#54 - Cliff Asness: Quant Investing, Market Inefficiency

30:55But in reality, when you're managing money in real life, there is an emotional aspect. There's a practical aspect. And that plays a much heavier role in all of this. Yeah. And then there's a well-meaning client saying, I can't blank and believe you're coming back to me with the same story again. And you go, well, the same thing happened again. And that can be very hard. Often those are the absolute best opportunities we've ever seen. So many things in markets are like that. It feels ironic and frustrating, but it's also almost has to be that when the baby's getting thrown out with the bathwater and people are acting on emotion, it might be very painful if that action hurts you, but it's also often the absolute best time to be looking forward.

31:43Yeah, let's talk about that a little bit. I feel like investing is fascinating because even with extensive knowledge and experience, You can still be misled by market dynamics, such as emotional biases that you just mentioned, fear, greed, blind spots, overconfidence. This complexity is what makes investing truly captivating. How do you view the interplay between knowledge and emotion in investing? It's huge. I have, you know, there are always these twin explanations. Whenever someone in usually academic finance, but sometimes their practitioners find this kind of stock beats this kind of stock.

32:23There are always three possible explanations. One is it was just random. You overfit the data. You bought companies with blue logos and sold companies with yellow logos. And you checked all the colors and you finally found one combination that worked. And it's not going to work going forward. Data mining, overfitting. If you pass that test, if you don't think you've done that too egregiously, so you don't think there is that bias, there are two reasons there can be a real spread between cheap and expensive. A so-called efficient market reason, meaning the ones that outperform are riskier than the ones that underperform.

33:03That's the only thing you should get paid for in a, quote, efficient market. In a diversified portfolio, you don't get paid for risk you don't have to bear, a lack of diversification. But in a diversified portfolio, you get paid for risk that you can't diversify away from. In a behavioral world, an emotional world, you can also get paid for taking the opposite side of other people's errors. I think both come into play. I'm not dismissive of either. Over my career, I probably shifted from two-thirds, one-third efficient market guy to two-thirds, one-third behavioral guy. And I think that's just, you know, seeing a lot of things that I think are very hard to explain with risk-based stories.

33:45I don't think either of these two bubbles I mentioned are very explainable with risk-based stories. But emotion is what, to the extent a lot of what we do is taking the other side of behavioral finance. We are literally trying to take the other side of people's either emotions or miscalculations. And miscalculations are a little different than an emotion, though they can be overlapping. You know, a lot of one of the major things people seem to tend to do is over extrapolate good news. They think it's an expensive stock is going to be a high quality, wonderful stock forever. That may be a calculation error.

34:24It may be an emotional thing. I just think of it together as behavioral finance. But a lot of what people like me do is try to take the opposite side of that. But the flip side, though, is your own emotions and your clients emotions also come in. to your ability, as we've been kind of dancing around, your ability to stick with taking the other side. You know, if these emotions exist, you have to figure out why you are not as subject to them as the people you are taking the other side of. And I think some of us have been able to do that over time. But that is, you know, the two-edged challenge.

34:59There are all these paradoxes. There's a story that I've told a bunch, so I warn you, some of your listeners have probably heard this story. before, but this paradox comes up all the time. In late 1999, when we were doing fairly horrible out of the gate, because we started in late 1998, so the dot-com bubble was a rude way to start a new firm for someone of our style. I was talking to my wife. She was my new wife. We got married in August of 1999. A separate story is for a little while, I was referring to 1999 as the worst year of my life. And my wife, who's way nicer than I am very softly, said, could you maybe say the worst professional year of your life?

35:46And I did make that concession to her. And I tried to remember to say that. But we were sitting around talking and I was probably cursing up a blue streak. Thank God I don't remember exactly. But it was this world is blankety blank, stupid and crazy and and and you know it's killing us and she said something very soft like i thought you guys make your money taking the other side of things like that and she didn't finish the rest because again she's nicer than i am but the implied rest is and now you're complaining that they're too crazy and too emotional meaning they're going further than you ever thought they would making taking the other side of them temporarily.

36:31And it was temporary, but temporarily excruciating. And I had to be like, well, yeah, you kind of got me there. Because what every active manager, I don't care if they're a quant or a Graham and Dodd, you know, concentrated stock picker. What we all want is the market to present us with wonderful mispricings, opportunities where we're, oh, God, this is a bargain or, oh, God, you got to short this. It's there's no chance it's worth what they're saying. and then you want the rest of the world to figure out that they were stupid and you were right about an hour and a half after you put the position on, and then you want to do it again, and that's just not how the world works.

37:08Once you presuppose a world that has emotion, that has behavioral biases, that has missed calculation, it can always get more extreme before it gets better. Now, I do think the more extreme it gets, the more the odds are on your side going forward. It is a bit of a rubber band to it. But it never is an arbitrage. It's just an increasingly good bet. So that emotion, that miscalculation side, I think is a huge part of the opportunities, active managers. And I'll say again, more than just quants, broadly speaking, that they face to take the other side of other people's errors. But living through when they get more extreme is ironically also one of the biggest challenges.

37:57a manager like that faces. And it has to be that way. It's not a weird paradox, actually. It's just the way it has to be. Things that are easy do not last. Things that are painful to live through can last forever if they periodically make themselves painful enough that people abandon them. Things that upset you, oh God, it shouldn't be this hard over time. I can't always pull this off myself emotionally, but should actually please you. Because you should actually say to yourself, this is why I might get to do this forever. Because it's freaking hard. And it tends to please you in the fullness of time when you look back.

38:37Oh, yes, very much so. But when you're in the middle of the maelstrom, that can be hard for even me to remember. I have literally said to partners of mine, Does anyone remember a day when we made money? And it was like three days ago. But these things can get shorter and shorter term in just what your focus is and the emotional side. Let me ask you a few questions about market efficiency. I know you spend a lot of time thinking about that. So let's go back to the beginning. You studied under Eugene Fama and Kenneth French, proponents of market efficiency. So how did you transition to focusing on capturing alpha or excess returns through market inefficiency at AQR?

39:20Well, first, I hope Fama and French don't get mad at me. I mean, this is a compliment, not an insult, but they're both, to various degrees, far more open-minded about that stuff. than simple reputation might be. Gene Fama has this moment. I took his class. I sat through his class three full times. I took it once, and then I was the teaching assistant the next two years. And I attended every lecture because I was terrified of doing a bad job for Gene. So somewhere around the third week of class, he looks at the class and says, markets are almost assuredly not perfectly efficient. And you get a little gasp.

40:01and only at the University of Chicago, and maybe at only Gene's class at the University of Chicago, does that elicit a guess. To the rest of the world, perfection is a very extreme hypothesis. And I think most of Wall Street, even most of academia would go, yeah, they're not perfect. And Gene readily admits that. He'll say it's a point. It's an extreme hypothesis. Now, I think Gene probably thinks they're more efficient than I do. And I probably think they're more efficient, I think, than many others do. But Gene flat out tells you they're not perfectly efficient. That's a very useful starting point.

40:36And it may even be a useful ending point, particularly if you don't think you can find an edge or stick with an edge. Assuming they're efficient, which tends to lead to very diversified index-like solutions, can be an ending point. But even Gene leaves the door open. I'll give you another example. The firm that Gene and Ken have been associated with many years. One of the firms I respect most in the industry, Dimensional Fund Advisors. We actually overlap a lot with them in kind of what you might call factors that we trade. We both read the same literature. We both added two on the same literature.

41:14We probably both have secret proprietary things we think are slightly better than the literature, but things like preferring low multiple profitable stocks that are not over-investing, that are in fact being careful with their investments and so on. We share that in common. Does DFA take a more efficient markets explanation than we do? Yeah, they lean that way. Is it an absolute sea change? No, I don't think anyone at DFA, if you started Fama, would say it's totally a perfect market. There's no role for behavioral finance at all. And I don't think anyone at AQR would go, So nothing is a rational risk premium.

41:55It's all free money. So I do think the empirical literature, what has held up, what has a good story for why it holds up, among reasonable people, I will not discuss unreasonable people, but among reasonable people I respect, we often get to a very similar place, even if we have nuanced, not diametrically opposed stories, but nuances in how much we think is coming from one source versus another. I suppose I should have asked you this first, but how do you define market efficiency? The literal definition is prices reflecting all available information. It then gets much more complicated because you might have immediately noticed that's a hard thing to be specific about or to test with only that sense.

42:44I'm going to get a little geeky on you here. Testing that concept has always had what the quants and the academics will call a joint hypothesis problem. The only thing you can test is whether prices reflect all available information and some model for how they should be reflecting information. To say something is wrong, you need some standard of what is right. And let me give you a classic example, the famous capital asset pricing model, that the only thing that should explain why one security has a higher or lower expected return than another is its beta to the full market. And this beautiful theory behind this early on, the Sharpe, Lintner, Black or, you know, what what real academics will call the model, the idea that you only get paid for risk, that you can't diversify away.

43:39Now, there are some simplifying assumptions, more modern models had more dimensions to it, but it's a beautiful model. It happens to be a horrific empirical failure for about 100 years every place we've tested. So we can look at that and go, we reject the joint hypothesis that markets are efficient and are trying to set prices using the capital asset pricing model. It gets harder to say which one is wrong. They both could be wrong, of course. But if one of them is wrong, is it the case that this model is actually how market participants want to set prices? but through various biases, difficulties in trading, human biases, they fail to do so?

44:29Or are there no biases and we just have the wrong model? That the model for expected returns is far richer and more complicated than the capital asset pricing model. You don't know which of those two. One of my founding partners at AQR, John Liu, and I wrote a piece when Gene Fama shared the Nobel Prize with Bob Schiller and Lars Hansen. I won't mention Lars only because Lars was incredibly well-deserving but was kind of doing other kind of work. But Gene and Bob Schiller were kind of on the opposite sides of this argument. Gene, again, is not dogmatic but certainly leans towards the efficient market side.

45:09and Bob certainly leans to the behavioral finance inefficient market side. And John and I wrote a retrospective on the split of the prize between them for institutional investor. And one of the things we tried to do, and it did not catch on, but we tried to introduce a standard of reasonableness. Because every once in a while, I think fancy the efficient market hypothesis can lean a little too heavy on the, well, there's always some theory of how prices should be set that could mean it's an efficient market but we but but with this theory and sometimes if the theory is well people just enjoy owning these kind of stocks they enjoy earning owning stocks that you could talk about at cocktail parties that may actually be true but to me that's an inefficiency that's not a fair model that you can say that that is efficient market that just uh has cocktail party pride as an input into it So adding some level of reasonableness, I think there are certain things.

46:14Momentum, in particular, famously is very difficult to reconcile with efficient market stories. Not impossible. Some people have suggested some. But, you know, value strategies. I still don't think it's all efficient markets by any means. I think there have been bubbles. But you could do a better job telling a risk-based efficient market story for why cheap beats expensive than you can for the momentum. So in all of these, there are subtleties. You asked a very simple question. What does it mean for market to be efficient? What's the definition? And as usual, you got a 14-minute answer. But I'm sorry, it is a very complex question.

46:52It is not a simple one-liner. Well, the actual definition is a one-liner. It's just fairly useless on its own. Understood. Do you feel that markets are becoming more or less efficient with time and technological innovation? Oh, you're throwing me a hanging curveball, I think. But I have a very long-winded piece, which your listeners will believe after listening to me. The Journal of Portfolio Management came to a bunch of us for their 50th anniversary. And none of us had been around the whole 50 years, but they came to a bunch of us who've written a lot of papers in the journal over time and asked us to submit papers for their 50th anniversary.

47:35There were a lot of wonderful things about this request. One is they were invited papers. So while I assume the wonderful editor, Frank Fabozzi, had some standards where he'd tell me, no, Cliff, this just stinks. There was not a referee. You were allowed to pontificate. You were allowed to opine. You were almost expected to offer some opinions. It was like grand old men kind of opinion. So, you know, even I get papers rejected after all these years because some referee says now we know this or you didn't do the test right. They're always wrong to reject my papers. Don't get me wrong. But it still happens to me.

48:12In this case, it was pretty much a lock the paper would be in unless unless you went completely mad. And it was encouraged to be looking back over over long periods because we were all kind of old men. And the criteria here was people who published a lot in the Journal of Portfolio Management and were still alive. And I happened to pass that twin bill along with some other great people. And I chose this exact topic, whether the market has gotten more or less efficient over my career. And on net, my hypothesis, and I admit in the beginning, there's a lot of opinion. Market efficiency itself, as we already discussed, is a very hard thing to test formally.

48:56So if it's hard to test in general, testing whether it's changed over some finite period is going to be even harder to be really, really statistically, you know, confident about. But my belief is over my career. And again, I'm using my own career as the but but what else are you going to use? That's my that's my life experience, which is now 34 years of of live results since my dissertation. I think the market has gotten less, not more efficient. efficient. And I love the way you asked the question about technological change, because I start out the whole piece saying, like many of my readers, I probably started thinking markets should get more efficient over time because technology leads to more efficiency in so many things.

49:44Information is in all of our hands, close to instantly, close to ubiquitously. So it had to have gotten more efficient. But then two things. I've observed that over my career, these two periods I keep whining about, 1999, 2000, and then 19 and 20, were respectively in highly measurable ways the most extreme mispricings, in our opinions, we've ever seen going back in the near 100 years. So that's not too consistent with a market that's gotten more, not less efficient. Those are just two data points. But as we say in the formal statistical world, they're two freaking big data points. Influential data points is the more technical term for that.

50:33So, A, I thought markets have gone crazy twice in my career to extents I would not have thought. I would not have guessed they'd go that crazy. I would not have said no chance. Hopefully, I'd be smart enough to go never say no chance in this business. But I found 99-2000 a surprise. And I found 2019-20 a bigger surprise. Of course, we had seen the same thing a mere 20 years ago. That's not 100 years. 20 years later, people like me and people like me will still be around. So to see something as extreme happen again made me think something has made the markets a little odder. The next thing about technology is when I thought about it more, at least I came to the conclusion that technological advances are mostly about speed.

51:24Do I believe information gets into prices faster than 34 years ago? Yeah. We're probably talking mili, if not nanoseconds, when we used to talk minutes, when an earnings announcement would come out. But when I started my career, I'm old, but it wasn't the Stone Age. We had telephones and faxes. We had Bloomberg's, right? Information got in pretty darn quickly. So the difference between 10 minutes and 10 milliseconds matters a lot if you're a so-called high-frequency trader, because your world has gotten faster and faster. But if you're talking about medium to long-term mispricings, it doesn't matter for a hill of beans.

52:12It's not about that. You can make or lose a lot of money on mispricings while waiting a week to do every trade from when you decide to. Because it's a slow-moving world. So immediately it was like technology is not really relevant to this general level of mispricing question. And I ended up deciding even more counterintuitively that some forms of technology have contributed to this increase in what I think is market inefficiency. And here I particularly mean social media, instantaneous 24-hour trading on your phone in a gamified fashion. I'm fond of saying if you're up at 4 a.m. on a Saturday night and you just need three more shares of NVIDIA, I'm not sure your financial planning is on firm ground.

53:07Social media, though, in particular, I pick on that a lot. I know I sound like an old man harumphing about social media, but market efficiency, while never, you should never assume perfect market efficiency, but a fairly efficient market has always depended on some idea of the famous wisdom of crowds, that individuals may make mistakes. And I could point to people doing crazy things, but the crowd itself is wise and will take the other side on net of mistakes and arbitrage them down, if not fully away. You know, a wise crowd has a crucial assumption behind it that is usually stated, but sometimes left out, that the crowd is relatively independent of each other.

53:56That's why you get a good decision. If the crowd all gets to talk to each other, maybe you still get a good decision. Maybe the people who know the answer convince the people who are wrong. But maybe you get an angry, crazy mob, too. And again, these are taglines, but I like to say, has there ever been anything in history better than modern social media for turning a potentially wise crowd into a potentially dangerous mob? So I think market efficiency in general, and particularly some of these extremes, which is even more relevant for of what I think are bubble like behavior. Have been exacerbated by a fair amount of our technological environment.

54:40I'm not a pessimist long term. I think with a lot of big technological change. The world tends to adapt over time. We may be stupid about it for a while, but eventually we figure out that it's leading us astray. So I'm not a total nihilist, but I do think in the immediate term and for the last 20 to 35 years, particularly the last 20, I do think the technological environment has contributed to less, not more market efficiency. And I suppose the meme stock example is a pretty extreme case that highlights what you just said. You're exactly right. I just call it the apotheosis of my thesis. it is i don't i don't like pointing to the most extreme that's why i didn't lead with it you know it's not fair arguing pointing to the single craziest thing and saying see i'm right so i don't take this as proof positive you know the spreads between cheap and expensive adjusted for maybe quality and growth differences that got so extreme that we look at are across Thousands of stocks around the world, diversified by industry.

55:51It is not about the meme stocks. But the meme stocks are probably a poster child for your social media driven extreme irrationalities. So, yeah, I fully agree with that. But I don't want to oversell the case. They're the poster child. They're not the driving force. Which is interesting in and of itself because that is a byproduct of technological innovation. So you had technology innovation actually potentially leading to less efficiency in that particular case. I know. It ended up, we started with technological innovation would make us more efficient. And we got, in my opinion, again, this is just a hypothesis, but it's a strongly held one.

56:30We got to technological innovation, at least for the time being, again, it may not be permanent, having the opposite effect than maybe a lot of us first thought it would. Well, it's not just that. I'm fond of pointing to our politics And I'm not going to get partisan here I'm just going to say the number of people in the world Who think that our politics has gotten much more rational And calm and deliberative because of social media There are probably some But I don't think there are a ton And I think 20 years ago We were all All is too extreme But a lot of us were techno-optimists that things like social media in the early days would bring us together as people.

57:17And I don't think I'm going out on a limb when I say it has not seemed to have that effect. Politics is a voting mechanism. So are markets. The votes are weighted by dollars. And the number of votes that go one way versus the other way determines the price. So why markets, if you believe that about politics like I do, why would you not believe it about markets? So I do, again, I have hope both politically and economically that eventually we internalize these new tools and they're not driving us to madness to quite the degree they have. But I do think for the time being, and certainly the last 20 years, they have done exactly that, driven us to some market madness.

58:02Yeah, it seems that you could argue that it has exaggerated the emotional and behavioral biases that we all have. I would definitely make that argument. And so what do you feel are the investment implications of potentially less efficient markets? Well, the end of the paper talks about this. And I start out saying, this is going to be the most frustrating part of the paper, because there's a very good and a very bad thing that comes if I'm right. Now, I always say if. It's, again, a grand, unprovable hypothesis. But if I'm right, a less efficient market prone to periodic bouts of extreme inefficiencies, again, call those bubbles, which I don't think happen too often.

58:44I think they happen more than Gene Fama and less than most market participants, who I think are somewhat promiscuous in the use of the word bubble. You know, a stock they think is too expensive. They say, oh, it's in a bubble. To me, it has to be a very pervasive, market-wide, epic mispricing to get to that point. I do think this feedback loop where technology has made us all crazy about it, what does it mean? It means the mispricings will be bigger on occasion. 99, 2000 saw spreads as we measure them, and this was very robust. Other people came up with their own ways to measure them after us.

59:22between cheap and expensive, getting to record levels, and then in many scales, surpassing those records in 2020 and early 2021. That means to an investor who can stick with what they do, who's rational, who's taking the other side of these emotions, they should make more money long-term. Think of it this way. If the markets were perfectly efficient, there's no such thing as alpha. That's one way to think of perfect efficiency. So if markets are wildly inefficient, someone who can stick with betting against them should eventually be rewarded more than if they're mildly inefficient. But you've probably already guessed the second part.

1:00:01If they can get to more extremes, and like we talked about in the very beginning, if those extremes can last longer, it's going to be harder to stick with these strategies. Not that the world cares what I find fair or not, but in a weird way, I find this a remarkably fair trade-off. Harder to survive and do and stick with, but more lucrative for those who can. That's the way markets work, baby. You can't get away from that trade-off. It often works that way. Do I think we'll be one of the survivors? I think we've demonstrated that again. Yeah. So it's a self-serving argument. It doesn't stop me from, and this is more my team than me these days because I'm old when it comes to great research, but I think we made huge strides in making our process also a little less about everything you and I have been talking about, a little more esoteric, a little bit more about not HFT, but higher frequency ML models, alternative data sources.

1:00:59So just because I extol old school investing and think the opportunities are bigger doesn't mean I don't acknowledge and want to diversify away from it a little bit myself, because I also acknowledge if I'm right, it's also going to occasionally and hopefully not for a long time from now. but who knows be excruciating on occasion so yeah you i think people should look with open eyes and go the opportunities if you agree with me are bigger than they used to be but so are the opportunities to for throwing in the towel at the low so think about sizing how much of this you do to a point that you think you can survive those periods and still devote as much time as ever for a quant that's building other things in their process that are Not doing the exact same thing for others that may be other diversifying actions.

1:01:51But yeah, setting yourself up to survive those periods that, again, by my own hypothesis, will be harder to do than they were in the past. If you don't think about that part, you're doomed to failure. One of those potentially diversifying strategies you reference a few times is trend following. Do you view this as reliably diversifying? And do you expect the persistent risk premium? Okay, let's do full disclosure first. I'm a believer in trend following and my firm both incorporates that into multi-strat strategies and has standalone trend following products. So everything I'm saying now, you should hold on to your wallet because you're talking to a trend following salesperson in some respects.

1:02:34It's one of the most consistent results out there. I wrote my dissertation for Gene on what's generally called momentum in the individual stock world, an individual stock that's going up, tending to an average beat an individual stock that's been going down. In the more macro world, stock indices, bonds, fixed income, commodities, actually quite a few other things also, those things tend to be called trends instead of momentum. though we're talking about a very similar thing. What has been happening tends to keep happening. That is measurable both with price trends themselves, and everybody who does this will have their own version, and every one of us will claim theirs is the best.

1:03:19Obviously, mine is the best, but we all have our own. But they can be measured with price trends. They can be measured with fundamental trends. Those are highly overlapping. if earnings have been increasing in a country more rapidly than normal that's correlated to when prices are increasing more rapidly than normal markets do notice but they're not perfectly correlated sometimes one is greatly exceeding the other and we prefer to see both but you put together a nice robust trend following model when you say consistent or persistent i think they have a decent sharp ratio, a decent risk-adjusted return.

1:03:58I don't know what constitutes really persistent or consistent. To me, delivering over multi-decade periods, on average, decently positive returns, while fairly consistently, it's not a perfect hedge, but fairly consistently doing quite well in big market drawdowns. Trend following has done well in every big market drawdown that wasn't a short, sudden surprise crash. The poster child for something that trend following will not protect you from is March of 2020. Everything is great in the world. Oh, we have a pandemic and everything's down 40%. There's no trend to follow. The GFC or 2022, to be more up to date, are poster children for actually far more destructive because they were bigger and to our point earlier lasted much longer drawdowns for traditional markets trend following has been a phenomenal diversifier so i'm a believer it should have a role in a portfolio um i'm a believer other forms of insurance um tail risk hedging if you will like buying options does protect you against those short sharp crashes but costs you a lot of money long term The option premium eats more than that up.

1:05:20So trend following is a bit of a free lunch. When I speak about free lunches, I mean on average free lunches. You don't always get to eat my free lunch. Every once in a while, they fail. But if on average they work, that is a free lunch. Getting a decent positive expected return on something that has empirically rather consistently acted as a hedge in all the big drawdowns for the equity market. Yeah, I'm a believer. This is an investment advice, of course, because we always are supposed to say that. But with all the full disclosure that I'm a trend-following salesman, as one of the many quantitative things we do at AQR, yes, I am an abject believer.

1:06:02But everyone should make their own judgment because I have a horse in this race. How do you define and think about risk both as an investor and as a manager of other people's money? Very complex question. There's no one-dimensional measure. of risk. I have defended the often attacked quantitative measures of volatility as risk. It is far from a perfect measure. Certain things that are extremely one-sided in their risk, like again, we were just talking about options. Imagine you sell options on a persistent basis and you try to pick up the variance premium, the fact that you should get paid for selling insurance, not for buying insurance.

1:06:46I think you do get paid for that over the long term. Occasionally, you get absolutely whacked, right? You're on the wrong side of March of 2020 if you do that strategy. Volatility would be a terrible way to measure this strategy because over very long periods, you would see very low vols as you just picked up the premium, and that would not tell you anything about these horrible periods to come. The day after that horrible period, you'd probably overestimate vol because you'd say, hey, that's dominating. Most models will use some rolling average that moves over time. So we'll be giving excess weight to that period.

1:07:25So anything that is very one sided, asymmetric, option like left tail, right tailed. Volatility is not a great measure. But for many strategies, it is a pretty good measure, particularly overall, but very short horizons. for factor investing, where you're long and short, often thousands of stocks around the world. It's not very well behaved at the short term. You could have so-called 10 standard deviation events in a day. I always laugh. Someone says it's a 10 standard deviation event. They're really saying it's not a very perfect model for risk. It's a broken model for risk. But at multi-year horizons, even there, it's not perfect.

1:08:08We've seen these factors trend probably somewhat more than we expect. That's how you get those 99, 2000 kind of periods. But it's much closer and it's far more useful. And one knock you often hear on volatility is, well, why do I care about upside volatility? I only care about downside volatility. Well, I think common sense and empirics tells you often, even if you haven't seen terrible downside. If you've seen tremendous upside, it's probably there. So I'm a defender, not as a be all end all. Worst cases, you can survive and stick with your strategy. It may be a very open, not too useful guide, but that's all.

1:08:48The ultimate risk model is that your ultimate model is if I can stick with this through what I think of the worst cases, which are always a guess, by the way, The idea that we know the worst case for anything but a limited liability investment, we're using negative 100%, which is often not a very satisfying worst case because it's pretty damn bad. The notion that you know the worst case, like some people use, and I know I'm going off on just an overall risk riff here, but some people will look at historical worst cases and use those to forecast future worst cases. I have another set shtick I do about this.

1:09:26you know that's not a perfect model because the worst case historically was not the worst case until it happened so that model got the worst case wrong um so there's a little bit of art estimating worst cases you do need some judgment i don't think it could be a purely quantitative exercise i will tell you one statement that drives me a little crazy at times is when people say risk is the chance of a permanent loss of capital. This does not drive me crazy because it's wrong. It is not wrong. It is absolutely right. It drives me crazy because ultimately I think it's fairly trivial. Yes, if you assure me a loss is not permanent, I agree it's not risky.

1:10:10How often are we assured of that? Do we feel that way during the loss? I think people who say that often have very good intentions and often are good investors. But I think what they're saying is risk is being wrong and our risk control is to be right. There's a lot of hubris to that. We're all trying to be right. So, yeah, if you can ensure me that something is not permanent, certainly as an individual investor without clients, who I also have to convince. If somehow I had a crystal ball and knew something wasn't permanent. Yeah, I'm good. But how do you get there? So I don't find that to be the most useful thing.

1:10:50I find volatility to be at least useful. I think conceptually thinking about worst cases, looking at the past, but not as a perfect indicator of the future, because, again, it isn't. And literally trying to guess at worst cases is even more useful. Even that's not perfect. after 1999-2000 if you told me I'd see something worse than that in my career for our kind of strategies and then make it all back and then some again in a market that you needed us but if you told me we'd see something worse than that in my career I would not have said no chance but I would have said very small chance and I would have been wrong I was wrong well no one actually asked so technically I was not wrong but I was in a real sense.

1:11:41So it's hard. Risk is not one-dimensional. I think you want to use every tool. If you have a fairly well-behaved non-option-like strategy, I think volatility can actually be quite useful. I think risk as a permanent loss of capital is the absolutely correct model. I just don't know how to use it in most cases other than be right. And with that, I'm pretty sure I didn't answer your question, but I filibusted it fairly well. And, you know, tying in some of what we talked about earlier, there's also the risk of selling low. So the more different whatever that return stream you're invested in is from whatever your reference point is, which is the U.S.

1:12:20stock market for most, it seems like the risk of selling low is probably greater. And that is a risk that I don't think a lot of people really think through or talk about? No, absolutely. I will tell you, and this is a self-serving bias because this helps me, I would want people to address that risk by getting better at not doing it. I have no problem, though, with someone who says, I can't get better at that. So I'm going to be in a low cost index solution and never look. I'm going to look a lot like my reference point. I think know thyself is probably the number one rule in almost any field.

1:12:58So just because I think there are great opportunities, right? If it's excruciatingly hard to be different, that is probably where the opportunities to outperform are, of course. And again, tying everything we've been saying together, if both the potential excruciating times and the opportunities are bigger than they used to be, that's probably consistent. but there's some subset of the market that should gird themselves in a lot of different ways. And I do offer some thoughts in the paper on this and try to take advantage of that. And there's some subset of the market that should say, no, we're just not playing the game.

1:13:33We believe markets can get wildly inefficient, but we do not believe we're the people who can stick with it. So we're going to be perfectly happy with our solution. I will not lecture those people. That's very wise. I did a recent podcast where I discussed four major mistakes investors often make, at least in my experience. One is poor diversification. Number two, they tend to buy high and sell low. Number three, they tend to have shorter time horizons than what is reasonable. And four, there's a general overconfidence in predicting the future. Do you generally agree with these observations and do you have any other mistakes that you'd like to add?

1:14:11Yeah, I think you went four for four on those. I think you'd agree. Some of them are overlapping overconfidence. It may be selling at the low is correlated with your confidence that, oh, it's going to keep going forever. You're over extrapolating. But I think there are four very good ones. I might throw in a fifth. It's a little geekier. But I think people tend to way overanalyze every line item in the portfolio relative to how much time they spend on whether they're happy with the whole portfolio. This is related to things we've been saying before, that even if you're supposed to be uncorrelated to the S &P, you're compared to the S &P.

1:14:55You can have portfolios that are doing quite well in a valuation bubble, and you have a 2 % allocation to a manager who's doing lousy, but is screaming it's super cheap now. A lot of the time is invested in looking at that manager. One of the things when I'm on an investment committee and I often serve on kind of the other side, you know, any group I get involved with sticks me on an investment committee. Sometimes they're pleased with it. Sometimes they're not so pleased with the action of sticking me on that committee. But one thing I always mention is, all right, I'm not going to stop us from looking at line items.

1:15:32Of course, we're going to know what the different parts of the portfolio are doing. We're not going to ignore it. but can we try to bring as much focus be it analysis or bringing the managers in to the things that are going better by a shocking or statistically anomalous amount as much as we spend on the things that are going worse it's human nature another bias is to is to internalize our good luck and externalize our bad luck right if something is doing much worse than it's supposed to. It's got to be somebody's fault. If something's doing much better, we probably picked a better manager than we thought.

1:16:11So if you just get symmetric about that, I think you've made a stride. If you just, to tie it again to things that were earlier, ask, all right, this is happening, but what do we expect this to do in the context of what's going on in the world? And can we bear it given what's going on in the portfolio? I think over focusing on every individual line item and trying to micromanage and spending less time on whether you've built a good holistic whole, I would add as a fifth. But your four are superb. You know, it is really interesting because in most of the world outside of the investing world, which can be very counterintuitive, historical underperformers are a good predictor of future underperformance.

1:16:54Whereas in this world, it's almost the opposite. So it can be very counterintuitive to not go through your portfolio, look at the line item that's doing poorly. And if you want to improve the total portfolio, get rid of the bad performer, put in a good performer. It can be very counterintuitive. And that's probably why it can persist. One of my favorite things to say, which is probably very counterproductive and has probably cost me clients, is during, again, somehow on podcasts, I focus only on our bad times. Been around, you know, it's going to be our 26th year. Life's been good on that. But the bad times are more interesting And stories of pathos are more interesting Than stories of success But one thing I have said Only to audiences I think will get My humor on this Is I quote the famous definition Of insanity Doing the same thing over and over again And expecting a different outcome And I pause and I go Yeah that's what we do And of course I mean that In the short term Over the very long term, I think we're doing the same thing that has worked long term.

1:17:59I don't think we're fighting it. But I think this probably came from people saying to me, oh, this has been bad for two years. So this is a definition of insanity. You're still doing this. And I'm like, oh, yeah, that's what we do. unless again getting back to the beginning of our conversation we see compelling reasons why the last 50 years of back tests and 20 years of real life returns should be dismissed and again we're open-minded to that has the world changed unless we see that yeah we do the insane thing of doing the same thing that has not been working again recently not long term um and you're right it is very counterintuitive to the world a lot of the rest of the world has less noise to it There are a lot of fields where if you're good at this statistical noise to everything, you know, the best in their field messes up sometimes.

1:18:52But I do think the edges in our world, you know, we're up a little over 50 percent of the days and you're a great money manager over time. That means if you're like me, even though you shouldn't, you know, in the high 40 percent of the days, you're not in a good mood. I don't think that's the same for if you're running a really good store. You may screw some things up, but you don't screw up 48 % of the days. Yeah. And then that also feeds into the time period being longer here, the time period for real assessment being longer here as opposed to the rest of the world. Absolutely. And you need longer because it's noisier.

1:19:32That's right. Oh, Cliff, this has been a lot of fun and highly insightful. I appreciate you spending so much time with us and sharing all your ideas and experience. This was the rehearsal, right? We're going to do the real one now. Exactly. It was a lot of fun, Alex. It was really nice spending time with you. And good luck, everyone. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes.

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