[REPLAY] Michael Mauboussin – Active Challenges, Rational Decisions and Team Dynamics (Capital Allocators, EP.36)

25:08They're just not sufficient to cover the fees that they charge, right? So it's a question of net versus gross. Yeah, I know. Last time we saw each other at the University of Virginia, I guess last month, Pedro Matos, a professor down there, had done this paper about concentration. And similarly, I don't think he had done asset -weighted, but he said if you looked at high active share managers, and he was defining it as 60%, so I would actually say that's not that high active share, But those managers, again, maybe you went from 40 % to high 40s in terms of who beat the market. So it's still hard.

25:39Now, most of these studies that we cite are all relative to the S &P and it's focused on the U .S. Have you looked internationally in the equity markets internationally? We've done very little of that, but I think you're exactly right. I always think about asset classes on a continuum of efficiency. and part of it's a function of the size and the potential value extraction and so forth. So it is convenient to pick US equity markets because it's roughly half the global equity capitalization and we have good data and we have going back a long way. But your point's an absolutely valid one, which is there's a continuum of efficiency by asset classes and US S &P is probably among, if not the most competitive markets in the world.

26:21So as you move away from that, you tend to see less efficiency. Now, the other thing I'll just mention about one of the Matos papers, which I found fascinating, is they did do a spin around the world and looked at closet indexing, which they defined as market active share of less than 60%, explicit indexing, and active management, and then looked at how different folks did. And there are a couple interesting things. Clearly, there's a trend toward explicit indexing, but they found that in markets where the explicit indexing was highest, best, active managers often did the best, which seems kind of weird, but it turns out there are a couple of factors for that.

27:03One is if you're an active manager in a market where there's a lot of explicit indexing, you feel compelled to do something very different. I basically have a high active share, right? You say, if I'm getting paid fees to be an active manager, I better not be closeted. I should really try to do something different. That's the first interesting thing is, And the second is, if there's a lot of explicit indexing, it shines a light on fees. So active managers tend to charge lower fees. And by the way, that's the other thing about big funds. Not surprisingly, big funds on average charge lower fees than smaller funds.

27:33And that's another thing that contributes to their relative performance relative to smaller funds. So it's an interesting thing. And look, it's a perpetual game. I mean, there always have to be inefficiencies and there always have to be ways to try to capture those things. But they're always moving targets, right? So Michael, your new seat here at Blue Mountain is a credit shop. As you shine a credit lens on some of these same issues, what have you found in your early months here? Well, I think Blue Mountain has multiple strategies, so credit is being one of them, but there are equities and systematic equities and distress and so forth.

28:06I guess, look, there are two basic elements. One is that, okay, at first I should say I've always been a believer that it's very useful, even if you're an equity investor or credit investor to understand what's going on other markets. So if you're an equity investor, you should understand what's going on the credit markets and the options markets and CDS markets, credit investors should understand equities and so forth, right? So just having other touchstones, I think is incredibly valuable for you to get a full context of what's going on. But if you step back and think about investment process, and some of the things we do here are not necessarily purely fundamental.

28:41There are two things that are consistent. One is there is fundamental analysis, which is how our business is going to perform. And whether you're a credit investor, distress investor, or equity investor, that's gonna be relevant. And so those sets of tools are gonna be important. And the second thing, which spans probably everything we do, not just here, but anybody who's making investment, is really about decision -making. And decision -making is, that's the sort of common denominator of all investing, or capital allocation in general. And at the end of the day, to me, a lot of investing, capital allocation decisions boil down to, yeah, it's probabilities and outcomes and trying to be on the right side of expected values.

29:20So, yeah, so notwithstanding the fact that there may be different strategies and people doing somewhat different things, you can distill these things down typically to some common denominators that are going to be relevant for everybody. And what are those most important ones for decision making? Well, I do, like I said a moment ago, I do think it's probabilities and outcomes, but the challenge is how do we screw those up, right? So a couple themes I'll mention. One of the ones that I've been very excited about, it's work on base rates. And this is really, I associate it mostly with Danny Kahneman, but it's this idea that when you're thinking about any kind of a forecast, it's incredibly important to understand and acknowledge the reference class from which this problem comes and to weight your own views with the evidence you have from the reference class.

30:09So let me try to make that slightly more concrete with one example. In March of this year, The Economist ran a cover story on amazon .com and Amazon's awesome, right? An analyst in there suggested that Amazon would be able to grow its revenues 15 % a year through the year 2025. And by the way, you know, they did 103 billion in 2015. They did 136 billion last year. They're on track to do 177 billion this year. So, right, they're coming out of the gates clearly ahead of that pace. So that's the inside view. That's the sort of analyst view. And by the way, if I sat down with that analyst, I'm sure they would have an amazing model where they, you know, go business by business and they build it up and it'd be very compelling.

30:50The outside view, right, the base rate would say, let's look at the sweep of history. Well, I'm exaggerating, but we went back to 1950. Let's look at every company that had initial revenues of 100 billion or more. So obviously adjusted for inflation and look at how they did in their subsequent growth rates for the next 10 years. And by the way, because this is such rarefied space, you know, 100 billion, there are only 313 examples of this, but 313 is not zero. And it turns out no company's ever grown 15 % a year and only seven have grown more than 10%. So seven out of 313, 2%. Now, might Amazon do it?

31:28Absolutely. What probability would you want to place on that? And the answer is probably not going to be your base case, right? It's probably going to be something like, so even if you're very optimistic, you should be measured in what your probability is. And so that's the thing. So Kahneman has this great line in Thinking Fast and Slow. He basically says, you know, people who are doing their own work don't feel like they need to understand the reference class. but understanding the reference class almost always makes you a better thinker. So that's one of the big things. And then there are just tons of biases.

31:58There are things like overconfidence. We tend to be overconfident as we think about the future, which means often our ranges of outcomes are too narrow. Confirmation bias. Heck, if you're in the investing business and you haven't fallen for this one, you're not doing your job. I mean, we all do it. It's just you make a decision, you seek information that confirms your point of view, and you dismiss, disavow, discount information that doesn't. And it's just a very natural thing for all of us to do. So it's our constant battle with ourselves, right? To think about these things probabilistically and to be very systematic about it.

32:28Have you spent time either on boards or with the allocator community that I spent a lot of time with? And through that, what are some of the lenses that you use, whether it's base rates, behavioral biases, luck and skill as it applies to allocators? You know, the closest thing, Ted, and I don't know if it counts, but I have done a fair bit with investment committees, which is probably related. And by the way, some of the work on investment committees has really encouraged me to do a lot of work just on teams in general, but let's call them committees in general. And so I think there are really three things that I've drawn from that literature that animate my thinking about this.

33:09The first is the size of a committee or the size of a team. And, you know, there's been a lot of work on this. The main guy that comes to mind is Richard Hackman, who's a professor at Harvard. And he studied teams across all different disciplines and found that the optimal size was four to six. And there was actually a really interesting survey of investment committees in particular. And basically, every person who's on a committee of seven or more says, we would be more effective if we were smaller, or we would not be more effective if we were bigger, right? So that's a really interesting thought, is just how many people are on your committee.

33:42And by the way, I'm chairman of the board of the Santa Fe Institute. two, we probably have 25 or, you know, 25 ish people on our board. Nothing's happening at a board meeting. I should say publicly. No, nothing's happening. All the work is happening at the committee level, right? Which is the smaller groups. And then the board, you're sort of, you know, okay. So, so there, there are political reasons or other reasons people could be on these committees that may or may not be good for decision -making. So that's the first, so team size. And the second is sort of team composition. And the big point of emphasis here is, is while we talk a lot about diversity, which is almost always social category diversity, race, gender, age, ethnicity, and so forth.

34:19The real key is cognitive diversity of people with different experiences and backgrounds and training and personalities that can surface different points of view. And that's really the key to, I think, good quality decision -making. And so there are mechanisms and we actually do them here, but we spend time talking about these mechanisms to make sure that we're surfacing different alternatives within that committee. But that I think is really, really key. And one of the things that seems to me very typical in an investment committee is to say, our committee is going to have the credit guy and the private equity guy or gal and so forth.

34:53And so anytime we make a credit decision, we rely on the woman that does that. So there's a lot of evidence that shows that's not really the way you want to do these things. You want to let everybody weigh in on everything else. And then the final thing is how we actually make decisions. And I've always thought that in the world of investing, it's just really rare to have an honest consensus. You know, most good investment ideas are controversial. It's very rare that everyone says, this is obviously brilliant or obviously, right? And so I'm a big fan of, you know, ballot voting systems, maybe strong majority, but majority ballot voting systems, let people vote independently.

35:31And so those are some of the things that I think are important. Now, the other thing that, and I think that you're, you know, you know much more about this than I do, but there's just an incredible literature, both for individuals and institutions to demonstrate that people tend to have bad timing, right? In other words, okay, there are a lot of reasons you fire a manager, but the number one reasons their performance has been poor. There are a lot of reasons you hire a manager, but truth be told, the number one reasons you hire them is their performance has been good. And we know that study after study demonstrates that if you bought the funds that were fired and sold the ones that were hired, you actually, just because of regression toward the mean, you do much better.

36:05So that's the other thing is, and by the way, it's totally human nature, right? You're on a committee, you have your 10 funds, these done, the three have done great, these three done badly. And you're like, why do we own these bad ones? Why don't we own more of the good ones? It's like totally human nature. But you have to resist that temptation because regression is such a powerful mechanism in investing. And that component of confirmation bias, where even if you lay out the reasons why you think this is an excellent manager and the risks of why that might be a weak manager. What happens is in these groups, when the manager underperforms, we say, aha, we were right.

36:40And not only that, the manager's not as good as we thought because these risks played out. So there's this awareness and cognition of chasing performance and confirmation bias, but it happens anyway, which is kind of astounding. Yeah, that's the other thing about a lot of these behavioral things, these biases, is that they happen, even if you're totally aware of them, they still really are to circumvent. So you do have to create mechanisms to try to be as effective as possible to address them as they show up. Is there a particular mechanism that you found? You touched on it. I mean, I think writing things down is really helpful.

37:09And just for someone to be aware, just Ted, what you just said, which is, hey, you know, I know that we had pros and cons for Manager X and they've underperformed. So now we're only dwelling on the cons. Let's revisit the pros, right? Or vice versa, right? These guys have been doing great. We're patting ourselves on the back. Let's remember these things we were concerned about and those things may still rear their heads. I want to circle back to sort of forming a team or a committee, as the case may be. If we're aware of this concept of cognitive diversity, how do you go about either interviewing someone for your team or selecting someone if it's a committee and become aware of what their cognitive bias is and how that would then coalesce into a higher functioning team?

37:49We all have biases, right? So it's just a question of degree. A couple of things come to mind. The first is just in cognitive diversity. It's just be willing to cast a wider net than you might be comfortable casting. So people who have very different background. By the way, one of the reasons I've really enjoyed listening to your podcast is you find these people who have been very successful in the allocation community who have sort of these quirky backgrounds. And I'm like, that's really awesome, right? It just shows to you that it doesn't, you don't have to be some, you know, finance major or whatever it is.

38:17You know, that's the first thing. And just being willing to entertain those people so people have weird backgrounds, bring them on board. The second thing I'll just mention, there's a strand of work that I just love, and I also think would be a nice complement to this, and that's work by Keith Stanovich. And Stanovich has made this really important distinction between IQ, which measures to be very real, helpful, more of it tends to be better, and what he calls RQ, rationality quotient, which is the ability to make good decisions. About a year ago, a little over a year ago, he published a book called The Rationality Quotient, with a couple of colleagues.

38:47And it lays out for the first time, sort of an assessment of rational thinking. And that might be a very nice compliment to this. So find people with sort of weird backgrounds, but essentially test them or assess them on their ability to think rationally. And it could be that combination that might be the sweet spot for success. What do you think are the biggest risks in the markets today? That's a hard one to answer. It's certainly not in the forecasting business. I guess what makes me feel least settled or most unsettled is that just the very low levels of volatility that we've realized. And I think one could make a case for why volatility should be lower.

39:25And there may be some arguments that are reasonable. That said, having been around for a long time and having charts going on volatility going back to the 1800s, we know that at least historically, volatility tends to be clustered. So we get periods of very low volatility interspersed with periods of very high volatility. So you said to me, like, what is the thing I worry the most about? It would be that we have some sort of a regime change in volatility that will catch people off guard. Now, you know, historically, sometimes low volatility is encouraged. There's actually an article today in the Wall Street Journal.

39:59This is the end of December, suggesting that, banks are trying to encourage money managers to borrow more, right? And it's a very clear temptation, right? Because you have low returns and low volatility, borrowing is leverages one way to get your returns up. So that would be one thing that concerns me. I think that there are other things that I find interesting. I don't know they should be concerns, but you remember the August 2007 quant meltdown. We've obviously seen a substantial increase in sort of quantitative systematic strategies. By and large, I'm fine with that. I think that makes sense.

40:34But I do wonder to what degree some strategies may be correlated in ways that we don't really understand. And so how some of these algorithms will behave in a period of stress, I think is unknown. So that's always a point of worry. And then the other typical stuff, which is I think we have a difficult time just in general, understanding, anticipating any sort of geopolitical problems. And so that those are put those down as the standard concerns at all times. But I think the thing that's sort of for me front and center is this notion of just very low volatility. And, you know, I saw an interesting chart the other day and went back probably 50 years, but looked at the average volatility for the S &P 500 and the average basis point change in the 10 -year treasury note.

41:16And if you plot those things on the x -axis, imagine just average volatility for the S &P 500 on the y -axis change in yield of the 10 -year note. And you plot these things. We're in the extreme left bottom corner, right? Very little change in the treasury note, very little change in the S &P 500. And again, going back to base rates, if you were to make a bet, you would unlikely to bet that it persists at that in that spot. So treasury rates are really low. So when you start with that denominator, you have to be on the left side. You're going to be on the left side no matter. You are. I think, but to your point, it's the volatility S &P that's anomalous, right?

41:52And by the way, going back to even the paradox of skill and the small variance and performance of active managers, part of that's also a function of the volatility being low. And we can demonstrate that. So, you know, it's very difficult to distinguish yourself either favorably or unfavorably. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? partner with a company that's been defining the future of dealmaking for nearly two decades instead. When it comes to M &A innovation, SRS Aquium has reshaped the way that deals get done, streamlining processes for maximum efficiency and minimum headaches.

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43:33Yeah, I guess liquidity is another area that I do have concerns. And I think you're right. Most of the volume, for example, in ETFs would be things like the SPDR, which is the S &P 500, and there's just not, there's unlikely to be a big issue there. But as you point out, we've had this massive proliferation, and especially into credit markets. And one area we could just pick would be high yield. And the ETF instruments are much more liquid than the underlying. And that might be the scenario you might imagine. So how do people get freaked out about ETFs in general, and we can call it indexing writ large.

44:05And it could be something like that, which is there's some sort of stress in the high yield market. The ETFs don't trade very well relative to the underlying. And there are articles in all the newspapers saying, gee, these ETFs aren't as good as we thought they were. That spooks people. And then people have a difficult time distinguishing between something that's illiquid and something that's liquid and so forth. And then it becomes somewhat of a cascading effect. There's been a lot of work done on liquidity, of course. Dealer inventories are way down. And I just don't think we've tested it Because many of the traditional tests of liquidity are things like bid offer spreads and realized prices.

44:41But you can't really test it in non -stressed environments. So if we get into a stressed environment, that would be another thing. I think you're exactly right. That would be another issue. And these all kind of go together, right? You get a volatility increase. You have concerns about liquidity. And it becomes these sort of amplifying effects that could freak people out. So I can't pass up the opportunity to turn the conversation to sports. I know that you have crossed over your book success equation had some really great, you know, whether it's paradox of skill or other anecdotes. And I also know from our conversations that you're fairly plugged in with a lot of the data junkies in the sports world.

45:15Why don't I just open it up and ask you what's most interesting to you today about the hybrid of data and sports? Well, I mean, it's amazing to me that we are thinking about games in ways that we hadn't thought about before and opening up our minds. Just a couple things come to mind immediately. The first is, and it's not sports per se, but even things like AlphaGo and AlphaZero is mind -boggling in a sense, first of all, the advancements in how those things became superhuman. Now, we knew that was going to happen with some probability, but more interestingly to me is when I watch, I listen to the great, whether go players or chess players, and they say these programs are playing moves that just weren't even our mental repertoire.

46:01And we're learning from them. Some of these moves in retrospect are really beautiful. So it's like opening up our mental space, which is super interesting. And then the second is just changes in actual strategies and games. And, you know, the famous one, of course, just shifts in baseball. And you say for baseball It's always been played for 100 and whatever, 25 years, and pretty much the same things. And all of a sudden, people realize, well, we now know where these guys tend to hit the ball. We're going to just put defenders in those spots, right? And the other one, to me, is totally fascinating is, for example, the evolution of the three -point shot in basketball.

46:33And teams like the Houston Rockets would basically say we want all our shots to be either three -pointers or basically layups, like at the rim or three -point. And I was talking to actually a basketball executive about this not long ago. and he said, we're actually nowhere near the point of saturation on three -point shooting. He said, given the percentages, we could move people back off the three -point line two or three more feet before their percentages go down sufficiently. Steph Curry phenomenon. And then, of course, the very fact that everyone's doing this is encouraging people to practice more so they get better at it and so on and so forth.

47:09Well, that's that recursive. One of my favorite books the last two years was Big Data Baseball, which was this Pittsburgh Pirates. I love that. Yeah. It's what happens after you understand Moneyball. Right. And these sort of repeat game theory of the same thing with new data. Right. And the thing that blew me away from that in that book, which I hadn't really thought much about, was pitch framing. And that goes back to the human element as well, right? The idea is that these catchers can position themselves to catch pitches in such a way that the umpire calls it a strike instead of a ball. And some catchers are better at it than others.

47:44And simply bringing in a catcher who's really good at pitch framing can lead to, the numbers seem to me, unbelievable. Over a season, substantial delta in the number of games won. So stuff like that. And that's a perfect example of analytics in the human dimension, right? Right now I'm reading scorecasting. which you know one of those key insights they study home court advantage in baseball and shockingly because we think of it as oh well the Yankees just picked up Stanton it's a short porch in left field and it was entirely the umpire's subconscious bias in key moments calling in a borderline pitch a strike for the home team right and actually you know so I was actually talking about the same basketball guy talking about this as well and you know it's the same thing he's like you know, you have, you're the home team and you've got 20 ,000 rabid fans, you know, how are you going to make the calls?

48:35You're the official, right? It's like, you make a call they like, they all cheer. You make a call they don't like, they all boo. It's like, okay, that's the feedback over time. You know, I don't know how subconscious or conscious it is, but yeah, you can see how that would work. Anyway, it's really, isn't that, yeah. So I love all that stuff. And, you know, some people feel like it takes some of the excitement out of it. I actually don't feel that way at all. And by the way, it seems to me there are still huge opportunities out there. It's amazing that even like in the NFL where there are huge stakes, there's still a lot of suboptimal decisions made.

49:04You know, the famous one is fourth, going forward on fourth down. And then there are other sports, you know, I think soccer is coming along, but other sports like ice hockey, where it's really, you know, still very early days in terms of understanding what we can do differently and so forth. So I find this stuff to be fascinating. That's one of the things that, you know, especially coming up with these sort of counterintuitive or things that we just didn't think were good ideas end up being better ideas than we thought. I love the framing of all the psychological biases too, because in sports, you mentioned it going forward on fourth down, which has proven to be a successful strategy, pretty much wherever you are on the field.

49:39And then of course, in basketball, you have the underhand free throw. Yeah. Which is, I'm trying to remember, was it Gladwell? Malcolm Gladwell had an awesome podcast on that. And apparently that day that Will Chamberlain scored 100 points in Hershey, Pennsylvania, he was shooting underhand free throws and made like 90 % of them. And it wasn't captured on tape. And apparently it was kind of a one -off. He just did it a few times and never did it again. And that was the whole point, right? For the other side of his life, the well -known personal side of his life, he couldn't possibly shoot underhand free throws.

50:09Yeah, it's like social capital. But I'll say, Ted, the one thing that, and I'm sure you fully appreciate this, is that I do think that there's an element of career risk. And this spans not just sports, but also investment management, right? Which is Bill Belichick goes four and a fourth down and it doesn't work out. People give him the benefit of the doubt. But if you're a coach who's got a 500 team, it may be the correct decision, but you lose that game. People don't think about the quality of your decision -making process. They do think about the outcome and that's a real big problem. So, so these guys might be saying, you know, if I punted, we may lose the game, but no one's going to say, you know, Ted punted.

50:43That was, Whereas if you go for it. So I think there's that element as well, that people go, what gives me the best probability of sticking in my seat? And this is this idea of career risk. And on the investment management side, the Scott Malpasses, Andy Goldens, Dave Swenson's of the world can try things with no career risk that someone who's two, three, four years in a new seat couldn't possibly risk. And it's probably the same thing if you think of stage of money management organization. Totally. And, you know, I thought in the comment, you know, your discussion with Scott, he mentioned one thing that I thought was really interesting and I hadn't thought much about, which was extraordinary continuity of their committees and sort of the leadership.

51:24And that's another one. You know, if I've been working for you with you for 10, 15 years, or even if I've got experience and I know that your decision making process is good, I can cut you much more slack. And that's something we do have that's absent in our industry. And that gets to another issue, I think, also for capital allocators, which is, you know, what is an appropriate time frame for us to evaluate decisions and so forth? And that's a really tricky, you know, because I would say that some of the academic work and some of the simulation work suggests that the time horizon is a little bit longer than it is practically.

51:55But the flip side is if I'm an allocator and I have someone who's underperforming, I really don't know if it's just a good process that's, you know, having a tough spell or they've lost their marbles. Right. And then those are, you know, sometimes those are not easy distinctions to make. So I get that how tricky it is. But it is an industry where, you know, it's the marathon, not the sprint. Let's turn to your work or involvement with the Santa Fe Institute. And similarly, I mean, there's so we've had some fascinating conversations about some of the things that you learn. But why don't you start with what is the Santa Fe Institute and then maybe share a story or two that comes to your mind?

52:33Yeah, so the Santa Fe Institute was founded in mid -1980s by a number of very eminent scientists who had a very similar sensation that much of academia had become very siloed. So the physicists talked to the physicists and the biologists talked to biologists, but that many of the vexing and most important issues in the world were at the intersections of disciplines. And by the way, if you go to Standard University, I mean, even go to Yale, awesome place, but it is typically quite siloed in many ways. So they started this institute, which was meant to be transdisciplinary. And the unifying theme is the study of complex systems.

53:08And complex systems are pretty easy to articulate. It's a bunch of agents. We'll call them heterogeneous agents. They could be neurons in your brain, people in the city of New York, of course, investors in the market. We allow them to interact with one another. And through that interaction, we get this concept called emergence. And then you get a global system, whether that's consciousness or your immune system or the operations of the city of New York and, of course, markets. So how does this all work and at what different scales? So that to me, you know, so we have, again, this hodgepodge from, you know, from computer scientists to physicists to psychologists all working on these kinds of problems.

53:42And is there a mission involved in that? Not really a mission. It's just, it's just, and by the way, it's basic research. It's not policy oriented. I learned about SFI first a little over 20 years ago from Bill Miller, who preceded me as chairman of the board. and bill in particular had been drawn in by some of the work by brian arthur an economist there and i'll mention sort of like what are these big big ideas so brian was a professor at stanford and had done this work on this concept called increasing returns and by the way it's much more accepted today than it was when he started working on this but we are taught in microeconomics and there's a lot of reason we're taught this is that returns marginal returns tend to migrate toward the cost to capital, right?

54:22High return on capital businesses attract competition, which drive returns down and so forth. And Brian had identified these situations, what he called increasing returns, where there was no regression toward the mean. There was actually repulsion from the mean. The winners were winning, losers were losing. And he identified sort of the qualities and features and things like network effects, things we talk more about. And that was, you know, it was completely out there. It was completely crazy. In fact, many people in the traditional economics field frowned on it. So that was one example of something.

54:51Once I understood, by the way, and I've always thought the efficient market hypothesis was, in a sense, I never thought it was literally true, but always a very beautiful construct. To me, it was a wonder, and I still feel that way in many regards. But then I started to understand markets as a complex adaptive system, and adaptive is really important because it means the agents, in this case investors, have decision rules on how they behave, but those decision rules themselves adapt based on the environment, right? So the market itself, so this is what Soros calls reflexivity. The markets themselves reflect on how you behave and back and forth, right?

55:26So there's this feedback loop between these two things. Once you start thinking about markets as complex adaptive systems, I don't think you can ever think about it in any other way. Interestingly, by the way, I think that the market as complex adaptive systems both explains why markets tend to be efficient. This is the wisdom of crowds concepts, but also explains why markets episodically go haywire, which they clearly do. And you read books like Andrew Lowe's new book called Adaptive Markets, which is great. Adaptive Markets, I think, is fundamentally a statement or restatement of markets as complex adaptive systems.

55:57So I think it's just an incredibly rich way to think about the world. It fits with many of the empirical things we see, for example, like cluster volatility. and it allows us to understand why this is, I think, one of the big fallacies with behavioral economics, which is the fact that you and I are suboptimal and it's easy for us to show that we're suboptimal as individuals. That doesn't necessarily translate into a market setting, right? Because our errors may cancel out. You're overconfident, you buy, I'm overconfident, I sell. It's a wash, right? Basically. So it's kind of, it captures a lot of that stuff.

56:28The one other thing I'll say, I mean, there are just many ideas that come out of SFI that are really cool, but there's one, there was a book that came out earlier this year, which I've recommended everybody I speak with is Jeffrey West's new book called Scale. And Jeffrey's a physicist by training, he's a former president of the Institute. And what he does is he uses basically physics to explain some of the empirical regularities we see in biological systems. And that, by the way, is wondrous to start. But he then carries that on to social systems, including cities and how cities operate, and even working to corporations.

57:00So we have all these really interesting empirical regularities that have been observed for a long time and our folks at SFI start to unpack it, which is so exciting, right? And so by the way, you get the sense of it. The people who are attracted to SFI tend to be people interested in lots of different topics. So there's huge self -selection. So people go out there, almost every conversation you have is going to be a fascinating conversation with people from all different walks of life. I recall, I mean, I spent a couple of weeks here a couple of summers ago and I remember sitting down with a lunch and We have lunch together, and there was this raging debate about whether a horse could beat a human in a marathon.

57:34And I'm like, where else do you sit down at lunch? And it's not just a discussion. It's like a— And what were the two sides? As a former marathon runner, I'm kind of curious. Yeah, exactly. What were the two sides of that debate? You like to believe that you could beat a horse. Yeah, the question was whether—because horses can't go that. They can't go for 26 miles. So the question is, could you train a horse to do it or not? And, you know, you can train a human. And so this goes back to the whole thing about, you know, is the reason humans are humans because we can run for a long time and bipedal and allows us to capture animals and so on and so forth.

58:06So anyway, it was the kind of thing like who's having these kinds of conversations? What's the next big piece of research that you're working on? So we have a couple things that we're working on now. I've been spending a lot of time thinking about the idea of comparing things. And it sounds very trivial, right? But as humans, we compare things all the time. And it turns out there's, it's actually been a big area of study in cognitive psychology. And by the way, the short answer is that the number one way we use to compare things is by analogy. This is like that. And that is, that approach is incredibly effective if you've got the appropriate analogy, right?

58:46But it breaks down pretty quickly in terms of breadth and depth. In other words, usually, you know, you might have a great memory, but it's probably finite. And so you may not remember the appropriate analogy or know of the appropriate analogy. And then depth is this idea that you may pick the wrong things, the wrong features of both of the things, the focal and the analogy, to make an appropriate comparison. So it gets into things like causality versus correlation and so forth. And then toward the end of this piece, we try to talk about how to deal with these things. And it is stuff we've talked a little bit about, things like base rates and so forth.

59:19we're doing a lot of work and it relates to this concerns about low volatility and liquidity on pro cyclicality so how do we think about loose credit and tight credit and i think the sort of bedrock a lot of that work will be that of john genocopolis at yale who wrote up some papers on the leverage cycle john's i think very provocative point is that it's not about interest rates it's about margin requirements it's about the ability to borrow and we tend to think that if we lower interest rates the world is going to be better and we raise interest rates it's going to be you know loose tight and he's saying that that's not really the key thing it's it's whether and so you saw this in the wake of the financial crisis where rates were obviously down but it was very difficult for people to borrow still to even to buy a home or whatever it was so it wasn't the interest rate it was the collateral and i would assume those things normalize over time that in an economic system, for the most part, when rates are lower, there's more borrowing, more margin.

1:00:18Yeah, it may not be the case. And that's the thing. You just think about the wake of the financial crisis. Even this coordinated central bank rates, it's not been an interest rate problem. It's been you can't borrow easily. And to your point, yeah, I mean, when things are good, you tend to get access to capital. So that's an interesting, you can just take a look at this and see collateral requirements over time. And they tend to be very liberal when things are doing well. And they tend to be very strict when things are doing badly. And again, you don't want the opposite. You want to take the punch bowl away when things are rocking and rolling and you want to bring it back when things are depressed.

1:00:56And so that's just, that's another thing that's really interesting. There's, there's some fascinating data on that. And, you know, we're obviously looking at that in sort of as a framework, but also try to get a level set of kind of where we stand today. I have been thinking a lot about this topic of, you know, it's almost always the case that regulators are fighting yesterday's battles. I don't suspect leverage is going to be the next big challenge. I do think liquidity might be the case. Rick Bookstaber's got a new book, by the way, called The End of Theory. And Rick talks a little bit about, he's got a couple chapters dedicated to this.

1:01:28And I think there's some, that's worth paying attention to, for sure. We are going to turn to my, as you'd expect, some closing questions. But before that, Our friend Morgan Housel had this wonderful quote that came on Twitter that said, the most underrated investing skills are controlling your emotions and having your career coincide with the 30 -year decline in interest rates. So as you and I sit here with this sobering reality of how incredibly difficult active management is, however we measure it, we can try to measure it in ways that say maybe it's not as bad as certain studies show. So at a simple level, our friend Warren Buffett will come out and say, oh, just index.

1:02:09It's that simple. Okay, maybe not. You have to pick what to index and whether the US is the right market. As an individual, as a person whose career has been in researching active management, understanding how it all works, and then you have someone as brilliant as Warren saying, forget all that, because at the end of the day, it all balances itself out. Are there mornings where you wake up and say, maybe I should apply this prodigious skill in researching to things that will be different, that have a better chance of winning, that have some better feeling of fulfillment? I don't know that these things are totally contradictory.

1:02:49So I'm in the same camp as Buffett and others where I would say that if you're not interested in investing and you're not willing to spend a lot of time and attention on it, indexing is probably a very sensible thing to do. A diversified index portfolio. Your discussion with Scott Malpass, I think Scott made a comment that struck me. I don't know if it's right, but he said there are probably 30 or 50 allocators in the world, or I don't know if it's in the States or in the world, that can really figure out who's skillful and how to do this. The rest of you guys don't try this, right? You know, and I think there's something to be said to that for that.

1:03:23That said, you know, being in an organization that does seek active management, you know, there are weird things out there. I mean, there are inefficiencies there. We call them the easy games. There are situations where there are opportunities to generate excess returns, but you need to be focused on those. You You need to be diligent, hardworking, and so forth. So I'm trying to have it both ways. I think you can have it both ways to some degree. So if I, you know, at a holiday party, if an aunt or uncle says, how do I invest? I would probably say, you know, indexing probably does make sense for you.

1:03:53But for people who are more sophisticated and will have the time and energy and resources, I think they probably can think about how to generate these excess returns. And again, it's a moving target, right? That's the other thing to recognize is that different asset classes have different periods of degrees of inefficiencies. and always to think about in your mind cataloging why you think this is something security is mispriced. And there are good reasons things are mispriced. I mean, there's been literature on spinoffs for a long time. There's been literature on institutions versus individuals.

1:04:23There are people who are forced sellers. There are people who are forced buyers. And they're doing things that are non -economic or for non -economic reasons. And those can present opportunities for the other side. I'm still going to push you on this because all of that is true. I agree with it. That's why I'm passionate about the business. But at the same time, the stats would tell you that it still all washes out, that if you're good at picking off those things, you probably are going to have too much money to find those opportunities. And so for you as an individual, do you ever have the point where you say, huh, this is just – I mean, I do think it's hard.

1:04:57And I do think you have to be measured about what is – you have to just be thoughtful about all these things, like what is an appropriate amount of capacity. And you're exactly right. I mean, and this goes back to what Charlie Ellis has talked – that was another great conversation you had. But it's sort of this great model that Charlie Ellis has argued about, which is the business and the profession. And the business is about generating fees and revenues. And the profession is about generating excess returns. And, you know, Charlie makes the point, I think, which is right. you need a healthy business to pursue the profession appropriately, but you don't want to let the pendulum swing toward the business away from the profession.

1:05:33I think that's a big challenge and something to be incredibly mindful of is that topic. So, you know, I guess I'm still trying to have my cake in it too, which I think that there is some balance. But I think you raise these really important issues. And, you know, at Lake Mason Capital Management, we, you know, the AUM got to, I think, $65 or $70 billion. It's a lot harder to run $70 billion than it is to run $7 billion than it is to run $700 million. And that's something you always have to take into consideration. Okay, here we go. What was your favorite sports moment for you, both as a participant and then separately as a fan?

1:06:09Well, as a fan, probably, this might be a little cliched, but man, 1980 Olympic hockey team is a hard one to beat. And Al Michaels calling that. Where were you at the time? I was in high school, and I still play ice hockey today. So I was a really avid ice hockey fan. And that was, you know, you play that game 100 times. I don't know. The Russians win 98 or whatever it is. I'll tell you, the very first live hockey game I saw, because 1980 I was 10 years old, was the Madison Square Garden warm -up. Oh, yeah, where they got crushed. Where the Russians fooled us. It was two weeks before. That's awesome.

1:06:47Yes, that's a good one. And, you know, for me personally, I mean, this is going to sound ridiculous, but I played a lot. I played lacrosse in college and played in some tournaments. And, you know, about I think it was 10 years ago, I was on a team. We only had 13 or 14 guys, which is too few. It was at a tournament in Vail. The category is called Supermasters, which tells you of a certain age. And we had this team that just wouldn't quit. And, you know, we won this one game in overtime, big underdogs. And we beat a team from Navy. We beat a team from Hobart. and we won that championship. And that was just a really gratifying, you know, it was sort of like the real underdog thing.

1:07:22We had a couple of guys just did an amazing job. But yeah, that was probably for me, my personal sports highlight. Great. What teaching from your parents has most stayed with you? You know, it's interesting. My house now is filled with books. And I think that hopefully that's something that will rub off on my kids to some degree. I grew up in a house without any books for the most part and TV watching. And so it's interesting. So it might work out for... Yeah. So no, it's really interesting. So in a sense, I wasn't in that environment. But from both my parents and especially my father, just very meticulous and doing the job the proper way.

1:08:02And I would have to mow the lawn and he would review my work. And if I missed a spot or did something inappropriate, he would send me back out. And of course, when you're a 10 or 12 year old kid, that's the last thing you want to do. But it's this idea of just being meticulous and being thoughtful about things and doing the job the right way. And, you know, there's a great section in the Steve Jobs book where his father taught him about, you know, it was like finishing the back end of something that no one would ever see, but it was just the right thing to do. Right. And that was, that was my father.

1:08:29He was the kind of guy that, that always want to do a meticulous job, leave everything really, you know, just a job well done. So that, that, this idea of like, it's not being a perfectionist, but it's really just trying to do things properly all the time. So I kind of have to ask, with five kids, which you have, how do you try to imbue that on your kids when there's probably something going on all the time? Yeah, I'm not sure there's much you can do as a parent for all that kind of stuff. No, I think, yeah, part of it's by example. Part of it is, yeah, it's just probably communicating a little bit.

1:09:02When the kids were little, I would tell them to do certain things like go to bed or whatever. But I try not to tell my kids to do anything. I try to offer recommendations or things to think about and try to get them to think for themselves a little bit. So here's some things to think about. Here's something I recommend. Just take this into consideration. And more times than not, they'll see sort of where I'm coming from. So, yeah, and doing a job well done, you know, even if I'm trying to help them with their homework or whatever, it's just this idea of, like, making sure you do everything you should be doing, do it well, have pride in it, and so forth.

1:09:33So it's effort, right? It's a Carol Dweck stuff. It's mindset. It's effort. It's hard work. What information do you read of the vast amounts that you do that you think others might not know about but would benefit from? Well, I don't know if there's – information is an interesting word in and of itself. For better or for worse, and many days I think it's for worse, but for better or for worse, I probably spend a lot of time thinking about more frameworks than I do – like mental models than I do nuts and bolts. And the reason I'm a big mental model fan is I do think that when ideas are thrown at you, if you have a framework, a latticework to hang it on, you're going to be much more effective.

1:10:10One example I give, and this is a pretty nuts and bolts example, but for example, we have a framework for thinking about mergers and acquisitions and how to evaluate the quality of an M &A deal. And I just found as an analyst over the years and a strategist and so forth, that analysts, almost every deal, it's like a one -off, right? They're analyzing it without a framework. And if you have a framework for it, it just allows you to put things into context, analyze it quicker, to be more accurate and so forth. So probably is that it's less the what information, but more like I'm very committed for better, for worse some days, like I said, for worse to mental models and thinking about big mental models.

1:10:46By the way, I'm a Buffett fan. I know you're a Buffett fan. I've learned probably more from Munger or I've taken, I've probably taken more from Charlie Munger's work over the years. And I'm just such a huge fan of this understanding big ideas from different disciplines understanding that constant learning will lead you down a number of intellectual cul -de -sacs but you never know when a framework or a model or or something will be useful to you and this idea of constant learning i'm just a huge just like it's such a big deal and in this industry by the way it's just you can't live without it right and todd combs one of my students i mean you talk to those guys and how much time they spend reading and thinking.

1:11:26It's astounding. It's astounding. And they're obviously the best at what they do. But recognizing it's not about shuffling paper. It's right about thinking. And that's how they can make these such big decisions in short periods of time. The answer is because they've thought about stuff, right? Yeah. What life lesson have you learned that you wish you knew a lot earlier in your life? There are less life lessons, But I do think that there are some of these, a couple of mental models. I mean, so the first and foremost thing is that, I guess a couple of things come to mind. One is just in terms of personal habits.

1:12:02It's very good for young people to recognize that sleeping properly, eating properly, and exercising properly are incredibly essential. And your productivity will really go up if you do those things properly. And I was probably, and maybe Ted, you were one of those guys too. But for years and years, I thought, and especially with young kids, you know the drill. You think you can get by on a lot less sleep than you can. And it's almost, there's a degree of cognitive impairment that comes with that. So that's the first one. The second thing is just you can't emphasize enough that hard work is really important.

1:12:38In the investment industry, hard work is not necessarily spending 16 hours at your desk. It's constantly thinking and reading and learning, right? But hard work in applying yourself, let's say it that way. And then there were a couple of these mental models that I really do wish I had known much younger. And the big one is that inside -outside view, this idea of understanding past performance and how that applies. And as we go through life, everything feels unique to you. You're moving from New York to Boston. It feels like you're the first guy to have done that. But many people have done it before, right?

1:13:10And so what is that? And, you know, how do I think about reference classes and how those can inform my decision making? So that sort of mental model would be something else I would cite. All right. It's the last years of your life. I've given up trying to throw a number. For you, it's probably 120 with the amount of reading you do. You are in a rocking chair cradling your lacrosse stick. What advice would you give yourself today? Yeah, I mean, I think at the end of the day, and these are really interesting questions. You know, Atul Gawande wrote that beautiful book, Be Immortal, about the end of life.

1:13:44And I think you realize at the end of the day that what makes humans most happy is ultimately relationships and family and friends and so forth. So probably the advice would be just never lose sight of that. There are a lot of little bumps that come along the road, and these are things that are addressable. But that, you know, keeping relationships at the focus is really important. I also think it's interesting that as you get older, it's probably really important to continue to stay in touch with young people. Now, it's easy when you have kids. It's sort of a natural to some degree, and that's helpful.

1:14:18But it could be even intellectually. It's just making sure that you're constantly exposed to young people, right, who have just a different point of view of the world. And so that would be another thing is just to make sure that you hang out with new and young people that have different ideas and you're open to those. Michael, thank you so much. outstanding as always. My pleasure, Ted. Thank you. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you've liked what you've heard, please rate a review on iTunes or Google Play to help others find out about the show.

1:14:53Have a good one and see you next time.