Welcome, everyone, to the 77th edition of "Bogleheads on Investing." Today, our special guest is Azwath Damodaran, the professor at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. Azwath is best known among practitioners and academics as the dean of valuation for the many books, articles, and ongoing data he maintains on equity markets around the globe.

Hi, everyone. My name is Rick Ferry, and I am the host of "Bogleheads on Investing." This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.

I have a couple of announcements before we get started today. The YouTube videos from the 2024 Bogleheads Conference in Minneapolis, Minnesota are now available online at boglecenter.net. All of the sessions were recorded, and they're all available for free at the Bogle Center website. Second, we are very close to signing a contract to have the 2025 conference at a conference center on the Riverwalk in San Antonio the weekend of October 17th through the 19th.

It's going to be a great conference at a beautiful location. I'll provide more information on future podcasts when it becomes available. Our guest today on "Bogleheads on Investing" is Aswat Damodaran. He is a professor of finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation.

Aswat is known in the investment industry and the academic community as the dean of valuation. He has written close to a dozen books, countless academic articles. He maintains a blog and maintains an in-depth database on equity valuations around the globe that you can access by searching for Damodaran online.

Today, we'll be discussing his teachings, the risk-free rate, the equity risk premium, and even getting into how AI is changing finance and maybe changing all of us. So with no further ado, let me introduce Aswat Damodaran. Welcome to "Bogleheads on Investing." Thank you for having me. It's a real pleasure to have you.

I've been following you for years, your books and teachings, your website. You've got a tremendous amount of information there on valuation. You're very open with what you publish. You want people to learn, and I commend you for that. It's a real pleasure to interview you today. Thank you. I want to start out with who you are, your background.

I'm a teacher, and I describe myself as a teacher. And that's pretty much all I do. I don't consult. I don't do appraisals for a living. I'm not an expert witness. I'm a teacher. I teach. And that's my passion. I happen to teach corporate finance and valuation because it's an area which I find fascinating because it's an interplay between numbers and stories and understanding businesses, which I find fascinating.

But I'm a teacher, first and foremost. That's how I describe myself. And talk about how you decided you were going to become a teacher. I was getting my MBA at UCLA. It was 1981, and I was short of money. I needed something to cover tuition for the next semester.

And I took on a job as a TA, expecting it to be just one semester I'd be a TA, then I'll go do what MBAs do. That time, you know, go work for an investment bank. It was the start of the huge growth in investment banking. So I never expected it to be more than just that 15-week assignment of-- it was actually a quarter, a 10-week assignment.

It was an accounting class, which-- and I don't even like accounting, for those of you who have heard me talk about it. It's not a subject I like. But I walked into that class expecting to do a TA discussion. And 15 minutes in, I didn't know what it was.

I realized this was what I wanted to do with the rest of my life. I mean, I call these moments of grace, where essentially you get this signal of, hey, this is what you were meant to do. I'm convinced we all get our moments of grace. Most of the time, we're too busy to be watching for it.

I happened to be lucky enough to recognize it. And I walked out of that class, said, I'm going to become a teacher. And I mean, I could have become a teacher in a high school. I could have become one of these teachers who teaches in five different colleges. But I'm also lazy.

And one of the advantages of teaching at a research university is you teach three classes a year. That's your teaching load. And I said, that's the kind of teaching I'd like to do. Because then I can enjoy teaching. I won't burn out. So I walked up to the seventh floor of UCLA, which is where I was getting my MBA, into the finance professor's office.

And I said, I'd like to get a PhD. And he asked me, why do you want to get a PhD? And I did not lie. I said, I want to become a teacher. To me, research is a means to an end. It's not the end. And I think he was good enough to be OK with it.

A lot of professors have said, if you don't want to do research, don't do a PhD. But I did go on, got my PhD, taught for a couple of years at the University of California at Berkeley as a visiting faculty member, where I taught, I think, six different classes, ranging from traditional corporate finance class to the undergraduates, to a central banking class.

And I knew nothing about central banking. I had to teach myself just enough to stay ahead of the curve. And it made me a dabbler. I understood that there were things in each class that I could draw on for the other classes. And I've always been a generalist. I remain one of the few people who teaches across the finance spectrum, because finance has increasingly become specialized.

I came to NYU in 1986, and they haven't fired me yet. So I'm still there. You started writing books, oh, back in the 1990s, I believe. It was your first book. My first book was an evaluation book. In fact, it was a huge ego move to put my name on the book, because I remember the publisher said, why don't you put your name on the book?

And I said, nobody knows who I am. Why would you want to do that? Could we put somebody who's better recognized on the book? He said, go ahead, put your name. And it's "The Modern Evaluation," 1992. I had still not been tenured. A dangerous thing to do if you're an academic is to write a book before you get tenure, because you're supposed to write papers that get published.

So that was my first book. And then I added to it in corporate finance and investments, and so it kind of extended from there. And back in 1998, you published a book with the late Peter Bernstein. That must have been an interesting experience for you. Peter was a legend.

Now, I miss what I called Renaissance men, people who could talk about different things, extend across disciplines. And we used to have quite a few of them, and Peter was a Renaissance man. He could talk about economics. He could talk about finance. He could talk about culture. He could talk about politics.

And it was towards the end of his legendary career. It was not really a book that we co-wrote. We co-edited. So basically, we took other people's articles. We each had an article in there. So it was a co-edited book. It remains the only book I've worked with with somebody else.

I've never co-authored a book, because I'm a control freak. But with Peter, I had no problems doing it, because I learned a great deal from working with him. OK, so so far, you're lazy. You're a control freak. And I also heard you say somewhere that you could never work for somebody else.

Never. I'd be fired. You'd be fired. You wouldn't make it. Couldn't go into corporate world. No. With your teaching, you started out with these two bookends that you called them. One of them was corporate finance, and the other was valuation. They remain the two core classes I teach to the MBAs.

I teach corporate finance to the first year MBAs, and valuation to the second year MBAs. And often, they walk into my office, say, what's the difference between your two classes? And I have to tell them the truth. It's the same class, taught from different perspectives. In corporate finance, we look at businesses from the inside out.

In other words, you look at it as managers, as decision makers saying, how do I run a business? In valuation, you look at those same businesses from the outside in. So you have less control over the levers. So management chooses not to borrow money. That's what you're stuck with.

You can't go in and change things just because you feel like doing it. I truly enjoy the corporate finance class more because I get to look at the levers and say, when does it make sense for a company to return cash to its stockholders? When does it make sense to buy back as opposed to paying dividends?

Fundamental questions that we face every day when we look at news stories. So to me, the two classes are bookends because they represent two very different perspectives on value. Now, one talks about how do we change value as managers. The other talks about, hey, how much is something worth?

And can I get it for a lower price? And we're going to get more into evaluation in a minute. But after a while, you also began to think about another area. And that was what you call investment philosophies. Now, Bogle has called it investment strategies. It's a little bit different.

For us, philosophy is passive or active. But you use it in the phrase of different ways of which you can invest portfolios. In fact, I'm glad you brought up investment strategies as opposed to philosophies. I'll give you an example. A strategy is picking low PE stocks. That's a strategy.

A philosophy is believing that boring companies get undervalued by markets because markets like excitement. Philosophies build on a market mistake, a belief about how markets work and don't work. Strategies are what you use to exploit that philosophy. So to me, the two are connected. But the reason I use the word philosophy is it started with observing that there are successful investors out there.

People are successful in markets. But they don't all fall into the same bucket. So you've got the Warren Buffetts of the world. You've got the Peter Lynches of the world. You've got the George Soros of the world or the Jim Simons of the world. Very different ways of approaching the market, and they succeed.

So there are two basic facts in markets. One is there are very few successful investors in the long term. This is a very tough game to make, which is one reason. I'm drawn to Jack Bogle because Jack recognised this very early on. He said, this is a very tough game to win.

So why are you expending time and resources trying to win a game where so few people win? But those so few people who win, they don't even share the same characteristics. Some come from the perspective of, I'm going to buy companies that look cheap relative to what they already have on their books right now, value investors.

Others come in with a philosophy of growth is what markets get wrong. So I'm going to go after growth companies. Still others say, look, markets are where you have to go. You have to tie markets. So basically, you've got Warren Buffett, Peter Lynch, and George Soros. They're already in terms of very different philosophies.

And rather than say, this is the best philosophy, which happens to be what you will find if you walk into a bookstore, if there are any left, and you walk to the investing section, you will find philosophies blaring out that they're the chosen ones. It's one reason why I'm uncomfortable in Omaha, Nebraska, is because the investors show up there, old-time value investors think they're the chosen one.

They have the high ground. And I don't think that's true, because there are hundreds of books on Warren Buffett. But if you look at all the people who've read those books and tried to imitate him, almost none of them deliver the same kind of returns. In fact, I'll wager, collectively, if you took all those investors who show up in Omaha every year, and you look at the returns that they've made on their investments that they've underperformed the Vanguard 500 Index Fund, even though they claim to be true believers.

So I start with a different question. I said, look, there are a few successful investors. There are relatively few. There reigns a spectrum. What is it that they brought to the table other than luck, which we can never discount, that made them successful? So my investment philosophies class starts with that premise.

There is no one right investment philosophy for everyone, but there's one right one for you, given your makeup, given what you bring to the table. And that one right philosophy might be to be a passive investor. One of the great things about investing is you can effortlessly beat the average active investor by putting your money in index funds.

- And that's the philosophy of most Bogle heads. I mean, people have their, what I call, bingo money account, fund money account. They might use a Roth IRA or something and pick a few stocks. But generally, 90% to 100% of their investments are in just US stock, total market index fund and international stock index fund.

A couple of bond funds or maybe just treasuries on the bond side. I mean, it's very simple, simplistic, low cost. But we always love to learn. So we're always interested in what everybody else is doing. We may not do that, but we're interested in learning about it. So this is the investment philosophies class that you teach.

But most recently, your last book was on investment lifecycle. Let's talk about your interest in that and how you evolved into writing a book about that. - No, it's corporate life cycles. It's about how businesses age like human beings do and how they fight aging like human beings do.

Which is, you know, you don't want to get old. So consultants and bankers tell you you can be young again. So you try to do an acquisition, enter a new business. And it's a structure I've used in my corporate finance, my valuation, my investment philosophies class as long as I've taught it.

So this is not a new topic. It's a structure that I've used in all my classes that I find incredibly useful in understanding why companies behave the way they do, especially as they age. So corporate lifecycle book is about tracking that aging process and how companies change or they should change as they age.

The kind of decisions they make, what they should focus on as companies should change. And as investors, there's a lesson there as well. Is I'll give you an example. You know, you buy into old-time value investing. Old-time value investing says you should buy a company for less than what it has as assets on its books.

So you look at the Ben Graham 12 screens for finding a cheap stock. It's about looking at what a company owns and saying, I want to buy it at 50% of that value. Good luck finding it, but that's what you're looking for. If you adopt that strategy or you go with that philosophy, then you know where you're going to end up with the lifecycle.

You're going to end up with a lot of mature and declining companies in your portfolio. You're going to end up with the Kraft Heins or Coca-Cola's, the three M's of the world, because those are the companies we have a chance of doing it. You're never going to be buying Palantir or even Facebook or definitely not Nvidia because it'll always look expensive to you.

Now you have to be okay with that. I mean, we know what Warren Buffett's biggest lament has been over his lifetime, which is he never invested in tech when it was young. I mean, Bill Gates was one of his best friends and he never invested in Microsoft along the way.

I know the investor now, Berkshire Hathaway, invested in Apple finally in 2017, but by that time, Apple was a mature company. But the reality is that's a feature, not a bug, of the Buffett investment philosophy. It's one of the side costs of focusing so much on what's on the ground right now is you're never going to buy a growth company.

And the problem with that is we might be entering a century where the cost of not having growth companies in your portfolio could be catastrophic. Let's take an example. In the last 15 years, if you didn't own any of the Fangam stocks or any of the Mag 7, as they're called now, the chance of you beating the market became minuscule because those seven companies by themselves have accounted for 15% of the increase in market cap of all US stocks, 7,000 stocks, in the last 15 years have come from the seven companies.

If you don't have those seven companies in your portfolio, how the heck are you going to beat the market? Conversely, if you're an index fund investor, you benefited, right? Because all you have to do is buy the index, you're going to get those seven companies. So it's actually made the case for passive investing even stronger because if you're an active investor and you end up with a philosophy that leaves those companies out, you're going to have a tough time beating the market.

- I was reading a stat that said 25 years ago, they listed out the top 10 companies on the S&P and the only one company that's still in there is Microsoft. All the other nine companies are gone. They've rotated out. So the kind of the glory of passive investing is you know that your portfolio is always going to hold those top 10 stocks.

- Yeah. - Okay, I want to move a little bit here and begin to ask you some questions pertaining to what you teach. So this is Valuation 101 and I want to go over some terms so that everybody understands where they come from. First, what is a risk-free rate?

- It's what you can make guaranteed. So take your whatever brokerage account you have. I'm sure everybody in the audience has some money in cash. What's the highest rate of return you can make guaranteed on that cash? I'll tell you what it is for me. I go into the treasury auction.

You can actually buy T-bills directly. I don't put my money in money market funds, but you know, you could do that. You get pretty close. And I feel almost certain, in fact, let me take the almost out. I feel certain that six months from now when I cash out my T-bills, I'm going to get that 4.7 or 5% I was promised when I invested up front.

It's guaranteed. The one catch there, it's assuming that the U.S. Treasury will not default. And for a century or more, we've assumed that that's true. One of the shakier things about what's happened in the last 10 years is the U.S. government has walked up, walked to the precipice of defaulting, mostly for political reasons, not economic reasons, because that, you know, you've got to put the debt limit, you've got to increase it, Congress has to vote on it.

So there's this residue of doubt now on whether the U.S. Treasury is truly default free. But for something to be risk-free, it's got to be default-free and guaranteed. So it can't be a corporate bond. It can't be a government bond if the government can't default. So it's got to be as close as you can get to that.

U.S. dollars, that's going to probably be a Treasury bond rate. I use longer-term rates if you want to lock it in, compare it to stocks. So it becomes the number you compare to what you can generate on stocks, saying, "Should I be investing in stocks?" So even if you're a bogelhead and invest passively, one of the decisions you've got to make is how much money do I invest in my equity index fund as opposed to, and this is the decision that drives that.

- You talked about T-bills. Other people use the 10-year Treasury. Other people use TIPS. - I would use the 10-year Treasury. I don't use T-bills. And the reason is very simple. Stocks are a long-term investment. So it's not that the T-bill is not risk-free, but it's risk-free for three months or six months.

You're comparing investing in equities, which is a long-term investment choice. You want to compare it to something that's long-term. The reason TIPS doesn't even enter the equation is the return on stocks is a nominal return. TIPS are a real return. You're comparing apples to oranges. If you want to convert what you expect to make on stocks into a real return, take out the inflation component, you can compare to TIPS.

But you can't compare to T-bills because the duration is mismatched and you can't compare to TIPS because you're comparing a nominal to a real. So I use 10-year T-bonds, and that's the easiest of all numbers to pull out of the market, know exactly where it is at every point of every day.

So it becomes my comparison point for should I be investing in equities in the first place? - So now we get to the equity side, and we've all heard the term the equity risk premium, which you have gotten this name as the Dean of Valuation. And part of this is you monthly come up with the equity risk premium.

So first define what an equity risk premium is. - Okay, right now the T-bond rate is 4.4%. So today if you put your money in a 10-year T-bond, assuming the U.S. Treasury is default free, you can make 4.4% guarantee. I come to you with the S&P 500. Let's keep it an index where we at least know that we're talking about the same thing.

I want you to take your money out of the T-bond and put it into the S&P 500. The question I'm asking you is how much higher would the expected return need to be for you to switch? Why does it have to be higher? Because the T-bond you're guaranteed that 4.4%.

With the S&P 500, it's not guaranteed. You'd need to earn more than 4.4% to move your money. How much more is your equity risk premium? So you can already see that this is a number that'll vary across people. If you're risk-averse and you're worried about risk, you might say, "I need 6% more than the T-bond rate." Your neighbor, who's much more risk-taking, might say, "I'll settle for 3%." So you can already see that this is a number that'll vary across people.

And I'm trying to estimate it for the entire market, which is millions and millions of people. So this sounds like an incredibly difficult task. And for the longest time, people gave up on it. They looked backwards. They said, "Over the last 70 years, I'd have made 5%. Therefore, that's my equity risk premium." But that's like driving 80 miles down a highway, looking in the rear-view mirror.

It's not going to end well. So starting about 30 years ago, I'd said, "Look, I'd like to figure out what the market is demanding as an equity risk premium." It's not a formula or an equation. It's basically an internal rate-of-return calculation. I know what you paid for stocks. I can see what the expected cash flows are for stocks.

The S&P 500 is the most tracked and followed index. I can see the expected earnings. I can come up with the expected cash flows. If I know what you paid for stocks and the expected cash flows, I can solve for what discount rate makes the present value of the cash flows equal to the level of the index today.

It's the way we compute yield to maturity on a bond. I do that at the start of every month. At the start of December of 2024, that number was 8.25%. You're saying, "What the heck does that even mean?" If you bought U.S. equities at the start of December 2024, a week ago, two weeks ago, you were building in an expected return of 8.25%.

Uncle, what you hoped you would make, what you prayed you would make, the very act of buying at that price. The T bond rate on that day was 4.18%. You were earning 4.07% over the T bond rate. Are you happy with it? If you say no, you know what the answer to that is, right?

You shouldn't be putting your money in equities because you want a higher return. So every discussion about stocks, whether they're in a bubble, whether they're too high or low, can be reframed as a discussion about what do you think a fair equity risk premium is. If you think it's 6%, you should definitely be out of stocks.

If you think it's 2%, you should be doubling down on stocks. But the number is the number. It's what you're paying right now. That 4.07% becomes the benchmark for what the market is demanding of you. - When you're looking at the expectation of return, how does growth factor into that, the growth of our earnings and growth of the economy?

- Yeah, so you have expected earnings, but earnings can't be paid out as dividends. Or put differently, it can be paid out. If you paid all of the earnings out as dividends, you're reinvesting nothing. If you reinvest nothing, you can't grow in the long term. So if I take earnings and treat them as expected cash flows from buying stocks, the only growth rate that's compatible with it is a 0% growth rate.

So here's what I do. I take earnings, I build in expectations of growth, and then I pause and say, well, how much are companies reinvesting to deliver that growth? And with the S&P 500, it's observable. You can look at what companies are putting back. So the growth enters into the equation in two ways.

One is a growth rate in earnings. That's a good side. But it also enters your cash flows as what you're reinvesting to deliver that growth. That's a bad side. The net effect is what shows up in my equity risk premium. - And you do this monthly for the U.S.

market, but you also do it for markets all around the world. And you put this on your website. - And there's a reason I do that. There are no U.S. companies anymore. They're multinationals that happened through the accident of history to be U.S.-based. Coca-Cola is Atlanta-based, but it gets 60% of its revenues outside the U.S.

Why does that matter? Your risk as a company doesn't come from where you're incorporated. It comes from where you operate. So if you're looking at a multinational, I need to know what the equity risk premium is for Asia, Africa, Latin America to value Coca-Cola, to value GM, to value Tesla, to value Apple.

Almost all of the data you see on my website, I created because I needed it. It was completely selfish. And once I estimated for myself, I said, what's the point of keeping it to myself? It's not like this is rocket science. This is not some secret I want to keep from everybody.

So that equity risk premium data by country reflects what I started doing 30 years ago because I was valuing U.S. companies with foreign exposures. I've increasingly started valuing foreign companies as well. And there it becomes incredibly useful. If the growth in the next decade is going to come from India, don't you need to track what the Indian equity risk premium is doing as frequently as you can to value Indian companies?

So I think we have no choice. Globalization, whether we like it or not, is here to stay, in investing, in valuation, in corporate finance, and we need to be ready for it. And that becomes one of the ingredients you need to deal with country risk across the globe. - We have the U.S.

equity risk premium, as you said, is a little bit over 4%. So, you know, somebody who's investing in a total stock market index fund who may have a little bit of a few basis points of fees, call it 4%. - Yeah. - What is it outside the U.S. if you were going to combine all of these countries together?

What should we be expecting from international stocks? Is it different than 4? - In Northern Europe, you're going to get about 4. Why? Because they're mature markets. And if the equity risk premium in Northern Europe was significantly different from the U.S., let's say 6% in Germany, here's what would happen.

Money would leave the U.S., go into German stocks, push prices up, and push returns down. So across economies that are mature, the U.S. equity risk premium becomes this number that ties together those markets. So if I'm looking at Germany, I'm looking at Scandinavian countries, I'm looking at Australia, I'm looking at Singapore, I'm looking at Canada, I'm using the 4% as my equity risk premium.

But if I'm going to Brazil, or India, or Indonesia, or parts of Africa to invest in, my equity risk premium needs to be higher. Why? Because I'm exposed to more risk that is country-specific. So it's a very simple exercise. You start with the U.S. premium, you assign it to what you think are mature markets, you know, mostly AAA-rated, mostly safe.

And then you attach an extra premium for countries that you think are riskier, not because, you know, you're being paranoid, but because you know there'll be shocks in these markets. You can't do this after the fact. You've got to bring in your expectations of risk before the fact, build them into your pricing.

So when that surprise happens, you've got some fat you've built up that you can use to burn off. - I want to get into your views on factor investing, quantitative analysis. And to you going, "Hum, hum, hum." - Yeah. - You know, there's this debate. Oh, it's mispricing. No, it's risk.

I want to hear your views on this. - It's funny because many of the people who are so-called factor investors come to the game with contempt for academic finance, which is efficient markets, who cares about it? You know, the birthplace of factor investing was a paper by Gene Farmer, who's essentially the father of efficient markets, and Ken French.

That Farmer-French paper came up with the first two factors, market gaps, small cap companies on higher returns and large cap companies, and low price-to-book companies on higher returns and high price-to-book. That was 1992. In the decades since, as data has proliferated, the number of factors that seem to make these excess returns higher than they should has also multiplied.

It's called the factor zoo at this point. There are dozens and dozens of factors, all of which on paper seem to beat the market. But here's my problem with it. First, Farmer-French, in their original paper on market cap and price-to-book, didn't claim that this was a sign of market efficiency.

They said this is a sign that our models for risk and return are flawed, that there's something about small companies that makes them riskier that we're not capturing in our models. So they actually took the paper to mean that markets are efficient, we were just not capturing it in the risk.

But the people outside took those same papers and said, let's create a small cap fund. Let's create a value fund. Saying that'll beat the market. But let's take that and run with it. Let's assume factors actually work, that they deliver higher returns. It's not a case for active investing.

It's a case for buying low-price-to-book stocks or small companies. So here's what's happened in the last 20 years. You had active investors start small cap funds and an index fund of just small cap stocks. And guess what? The index fund beat the active investors. So-called value investing that beat the market in the last century, almost all of it came from buying low-price-to-book stocks.

In the last 20 years, you had index funds that are value index funds that buy the low-price-to-book stocks without any cost and they beat the active investors. To me, the promise factor investing is even if factors deliver these excess returns, I can get them effortlessly by buying an index fund around those factors.

It's not a case for active investing. It's a case for more nuanced passive investing. Don't put all of your money in the S&P 500 index fund. Spread it out across a value index fund, a growth index fund, an emerging market index fund, and you will be beating active investors in each of these spaces.

I have another reason why I am wary when an active investor says, "I'm an active investor and I invest based on factors." Now, I was saying, if you bring nothing to the table, you should expect to take nothing away. So if you're an active investor and your claim to fame is, "I can find low-price-to-book stocks "and earn high returns in equity," the Bruce Grunwald approach to picking stocks, my response is, "Why do I need you?

"I could get, in today's day and age, "I could get an AI to do that for me. "It'll cost me absolutely nothing. "Why would I be paying you 100 basis points "or 150 basis points to do something "that I can do effortlessly?" So first, I'm not sure the factors actually deliver excess returns because much of that factor excess return comes from looking at US data going back to 1927.

And if you look at US data going back to 1927, there's a cleavage in the middle. 1927 through 1980 looks very different from 1980 through 2024. Take the small-cap premium. Huge between 1927 and 1980, almost 7%. Since 1980, there's been no small-cap premium, none. It's zero, it's gone. Value investing, low-priced-to-book stocks delivered higher returns than high-priced-to-book stocks in the last century, 1927 through 1990, maybe even 2000.

The last 24 years, low-priced-to-book stocks have underperformed high-priced-to-book stocks. We might be chasing mirages out there with these factors, charging people for chasing them and not delivering any returns. - Once these papers are published and fund companies and asset managers start piling into these strategies, doesn't it change the dynamics of the market itself and change valuations?

- Less so with factors than with specific event studies. For instance, there are studies that show that when a company gets added to the S&P 500, it gets a jump in price. That's an indexing effect. It's an event study. Those event studies, once people agree that there is an event effect, seem to disappear very quickly because then people say, "Okay, if that's going to happen "and I know that Tesla is going to get added "to the S&P 500 next week, "I'm going to start buying Tesla before it actually happens." It's less so with factors because I'm convinced that at least between 1927 and '80, there were good reasons why small cap companies earned what looked like excess returns.

Information on them was difficult to get. There were all kinds of corporate governance issues. Transacting on them. I'm old enough to remember when I had to call a broker to buy a stock. And if you tried to call a broker to buy a small NASDAQ stock in 1980, the hoops you had to jump through, the costs you faced were insanely high.

One of the things that changed is we live in a very different world. And maybe the reason the small cap premium has disappeared is I can go to the SEC website, pull up the last 20 years of financials for even the smallest company, and I can trade effortlessly through my broker's house.

Slightly higher bid-ask spread. But the difference has been small and large companies. From an investor perspective, I've narrowed. And if they've narrowed, maybe the small cap premium has disappeared for a good reason. So some of these factors, I think, had good reasons for the original premiums. They were not excess returns.

They were returns for something that you were facing that you were not capturing in your models. And I think those factors have shifted because we live in a very different world as investors, and we're capturing that in our returns. - Well, thank you for that discussion. I appreciate it because the Bogleheads are always talking about, should we follow factor investing?

How smart is smart beta? And so forth. I mean, these come up all the time. I do want to get into another area that you have discussed frequently. In fact, you wrote a book on it. It's "The Difference Between Equations and Models and Stories." You have come to a medium between the numbers and the stories.

There's earnings, there's dividends, cash flows, and then there's a lot of things out there that don't, but they still deserve a value. So can you talk about this whole area? - I mean, it's really the recognition that when you value a business, you're always telling a story. It's a story about that business.

It might show up as numbers. It's growth and margins and reinvestment. But one of my pet peeves with valuation as it's evolved has become financial modeling, an Excel spreadsheet. I've seen equity research analysts take a company and have the working capital requirements. Easy to do on a spreadsheet. And my response is, have you ever worked at a retail business where you've tried to have inventory?

What does that mean? Are you going to take four of the eight colors out? Are you going to have fewer items? There's a cost involved here that you're not factoring in. What telling a story forces you to do is think about what it is that you need to do as a business to deliver that 5% extra growth.

Where's that growth going to come from? What are you going to do? So connecting stories, numbers, makes you more disciplined in how you approach companies. You can't just arbitrarily raise the growth rate for Nvidia to get to the price you want to. Because the question I'm going to ask you is, where is that additional growth going to come from?

The entire AI chip business is going to be $500 billion, and you're giving Nvidia $700 billion in revenues. Where's the extra $200 billion going to come from? So it makes you think about businesses that underlie your spreadsheets. And that makes you more restrained in changing numbers you don't like to get whatever value you want to get in your valuation.

So I want to move into areas that have no cash flows, commodities, gold, fine art, Bitcoin. How do you put a value on these things when they have no cash flow? You can only price them. I make a big deal. And my valuation class, they get sick and tired of me doing this.

Do you want to value something or do you want to price something? To value something, you need cash flows that come from it. You can value a gold mining company, but you can't value gold. You can value Coinbase because it's a transaction-based company and there is revenues you get from the transactions, but you can't value Bitcoin.

You can only price it. What's price driven by? Demand and supply. What's demand and supply driven by? Mood and momentum. I mean, look at what's happened to Bitcoin this year. You could point to a series of events that have caused the price to go up above 100,000, but it's mood and momentum.

It's a pricing game. There's nothing wrong with it, but recognizing you're playing a pricing game will make you more honest about what you're doing. You cannot be an investor in Bitcoin, but you can trade Bitcoin. So when people say, "I'm going to add Bitcoin to my portfolio," I say, "Okay, go ahead." But remember, that's your pricing component.

There's no intrinsic value. It's going to be based on demand and supply, and you've got to get really good then at detecting shifts in mood and momentum and getting ahead of the game. So I have lots of respect for traders. They play the pricing game, but it's a very different game than one that tries to assess value and base decisions based on value.

- And what about venture capital or companies that might have just gone public, say quantum computer companies that have no, I mean, they have revenue, but they've become profitable. You're talking 10 years down the road. I mean, how do you value that? - Making a lot of estimates, right?

There's no difference between valuing a Coca-Cola and valuing a Palantir. The difference is that you don't have the crutch of past data. You don't have the crutch of knowing what the business model is in making your estimates. In both cases, the future that drives value, not the past, but in the Coca-Cola case, you have a lot of past drawn.

It gives you a way of justifying your estimates and pointing to something when something goes wrong because, you know, I base it on past growth rates. Don't blame me. You don't have that luxury with a young growth company. That makes people uncomfortable. So you know what happens. They don't value these companies, including the people who claim to value the companies.

People like VCs, they price companies. How do they price them? Price per user. Market cap per subscriber. Basically, they're pricing on a metric where they hope to sell to somebody else based on the same metric. Nothing wrong with it, but it is what it is. - Price per click, I remember.

- Price per click, exactly. - So you yourself, when you invest, you have a portfolio of about 40 individuals stocks that you buy. I'm not gonna ask you what they are because we don't want to go down that road, but I'd like you to talk about why you have this portfolio and what is your interest in doing a little portfolio management on the side for yourself?

- I love investing. I love companies. I love understanding them. I don't do it because I hope to beat the market. I follow the Hippocratic oath. I try to do as little harm to myself as possible. Now, what does that involve? I don't trade very often. I add probably two or three companies, maybe four in a big year to my portfolio.

I sell maybe two or three companies, maybe four in a big year. I am not constantly tracking the market. I'm not trying to get ahead of an information announcement. So I try to trade as little. I mean, let's face it. One of the lessons we've learned from looking at active investing is the more activity you have, the more difficult it becomes for you to beat the market.

So I try to be as passive as I can much of the time. Second, if at the end of the next 40 or 50 years, and I've said this before, on my deathbed, you came to me and said, look, based on what you did over the last 50 years, you delivered half a percent less than you could have made investing in index funds.

I'd be completely okay with that. I don't feel righteous in this. I don't feel I deserve to get an excess return 'cause I did all the right things. I do it because I enjoy it. And I do it in a way where I don't think I will trail the market by three, four, five, 6% in any given year because that's not my strategy.

Notice I have 40 stocks. I don't have four or five because I believe concentration is violating the Hippocratic oath in investing. Because when you put your money in four or five stocks, in a great year, you might be up 200%. You could have something to boast about at cocktail parties.

In a bad year, you could lose 40%. I'd never enter with a position that's greater than 5% of my portfolio. I'd never let any company in my portfolio exceed 15% of my portfolio, which means I've got to shed some winners. I've sold in video over the last three years.

And people say, "Aren't you upset about the fact that you've left a lot of money in the table?" Not in the least. Because I have to play the game I came to play. In my game, if I let a company become more than 15% of my portfolio, I risk violating that do-no-harm oath that I took when I started the active investing path.

- So I want to talk about a portfolio that is very common for the Bogleheads. And I just want to get your initial reaction to it. It's called the three-fund portfolio. Let's say that you've decided your asset allocation between stocks and bonds is going to be 60% in stocks and 40% in bonds.

So the three-fund portfolio would be 40% in a total U.S. stock market index fund, 20% in a total international index fund, and then 40% in a total bond market index fund. What do you think about that? - The only thing I would take issue with is that mix staying the same for everybody.

- Granted, yes. - If you're 25 years old, I'd expect that mix to be more equities, less bonds, simply because you don't need that income. Why pay taxes on income you don't need? I would tilt it more towards equities. - Yes. - And as you get older, assuming that your spending levels exceed your social security income or something, I might alter it.

But I think that three-fund strategy is very close to what I follow with my own kids. To show you how much the line on active investing is drawn within my household, I invest actively the portfolio that my wife and I maintain. For each of my kids, I've managed their money, but I increasingly have shifted their money to index funds.

And I have probably five funds rather than three. So basically the U.S., I break it out into little more, 'cause my problem with even with the total stock market fund is you end up probably overweighted in large cap companies. So I want to get my own exposure across market cap classes.

I know there are people who take issue with the international fund, because we know in the last 20 years, those international funds, and you can look at your own portfolio, have underperformed the U.S. And some people have concluded, therefore international investing doesn't make sense. They're missing the long-term part of equities, which is, hey, you win for decades and then you lose for decades.

So I do invest my kids' money in international funds. And when they come back and say, "Hey, dad, why do you invest our money "in this international fund? "It seems to have earned only 8% of U.S." I tell them, "Look, it's law of averaging. "It's going to work out for you." So I think that's a good strategy.

Keep it simple, because you've got life to live. I mean, that's one thing that bothers me about people who don't enjoy active investing, who still go out and try to pick stocks, taking the limited time they have. They don't enjoy the process, but they feel that they have to do it, because if they don't do it, it's like admitting failure.

So I think it's actually a simple strategy, a good one, and one that won't get you into much trouble. - So now I need to know your view of the critics of indexing. And every year, it seems, a new critic comes out of the closet with a new study talking about how indexing is going to destroy the markets.

When people all decide to sell at once, it's going to cause havoc. How do you feel about all of these studies? - Notice how the terrain has shifted. They don't even try to make the case anymore that you as an investor would be better off with active investors investing your money.

They've given up on that, because you can't win that fight. That fight's lost. So now they have to point to macro concerns they have because of the push towards indexing. And they do have a point. It's really a question of whether you, as an individual investor, want to take care of the fact that the market might be becoming less efficient because of indexing, to which your response is, why do I care?

I need to get my pension lined up. So first, you've got to be clear that much of the macro concerns are not going to convince somebody to move away from indexing because they're macro concerns. They're things about, and there are issues, I think, that we have to be clear about.

It is true that the shift towards passive investing, that has been massive in the last 15 years. Active investors are in an existential crisis right now. It's adding to the momentum issue, which is it makes momentum a stronger force in both directions. Why? Because money flows to the biggest winners, right?

Because it's based on market cap. So it is going to make momentum stronger in both directions. That's neither here nor there because momentum being stronger in both directions can benefit traders in the market. It can also mean that if you're an old-time investor, even if you're right about value, you've got to wait a lot longer before the price corrects to value.

I've adjusted for that in my time horizon. I am willing to wait longer now because that's one of the side products of passive investing. So there are macro effects. I'm not sure whether they're good or bad, but there are macro effects that have come from passive investing. But it's not your job or my job to worry about those.

I'm not going to invest actively because this will make the market more efficient. First, the link there is very weak. How does my investing actively make the market more efficient? And second, I don't see the payoff to my making the market more efficient in my pension that I collect out of my fund.

So I think there are macro concerns. But I think if there are macro concerns, it's going to come through regulation that's going to affect you. And that is one of the things I would keep an eye out as a passive investor is you're going to see active investors go to the SEC and say you've got to rescue the market because passive investing is destroying it by adding layers or limitations to passive investing.

And I would fight that every step of the way. But you can see it coming. That's the case they're making. They're not making the case to you and I as individual investors. They're making the case to regulators. - I see that more and more. Oh, these three big companies, Vanguard, BlackRock, and-- - State Street.

- State Street have too much power. They control boards. They are running our lives. And you begin to see more and more of these articles. And it is concerning because politicians can hone in on that. - And you know what, Larry Fink fed into that. I think that was one of my pushbacks on the ESG is, come on, guys, you got to stop.

When you are the biggest passive investor in the world in BlackRock, and Larry Fink gets up there and says, "ESG is good for value." To begin with, that was false. You are playing right into the hands of your critics. So in a sense, Vanguard has been very good. Notice how low key they are.

They try to stay below the radar, which is the way you need to be as a passive. Don't make yourself a visible target. And I think that BlackRock learned from the ESG lesson, hopefully, and is going to crawl back into its space. But I think that they brought some of that on themselves with the relentless pushing of virtue investing as part of indexing.

It should never be in there. You have a job, you have a fiduciary responsibility. Just do it. - Want to get into one more area, and that is AI. So AI is going to change the world, we're told. Maybe it already has. How is it going to affect us as investors?

- For me, this became real about nine months ago when I was teaching my spring 2024 class. It was the 10th week of a 15-week class. I get a call from a friend of mine, Vasanth Dar, who teaches machine learning at NYU. So he calls and he says, "Aswath, we built a demoderant bot." I said, "A what?" He said, "A demoderant bot." He said, "It's an AI entity "that we've essentially fed every single post "you've ever written." And I'm verbose.

I've written like 2,500 pages on my blog. I've fed it every book you've written, every valuation you've done, every YouTube video. And I'm a prime candidate because my entire life is out there online. And the AI entity had not just read it, it assimilated, remembered everything. I don't remember what I wrote 10 years ago, but my AI bot does.

And then he said, "Look, we want to run a test, "a test where you give us 25 students from your class "who each individually value companies, "and we'll get the demoderant bot to value the company "to see who wins." He's not come back with the results yet, but I'm terrified.

If he finds that the bot does better, then it's a signal to me that my days are numbered. That a bot can effectively do what I do. If he finds a bot doesn't do well, then everything I do is about teaching. So all my teaching is to not, if somebody's read everything I've ever done, watched everything I've ever done, is not able to value a company.

But I wrote a post about that. And I wrote it from a personal perspective. I said, "I can see what the bot is. "I can see what it can do. "What can I do to stay ahead of my bot?" When I finished my valuation class, I said, "Each of you has a bot looking over your shoulder." And the question you've got to ask yourself is, "What can I do better than the bot?" Let's face it.

If what you do in your job is mechanical, a bot's going to be better at you. A machine is always going to be better at mechanical stuff than you are. If what you do in your job is primarily rule-based, accounting, software, one of the reasons coding is so easy to turn over to AI is it's rule-based, right?

You follow the same rules. A bot is going to be better. If you're so biased that I can see where you're going before you even start, a bot will figure that out and do it for you, which means a lot of appraisals and valuations you see out there become pointless because you know where the end game is.

So I listed out these things that bots do that they can do as well as you. And I said, "If your job is primarily mechanical, "rule-based, and bias-driven, "a bot's going to be able to beat you, do it better." And then I asked a different question. What do we do as human beings that's going to be more difficult for bots to replicate?

I talked about renaissance men, people who do a bunch of different things, maybe none of them really well. Now, people who are in multiple disciplines. We've become a world of specialists. We're setting ourselves to be botified, be more of a generalist, you know? So if you want to learn about markets, not just equity markets, not just about bond markets, think about price.

So spread your interests widely. The second is the stories and numbers. If what you do in valuation is financial modeling, put numbers in an Excel spreadsheet, computer ratios, hey, I don't need you. A bot can do that. And the third is a little strange, but I talked about the importance of having an idle mind.

I get questions every week from people who read my blog or read my book, and they say, "Can you give me more reading suggestions? "What should I be reading?" And my response sometimes surprises them. I said, "Read less, think more." Because we have so much stuff out there that we can fill every moment of every day that we're not thinking enough.

Now, we're not using our reasoning muscles. Let's face it, we have a question. I don't know about you, but what's the first thing we're all trying to do? We go on Google search. So convenient, it's right there. And we become so used to that that we no longer reason our way to an answer.

And a reasoning muscle, if you don't use it, will get flabby, and evolution will work its magic. And who knows, a generation from now, two generations from now, human beings might be unable to reason. But the other thing about having an idle mind, it's where these thoughts can connect.

Thoughts that look disconnected can connect. I mean, think about Newton sitting under that apple tree, and apple falls on his head. If he'd been looking at his iPhone, he'd probably have taken the apple, thrown it to the side, and he'd have gone back to his iPhone. He had nothing to do, so he started thinking about why did the apple fall down rather than go up, and the theory of gravity came about.

We make these amazing connections. Human beings can make these amazing connections that lead to insight. But you have to let your brain have that open space. And unfortunately, we live in a time where every moment of every day is filled up. I mean, I remember 30 years ago, standing in a line at the bank.

You know, what you could do? Nothing. So you were idle-minded. Now you're standing in line. Everybody's looking at their iPhones, checking out their emails. We're not giving ourselves enough open space to think about things, to have those aha moments. We have insight. So I would encourage people to rediscover their humanity, because that's going to be your biggest weapon against the bortification that is coming down the pike.

- Well, it's been wonderful having you on, Bogle Heads on Investing. Your insights are fantastic, and I really enjoyed this conversation. So thank you from all of us. - Thank you. Enjoyed being on. - This concludes this episode of Bogle Heads on Investing. Join us each month as we interview a new guest on a new topic.

In the meantime, visit boglecenter.net, bogleheads.org, the Bogle Heads Wiki, Bogle Heads Twitter, the Bogle Heads YouTube channel, Bogle Heads Facebook, Bogle Heads Reddit. Join one of your local Bogle Heads chapters, and get others to join. Thanks for listening. (upbeat music) (upbeat music) (upbeat music)