The Science of Investing and Tuning Out the Noise With David Booth (EP.194)

0:28We all need to make smart decisions with our money. founder David Booth, who joins me to discuss the groundbreaking academic research that revolutionized finance and challenged Wall Street's traditional stock picking strategies. This is also the topic of a new documentary that is now broadly available to the public titled Tune Out the Noise, directed by Academy Award winning director Errol Morris. And I've included a link to the film in the episode description if you'd like to dig deeper after listening to this conversation. You'll also notice in the episode description, a link to my new financial assessment, where you answer nine simple questions and get immediate feedback on your financial situation.

1:08And not only that, but you'll automatically get subscribed to my newsletter, which is delivered every other Wednesday morning. As always, you can find detailed show notes for this episode and links to all resources mentioned by visiting the longterminvestor.com. Now, here is my conversation with the co-founder of Dimensional Fund Advisors, David Booth.

1:32David Booth, welcome to The Long-Term Investor. Well, thanks for having me. I've looked forward to this. Well, it's such a treat to have you here. I've heard you speak so much. And the reason of you being here is that we are going to be premiering your movie, Tune Out the Noise, in New York, March 6th, but also going to be available online in this documentary film about just an unbelievably talented group of individuals who crossed paths and really created the science of investing. And before we get there, though, I've heard you speak so many times, and you've often spoken about your early experiences selling shoes and how that shaped your views on business and investing.

2:13So I was hoping we could start there. How did that experience influence your philosophy on markets and honesty in finance? Well, it's interesting you bring that up because I used to tell people about my experience selling shoes and we did a little video of it and it turned out to be one of the most watched videos we've ever done, which I thought was kind of surprising. But the rest of it is, look, I was a commissioned salesman selling shoes. This is like in the mid 60s. and there's a big incentive to make a sale right but what I learned from that experience was went home at night I wanted to feel good about myself and so basically I tried to do the right thing and what I've found was somehow that changed the magic or the dynamic of the sale when people realized you're trying to help them out and sometimes you didn't have the right size or the right style that they were looking for, and that's okay.

3:07But if you focus on helping them out, they're more likely to come back as a repeat customer. So it turned out to be that was a winning business strategy as well. And I bring it up because frequently when the young people coming in at the firm often have this impression they're going to have to lie to people and make up stories that aren't true in order to get ahead in this dog-eat-dog financial world. And it's just not true. If you approach it with a degree of honesty, we all have differences of opinions. But if you approach it honestly and do the best job you can, you'll be fine over the long haul.

3:41And what's so interesting is when you read about the history of investing, and I want to say investing advice, but I'm not even sure it really was investing advice. It was more like investment stories, as you mentioned. And you were at University of Chicago at a time when investing was shifting from this art of storytelling and maybe some sort of form of witchcraft even to a real science. So how did that environment shape your worldview? Oh, well, it was incredibly exciting. I went to the University of Chicago. I grew up in a small town in Kansas. Well, eventually I went to Lawrence, which I think is a big city.

4:19But the point of it being that my parents never had the liquid assets to worry about investing. So I had no experience listening to my parents talk about investing or anything. I just ended up at Chicago. My first course, first day, was a course taught by Gene Fama. It was a course that was a two-quarter course. And he just kind of outlined this notion about how markets work. And I go, that all makes sense to me. I didn't realize what an unusual point of view that was. And I think for your clients, a lot of people feel like they're outsiders when it comes to investing, that somehow insiders run everything and you need to be an insider to have a good outcome.

5:04And that's just not true. What the evidence was is the insiders didn't do better than kind of random selection. But this message had to be brought to you by outsiders. outsiders. I mean, these people like Gene Fama, Merton Miller, these people are just brilliant academics doing research. And most of them grew up with very modest backgrounds. And so part of the revolution was just the tectonic shift away from Wall Street research to academic research. And if you're watching us on Cheddar, viewers, you can go to thelongterminvestor.com to get a link to the movie where some of these Nobel laureates who are at the University of Chicago with David, although they had not won their Nobel Prizes yet.

5:47It's just such a fascinating story of how things were uncovered. And before the 1960s, the view of markets was just completely different. So can you describe for our audience a little bit of what the traditional approach to investing was and how the academic revolution disrupted that thinking? Well, basically, the traditional money management is people trying to out-guess the market. In other words, market prices are wrong. I can capitalize on market inefficiencies. That was the argument. They never had any empirical evidence to support that. But, and that was the breakthrough. What was needed was a survivorship bias-free database.

6:27And we don't need to get into why that's so important. But it was developed at the University of Chicago. The first data came out like in 1963. And that changed everything. So for the first time, you could test out a hypothesis. For there to be a science, like you brought the term science, you have to have hypotheses and testing. You know, you can't just sit back and say, well, I believe this or I believe that. Basically, what they found was the emperor had no clothes. You know, there's all this puffing going on about what people could do. You'd hear all these wild stories. A lot of them just turned out not to be true.

7:02And it shocked people. I think the first period of data showed stocks did about 9.5 % a year compounded, which means you double your money about every year, something like that. And people go, holy cow, that's pretty good. And if you examine all the trust departments and mutual funds out there, nobody had a recent return like that. So it was a real shock. I think even today, many people look at markets as chaotic and unpredictable. And yet there is an underlying order. Markets functioning as an information processing machine. And I think Eugene Fama, who you mentioned, was the first professor you had, who is the one who is considered to be the father of the efficient market hypothesis.

7:47Can you talk a little bit about how markets are functioning as an information processing machine and how efficient market hypothesis really represented a total paradigm shift? Well, I mean, you hit on the right term, I think. The market process, the stock and bond markets open every day, set prices. And somehow, even though everything looks chaotic, there's an underlying order that emerges. That's really surprising to people. The idea that stocks over the long haul will do about 10 % a year in almost any long period of time. That's kind of what you find out, even going back to before COVID hit recently.

8:25So the question is, how does that happen? Well, I think the way to think about it is prices are largely set, I think, by big, sophisticated institutions with enormous resources trying to get any kind of edge they can get. And so what happens in a trade, this whole trading process, is you have really sophisticated people wanting to buy something and really sophisticated people wanting to sell something. And they somehow negotiate prices in a way that they both feel like they got a good deal. If they didn't feel like they got a good deal, they wouldn't trade. So you look at this trading volume, this enormous trading volume going on.

9:02That's the beauty of public markets. And someday I'm going to write an essay on beauty of public markets. Public markets are always working to your advantage in the sense that prices have to get set at levels that induce people to come in to invest. And they're not going to come in to invest if they don't think they're going to get a fair return. So that's what's going on. And, of course, sellers are trying to get the highest price they can, but buyers are getting the lowest price they can. And somehow it all works out in a way that we'll never totally fully understand. But we're comfortable. As long as you have an adequate rule of law for investor protection, enough transparency so that people can feel like they all have an equal chance and adequate trading volume, prices are going to get set at fair levels.

9:45Or another way of saying it is kind of the notion of comparative advantage, which is one of the first things they teach you in economics. It doesn't make any sense for you to waste your time going home at night trying to figure out where the markets are going. Spend the time with your kids. Markets will adapt faster than you can. And all this evidence is really reassuring to people. Because it says capital markets kind of behave the way you would hope they would. Where there's a little bit of democratization in the whole process. The average person is not at a disadvantage compared to these big, sophisticated institutions.

10:19You know, maybe they can figure out ways to add a little bit of value. And now that we're big, sophisticated institutionally, there are things you can do to add value. In our view, it doesn't come from outguessing the market, but rather accepting market prices and figuring out the information that's embedded in prices to help you figure out how to structure portfolios. What's amazing to all of this as well is that kind of the revolution in finance, really pretty much the ingredients are all there in about a 10-year window. So I would say, of course, you have the efficient markets hypothesis, which says you can have a good investment experience without trying to outguess the market.

10:57And then you have along people ideas, a theory of Bob Merton, multi-factor theory. It says there can be many sources of risk and return. It can be pretty complicated, but there are ways of beating the market without trying to outguess the market. You can just focus on the parts of the stock and bond markets that have higher expected returns. That's a powerful idea. Unfortunately, that theory is so complicated, even Fama said it took him three or four years to actually really totally understand it. But that was a theory that really didn't get fully developed until Fama in French, Professor Fama with his long-term colleague, Ken French, in 92, presented the data as an empirical model to support the theoretical model of Bob Merton.

11:41So anyway, going back to the 70s, then we have an idea that you can beat the market without trying to outguess it. And then the second part of the academic work that's really relevant is all this option pricing theory. Black-Scholes-Merton option pricing model for which Migrant and Bob got their Nobel Prizes in 97. Fisher Black would have gotten it too, but he had passed away, unfortunately, by then. Which, for purposes here, the main implication is flexibility has value. So these two things taken together, you can beat the market without guessing it. And if you use the flexibility in execution, you can do a better job than people that are trained mechanically and don't fully understand market mechanisms.

12:26And that's how we launched the firm. And it's been incredibly rewarding because we've been preaching that same message for 43 years now. And even the last few years, all of a sudden, we're starting to get much better acceptance of these ideas. The one hang-up people had with it primarily was, how do we know you can do it? I mean, just because you can say trading mechanically doesn't work, how do we know you can do a good job? Well, now we have a 43-year track record. These things are very doable. You know, like 80 % of our funds, if you look over the last 20 years, have beaten their benchmarks.

13:02Benchmark indices, by definition, none of them beat the benchmark. I mean, they are the benchmark. So it's surprising to people. This is one area where their intuition leads them down the wrong path. Most people's intuition is if you work harder and smarter than the next guy, you'll do better in picking stocks and bonds. There's just not much evidence of that. One of the questions that comes up when people say, well, stocks are down 10 % a year. Why is that return so high? If stock returns were predictable, you would think returns would be like 4 % to riskless rate because there wouldn't be any risk to investing.

13:36And I think my answer, the more I think about it, and academics study this like crazy, is it all comes back to human ingenuity. Basically, human nature is such that you're always trying to improve your life. When something untoward happens to you, you don't just sit there and take it. You figure out what it takes to get back on track. That's in your personal life. And when you go to work, you do that at your firm as well. So I think that's what really happens with firms and then with the overall stocks and stock market is human ingenuity. People going to work, trying to figure out creative solutions.

14:13And some of them will win and some of them will lose. And we can't predict which ones those will be typically. Or sometimes you can predict the losers, but you can't always predict the winners. And when you talk about market-type portfolios, which is where we run thousands of stocks in a portfolio, well, when you're talking about market portfolios, you're really betting on an economy. And an economy is based on this human ingenuity, people trying to make their lives better. And the way to do that is to make the lives of other people better. That's the best way to make your life better. There's so much that you say there that's interesting.

14:46I took a couple notes. You mentioned at one point that it's just not worth the time to try to outsmart the market. If I'm headed out to lunch later and I see a$20 bill on the sidewalk, I'm not going to quit my job and look for$20 bills all day long. You know, you might find an occasional$20 bill, but dedicating your life to finding them makes no sense. But what's so interesting to me, David, is when you talk about how markets work and people accept markets all around them. They don't want to somehow remember the stock market, the bond market, the financial markets are markets just like when I go to the grocery store.

15:20And I love raspberries and raspberries are obviously not in season right now. But there is a point in time in the summer where raspberries sell for a dollar and I buy probably more cartons than even makes sense. Let's say nine, 10, 11 cartons. But in the winter, they're four or five dollars because there's less supply. And if demand were high enough, they'd probably push the price higher. And I go to the store and I don't say, well, those prices of raspberries are wrong. No, it's supply and demand. And I think so much of what you're sharing here, while there's probably pushback at the front end of what you all were doing, you know, it's become, as you said, more accepted over time.

15:58And let me ask you this. So you were there when the first index funds were being launched. What was the reaction from Wall Street? And did you anticipate how big this idea would become? Well, I look back on it. I thought we were old, but we were pretty young people. I took Famba's course. I was 22 and he was 30 and I thought he was an old man, you know, so. But it characterizes the first passive portfolios. Yeah. Eventually, I decided I didn't want to be a professor. I was working for FAMA as his research assistant. And I realized, going back to comparative advantage, the world was better served if he did research.

16:38And I tried to figure out how to apply the ideas rather than having him try to apply it and me think up the next great idea. And that was really the excitement. Once people said, look, the evidence is trying to outguess the market doesn't make a lot of sense. What are we supposed to do? And that came where the idea of, let's call it passive management. I hate the term, but that's what generally is accepted, came along. Passive being, you're not trying to outguess the market. Well, there's still plenty of things you can do. Now, there are two basic approaches that popped up as to the best way to manage money, given you can't outguess the market.

17:13First was an idea of index fund. So I went to work at Wells Fargo for Mac McQuown, and he got the trust department to bring in somebody to start an S &P 500 index fund. So that's what the trust department at Wells was working on, an S &P 500 index fund. And eventually it took, it took them years, but eventually it took off and it exploded, actually. And eventually Vanguard starts one and does a good retail offering for S &P 500 mutual fund. And you have what became, after many sales and transfer of ownership, gets lodged at BlackRock. Now, BlackRock became the world's largest money manager, basically on the backs of this idea of indexing and S &P 500 indexing.

17:59So that was one part of the bank, the indexing. The other part was this combination of Merton, Black, Scholes theory, the multi-factor theory, the option pricing theory. And that was the group I worked on was trying to figure out how we could do better than an index fund. And we came up with some ideas. A couple of them were pretty silly, actually, but that's what happens when you're kind of just starting out. But that approach to the outline is really complicated at first point. You know, people are still thinking you have to outguess the market. And at least with an S &P 500 index fund, you say, look, this is what we're going to do is we want to track this index.

18:38People go, OK, I understand that. So that's a pretty easy sell to come in and say, look, we think there's this whole idea of this multi-factor option pricing stuff says that what you're really interested in is figuring out the distribution of outcomes that works best for you. And that's the cornerstone of dimensional. And that's why we actually work with financial advisors like PlanCorp. I think a lot of your job is helping people figure out, based on various ways of investing money, various portfolio mixes, what distribution of outcomes works best for them. It's a very personal kind of problem.

19:16What works for you may not work best for your neighbor down the street. It's that sort of thing. So those are the two elements that was going on at the same time at Wells. Wells, eventually the index fund idea won out at Wells and it created the opportunity for us to create Dimensional. And it's really interesting because as you're creating Dimensional, you ultimately decide to focus on small caps. And I guess what I'm curious about is this idea, and maybe you could expand a little more on it, this idea that small cap and value stocks would outperform over time was really groundbreaking at the time.

19:54And so I'm curious, before I get into some of the seeds of dimensional, how did the research on risk premiums evolve? And what convinced you specifically that these factors were real? Well, to begin with, part of it is luck and part of it was good research. Back in 1981, when we started the firm, our first clients were all large defined benefit plans, pension funds, and corporate and public pension funds. And what we found was those pension funds systematically avoided small cap stocks. The idea, if you think your purpose is to outguess the market, you can't make a business around picking stocks in small cap space because you can't invest enough money to create a reasonable size firm.

20:39So there is a huge need. There's a void in institutional portfolios with respect to small cap stocks. So what we're able to do is, say, use the portfolio theory. It's the first kind of application of portfolio theory. I should have mentioned that. Fundamentally, one of the main differences between the old way of thinking and the new way is the old way is about picking stocks. The new way of thinking is about designing portfolios that give me the characteristics that work best for me. So our portfolio argument was we'd go into big institutions and say, look, it seems sensible. well, you'd hold stocks of large companies and small companies.

21:17You wouldn't have just all your money in large. And for 43 years, I haven't heard anybody go, you know, that's a stupid idea. I mean, of course that makes sense. You want to do both. And you're not holding those. And the first people we talked to, sometimes they would say, well, how have they done? I go, well, I'm not going to tell you. And they go, why? I said, because you already believe the story. Don't get too hung up on data. I mean, even though we're known as kind of a quant shop and we have the best researchers known to mankind working with us. There's a time when you have to get off of models and go into just kind of practical solutions.

21:55All this research is done based on models of risk and return or whatever. Those models don't explain everything. If they explained everything, you'd call them reality. You wouldn't call them models. So you do want to use all this academic research. At the same time, you want to come up with something you think is sensible. So our sensible idea was you ought to have large and small, and we'll give you access to small. And people go, gee, that's great. But how do we know you can actually execute? Well, now we have 43 years. That first small cap fund we started 43 years ago, if you look at through the end of the year, that 43-year experience, it ended up with twice as much money in our fund than the benchmark index, the Russell 2000 index.

22:40And it has nothing to do with stock picking. It's just figuring out how to structure portfolios and executing better than index funds. 43 years. So now people, they're finally coming around going, I think you can do it. Because the way we've done it is based on good, solid theory and empirical evidence. So there's a chance it could repeat. And we've been telling this story, let's say, for 40 years now. And at first, People say, well, how do we know you'll repeat? You look at our 43 years, the first half, in terms of performance relative to the benchmark, looks like the last half. I mean, it's just, there's something systematic going on.

23:21So our challenge then, in a nutshell, is not the theory or the ideas. Our challenge is communication. Look, investing is complex and uncertain. Life is complex and uncertain. Let's say all doctors study the same medicine. And it just turns out some of them are better than others. And that's all we're saying is that this science that we've learned is pretty much in the public domain. You know, it's how you do it and how you interpret it for clients. That's why people need people like you to help them apply the ideas, you know. You mentioned it's this balance of the science of efficient markets, of the science behind the theory that you so carefully implement in your portfolios, and then the practical application of these investment strategies.

24:05And one of the things that the movie Tune Out the Noise, which again, you can see a link to that movie in the show notes at the long term investor dot com. If you're watching us on Cheddar, subscribe to the long term investor dot com. And you're going to see a link to the movie in the episode description here with David and I. And David, you'd mentioned at one point there you didn't like the word passive. And I nodded pretty aggressively and I jotted a little note because, you know, we used to just say it can only be passive or active. And what I tend to think of index funds, as well as a lot of the quant funds that, as you described at Dimensional, is they're rules-based.

24:43They don't predict the future. They're low cost. They're transparent. Dimensional's approach, I feel like, is better described as active in implementation but passive in philosophy. Can you maybe comment on that and maybe elaborate why such a distinction might be important? Well, in the first place, there is no such thing as a passive investing. Sometimes people say, well, index funds, what about them? Well, you look at the Standard & Poor's, the S &P 500, which I think is the largest index fund out there. Or, I mean, not only if there's, because there are so many different S &P 500 funds. What happens when a stock leaves the index and they want to bring a new one in?

25:24Standard & Poor's, the investment committee sits around and they bat around ideas. is what do you like? What stocks should we put in that 500 to replace it? We want to have larger companies rather than small. So the S &P 500 is 500 of the largest companies, but it's not the 500 largest companies. And the difference between the two is based on the judgment of the folks at Standard & Poor's picking stocks. So that's not exactly passive either. And when you go to trade, you better not be too passive. I mean, you go to the marketplace and you look at that chaos as you describe it, figuring out at what price to execute is a very sophisticated problem.

26:05And professional investors can do a better job than individual investors in figuring out how to execute. So you want to use your flexibility at that point. So yeah, we are blatantly active, I would say. I mean, we have to go into the rubric of passive because we're not trying to outguess the market. But it's kind of insulting in a way because we work so hard to do all the little things that can add the bit of value. You know, we have a couple hundred people every day working on execution around the world. That's a tough task. I mean, that's why they call it execution, because there are some losers out there, too.