A Framework For Evaluating Investment Fads With Marlena Lee (EP.171)

0:28We all need to make smart decisions with our money. head of investment solutions at Dimensional Fund Advisors. In her role, Marlena leads a team dedicated to providing clients with thought leadership, analysis, and education on a wide range of investment-related topics. Marlena serves as a member of Dimensional's Investment Research Committee and previously served as co-head of research, helping shape the firm's global research agenda by working with clients to identify topics of interest and overseeing the creation of research papers. Prior to joining Dimensional, Marlena worked as a teaching assistant for Nobel laureate Eugene Fama and earned a PhD in finance and MBA from the Chicago Booth School of Business.

1:13But the thing I love most about Marlena is just how well she communicates complex ideas to broader audiences. So today I asked her to share a framework that you can use for evaluating popular investments and determining whether or not they belong in your portfolio. As always, you can find detailed show notes, links, charts mentioned throughout the episode, all at thelongterminvestor.com. And with that, here is my conversation with Marlena Lee.

1:48Marlena Lee, welcome to The Long-Term Investor. Oh, I'm so excited to be here, Peter. Well, you have been on my list of desired guests for a long, long time. And as I read in your introduction, a lot of people who know you well understand your relationship with Nobel Laureate Eugene Fama and some of the funny stories that you have about your experience with him. I thought maybe we could just start there. Give us a little sense for us finance nerds, maybe a behind the scenes look at Gene. But then also for those who don't know Eugene Fama, maybe you can also just explain to the audience the importance of his contributions to portfolio theory, to asset pricing, to efficient market hypothesis?

2:28Yeah, sure. So how about I start with the latter, because that will just give weight to the funny parts. So yeah, he's a giant in the field, obviously. Sometimes people call him the father of modern finance. He has so many contributions as I was thinking about, God, what should I focus on? There's just so many. I think oftentimes he's the best known for either his work on efficient markets hypothesis, or maybe the Fama and French three, five, whatever number of factor model you want to name. But he also has work that's some of the most cited work on fixed income and interest rates, which also I think are almost as important for thinking about investing in fixed income.

3:10So I'll hit on efficient markets maybe really quick, which is he'll just say it's just the model, but it's this idea that information gets into market prices really fast. So that makes it hard to act as you're reading information in the newspaper or on Twitter, or I guess it's not called Twitter anymore, but on X, that you can't really do anything about that information in your investment portfolios, because as soon as it's out there, it's in the price. So that's efficient markets. I think he's also incredibly well known for his work with his longtime co-author, Ken French. And in a series of papers that span decades, they really highlight empirically, and they created entire empirical methods to show and test these things, that there are areas of the market with higher expected returns.

4:05So even if you accept that markets are pretty much efficient, at least to the point where it makes sense to at least treat them as efficient, even if they're not perfectly efficient, that that doesn't mean you have to then just accept and invest in a market portfolio, that there are still ways to improve your expected return relative to the market. So that's what I would just summarize decades of work from Gene, from Ken. And it has revolutionize the way people invest. I mean, think about how investments were described before Fama and French. You didn't have like a Morningstar style box of thinking about investing from large caps to small caps, from value to growth.

4:52It was more things like dividend focus or income focus, growth, which today you don't really see nor hear because they don't actually mean anything. So I think that that's pretty cool. Certainly, I think that's some of the research that drives the huge growth in index funds is just this idea of you can't really pick individual stocks because markets are so efficient. So some of the not only, I'd say, really great theoretical work, really great empirical work, but the applicability of it is just, I mean, astounding. And it impacts the lives of most investors, I think. So that's the work of Gene.

5:32I don't think I've overstated the contributions of his work. And he is also just such a, like a straight shooter, first of all. He's not all that effusive. And he's just very, I don't know, direct. He's also just a fantastic teacher. So in his class, so I first met Gene when I took his first year PhD course, and then became his teaching assistant. So in that, his teaching style is very much do 30 hours of reading before you get to class, and then he'll quiz you on it. That's the structure. And of course, if you have a teacher that cold calls, there's a strategy for how you handle that class because you don't want to be called on and then reveal that you only gotten 15 hours of your reading, not 30.

6:24So if you know the answer, you need to raise your hand and volunteer and hopefully you'll be safe for the rest of class. So I took all of one undergraduate finance class before getting to Chicago, taking this class with Fama. And there was one question that I just thought that I knew the answer to. And I raised my hand. I gave the answer. He says, nope, anyone else? And I just thought I must not have worded it correctly. He must not understand. I clearly know the answer and he must just not have understood me. So I raised my hand again. I try again. And I don't know what was wrong with me this day.

7:00But he said, nope, wrong. Anyone else? And I was so frustrated. I raised my hand yet a third time. This time just said the answer louder because, you know, he's up there in age. He just must not have heard me. And he said, three strikes, you're out, go stand in the corner. So that was one of my first interactions with Gene was striking out really embarrassingly. But somehow I still made it up and he still was willing to make me his teaching assistant. Well, and as I've heard, you are the only student he's ever recommended for a job post-graduation. So I think that speaks volumes about both your hard work, your knowledge, and your ability just to share that knowledge.

7:39In school, a lot of the regurgitating knowledge is not for public. It's just to prove that you know it. But I think you do such a good job. Your understanding is so deep that you are able to teach others. That's really maybe the greatest showing of mastery of a topic. And I'm hoping today that you can help our listeners master what I feel like is a difficult thing to tackle, which is just evaluating whether certain investments should enter your portfolio in some capacity or not. And we could get very scientific about it. However, I've heard you introduce a framework for how to think about whether or not to invest in some sort of fad.

8:19So maybe we could just start there. There's a part of me that wants to read off the different framework, but maybe I'll just let you go through it yourself so that I don't steal the thunder. Sure. So in my time at Dimensional, I've been here 16 years now. I feel like I've gotten so many questions from whether it's clients or advisors, just about, hey, here's something that seems hot or that has performed really well. Is it something that belongs in my portfolio? And through the years I've come with, okay, here are different reasons why you may not want that in your portfolio. But just what are some of those evaluation questions?

8:56But maybe first we should define what a fad is. I think we all kind of know, but I like the definition of it's the dumb things we do because everyone else is doing them. And that may be true in clothing, in health. There's diet fads, things like that. But certainly I do think that there are also investment fads. And as I've seen them come and go through time, you know, I just really think that in the end, investing should be pretty boring. And if something's really hot, then that generally is something that maybe doesn't belong in a really well diversified portfolio that's designed to get to long term investment goals.

9:39But still the questions come up from both financial professionals and investors alike. So let's just dive in. I think the most important question to ask is, why do you think it should have a positive expected return? And that seems kind of like a basic question. But of the things that people think of as investments, I do think that there are buckets of things that there's not as rigorous of a story for why you should expect a return. So maybe let's start with just a regular stock and bond. Like, why is it that we have stocks and bonds in the first place? It is because companies are raising capital.

10:20They're going to invest that capital and do hopefully something productive, invest it into hopefully positive NPV projects to provide goods, services, they are contributing to the economic activity of the economy. And providing capital, we should expect a return associated with that. And that return is driven by future cashless. So there's a very good reason to expect positive returns from stocks and bonds. When it comes to other things, there are things that just sit there and are not generating economic activity. So things that are more stores of value, like gold, more recently, things like cryptocurrencies.

11:09What is the economic mechanism by which you should expect a return? There, I think it's this idea of, well, someone down the line may be willing to pay more for it than I am today. But it's not really the same mechanism. There's no economic activity associated with it. So I think the idea of why should you expect a return in the first place? There's no data to it. It's just this more of a philosophical, what is this thing doing? we have to remember that my expected return like when i'm investing in stocks or bonds it's the company's cost of capital and those two things are the same they're just different sides of the same coin and it's not really clear what that mechanism would be for something like a bitcoin well i'm glad you bring up something like scarcity because that is often a reason And someone say, well, it's going to do well because there's a limited supply of it.

12:07And it's like, OK, but what does it actually contribute to the world? Because as you point out, if there's a limited supply, you're really just relying on somebody paying more than you did, much like for a baseball card or some of my kids collect Pokemon cards. And it's incredible that people do pay money for them. And it's fine to want to own things like that out of hobby. but to think that it is going to fund your retirement, it doesn't really meet that standard. Let me ask you a question, though, something like Amazon, where people might say, I want to invest in Amazon, which obviously does something productive, but perhaps their thesis is, well, obviously, Amazon is dominant.

12:46So it's a safe bet. So maybe there's a positive expected return. But if it's so safe, maybe that return isn't as large as what you might get from something that's a Yeah, totally. And that brings me to, I would say, framework number two or item number two in the framework, which is, hey, are you interested in something because you're extrapolating past returns? Which you use the example of Amazon, but you can apply that to any of the mag sevens or just anything that has done really spectacularly well. And that other framework we just mentioned of the investors expect a return is the company's cost of capital.

13:25If we're talking about some of the biggest, most well-known, safest household names, does it also make sense that they should have the highest cost of capital out there when you're comparing different companies in an economy? It just doesn't make that much sense. So rather than informing one's expectations of future returns by looking at past returns, which there's a reason compliance tells us, hey, you have to put the disclosure, past returns are not indicative of future returns or no guarantee. I actually think that the mechanism is almost the reverse of what people think. As prices go up, as things have really high returns in the rear view mirror, If that means that they are getting more expensive, then if anything, that tends to mean that they're going to have lower expected returns on a go forward.

14:24Right. So we're starting to really peel back the onion. That's the value growth difference there of, yeah, value companies historically, they have lower valuation ratios and they have higher expected returns. And we're kind of like twisting a few different concepts here. But very often when we look at the companies that have done really well in the U.S. market, and they're the big top tech names that we all know, and people ask, you know, why should I invest in anything but XYZ company? They've done really well. They are typically more on the growth side of the market. If anything, I would expect them to have lower expected returns on a go forward.

15:09So it's not even don't extrapolate the past. It's almost like the past will cause them to have lower expected returns on a go forward because now they're so pricey. And we've certainly done experiments on this. So if you look at the returns of companies until they get into the top 10. So let's just look at the top 10 companies in the U.S. The returns leading up to getting into the top 10 are always astounding. They're double digit. That's how they got into the top 10. But once they're there, they have market-like, even a little bit of underperformance relative to the market once they become the top 10.

15:45So that's something I can both say it from a theoretical valuation type of perspective, But even in the data, it's showing this idea of you shouldn't be chasing these names that have performed really well in the past. Well, you have, as you mentioned, you've done research here on this topic, and you have an incredible chart that I'll be sure to put in the show notes at the long term investor dot com. And I will live here on the air, put my editors to the test and see if it can show up as we're talking. You never know. They're actually really talented. So I'm sure it's definitely going to be here.

16:20For those of you watching us on screen, another thing, so we're talking about extrapolating recent returns and a lot of where the FOMO comes in, but also another part of your framework is trying to outguess markets. And so when I think about extrapolating recent returns and we're talking about individual stocks, I also have a lot of people who don't want anything to do with international anymore. And some of that's because US markets have been absolutely dominating since the great financial crisis. But that feels a lot like trying to outguess what is going to move next. How do you think about that?

16:53What are some other examples that you can give as people are thinking through different fads or different ideas to identify, oh, wait, maybe I am trying to outsmart things? Yeah, absolutely. So whether it's focusing on past returns or having some sort of prediction based on information that everybody knows. like we all are reading oh well i'll just give you an example maybe we're gonna see a huge boon in economic productivity and efficiency due to ai okay that's great we all know it but does that mean you should pile into ai stocks or just because the u.s has done well should we focus our portfolios just on U.S.

17:40stocks. I think that anything that's pushing you to less diversification, you really have to look at that as, okay, but diversification is the only free lunch out there. So what is the framework that would cause me to really want to abandon diversification and focus on a narrower set of stocks? And time and time again, I would say that there's really not a great reason to do that. Just because the U.S. has been, I mean, honestly, they have been on a tear now for quite some time. There's nothing to think that that always has to be the case. If you really pushed me on it, I would say I think that the U.S.

18:22has similar expected returns on a go forward as most other developed countries. And of course, we always have to go back further and further. But there have been long periods of time where the U.S. has underperformed markets outside of the U.S., right? So the decade after the turn of the century was an entire 10-year period where the S &P had negative returns. If we're talking about the names that we are always talking about today, right, the NASDAQ 100, so the biggest names, which have been doing really well lately in the U.S., they did even more poorly during that last decade. So without knowing where the returns are going to show up.

19:02I think it makes the most sense for people to just hold a globally diversified portfolio. And when we talk about like not extrapolating past returns, but then also considering prices give us the most information, today's prices give us the most information about future expected returns, where the U.S. valuations sit today, we really have only seen once in the past. And that was kind of during the dot com run up and then bust. I can't tell you, well, there's a reliably statistical relationship there between aggregate valuation ratios and future equity returns. But part of that is because when you only have one instance in time, it's an anecdote.

19:45You don't get to do research when you only have one observation. But in my heart of hearts, I do think that prices tell us something about expected returns. and they are, if anything, the prices are telling us, hey, now's the moment. You really actually do want global diversification. You always want global diversification, but I can come with a few different reasons why today is a really good time for global diversification. Part of it has to do with evaluations that we're seeing in the US. Part of it also is just concentration we're seeing in the US. So these days, over a third of the S &P 500 is in the top 10 names.

20:23That's been creeping up over time as the MAG-7s have been doing really well. And just to give you some perspective on how big the MAG-7 represents of the total market portfolio, if you add up the weight in the MAG-7 names in like a globally diversified portfolio, its weight is now pretty similar to the next biggest seven non-U.S. countries combined. Seven stocks, seven countries. Not the little ones, the biggest ones. And it's just giving you some idea of just how, and a lot of that is because of their prices, not their economic footprint, right? If you add up the earnings footprint of these companies versus the next seven countries, their earnings footprint is much smaller.

21:13So how are they getting to that outsized weight in the global portfolio? It is through having pretty high valuations. To me, that's a reason why you probably want to pull away a bit through things like global diversification, through things like size value tilts, are ways that you can kind of reduce weight in some very expensive names. All great points. And something I want to bring up, one of my favorite, I don't know if it's a statistic, we'll call it a statistic, that I like to share with clients who are talking so favorably about the U.S. markets, specifically the S &P 500 versus really any asset class, even if it's U.S.

21:53small value or international as a whole. But there are three periods I like to point out, 1929 to 1943, so it's a 15-year period, 1966 to 1982, a 17-year period, and 2000 to 2012, a 12-year period. All those three periods, the thing they have in common is that cash beat the S &P 500 over those periods of return. And so for people thinking about, hey, I want to do this because returns have been great. Yes, even if you look over the long term, U.S. markets do end up beating a diversified portfolio, just if we're looking at pure indexes going back to 1970. But could you have really sat around that long and watched your portfolio lose to cash?

22:41And I think the answer is no. And it's really an interesting thing. I mean, you and I accept the importance of diversification. Not everybody does, particularly if this isn't your profession. I would say that within the conversation that we're having, I often tell people the only rational reason you'd add something to your portfolio is it's going to enhance return or it's going to improve diversification benefits. However, as we think about your framework for just helping people evaluate whether an investment fad or any investment idea is a good one. And the last question you ask is, are you relying on a low correlation to infer diversification benefits?

23:18Can you talk a little bit about that? Yeah, that one's more for the financial professionals in the audience. But I think that there's a whole group of investments that are being sold as great diversifiers. And while they may or may not be, a chunk of the evaluation has to do with, hey, but they're negatively correlated with stocks and bonds. And the commonality in these groups of assets is they may not be mark to market. They may not have daily or frequently evaluated prices. So the key example, of course, would be any kind of private investment is by its nature. Because it's private, it's not traded every day.

24:02And therefore, you don't get to see the volatility in the asset. Kind of similarly, we don't observe the volatility in our house prices that we live in. We just live in it. And unless we actually go through the work of trying to get like an appraisal or something like that, we probably are not really all that aware of how correlated that might be, for example, to a REIT portfolio, which is marked market on a continuous basis. So when you have a price that is not being marked market on a regular basis, you can't really compute a correlation. It's going to have a low correlation only because you're not observing market prices.

24:38So I really do think it's for anyone who's kind of trying to sell these types of solutions based on their correlation, which we see all the time, or incredibly high sharp ratios, for example. It's like, OK, well, yeah, that's because you aren't getting a true sense of what the real volatility is. All of these measures, in my mind, are meaningless and therefore should not be part of the evaluation. That doesn't mean that that's not something that maybe you want in the portfolios, but just using correlation is a red herring approach to how to evaluate it. And again, I think a much more reasonable way to evaluate it would be things like, does it increase the expected returns of my portfolio?

25:22I think a much better way of evaluating diversification is did it expand my investment universe? So is it something that I already hold in a globally diversified portfolio of stocks and bonds? Because there are ways that, like liquid alternatives, for example, may just go long something, short other things, and may get to a low correlation because it's removed the beta. But all it's doing when you combine it with your other portfolio is now you're underweight some things and overweight other things. Just because it has a low correlation doesn't mean it's something that automatically goes into your portfolio.

25:56The real question is, did underweighting some things and overweighting the other things improve my expected returns? But that oftentimes is a harder way to evaluate because like all of the research that we're looking at, sometimes you need decades of data to be able to assess, is there a premium associated with these? Is there a really good economic story associated with these? and just selling things because it's, well, look, it's got a little correlation. It feels like a shortcut, but I really don't think that anyone should be buying that shortcut. So we've gone through the framework and I actually had a list of different investments, asset classes, ideas that I thought we could walk through the framework with.

26:39And even though we've touched on some of them and we'll probably repeat ourselves a little bit, there is one that we somehow didn't touch on yet. So we'll start there. And I'm going to pretend I am a individual investor speaking with their advisor and saying, hey, I've noticed U.S. growth stocks have done really well. And let's say this person is in an index portfolio or maybe they're in a value biased portfolio or maybe they don't even know what they're in. They're in all sorts of things, but they want to make sure that they're going to invest more in U.S. large growth. Can you walk us through the framework of how someone might think about that?

27:15and we can evaluate whether or not that's a good idea. Right, absolutely. So just going through the framework, does it have a positive expected return? Yeah, it's a stock. I would expect it to have a positive return. But I think where I would question, why do you want US growth? Is it because that's been a better performing segment of the market? Then that's really falling into the extrapolating past returns part of the framework where I don't think that that's a reasonable expectation on a go forward. Just laying out that idea one more time of how can we assess differences in expected returns within a market?

27:58And there, again, relying on market prices is going to be our best bet. So when we're thinking about a stock, if it's a growth stock, by definition, a growth stock is one with a higher relative price. and how do you get to that higher price? It's gotta be because the market is one of two things, either expecting really attractive future growth in cash flows, profits, which is probably some of it. Certainly we do see growth stocks do tend to have higher profitability, for example, than value stocks. But some part of it, at least this is what the empirical data suggests, is that it got there because the market discounted their future cash flows by a lower discount rate.