
00:28:00.460 | There's one market portfolio levered up or down.
00:28:03.720 | And of course, people don't just take one market portfolio and lever it up or down.
00:28:08.020 | They tend to shade a bias towards less risky funds for a bias towards more risky, et cetera.
00:28:15.240 | The real world is more complicated than the simple models that economists create.
00:28:21.660 | People cannot borrow at the same rate at which they can lend or risklessly invest.
00:28:27.780 | There are arguments there and I will not argue that life is as simple as in our simple models.
00:28:33.900 | And again, you need to take your whole portfolio into account, your assets.
00:28:38.100 | If you have a home, an occupied home, that's an asset.
00:28:41.480 | If you have a mortgage, that's a liability, et cetera.
00:28:45.960 | I sort of think of that as more a bond stock issue.
00:28:51.560 | Now in the simple theory, you know, there's the market portfolio includes bonds and stocks
00:28:57.660 | and you lever that up or down at the riskless rate.
00:29:00.120 | Well, let's face it, we really don't do that.
00:29:03.040 | I think a lot of those issues can be addressed by changing the proportions of bonds and stocks.
00:29:09.520 | And that I think is the lever that I would prefer to see people pulling and pushing to
00:29:16.480 | get a balance.
00:29:18.480 | And that goes back to that basic Boglet's principle, which is take the right amount
00:29:23.560 | of risk.
00:29:24.780 | And you can do that by adjusting that lever.
00:29:27.160 | How much do you want in bonds versus stocks?
00:29:30.480 | Yeah, that would certainly be the place to start at the very least.
00:29:35.280 | I wonder if Exodus is asking about factor investing in this question.
00:29:40.160 | Some people's favorite strategy of overweighting small stocks, for example, you can do that
00:29:44.960 | with index funds.
00:29:46.600 | I don't advocate overweighting small stocks because you think they're underpriced.
00:29:51.340 | More risk for the chance at higher return.
00:29:53.940 | Those higher returns are not guaranteed when overweighting small caps.
00:29:59.360 | Let's talk about TIPS, Treasury Inflation Protected Securities.
00:30:03.640 | These are inflation-adjusted government bonds.
00:30:06.760 | We have another question from Boglet's forums.
00:30:09.080 | This user writes, "Now that TIPS have positive real yields, should individual investors who
00:30:15.120 | have enough space in tax-deferred accounts be using them exclusively instead of regular
00:30:20.840 | or nominal treasury bonds?"
00:30:24.240 | It's certainly nicer now that they have positive.
00:30:27.240 | It's not so nice for those who help them if they need to sell them.
00:30:30.360 | Well, definitely in an important sense, TIPS for somebody in the U.S. are the riskless
00:30:35.200 | security or as riskless as you can get in terms of consumption.
00:30:40.320 | Let's return to a question that we touched on earlier on factor investing, such as those
00:30:44.980 | factors found by Fama and French.
00:30:47.400 | Do you believe in those factors?
00:30:50.040 | Well, believe is perhaps too strong a word.
00:30:54.000 | Are they useful?
00:30:55.000 | Yes, for some things they are.
00:30:56.960 | But do I believe that it is clearly true that people should overweight exposure to a small
00:31:04.720 | factor or a gross factor or whatever factor of your choice because there's something wrong
00:31:10.600 | with the markets?
00:31:12.400 | No.
00:31:13.640 | What are your thoughts on international diversification?
00:31:17.460 | Should investors be only investing in the U.S. total stock market or should we be investing
00:31:22.320 | globally?
00:31:23.320 | I'll have to tell a story here.
00:31:26.220 | I was on a nonprofit investment committee and one of the members was a semi-retired
00:31:35.760 | private equity guy.
00:31:38.720 | And we had a consultant who was helping us, et cetera, the usual story.
00:31:45.020 | And at one point we were discussing a foreign investment and he gave a little speech as
00:31:51.680 | far as I could tell was not kidding, said, well, if he had his druthers, we wouldn't
00:31:57.080 | have any foreign investments because they don't know how to run businesses over there.
00:32:01.500 | And I thought, well, surely, okay, haha, this is a joke.
00:32:03.720 | It wasn't.
00:32:04.720 | He was serious.
00:32:06.460 | That's one view.
00:32:07.460 | It's not mine.
00:32:08.660 | My view is that international diversification should be a good thing in theory as long as
00:32:16.860 | people can without too many problems in terms of repatriation and all the rest and divergent
00:32:24.420 | tax systems.
00:32:26.260 | I believe in globally diversified portfolios, there is a sense of diversification.
00:32:33.220 | That said, there is an argument for investing at least more than market proportions at home
00:32:41.380 | because that's where a lot of your consumption originates.
00:32:47.180 | You know, if in fact the company that you have traditionally purchased goods at the
00:32:51.940 | grocery store does very well because they raise their prices a lot, you at least have
00:32:57.300 | a balance.
00:32:58.300 | Well, I'm paying more, but my stock went up and that's a trivial and sort of a silly example.
00:33:04.580 | So I think there is an argument for home bias, but I don't think it's totally offset by the
00:33:11.140 | advantages of global diversification.
00:33:13.860 | So there's a happy point in the middle somewhere there.
00:33:17.860 | For those who aren't investment nerds, know that the global cap weighting is roughly 60/40.
00:33:24.340 | That's to say roughly 60 cents of every dollar invested around the world is invested in U.S.
00:33:29.980 | companies and the balance of that 40 cents is invested outside of the U.S.
00:33:34.380 | So that is the global cap weighting.
00:33:36.780 | If we have a home bias, we'll invest a little bit more than that roughly 60% compared to
00:33:42.260 | international.
00:33:43.740 | For example, Rick Ferry, the normal host of this podcast, frequently suggests 2/3, 1/3
00:33:49.460 | in favor of U.S. stock markets, giving us a little bit of a home bias.
00:33:54.780 | He talks about that in episode one of the Bogleheads Live podcast.
00:33:58.380 | I'll link to that in the show notes for our podcast listeners to check that out.
00:34:02.180 | Bill, what do you think is a reasonable mix for home bias?
00:34:07.180 | Whether or not you go to world market proportions, which is what I would favor as a default.
00:34:13.900 | Ask yourself, I don't buy only companies in California, I buy companies in the U.S. and
00:34:20.060 | I don't buy only companies in the U.S.
00:34:22.660 | I think you need to really think a little bit about what are your other holdings.
00:34:26.580 | You obviously have a disproportionate holding in the U.S. if you own your own home.
00:34:32.360 | So if you take your overall portfolio, including things like equity in your home, then that
00:34:38.700 | gives you a difference.
00:34:41.140 | Certainly if you've got real estate, your primary residence, maybe even some investment
00:34:45.860 | properties, then that further tilts you towards that home bias.
00:34:51.380 | Then if you've got that global cap weighted portfolio for your liquid investments, that
00:34:56.060 | is a phenomenal point.
00:34:57.660 | There was a time there was some investor would say, I only invest in things that are close
00:35:01.740 | to home.
00:35:02.740 | You think, no, wait a minute, that's from a diversification standpoint, you win a lot
00:35:06.980 | of stake in California or if what have you from your property.
00:35:12.500 | Let's talk more about bonds.
00:35:13.900 | Bill, I'm curious about your thoughts on the following.
00:35:17.500 | The risk of equities shows up in corporate bonds, therefore, if I'm trying to manage
00:35:22.140 | equity risk, I don't want to hold bonds that are subject to equity risk in my portfolio.
00:35:29.460 | That means opting exclusively for U.S.
00:35:31.620 | Government bonds for the bond portion of my portfolio as advocated by David Swenson, the
00:35:38.820 | late chief investment officer over at Yields Endowment.
00:35:43.140 | I haven't thought of the issue that way.
00:35:45.700 | Why should it matter in what manner you invest in the company?
00:35:51.820 | It's out there.
00:35:52.820 | It's part of the market, broadly construed.
00:35:55.660 | There is obviously the risk issue.
00:35:57.420 | If you take the simplest of a theory, in theory, you should deal with combining the overall
00:36:04.460 | market with riskless securities to deal with your risk aversion and you should get everything
00:36:11.420 | that's out there in the market, if you can get it at reasonable expense.
00:36:16.260 | Now kinds of issues you're raising are more subtle, theory is not subtle enough to deal
00:36:22.700 | with it.
00:36:23.700 | My first impression would be whatever the company's issued will buy our proportionate
00:36:29.460 | share of everything and then leverage to move the overall risk of the portfolio up or potentially
00:36:38.380 | down.
00:36:39.380 | Barita Lover from the Bogleheads Forums asks, "Is chasing higher yields via a lower-duration
00:36:45.940 | bond in the current environment a viable strategy?"
00:36:49.380 | Well, I would just say generically anything that assumes that you can exploit somebody
00:36:55.500 | who is dumber than you would not be recommended if you believe in efficient markets.
00:37:01.180 | What are your thoughts on changing bond maturity over time, that's to say right now short-term
00:37:06.700 | yields are really attractive, therefore I'm going to hold a short-term bond portfolio
00:37:11.900 | and then maybe when rates normalize, I'll update my bond portfolio going farther out
00:37:16.940 | on that yield curve.
00:37:19.140 | What do you think about market timing your bond portfolio with respect to interest rates?
00:37:24.820 | Yeah, in general, I don't think much positively about market timing because market timing
00:37:32.180 | means the other people in the market are stupid or at least not as smart as you are.
00:37:37.900 | And there are a lot of smart people in the market.
00:37:41.020 | It's not at all clear that you know significantly more than is embedded in the market.
00:37:46.940 | Maybe you do.
00:37:47.940 | I think you know more about the future than the average investor and you have to think
00:37:52.380 | of the average investor as dollar-weighted, not the average investor, you know, down the
00:37:58.340 | street with a small portfolio.
00:38:00.180 | The average investor is pretty informed and pretty smart.
00:38:03.740 | If you're going to underweight or overweight anything because you think the market is quote
00:38:08.300 | got it wrong, then you're betting against a bunch of folks, many of whom in terms of
00:38:15.420 | dollars invested, know a lot about some of these things.
00:38:20.260 | I do not play that game and I would not recommend it to the average investor.
00:38:25.820 | What are your thoughts on foreign bond holdings?
00:38:28.240 | This question is from user name McHugh from the Global Heads Forums who asks about just
00:38:32.740 | holding the U.S. bond market on the bond portion of their portfolio.
00:38:38.740 | Well there's an argument you should overweigh that which you eat.
00:38:43.300 | In other words, you live in the U.S., you buy things from the U.S. predominantly, although
00:38:48.740 | not exclusively of course, there would be an argument for doing things that are closer
00:38:54.940 | to your consumption basket, put it in economist terms, and I think that's an argument worth
00:39:01.820 | thinking about.
00:39:02.820 | Of course, we consume a lot of things that in whole or in part come from elsewhere, but
00:39:09.960 | the whole bias, you know, maybe makes some sense, but you have to think about it that
00:39:15.220 | way I would argue as you make the decision.
00:39:19.780 | Let's talk a bit more about real estate.
00:39:21.820 | This question is from user name Abbas368 from the Bullguards Forums who writes, what are
00:39:26.560 | his thoughts on private real estate investing, such as Fundrise and Grant Cardone, as an
00:39:32.100 | alternative asset class to invest in alongside a diversified low-cost total market index
00:39:38.420 | fund portfolio?
00:39:40.700 | I think you should certainly get market proportion, think about market proportions of real estate
00:39:47.940 | in the sense of things that are traded on security markets where you've got liquidity,
00:39:52.980 | et cetera, not in the underlying asset, but in the security.
00:39:57.580 | When you start talking about direct investment in real estate, that raises a number of other
00:40:03.820 | conditions.
00:40:04.820 | I mean, you're not going to try to get a piece of every shopping mall.
00:40:09.260 | I think it's a practical matter.
00:40:11.860 | There are traded securities on major markets, that's definitely something worth considering
00:40:18.980 | in proportions on those markets.
00:40:22.540 | Abbas368 goes on to say, these funds typically have high fees, such as 1% and are illiquid.
00:40:31.060 | Does that illiquidity increase the probability of achieving alpha?
00:40:35.020 | Well, I would not argue that anything with certainty increases the probability of increasing
00:40:40.060 | alpha.
00:40:41.060 | I think there's a pretty good argument that the truly average investor should consider
00:40:46.860 | liquidity.
00:40:47.860 | You obviously don't do it when you buy your own house.
00:40:50.700 | You buy real estate that's illiquid because you can live in it, but to buy on the illiquid
00:40:56.420 | asset as an investment, period, I think you should give some thought before you do that.
00:41:03.860 | Let's talk about publicly traded REITs.
00:41:06.980 | For example, using Vanguard's low-cost REIT index fund, V&Q, these were highly recommended
00:41:13.220 | 10 to 20 years ago by Burton Malkiel and David Swensen.
00:41:18.380 | I think you should consider investing in them in market proportions, in the risky part of
00:41:23.560 | your portfolio.
00:41:24.560 | Again, if they're highly liquid and they're traded reputably and such, yes.
00:41:30.900 | When you invest in VTI, VTSAX, that low-cost Vanguard total stock market index fund, you're
00:41:36.680 | already getting everything in V&Q, to your point.
00:41:40.840 | Let's pivot to annuities.
00:41:42.540 | This one is from username Afan from the forums, who writes, "Can you discuss the role of
00:41:47.300 | annuities versus bonds in a retirement plan?"
00:41:51.780 | Annuities versus bonds, well, there's a really big difference.
00:41:55.600 | When you die, your kids can tell there's a difference, or your universities, and that
00:42:00.460 | when you die and holding annuities, there's nothing for anyone else.
00:42:04.980 | That's a major difference, and the whole issue of should you annuitize, should you partially
00:42:10.780 | annuitize is one that takes an awful lot of thought.
00:42:15.140 | There are very, very important things that transcend investment discussions on whether
00:42:20.140 | you should annuitize or not.
00:42:22.020 | One of the questions is whether or not you can even make it to a very old age, which
00:42:26.820 | you have some probability of reaching.
00:42:29.880 | And do you want to play the probabilities, or just say, "I'm not going to bet that I'm
00:42:34.180 | going to die soon"?
00:42:35.660 | It's a very complicated decision that involves many issues that transcend or at least overwhelm
00:42:42.300 | the economics involved.
00:42:43.860 | A single premium immediate annuity, that's the type of annuity you described just now.
00:42:51.100 | Let's jump to some questions that you suggested about asking artificial intelligence, AI,
00:42:57.300 | how to invest.
00:42:58.900 | It's pretty interesting.
00:42:59.900 | First of all, of course, as you well know, everybody now well knows the answers.
00:43:05.820 | It's astounding what kind of answers you can get.
00:43:09.580 | Answers do differ.
00:43:10.580 | I asked the arithmetic of active management, "Can the average dollar invested in a market
00:43:18.060 | portfolio after costs outperform the average dollar invested in active strategies?"
00:43:25.540 | And one of them said, "No, period."
00:43:29.320 | One has to think about what the role of AI will be in investment advice, whether it will
00:43:35.060 | replace some humans or it will just give advice to people who otherwise didn't get it, and
00:43:41.620 | what the impact of that might be.
00:43:44.120 | We need to find a way to make sure that the AI reads some of the things that you and I
00:43:48.820 | are talking about and such.
00:43:50.860 | Certainly, at least for the short-term inspirer, be aware if you're using those AI platforms
00:43:55.740 | for investment advice.
00:43:57.540 | Amen.
00:43:58.540 | Bill, thank you so much for your time.
00:44:01.060 | I really appreciate it, as I'm sure as do all the Bogleheads.
00:44:05.020 | Any final thoughts you'd like to share with the Bogleheads?
00:44:08.380 | My guess is the Bogleheads are on pretty much the right course, if they're truly following
00:44:13.140 | Jack.
00:44:14.140 | That's a very good thing.
00:44:15.420 | I appreciate your interest and I appreciate their interest and I appreciate anybody who
00:44:20.340 | listens to whatever the edited version of this will be for spending the time.
00:44:25.380 | And that wraps up our interview with Dr. William Sharpe.
00:44:29.860 | Don't forget, you've still got time to take advantage of the special room rate for the
00:44:34.260 | hotel for the 2023 Bogleheads conference.
00:44:38.220 | Go to boglecenter.net/2023conference for more information.
00:44:43.460 | I'll be back next month returning as guest host for the Bogleheads on Investing podcast.
00:44:49.340 | Until then, you can check out a wealth of information for do-it-yourself investors at
00:44:53.620 | the John C. Bogle Center for Financial Literacy at boglecenter.net.
00:44:58.700 | And check out bogleheads.org, the Bogleheads Twitter, Bogleheads Wiki, the Bogleheads YouTube
00:45:05.380 | channel, Bogleheads Facebook, Bogleheads Reddit, the John C. Bogle Center for Financial Literacy
00:45:11.900 | on LinkedIn, and local and virtual chapters.
00:45:15.620 | And to you listening right now, yes you, I'm talking to you.
00:45:19.940 | If you could please take a moment to subscribe and rate the podcast on Apple, Spotify, or
00:45:25.180 | wherever you get your podcast, and also be sure to leave a review, the more listeners
00:45:30.980 | who do that, the more other folks will find this resource for do-it-yourself investors.
00:45:37.500 | Thank you for checking out this episode of the Bogleheads on Investing podcast.
00:45:42.120 | If you want to submit questions for next month's guest, check out the Bogleheads forums.
00:45:47.600 | We have a thread going for questions for Jonathan Clements of the Humble Dollar, who will be
00:45:52.740 | our guest on the next show.
00:45:54.980 | I'll link to that thread in the show notes so you can drop your question for Jonathan
00:45:59.500 | Clements.
00:46:01.000 | Until that next show, have a great one.
00:46:03.340 | [Music]
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