Episode 14 of the NewRetirement podcast is an interview with Jim O’Shaughnessy – founder of
O’Shaughnessy Asset Management. We discuss the investing lessons he’s learned from 30 years of investing – partially summarized in this
tweet storm and why human behavior is the most predictable (and exploitable) element of the stock market.
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Steve: Welcome to the New Retirement podcast. Today we’re going to be talking with Jim O’Shaughnessy, founder of O’Shaughnessy Asset Management, otherwise known as OSAM, about active versus passive investing, and what he’s learned over a 30-year investing career. Jim is a life-long investor who has built a successful asset management business that manages about $7 billion for institutions and individual investors. Prior to founding OSAM, Jim was the director of systematic equity at Bernstein Asset Management, and prior to Bernstein, he was the CEO and Chairman of O’Shaughnessy Capital Management where he also started an early ROBO called Netfolio, and I’ll be asking him some questions about that later. He’s a pioneer in quantitative equity analysis. He’s been called a “World beater” and a statistical guru by Barons.
Forbes included Jim in a series on Legendary Investors, along with Benjamin Graham, Warren Buffett and Peter Lynch. I invited Jim after seeing his tweet storm on what he’s learned over his investing career which has about 8,000 likes and we’ll be discussing and quoting from that in this and you can see a link to it in the transcript of this show. Alright, with all that Jim welcome to our show. I’m honored that you joined us and that’s a pretty amazing list of investors to be grouped with on the Forbes list.
Jim: Thanks Steve. I’m clearly the odd man out there, but yeah, it was … It’s kinda funny because, as you know if you’re familiar with the things that I’ve written and said, honestly I think that for most people especially people who are active managers, there shouldn’t be any gurus. Its kinda like the quote, “If you meet the Buddha in the road, kill him because he’s the real Buddha.” And so, obviously I’m flattered and obviously I have the utmost and highest respect for everyone on that list, but I think a really important thing for people to do if they want to pursue and active strategy is to number one, learn as much as you can about the stock market, about human behavior, about all of those things, but then … And here’s the important part of my opinion, apply it to yourself.
I’ll give an example, so there was a fellow who worked for me who, when he was giving speeches and he was like right out of college and when he was giving speeches, he would basically try to imitate me and most people didn’t like his talks, right? And I think the reason they didn’t like them had nothing to do with him and had everything to do with authenticity because when I took aside and said you know what … For example, he loved sports and he loved a bunch of things that I’m not a huge fan of and I said, “Look just put this completely into your own words.” Well long story short, he’s one of the best public speakers you could see today. As long as you are very authentic and true to your likes and dislikes, you’re gonna shine through.
So I’m a huge believer that people need to design investment strategies that fit them. Okay so, if you’re not gonna be an active investor i.e. one who buys and sells stocks on his or her own, then you still want to develop a strategy that makes sense for you personally, right? And for some people, that might be investing entirely systematically the way we do at OSAM. For other people, it might mean indexing. For still others, it’s gonna mean maybe a mixture of those two. My point is that you can’t like buy a book that is a checklist and then say, “Well I’m just gonna follow this checklist,” because if you haven’t kind of made it uniquely your own, the fact is you won’t really follow that checklist especially when things get rough.
So I really urge people when talking about investments and how they go about it so find what feels right to you and that sounds like a weird thing coming from a quant, right? But the fact is, it’s our emotions that undo us almost 100% of the time when we make huge investing errors. So it’s not gonna do you any good to follow a strategy that looks great on paper, that has 300 bases point alpha over its index. If you can’t handle the fact that instead of a say 20% draw down, this one has a 40% draw down because it’s during those draw downs that you’re gonna question what you’re doing the most and unfortunately most people end up capitulating.
Steve: Right. I think that’s great insight and part of what drew me to your … The tweet storm that you put together, which a lot of it was around the whole behavior of finance and how that derails people and from doing this podcast and talking with people like Jonathan Clements, Bill Bernstein, Allan Roth and other folks, it’s clear that kind of the behavioral side of this is what undoes many people or hurts so many people. They really just can’t manage it and then they make these kind of basic sell out the bottom, buy at the top mistakes that hurts people, hurts the retail investor.
Jim: Well you know what’s really funny is … Yeah, Daniel Kahneman who wrote the book Thinking Fast and Slow and has kinda been the godfather of the behavioral finance movement. He himself admits that even though this has been his topic of inquiry for more than 30 years, he is still a victim of behavioral biases in his own behavior and one of the things that we believe very, very much is most of these behavioral biases are not going away because it’s one thing to intellectually understand something and it’s entirely another thing to emotionally understand something. If you intellectually understand something, you think in your mind, right? Oh well yeah, okay I get that. I get this. I understand that the majority of people react emotionally. I know that I’m probably prone to that too, but then we fall right into one of the granddaddies of behavioral biases overconfidence, right?
Because when you look at surveys of people asked to put themselves in a bucket as to the quality of their driving, right? And there are 10 buckets, the first bucket is the 10% of best drivers in the world and the 10th is the 10% of worst drivers in the world. Well virtually everyone puts themselves in either bucket one or two. What we understand statistically this isn’t possible and so, we are all victims of overconfidence and so, one of the things that I have seen over the course of my career are people saying to themselves, “Oh yeah I get that. I get that. I understand that. I understand that that happens to everyone else, but it’s not gonna happen to me,” and my answer is yes it is going to happen to you and I think I might’ve mentioned in that tweet storm for everyone who works for me and myself included, if we did not invest the way we do, we would be just as likely maybe even more likely because we lived this stuff on this day in day out basis to fall for all of those behavioral problems.
So you’re really kidding yourself if you think that well that applies to other people, but it doesn’t apply to me. It applies to anyone who is the category human being and it’s just … I’m not gonna give you the full dissertation on why this is, but basically evolution did not design us to live in a modern world, right? So our hardware, right? Which is our brain and our bodies, our hardware is designed for 50 to 100,000 years ago, right? All of the way that the pre-installed software of our brain works is still working as if we had to worry about being eaten by a lion, right? So my son, Patrick, just came back from South Africa where he did a tracking expedition and I’ve been to Africa as well and anyone listening, if you get the opportunity to go to Africa, go because it is truly magical, but the point here is when you’re actually out there, your brain is working the way it’s supposed to work.
In other words, I see those bushes rustling, I’ve gotta either run away, stand my ground, etcetera. Well that isn’t the way the modern world works at all, so the software or society, right? Is like a 1,000 generations advanced and removed from the hardware and I think in this fundamental disconnect is where we all run into trouble and people don’t really think that way. I know on a normal basis, you and I don’t think about ourselves that way, right? But the fact is, that really is why we run into all this trouble because our brains are what I call, are lizard brain, right? And not the most advanced portion of our brain, the prefrontal cortex which half of it which is organization, executive skills, the ability to be rational and reasoning, etcetera. But it’s the primal … Yeah, it’s the amygdala basically is what’s making decisions for you when things are going against you and to our brain, that market correction or bear market is we’re reading it as this could kill me, right?
And our brains are very literal. They think oh my God, if I stay here I’m gonna die and obviously we all intellectual know that that isn’t true, but that doesn’t matter. So basically the idea is that you’ve really gotta build a fortress if you will, around yourself if you want to succeed as an active investor and it doesn’t … By the way, it doesn’t have to be the way I do things. It could be something as simple as writing yourself a letter that you promise you will open when you’re thinking about selling out during a bare market and in that letter, your much more rational self that wrote it when things were good will tell you, “Oh by the way, you realize …” Or videotaping yourself might even be better. You realize when things were going fine that things would ultimately end up going down, this is that time, don’t be stupid, remember this you. Something as simple as that, that can break that emotional hole and allow people to kind of rethink what they’re doing.
Steve: Totally, hold on I think that’s where the having a wealth advisor … that I think that’s really their maximum value is that they coach you behaviorally and also stop you, they act kind of like a firewall when things are really going sideways. If they’re doing their job right, they’ll help control your … Those primal urges you have to like fight or flight, right? And dump your stocks if things are really scary. Also, I think your analogy about kind of like hardware and softwares, they’re a really good one. I hadn’t thought about it that way, but having just last week, having my five year old laptop die ’cause it’s trying to manage all the different software I’m running on it and it just can’t deal with it and I had to basically upgrade the hardware to deal with the software that I’m trying to run on it.
I think that’s a pretty apt analogy about how we work and unfortunately, as humans we can’t change the hardware overnight, but you’re right, society is changing so fast. There’s so much more information available that it is hard for us, our brains and kind of core emotional responses which is hard for us to manage that.
Jim: And the other thing is that people often confuse information with knowledge and those two are maybe not even distant cousins. We are washed in information today, right? At no other time in human history has your average human being had the ability to access as much information as we do today and one could argue that that was a really great thing and there are a lot of really interesting and good things to come from that, but some really bad things come from that too and that is that you are so overwhelmed with all of the information that you just say, “Ah, you know what? I’m just gonna use my default assumption and do x.” And so, I always remind people or try to remind people, don’t confuse information with knowledge because knowledge is far more rare than information and that is what you want to develop.
You want to develop knowledge about say for what we’ve been discussing, human behavior. You want to develop knowledge about the history of markets. So for example, if you’re in the United States and you have say the bulk of your portfolio and US companies as the majority of American investors do, one of the things you could remind yourself of is that since the late 1700s, when they found that the New York stock exchange, US stock returns have been positive about 70% of the time, negative about 30% of the time. Now, think of that as odd, right and let’s move those odds 70% win 30% loss, lets move those odds to a roulette wheel. If you knew that the odds were you’re gonna win seven out of every 10 times you played, you would never get a chance to play at that wheel, right? Because the guy in front of you would never give up his spot and yet, when we don’t think about it just in the terms of odds and think about it in terms of the narrative that everything going through a bare market.
We completely throw the odds out the window and that’s another thing that is one of my points of real underlining and trying to get people to really understand you’re generally not doing yourself a favor if you are watching tick-by-tick the market and the news about what is going on in the market because everything gets a narrative. Everything. It doesn’t matter if it makes sense or doesn’t make sense. For example, the crash of 1987 which was the largest percentage drop in one day for the dow jones industrial average in its history, right? That happened in October of 1987 and the fact is, there are still no good papers or books or any other kind of intelligence on exactly why that crash happened and yet, the narratives around that crash, I actually have right here in the office, the Wall Street Journal, the New York Times, it’s the magazines from right after the crash and the narrative developed immediately, right?
The market crashed because and then it’ll fill in the blank. Well, no it didn’t. That isn’t the reason, but I bring this up because the narrative that you’re listening to, at the time you’re listening to it is gonna make a lot of intuitive sense to you. Why do you think that’s the narrative? Because it makes a lot of intuitive sense to the people who are coming up with that narrative. The thing to remind yourself of always in my opinion is that narratives is constructed after the event happens, not before and that way the narrative is always going to sound absolutely convincing and unfortunately the more violent the down turn in the market, the more scary that narrative is gonna be and after the 1987 crash, there was magazine upon magazine and TV broadcast on TV broadcast, are we going into the second Great Depression? And put yourself back in time and think what would you have felt at that time? Those people were absolutely terrified and if you can’t put yourself back to 1987, put yourself back to 2008.
Steve: We tell ourself stories to kind of explain the world around us, right? To try to make sense of it and it’s interesting to hear you draw that analogy with the markets and how we try to interpret what’s happening there.
Jim: Yeah.
Steve: Yeah, no, and I remember in 2008 like people were feeling the whole thing was gonna grind to a halt. I remember like in our business we were like oh we gotta make sure that every bank account has less than $250,000 in it so we’re inside the FDIC insurance, like stuff like that was happening ’cause we were like it’s gonna end, right? Like the whole thing’s gonna stop working.
Jim: Yeah.
Steve: Versus if you were like hey I recognize this pattern. I’ve seen this before. It’s like buy when there’s blood in the streets. If you were like alright, I’m moving in. I’m gonna invest now. You did incredibly well, but most of them didn’t do that.
Jim: Yeah and of course the problem is that I wrote a paper in March of 2009 called A Generational Buying Opportunity and what did we hear? Crickets and if we didn’t hear crickets, we heard people saying that I was insane and yet, that ultimately it’s … Again, it brings up a really good point. It’s very easy to say and almost impossible to do, right? So we can all … I mean talk is very, very cheap and people could be filled with vibrato and oh I’m like not like that and boy, when the bullets are flying, you behave very differently than when you’re in a comfortable living room talking about you not being afraid of the 20% correction in stock prices after the market has gone up nine out of the last 10 years.
Steve: Right. Well I th- … This is kind of a pretty timely conversation because everyone’s pretty complaisant right now. The VIX as … Well, mean in the past few months the volatility went back up, but for a while that was super low and I know you kinda talked about this in your tweet storm that most people can’t manage their behavioral biases and you think that also that when the next correction happens, even though there’s a lot of … lot more passive investors out there, that they’re still gonna react emotionally and still yank their money out. One of those a big pullback.
Jim: No question. I wrote a paper on this and basically I said that passive investors really only have one point of failure and their one point of failure is that they react emotionally during a bare market and sell out of their holdings, okay. Active investors have two points of failure. The same first one that the passive guys have, but a second one which is that they look at their active manager or mutual fund or ETF and see that they over the last three years its done 150 basis points 1.5% less well per a year than the index that its benchmarked against. The second point of failure for active investors is jumping in and out of strategies way too often, getting to the point where they would’ve been just better off investing in an index or even better or worse for them, they end up doing worse than they would’ve done had they invested in an index.
So that also comes … becomes important in terms of timeframes, right? So if you were using a three years time frame to judge a manager or your strategies, performance and how well its done, you are using potentially the most misleading timeframe that you possibly could. The only way you could do it worse is make a shorter duration of time, right? Like a year or six months or how to do last quarter. Last quarter is noise. 100% noise. As you elongate a time horizon, it gets to be more signal and less noise, but again, because we’re temporal creatures, we don’t process like that, right? We are living in the here and now, right?
And this is something unless you are an absolute sage and have achieved enlightenment, which is very rare in the world today, you’re going to be as temporally based as anyone else, but when you look at the facts you see that … For example, there’s this study that shows that people who’ve fired managers because they had bad three year performance against the index or other managers, what happens is when you go back and look at how that manager and the manager they replace them with performs, well you can see this one coming a mile away. The one that got fired does much better than the one you hired. Reversion to the means, right? And so, people just really have a hard time thinking numerically
Steve: Right, so let me ask you a question. How do you … I mean I totally agree with you, there are all these biases out there in terms of like managing your emotions, right? Moving in an out too fast. How do you manage it inside of your own organization? So you recognize that these are there, how do you solve for that?
Jim: So we solve for that by basically making every investment decision that gets made with very, very few exceptions, quantitatively derived, right? So we have a strategy that we’re continually trying to improve. That’s on the research side, right? So those are being implemented and then we have strategies that have been approved for actual use in the market and we quite simply never override those strategies and that ultimately is the key. The ability to have the discipline, even during periods of 08′, to not override a strategy is the entire game, if you’re a quant and so we had a consultant through here in 2009 and he mentioned to us that we were in the minority of even quantitative managers in that we did not override our strategies during the financial crisis.
He said more than 60% of quants that he followed did in fact override these strategies. What does that mean? It means that they reacted emotionally to what was happening during the time. So people used to ask me, well what happens if you get hit by a bus? And I would always say well very little because the strategy that gets run the day after my funeral is gonna be exactly the same strategy that was done the day before I got hit by that bus and I would say the one thing you have to watch out for is does the person who replace me have the same willpower and discipline to never override the strategy.
Steve: Got it, so your key to success is basically coating the humans out of it. Setting these rules and adhering these rules. So let me ask you a question, would you ever consider locking yourself out of the system saying “Okay, here are the rules, we’re gonna invest this way and we’re not gonna actually allow ourselves to make changes for some period of time.” It’s kind of like what when you hire a wealth advisor, someone who advises you on your money and you say, “Okay, you manage it and I’m not even gonna interfere with you.” Having them do that, would you ever consider that for yourself or your firm?
Jim: No, I wouldn’t and here’s why, because that would negate the other side of our work here, which is actually what we spend most of our days doing and that is we have no monopoly on perfection, right? Our strategies have evolved considerably from when I launched them 25 years ago and they have evolved through research and you’ve got to have the ability to say, “Okay, I love this strategy but how can I improve it?” And that’s where we spend most of our time. I’ll give you an example, so we don’t use price to book in our value composite, which is a group individual factors, but so … But here’s an example of what I mean.
So one of our colleagues here, Travis Fairchild, took a price to book absolutely apart and he figured out that price to book as it is currently calculated is completely antiquated to the new business environment that we find ourselves in today. Things like goodwill, research and development, a bunch of things, intellectual property, they’re all handled very poorly under the old definition of price to book and so he came up with a series of enhancements to add back in and came up with a modified price to book that basically showed that there was some 200 companies on average at any given time that if you were looking for a true value stock, you are not finding because of the way price to book is currently calculated and that group of stocks did extremely well.
So we are trying to do exactly the same thing with every factor that we use. Is there a better … What are we missing, right? What are we missing about the way this is constructed? And so, we always want to be able to add to a strategy to enhance its performance and that’s why we would never lock ourselves out. This is a continual act of creative activity and that never stops, nor should it.
Steve: Alright, that’s pretty interesting. That’s exactly how every software company thinks. That’s how we think. We’re always tuning what we’re doing, trying to build the best practice into software and use software to kind of get that functionality out into the hands of more people. When I was looking at your company, it looks like you’re pretty open in terms of your research and trying to get other people on your platform to kind of leverage your research. Are you also sharing these strategies or like what do you keep proprietary to keep a competitive advantage versus what do you share and sort of how do you think about what you share and what were you thinking in that process?
Jim: Sure, so if you look at what works on Wall Street, you can see we’re pretty transparent. We publish in the fourth edition of the book, we show you a lot of evidence on how certain factors or group of factors perform over long periods of time. So at the kind of intellectual level, we are 100% transparent. On in terms of being proprietary, we’re not gonna show you the way our code works. We’re not gonna show you the exact specific way we define factors. We will you very generally and broadly and accurately about what we find to be most important and what we find to be less important, but our exact and specific definition of factors, tend to be considerably different than what you’re gonna get from looking at Bloomberg or looking on a popular website. Things as simple as PE rations, right now if you go to three different sources, you might see three different PE ratios because there’s a slight difference in the way each one of those organizations calculate the price earnings.
And so, our code, which also we think is a big part of our alpha over time is the implementation of these strategies. The design and in my opinion, the elegance of the way we do things that we call what we do dynamic rebalancing and all of that code, that’s all proprietary and it would take a pretty significant effort to reverse engineer that, but honestly, if you’re talking about factors, if you’re talking about all that stuff, people will say to me, “Well God, why would you ever even” … I got asked this before, what works the first version came out, they were like, “Why would you ever publish that?” And there’s a great quote and I don’t have it in front of me so I can’t remember who said it, but if you have a really great idea, don’t worry about it. You’re gonna have to cram it down people’s throats and I have found that to be absolutely true in my own career.
You can provide bushels and bushels of evidence and an ounce of emotion destroys a pound of fact and that is in fact what we have found over long periods of time. That’s why we call what we do arbitrating human nature and … Really, that’s the thing that isn’t changing, so I think we’re gonna keep our day jobs for a little while.
Steve: Quick last question on this topic, any thought on what percentage the market needs to be active to efficiently set prices? ‘Cause if everyone’s going passive, you’re kind of like a price taker. You’re just like I’m just gonna invest my money at whatever the price are at, right? But to actually efficiently set prices, you gotta have people making choices and that’s what you do. What … And one quick thing, I was at the EBI Conference, the Evidence Based Investor Conference. Morgan Housel was out there, I know you know a lot of these guys and someone said, “95% of trading volume is due to active investors.” So there’s always passive people are growing the cohort of passive people, but the volume is still being driven by the active community. So any thoughts on what percent, like ho many people need to be active?
Jim: Yeah, so Morgan’s a friend and I think he’s fantastic at explaining why markets and people do what they do and so, one thing I would say about that 95% figure, they’re lumping in a lot of the high frequency traders as so called active investors and that isn’t really true. Those trades are not being made because the fundamental decision was being made by an active manager. They’re being made mathematically and statistically to try to take advantage of the very small short-term anomaly and pricing behavior, but so, I think that as long as a significant minority of investors who remain active, markets will remain relatively efficient in terms of not just being haywire, right? I do think that when you look at how markets behave in general, really the passive investors, they’re following a strategy too and for the most part of their investing in the S&P 500, the strategy they’re following is buy big stocks and overweight the biggest stock, right?
And so, we think that that’s a very mediocre strategy historically, but they are following a strategy right? And so I definitely think though as long as there is kind of a multiplicity of heterogeneous information and interpretation of that information, you’re going to be able to have markets act very efficiently. So I don’t think that we’ll ever get to place where even a majority of investments are made passively, but I don’t think … Let’s say that happens, right? Let’s say that suddenly the light went on in every American’s head and they decided you know what? I’m just going to Vanguard or I’m just going to DFA and I’m indexing my entire portfolio and that’s sort of what I’m going to do. Even if there was significant minority, let’s say 40%, that were active, that … I don’t think that’s going to affect the market very much because those active decision makers are obviously and necessarily going to disagree with one another and that’s really not a bad thing, right?
I mean because let’s say I’m a momentum investor and Mr. Value Investor is offering me a stock that he bought long ago, but that did very, very well. He’s selling it because he is a valuation guy and thinks that the values have gotten out of whack. I can happily buy it as a momentum investor because I think that momentum works and statistically it does. So it doesn’t necessarily have to be a zero sum game, and so yeah, I think that a good sizable minority of active will still keep markets relatively efficient in the sense that they don’t break down.
Steve: Sure and I think it’s gonna … That the great thing about markets is they tend to stay efficient because if people swing too far to passive, more active people get involved to try and take advantage of any inefficiencies created by the fact that everyone’s going passive and bring it back in the line. So I imagine that it’ll hopefully stay in a healthy state. On this topic of kind of active versus passive, what do you think more retail investors should do? Or how should they approach this? You have any thoughts on that? Like active versus passive?
Jim: Yeah. Yeah actually I think that for most ordinary average retail investors who are not students of the market and they have a life to live, right? Maybe they’re doctors or architects or whatever they happen to be, obviously the majority of their attention should go and does go to what their professional and or recreational loves are and that’s as it should be. I think that the majority of those people would probably be very well served by indexing their portfolio because let’s face it, they’re not going to have the time inclination or effort to try to get better results. Now let’s say that that same person instead of just doing on their own, has an advisor, which I think generally is alluded to earlier, generally helps a lot right? Because the advisor is a wing man or a wing woman and they’re there when things get rough and they’re kind of your coach.
In that environment I would say that your average retail investor could be very comfortable using a core and explore type method. By that I mean, put 80% of your portfolio in index funds and take 20% on the advice of your advisor and by people like us or by people like DFA or others that are active investors that have portfolios that look a lot different than the index and but, that I’d really only advise that if you’ve got an advisor whose doing this all day, every day and has the ability to do the homework required to find out which mix is going to be the appropriate mix.
Steve: Right, I think this goes to one of the big potential issues out there. So one, there’s just not that many advisors out there relative to the number of potential investors. If you look at the ratio, I think I was doing the math, it looked like there was about 2,000 people, 45 plus for every one single CFP that’s out there. So many people don’t get advised and even the ones that are looking at advisors, how do they pick a good advisor and most people they pick someone they know and that’s how wealth advisors market. They kind of mark their friends and family and then they hopefully do a good job for them and they get referred in and it’s just very local, almost cottage industry and it stayed that way.
It hasn’t really changed … One of the perspectives we have is that this is gonna … Like the rest of financial services, one there’s gonna be a little bit more fee compressions right as more stuff gets automated and also, I think there’s gonna be more of an evidence based approach where people are really gonna look at the data and say, “Okay, where are their returns? Who is really good at this? How do I find those people?” But I would say right now, it’s a pretty … It feels like it’s a pretty inefficient market out there to find good people that can really help you and the way people decide, it’s very much like I like this person, I trust this person and therefore I’m gonna let them manage all of my life savings. Versus some more quantitative approach to finding somebody. Do you have any insight on that or thoughts on that?
Jim: Yeah. I definitely think that you’re right that the idea that people are going to be demanding more an more evidence from their advisors makes perfect sense and it’s actually something you see happening. So I think and I also think you’re right that at least a historically a lot of people pick their advisor based on he lived down the block or I golfed with him or her and I have a lot of respect for them, they have high integrity, etcetera. I think that in addition to all those things, right? You also are now going to see people saying, “Okay well, show me how your average client did doing the financial crisis? Did your average client hang in there? Or even better, buy? Rebalance their portfolio?” That’s one of the easiest things that you can do by the way.
Let’s say you have a classic 60/40 portfolio, 60% stock, 40% bonds. If you rebalance it, if that gets say 10% out of whack, well what does that do? It forces you to sell the instrument that has been doing really well and move that money to the allocation that has been doing very poorly. So if you were consistently doing the financial crisis, what would you have been doing? You would have been consistently trimming you bond exposures to bring them back to 40% and adding that money to your stocks right when stock prices were considerably lower.
So there are some pretty simple rules of thumb like rebalancing that really work very, very well, but again, you gotta let them, right? You can’t let the emotions get in the way, but I think what we see are people are asking a lot more questions of advisors now that are not layups and show me how you did during all these stress points and if the advisor shows you that his or her clients all sold out in February of 2009, well then they maybe aren’t the best advisor in the world.
Steve: Its like medicine now when I go to the doctor or most people go to the doctor, they’re all over Google beforehand and like …
Jim: Right.
Steve: I think I’ve got this, I got that and suddenly I know all about what this or that could be and I’m quoting you this like medical research that I looked up online and that’s probably starting to happen here. Where people are like taking more honorship and they’re like oh yeah, what is alpha? What is beta? What’s faultily? How does this work? How should I be investing? What are the best practices and are you doing those things? So that’s healthy if more people … Health is a little bit different ’cause it’s kind of like for many people it’s life and death, so they’re gonna be all over it. Finance people don’t necessarily like to think about it as much, but if they’re worried about, I think that they get more involved. So that’s good to see or hear that they’re actually starting to ask these more intelligent questions or more informed questions I should say.
Jim: Yeah and I think that could only go towards a better outcome for the advisor that that person ultimately selects and for the advisors themselves. Look they realize that it’s only getting more competitive in every aspect of investing, right? If you look at the history of investing, they didn’t even report your portfolio’s performance against a benchmark. You just got … Here’s your portfolio, here’s what it’s for and so in a very short period of time, 50 years, we have come remarkably far and relatively vast and I don’t see that slowing down and the one thing that I do think is gonna continue to exist as we’ve been discussing is human nature and if you are positioned to take advantage of the systematic mistakes that people make, you should over time end up doing very well, but the other stuff it’s getting more and more competitive, the cycles are speeding up and you really have to be …
It’s interesting because you have to be forever trying to find an improvement the way you do things, but you also have to have the patience to understand that when the mistakes happen, they’re gonna be made by people and they’re gonna make them rather consistently and you gotta be on the opposite side of that trade when that starts to happen.
Steve: Wow, yeah I think you’re raising an interesting point and I’d love to get your thoughts on this. We’re definitely seeing … Working out here we … The software eats the world right? Or software is eating the world is a quote that is used out here, I think Marc Andreessen said that. It’s impacting every industry. Everything’s getting automated so cost are getting driven down and hopefully productivity is going up and that’s happening in financial services, right? Fees are coming down inside of mutual fund fees are getting compressed because ETFs are out there and index funds are out there that are kind of pushing fees down across the fund world, which I’m sure you see.
It hasn’t impacted the wealth advisors as much. The average wealth advisor fee load is about 1.3% still. So if you have a million bucks, you’re paying $13,000 a year. I definitely seen on Twitter and these communities I’m part of, there’s much more active discussion about are those fees justified? What are you doing to just kind of earn those fees and I think we’re gonna see more pressure … Well I guess here’s the question, I was talking to Michael Kitces about this, he’s like, “Well I don’t know if we’re gonna see fee compression versus you’re gonna have to do a lot more to earn that fee or is it that we’re just gonna see fees come down.” What’s your perspective?
Jim: My perspective is that to a point on the active side, you will see the compression, but it won’t ultim- … it’s not all going to zero, right? Active management will never be zero, however our operating assumption in kind of gaming these things out is that index funds primarily those like devoted to DSB500, their price will be effectively zero because those companies could make money other ways by lending securities, etcetera, etcetera. But active management, I think that’s a different deal and I think that highly differentiated active management, there’s gonna be a floor. I don’t know what that floor is, but we’re pretty close to it, right?
In terms of where we think things are gonna settle out and again, you will have the luxury of basically saying Mr. Potential Customer or Mrs. Potential Customer, if you are not willing to pay us x, then we don’t want you as a client.
Steve: Right, what do you think that floor is.
Jim: Oh I think it’s probably somewhere around 35 basis points would be my kind of seat of the pants estimate of it right now. I think the other thing you’re gonna see is investors who are really confident of their ability to generate alpha over longer periods of time, are gonna be very willing to do performance fees and for example, Ed, pharmacy asset management will do a performance fee on any of the strategies we offer.
Steve: Does that work like a hedge fund? So I know a hedge fund have two and 20 right? You’re paying 2% management fee and 20% on the upside.
Jim: Right. No, for the long only strategies we offer, it would just be a performance … It wouldn’t be the 2% management fee, right? It would just be if you’re x percent ahead of the benchmark, then you get to keep this percentage of the upside and it’s … What’s interesting to me though is that that should be, in my way of my thinking, that should be the fee that any rational investor would want to use.
Steve: Totally, you’re completely aligned.
Jim: And yet, exactly, you can’t get any more aligned and yet, we’ve offered performance based fees for a long time and really, really few people opt for them.
Steve: Yeah, it’s interesting. I think people get attached to existing fee structures. We surveyed our users and said, “Hey if you had a choice between paying software, paying a software fee, paying an hourly fee for advice or flat fee for advice or paying a percent of assets, which would be materially higher?” A very high number of people were like, “No, I’ll pay a percent of assets,” and I think its ’cause they’re used it. They don’t see the fee. It’s like oh well you have a million bucks, you can pay 75 base points for this. So you’re paying whatever $7,500 or we could do it as a flat fee for $2,500 which would you prefer? We didn’t say that … We didn’t do the math for them, but a lot of them were like fine I’ll pay the higher fee. I mean sorry I’ll pay the old fee.
Jim: Hey, it’s really odd and I think the key to that is what you mentioned, they don’t see it. If they had to write a check for that, you’d find that inverting, but since they don’t, it’s again, it’s another quirk of human psychology. Out of sight, out of mind and so … And the other thing people like is certainty, right? So they look at the performance fee and then they look at the history of your strategy and they’re like, “Oh my God, in this year we would’ve paid in a year where we had a great year. Wow we would’ve paid double what we would pay on the flat fee.” Well yeah, but you’re not looking at all the years where you wouldn’t have to pay anything at all, but it’s one of those funny things. I am always surprised and shouldn’t be at what I find people opting for, it’s often very suboptimal.
Steve: Every thing that surprises you comes from human nature, not from computers. Okay, well that’s super helpful. So I wanna just ask you a couple quick questions about kind of the state of the market and I know you don’t make predictions about what’s happening and but, I know you do study history and one of the things I saw you call it in your tweet storm was like hey there 3,000 automobile companies that have been existing in the United States over history and that over the remaining three, one was bailed out, one was brought out and only one is still chugging it out on its own.
Jim: Yup.
Steve: How do you use history when you’re designing … Doing your work and designing your algorithms?
Jim: So we believe that history doesn’t repeat itself, but that it rhymes and so the example you gave that I gave in that tweetstorm about there being hundreds of automobile companies at the turn of the century and now there’s basically one that’s independent is something that you see time and time and time again and so, ultimately though, what we’re looking for is we’re looking for what combination of attributes if you will, have shown the highest degree of success in doing well over market cycles and so, it shouldn’t … And for us they also have to make intuitive sets. So I like to break it down sometimes into simpler examples because people immediately understand.
So an example, let’s say you come to New York to visit me and we’re walking around midtown and we’re both starving and we go up to a food truck and we get some food and we look at each other and we’re like, “Wow this is the best burrito I’ve ever had in my life,” and so we both say, “Wow that’s probably a good business to get into. Why don’t we go see if we can buy it?” And so we go and talk to the owner and ask him, “So what are your sales?” And he says, “Well I do $100,000 out of this truck every year.” And we’re like, “Wow that is awesome! Can we buy the truck?” And he says, “Sure, you can buy it for $10 million.” Well, we’re gonna look at each other and you’re gonna say, “Jim, this is crazy.” And I’m gonna say, “Steve you’re right. We’ll never make our money back.” Right?
But slap a great story, Netflix for example, Google, Amazon, what have you and people the most outlandish amounts of money for every dollar or revenue because they are hoping and praying that that revenue expands by leaps and bounds. Well for the most part, that is what happens and that’s the way we use history. We look at other companies, the other Amazons of their era, so to speak and we look at how they did and they did for the most part, very, very poorly. Was that the case of everyone? Nope. We have no opinion as to whether Amazon is gonna continue being valued at what it’s valued at right now or even going higher. We do have a very strong opinion of the class of stocks that Amazon belongs to.
That class of stocks goes on to horribly over long periods of time. There’s always gonna be an exception, right? And Amazon is it and I love it when people try to reverse the argument and say, “Well yeah, but what about Amazon?” Well of course, but what about the 49 companies that were started the same time as Amazon that people bid up to crazy, crazy valuations. What about Pets.com? What about Myspace.com? What about Lobe.com? They all went bankrupt and so Amazon succeeded while the vast majority of its competitors failed and we could think of all the reasons of why that is. Remember what I said about creating the narrative after something has happened and so that isn’t the way we look at it.
Another example would be think about it like you’re an insurance company. If you’re an insurance company, what do you do? Well what you do if you wanna make money as an insurance company is you don’t treat Jim or Steve as an individual in terms of boy they’re nice guys, whatever. Personality? No. We’re numbers and the numbers that they look at is family history of heart disease, of other diseases, when did the parents die, are the parent still alive, any high blood pressure or any history of heart problems, any history of cancer and they add all that stuff up and they create an actuarial table and they see that people with these types of characteristics tend to die earlier or later if they have good characteristics and they advance you your life insurance at a price that bears that in mind for them to make a profit, right?
And so if you’re 25 years old and your father is 100 and your mother is 99 and you have just run a marathon and have blood pressure that’s 90 over 50, they’re gonna basically give you your life insurance policy, right? ‘Cause chance of you dying anytime soon is really, really remote. If on the other hand, you’re 65 or 70 and you have a family history of heart disease and exact no male in your family has lived past age 72, if they do give you a policy, it’s going to cost you so much that it couldn’t be even worth taking. Well, the … Imagine if insurance companies did things the way traditional stock pickers do. Imagine if they went, “Hey Steve, all of these family indicators are really bad, but you’re such a nice guy, we’re gonna give you this policy.” Well, they’d be out of business really fast.
Steve: I wanna ask you a couple last questions as we wrap this up.
Jim: Sure.
Steve: One is, have your beliefs … Can you give some examples of how your beliefs evolved over your course … You’ve had this 30 year career as an active manager, obviously successful, you’re managing a lot of money for a lot of different people. What are some top things that your world view has changed?
Jim: Sure, so when I was younger, I believed that everybody would just naturally accept the rational way doing things. So for example, when my first company launched mutual funds, we launched no load mutual funds even though we had a relationship with one of the biggest brokers in the country who said that they would waive all the requirements and let us launch on their platform if they were load funds and I said “No, no, no. Load funds are dinosaurs. People don’t need advisors. Everyone’s gonna do it themselves and be investing in no load.” And of course, I was completely wrong. People actually want advice and I didn’t understand that when I was younger and now I understand it so much better.
Another thing that’s changed dramatically for me is understanding I used to be kind of like … When I was designing strategies when I was first doing this, I always went for maximum alpha, right? Maximum alpha, draw downs, big deal. We bounce back. Well that’s … That is a young man’s folly. The fact is people can’t handle those kinds of drawn downs that maximum alpha requires and so, we design strategies that still do very, very well, but we are very aware of what kind of draw downs they have and we’re far more realistic if you will about human nature and our capacity for risk-taking.
I also have changed my attitude. I had a very logical, rational viewpoint when I was in my late 20s, early 30s when I was launching my first company and everything and I think now, I have a far greater understanding and sympathy for the idea that the average human being, myself included, is far more fragile than I would’ve thought when I was a young man and that obviously is a much more nuanced opinion, but it also informs how we make decisions in terms of designing strategies, how we talk about them, etcetera. And I think being … I’m just a lot more accepting of the fact that there’s just a lot of virility in the average human being and that is something that’s probably not gonna change, it certainly not in my lifetime.
Steve: That’s great that you’ve kind of developed that kind of emotional intelligence over the course of your life. By the way, one thought is have you ever thought about retesting the idea of the maximum alpha fund? Now that people are kind of, I think getting more … Some people are probably getting more comfortable of the risk and how the market works and some of them might say you know, now I can deal with it even though maybe 20 years ago they couldn’t have dealt with it.
Jim: Yeah. We haven’t. We tried to develop strategies. We’re huge believers in getting in the game and it’s kinda hard to get more skin in the game than to have your name on the door. Other than you also have to have your money in the strategies and so yeah, I guess we could say we’re gonna test a super concentrated strategy. Somebody like me, I’d be happy to put money in that, but the fact is if we pretty much know going in that it’s gonna be only a handful of clients that are willing to use that strategy, we try to remain as aligned with our clients as we possibly can. So it’s not anything we looked at recently, let’s put it that way.
Steve: So last question here, which kinda back to where we started, when you wrote that tweet storm, right? So trying to kind of summarize 30 years of lessons. Was that kind of one stream of conscious, you just sat down and cranked it out or did you actually think about it and kind of put it together and then put it out?
Jim: No, I actually wrote it in 45 minutes. Actually, in a response to a tweet that I saw that I thought was kind of perfect in that it had everything I thought was wrong with the way people look at markets and I read this tweet and I originally was gonna respond to that tweet, then I thought, you know what? I think I’m just gonna … What do I know after 30 years? Right? What have I gleaned in my 30 year career? And literally took me 45 minutes and then posted it.
Steve: Yeah, I think Twitter’s amazing that way and that I’m really coming to appreciate it a lot more where it’s this kind of completely open platform for people to kind of discover one another and their points of view and things are voted in at real time. I mean your tweet got 8,000 likes and I don’t know how many shares, but I mean I’m sure tens of thousands of people, maybe 100,000 people or a million people saw that. I saw it. I was like, “Oh this is really interesting. He’s got a different perspective. He’s obviously clearly …” I had seen your name before, but clearly very smart person and it inspires also other people in conversation back and forth. Kind of across the spectrum, ’cause you see some of the political stuff that goes on, everything else, but it’s a pretty powerful platform and I thought I was really curious to just hear how you put that together.
Alright, well I think on that note, I think this has been great to record this with you Jim. I appreciate your time.
Jim: My pleasure.
Steve: Thanks Davorin Robison for being our sound engineer. Anyone listening, thanks for listening. Hopefully you found this useful. Our goal at New Retirement is to help anyone plan and manage their retirements. They can make the most of their money in time. We offer a powerful retirement planning tool and educational content that you can access at NewRetirement.com and we’ve been recognized as best of the web by groups like American Association of Individual Investors.
