Why I Stopped Picking Stocks: The Risk Matters Hypothesis

great so good evening everyone and welcome to the London School of Economics for this public event hosted by the financial markets group I am Christopher P a professor of Finance here at lsse first a few words about the financial markets group our fmg on the third weekend of October 1987 three important events occurred a hurricane hit London that Thursday evening Global markets crashed that following Monday morning and the fmg was established by Charles goodart and Lord mvin King the first two events are certainly memorable but the third is also quite important as the fmg laid

the foundation for the creation of what is now a world leading Department of Finance here at the lsse indeed the FG has become a leading Center for research on financial markets as well as a focal point for the Department's interaction with policy and practice like tonight's event speaking of which uh as a proud former director of the fmg it goes without saying that I'm delighted to chare this exciting event this evening tonight we had the pleasure of having Victor hagani speak to us on why I stopped picking stocks the risk matters hypothesis now Victor's going

to speak to us about 35 maybe 40 minutes on ideas from his book as well as his broader experience working in finance after which we will be taking questions from the floor before I introduce Vector uh a few administrative points one for those in the audience on social media the hashtag for tonight's event is LC hagani two we have a photographer present uh and the lecture is also being filmed both photos and that video will be on the fmg website um subject to no technical issues if for any reason you do not want to be

in those photos please do let us know but after the event and then finally I have it on good word that there is no fire drill scheduled for this evening thus if you hear a fire alarm please do leave the building via the marked exits all right for those of you in the know Victor needs no introduction he's an LS Alum receiving his BC in economics back in 1984 and then going on to have a quite remarkable career in finance after graduation he started at Solomon Brothers in New York as part of their bond Arbitrage

desk famously depicted in Michael Lewis's book liars poker in 1993 Victor kof founded the legendary hedge fund long-term Capital Management uh and co-head their London office uh more recently in 2011 he founded Elm wealth to help clients including his own family managed and preserve their wealth through a novel approach he calls Dynamic index investing now Victor came back to the lsse uh in the early 2000s joining the fmg as a senior research associate and talking before the event he said it was there and then when he put together many of his ideas underpinning uh Elm

wealth uh he has been a prolific contributor uh to the finance literature most recently co-authoring the book The Missing billionaires a guide to better financial decisions which was named by The Economist as one of the best books of last year now I don't want to steal Victor Thunder but I do want to emphasize the importance of his talk tonight for various reasons there can be large gaps between what Finance Theory prescribes and what investors even professional ones actually do tonight as part of closing those gaps Victor will delve into to the hidden risks of a

cost-free market and highlight that while investors may have won on fees they're losing on risk back in 1932 KES wrote that he looked forward to a distant future when economists would be quote thought of as humble competent people on a level with dentists tonight is a big step in that direction with Victor's ideas guiding all of us to make better financial decisions humbly improving our financial hygiene please join me in giving a warm welcome to Victor hagani [Applause] all right well it's great to be here it's uh um a great honor I never thought I

would be coming back to uh to give a talk after graduating from the lsse but um with a little bit of practice here I am so um so what I want to talk about uh this evening is um is basically basically a conversation that I've had over a number of years with this person this is my Mom Lucille she's uh this is a picture of her on her 90th birthday back in May um my mom is very active she lives in the states in New Jersey uh she's still driving and going to the Opera and

playing bridge um but uh she also has become a stock day trader she uh starts her day off by putting in different orders into her brokerage account app uh and then again later in the day she puts in more orders and she's trading she's doing maybe 20 trades a day uh you know which is um 5,000 trades per year in her brokerage account and what I want to talk about this evening is my conversations more or less um with my mom uh as I've tried to uh dissuade her uh from doing that um and uh

and I should say you know my mom is my mom is is very good with numbers um she's uh you know uh yeah she was a she was actually trained as an opera singer but uh yeah she's she's a good she's got a good business head but still um you know I've been trying to dissuade her so you know the first thing that I tried to uh um convince her of and to talk to her about is what's known um uh as the cost matters hypothesis an idea formulated by the the founder of the vangard

um Index Fund group John Bogle um and it's basically this idea that if you take all actively managed stock portfolios and you combine them into one big portfolio that by definition that needs to um equal the market portfolio right that there's no other there's no other uh thing that that could equal than the broad market cap weighted index of stocks and so therefore if you take all of the active stock picking investors and put them all together that the um the return on the average Dollar in that portfolio is going to be the market return

minus the costs of active investing um this idea was uh was kind of a riff or development on um an earlier paper by William sharp where he termed it the um the arithmetic of active management in 1991 and um you know this is this is a really simple idea that I tried to convey to my mom and I think she totally got it um but uh you know and I and I even showed her a little bit of data where you can see that um even if we take uh a subset of the entire uh

stock market so this is just us mutual funds that it turns out that over the last 10 or 20 years the difference between the Returns on actively managed mutual funds has been about 1% lower than the return of the index uh this is a really well-known result and um you know backs up that even even though these mutual funds are not all of the active investors in the marketplace that they a broad enough um uhp group of them where you get this result so you know I told this um to my mom and she said

yes I get it I agree but um the costs matter but my costs are zero don't you know that I'm trading with zero commissions at my uh my brokerage app I was like okay and you know that that you know here's a chart of the standard um stock and ETF commission rates from Schwab that show that right around when my mom started to do this day trading was right when commissions went to zero and in fact what happened was my mom never day traded before that um but sometime around uh 2019 her full service stock

broker told her that she could open a a separate account with that broker that would have zero commissions and she could do all the trading that she liked so that's how that whole thing got started so um you know it really got me thinking about this this question more broadly about what's been going on I mean we know that there's been a huge move a huge increase in lowcost index funds that are used by investors but at the same time uh you know we've really seen a tremendous um uh growth of uh of of retail

trading activity it's hard to pick up the paper without hearing about uh you know some corner of the market where people are going crazy with with their activity and and it kind of became clear that um you know what's happening is that there's a certain desire out there for people to punt things around to to there's a certain kind of speculative um uh you know emotion that that is that goes through uh a lot of people and it's so strong that people actually get up and go to places like Las Vegas and they go into

these casinos and they know that the odds in the casino are against them that most people that play a slot machine or play blackjack or whatever it is they know that the odds of them winning are um uh that that that the odds are against them and that they're expected if they play long enough that they'll lose but they still just enjoy it so much the overall experience that they get up they go there they lose money they come home and then they go back again well here what we've got with zero commissions is what

appears to be a positive Edge gambling opportunity um that you can do from the comfort of your own home and so it's kind of clear why um this has really taken off how things have really changed since we've gotten into this zero commission zero fee world that that and a lot of people have been talking about it I mean imagine you know how uh attractive and addictive these these um these these opportunities are and then you sort of say okay actually you can do them and expect to make money I mean it's like you're just

you know pulling my mom out of her chair when she's doing her day trading it's impossible she's locked in there until until um her trades have been executed and she can enjoy her day and then put the trades in at the end of the day and um you know this is um like the on the left here we have a uh this is what a brokerage account uh homepage looks like on the left and on the right we have a uh a sports betting app I mean you can see that they're really sort of channeling

the the very same types of ideas you know between them it's kind of something that we know um you know that that some of the um some of the crazier excesses in this like the confetti at Robin Hood has been toned down but still you know this is a shot of Robin Hood from just a month or two ago you know it still has that same sort of look doesn't it so what we're seeing right is that um you know even though like you might expect that with um index funds getting B bigger and bigger

and so much money moving towards indexing shouldn't we have thought that trading volumes might go down as more people become index investors but no what we see is that um you know trading volumes have continued to just monotonically pretty much um go go up and when we look at uh options trading volumes that's even a stronger uh even a stronger uh picture where um where options trading volume has more than doubled in the last five years it's more than quadrupled in the last uh 10 or so years and um what are people trading single stock

options for what are they trading calls and puts on on all these different single stocks for other than um you know it's a really really big bang for your buck and again zero commissions and so you know I think that in this zero fee this this zero cost trading world that we live in we getting all of these things that we haven't really seen before you know the meme stock craze single stock ETFs leverage single stock ETFs zero dat to expiration options absolutely exploding um structured notes getting bigger um you know just all of these

different things the spa craze that came and went I think all of it is kind of related to um is is is is somehow a manifestation of this this um this zero zero fee uh world that we live in so um so I go back to my mom and I'm like okay so the cost matters hypothesis you got me on that one you know I think the insight there that all active portfolios um aggregate to the market portfolio is is something that's important but okay your costs are zero fair enough but mom who's on the

other side of your trades it still is you're still engaged in a zero sum activity right that whatever trades you're doing somebody has to do the market portfolio minus those trades somebody has to have the mirror of your trades do you think that you're going to do better than the person or the people that are on the other side of you and um you know it's it's kind of like saying you know do you think that you know on the other side of you might be somebody like this or it might be guys like like

these that are on the other side of your trades you know do you think that you're going to profit Rel relative to these highly uh capitalized um uh you know highly um organized uh pools of capital or or or not and of course um you know the picture of those guys is kind of the tip of the iceberg when it comes to the smart money out there that we hear about I mean probably some of these names are are unknown to you in the audience although other ones have become more current I mean just in

this table alone of about 50 names um you know I would come up with a rough estimate that this represents about $500 billion of trading capital and from what we hear this trading capital is taking out something like a 25% return uh per anom that's $125 billion that really adds up to a lot of money that is being sucked out of the nonprofessional day trading or or stock picking uh Community but my mom says to me okay you know what do you mean that uh okay they can make money and I can make money you

know I own Nvidia on Monday somebody else owns Nvidia on Tuesday somebody else owns it on Wednesday we can all make money I'm like yes but you're not making as much money as you should when the market goes up but she's like no I'm making money you know what um you know what's the problem with that if I'm making money so I'm still not quite getting there but you know I'm making some some progress so I say okay Mom let me show you something else have you ever thought about this you're a day trader so

generally you're buying at the beginning of the day some stocks and at the end of the day you're putting in your orders to take your profits and and sell I said are you aware that over the last 30 years or so that almost all of the return of the US Stock Market has occurred from the closing bell of the day to the opening of the next day and that if you just own the stock market from the opening bell at 9:15 a.m. until 400 p.m. when the market closes that over these 30 years you would

have basically made uh no money at all and actually if you had owned um a an index of smaller cap stocks uh which a lot of retail investors trade in you would have actually lost 86% and this is over the last 20 years you would have lost 86% of your money from the open to the close in that kind of day trading relative to what was made in the overnight that you would have made 42 times your money in the overnight but you actually lost 86% of your money in um you know in the daytime

as a day trader and um you know here's a couple of other pictures that it's not just that obviously it's not just at the index level to the extent that it's at the index level it's even stronger at the individual stock level so Nvidia for instance in the last 25 years you would be down 44% you would have lost 44% of your investment could you imagine saying I I bought Nvidia and without transactions CU I bought Nvidia every morning I sold it at every close I was long it for the last 20 odd years guess

what I'm down 44% and the guy who owned it in the overnight was up 450 times his money right I mean it's just it just is um it's it's insane um you know the same with apple even stronger with some of these these other stocks um so you know I'm working on my mom I'm trying to get her to uh to kind of see the light and uh say here's some more evidence mom here's a study that was that was done that was looking at people that had uh Accounts at a discount broker this was

actually um at Schwab these two professors Barbara and Odin looked at um about 70,000 accounts uh there and and analyzed how they were doing trading wise and they found that the most active Traders were underperforming the market by 6% a year I mean that's a huge number and uh we also have other research I mean there's a ton of This research out here this is just two pieces Morning Star publishes every year they publish a report that's called mind the gap um which talks about the difference between fund returns and investor returns it looks at

if you put a dollar into a particular fund how would that have grown if you just left it in there that's the fund return and then the investor return is looking at all the cash flows going into the fund coming out and looking at the irr of those flows and it finds that if you look at all the mutual funds out there that for the last 10 years investor returns were over 1% lower than fund returns and in some cases it's it's unbelievable like I don't know if you've heard of Arc the um the arc

Cathy Woods Arc investment uh vehicle um if you invested in that the fund return from inception uh over 10 years ago the fund is up like uh 8 um but investors have net lost several billion dollars because they some people invested at the beginning but a lot of flows came in after she had made 40% returns for a number of years they invested at the top then things didn't go so well people pulled their money out and Etc so investors have actually had a negative irr in her vehicle it's not not saying it's her fault

but this is the difference between fund returns and um and investor returns that we get from um active investing well you know starting starting to be starting to be a pattern here with my mom but I don't know maybe I'm kind of softening her up a little bit I don't know but I'm kind of getting a little bit exhausted at this point and there's like a gap in the action as I try to catch my breath again I'm feeling pretty exasperated by the whole process and meanwhile you know she's actually telling me she's asking me

how how am I doing on my investments and um you know she loves to tell me that her return is higher than my return and you know it's going and it's going on and um and I'm talking to people about you know I'm telling people about this you know and they're saying gez you know I have an aunt who does this or yeah my mom does this too and I just want to try to find a way of of of um convincing her that it doesn't make sense and so a lot of people are thinking

about this and um and I guess at at some point you know I was really thinking about a lot and I was like okay you know what what's missing from all this conversation from the cost matters hypothesis from thinking about who's on the other side of your trades is what's missing from all of this is a discussion of risk so um so the question is you know like how does risk factor into all of this well we know that in general people should be risk averse in that the more wealth that we have each extra

dollar is making us uh happier but at a decreasing pace the decreasing marginal utility of wealth um is a pretty standard idea um you know you can think about it in terms of you know what would you prefer a 10% guaranteed return or just a 50/50 chance of minus 20 plus 40 that has the same expectation as 10% you know I think most people maybe everybody in this room would prefer the 10% guaranteed return in which case risk matters to you um as it as it should and so for a given amount of risk um

we should want to get the highest return that we can that we can get or stated in another way we want to maximize our expected risk adjusted returns and hopefully this is where I'm going to get my mom eventually but um you know I talked to her about and she's like yeah it kind of sounds good but you know um you know tell tell me more so I said okay let me give you an example or let me give you um a toy example of this to think about so I say okay imagine well in

my mom's case it was a million dollar but for the audience here we're going to pounds I say imagine you've retired and you have a million pounds of of savings and you invested in a portfolio that you feel really good about it just happens to be a relatively high-risk portfolio so it has a 5% annual expected return but it's got 30% risk so it goes up and down by 30% either one year goes up 35% the next year goes down 25% so it's averaging 5 % but it's pretty risky but you know that you're going

to make this 5% average over time just with these fluctuations and so you decide okay well if I'm going to make 5% on my million pounds I should be able to spend 40 pounds a year and all of this is adjusted for inflation so the return is 5% after inflation and the £40,000 I'm going to grow that with inflation too so I should be able to um to just spend um 40,000 a year right if if I'm making 5% on average um so the question is if I do that what is the most likely amount

of wealth that I'll have after 25 years is it uh about 1.3 million pounds which would be basically I'm making 5% but um I'm spending 4% so if I grow a million pounds for 25 years it adds it it compounds up to 1.28 million pounds is that the answer no the answer is zero that after 23 years I'm bust and and why is that right so we can see it here um you know you can look at the um at the table on the right what's happening is basically this volatility is dragging is dragging me

down to go up 35% and then down 25% doesn't leave me with 10% uh more wealth it doesn't leave me with 5% and 5% I'm actually pretty close to zero my compound return under that case is more like 1% a year so I can't eat as as you know I can't eat my expected return I have to eat my compound return effectively my compound return is much lower and you can see that this there's an acceleration here where I'm getting to zero Capital really really quickly but if I had that same 5% expected return but

the risk was much lower say it was just plus or minus 10% a year relative to the five so one year I go down 5% the next year I go up 15% and that averages out also to 5% a year in that case I'm fine spending the 40,000 um uh adjusted for inflation over time as as you can see there so you know I showed this to my mom and um and uh you know started to soften her up a little bit uh but what it really did is it kind of uh led me and

and my co- researchers to to uh come up with an idea um of the risk matters hypothesis and basically we went back to the Bogle cost matters hypothesis and realized that again if we take all of the stock picking concentrated portfolios and we put them all together into a big bucket they're going to equal the market portfolio in composition right that's just a an identity um so the question is is it possible that the risk that the average risk of all of these portfolios could be lower than the risk of the market portfolio and here's

where we realize that we've never seen that result um calculated before but it kind of intuitively seemed to us that no I mean any way that you break up that portfolio that it has to have a higher average risk across all of those sub portfolios than the market portfolio itself so posited that we uh we thought about it I'll show you a simple proof of that in a second and and that is the case that the average risk the average risk across any subdivision of the market portfolio is higher than the risk of the market

portfolio so in that case we know that the that the aggregated um active portfolios is going to give us a return equal to the market return but the risk is higher so no matter matter what the risk is going to be higher the return is going to be the same so even if fees and trading costs are zero we know that the risk adjusted return the return that we care about the risk adjusted return on average across all of these active portfolio is going to be lower than the risk adjusted Return of the market and

um you know I think this is one of those ideas that is so simple that nobody bothered to write a down and I think that sharp and Bogle kind of felt like all we need is the simple arithmetic on returns in a world where costs of active management were high and so they didn't come to this corollary of the same idea and and write it down um and what's really uh quite remarkable in this case is that um if you think about the fees of active management right if there are fees and costs associated with

active management all of that is zero sum right it's like somebody's paying a fee to somebody else and so there's no dead weight loss in the system but here um there's a this is a negative sum instead of being a zero sum activity when thought of in this way we have a negative sum activity right that everybody in aggregate is worse off with nobody else getting a commensurate payment to make them better off um and so um I think it's a really cool idea um and here's a simple proof of it um you know if

you if we um my mom thought she my mom also thought that this was not a simple proof but um you know here's a pretty simple proof of it where you just think about um everybody's portfolio of Express try to express everybody's um active portfolio as being the market portfolio plus a portfolio of deviations relative to the market so what I mean here by Sigma a is the risk of the deviations is the is the is the risk of the portfolio of deviations from the market portfolio so then we can say okay so every active

portfolio is going to have risk equal to the market risk plus this active risk that they're taking this deviation risk uh plus um the uh the covariance of the um of the active and the market risk fine but then means that but but now we know that the only way to get back to the market portfolio is if I'm going to have this concentrated portfolio of 100 stocks equally weighted or something like that that somebody else has to hold a portfolio that combined with mine gives me the gives us the market portfolio so there's a

mirror portfolio that's held by somebody or by somebody's out there and that mirror portfolio has the same uh kind of risk set up as my active portfolio except here the co-variance is getting subtracted so when I take my portfolio and the mirror portfolio and I put them together the risk of them has to be higher than the risk of the market portfolio unless these deviations have a correlation of one um with um with the market portfolio which is uh which would be a limiting case but is not you know is is not something that we

would expect to see and you might say well but what about if there's a whole bunch of people you know that have that here's my active portfolio and there's a hundred other active portfolios over here that are summing up to equal my uh to be the mirror of my portfolio and what what we can do here is we can just um keep taking this down the chain right so now uh we've established that um that uh my portfolio plus the mirror portfolio has more risk than the market portfolio so now we can come into this

mirror portfolio and do the same thing we can say take somebody that has an active set of bets relative to the mirror portfolio that that person plus everybody else has a higher risk on average than the mirror portfolio and we can keep going down the line uh and get this and get this inequality we can show it more directly as well but maybe this is the easiest way to see it but I wouldn't say exactly that my mom took that one on board quite the same as as the others um so you know in the

same way that we tested the cost matters hypothesis in one of the early slides we can also test this hypothesis a little bit just to see whether it's generally um uh consistent with reality and um and so here what we can do is we can say look let's look at the S&P 500 and look at what its risk has been say over the last 10 years so the s&p500 had risk of 16.6% measuring it as the annualized um the annualized daily changes as a standard deviation of returns and we can look at the risk of

two pretty Diversified uh other mutual funds by Vanguard a growth fund and a value fund which between them own a little bit more stocks than than the S&P 500 they own 542 stocks um but they basically are owning stocks that are the complements of each other right that if you put these two funds together it basically gives you back the S&P 5 00 and guess what one of them has a higher risk the growth fund has had a higher risk over the last 10 years the value fund has had a lower risk but they average

to be over 1% more risk than the S&P 500 and we can look at another 15 or so of these just somewhat randomly pulled just looking for big I was looking for some big and lowcost and diversified funds and you can see all of the red here means that their risk is higher than the market portfolio and the average of them alog together is about 1 .2% higher than or 1.3% higher than the S&P 500 um we can also look at the mirror portfolios of all of these to really get back to the market portfolio

and the mirror portfolios would have had 17.7% risk roughly the same so it shows that we've kind of chosen a pretty we've kind of chosen a set of um of mutual funds that do kind of aggregate back to the market portfolio to some extent um so you know kind of indicates that um indicates that yeah even even when we're starting to cut up portfolios into a couple hundred stocks we're not getting back to um the market risk and so you know I would say that even holding 185 or 200 stocks is not necessarily enough diversification

to take you back to the market and um you know probably some of you are aware of of some research that's come out of um from a professor in Arizona State University hendrik bessen binder where he's looked at the return on all US stocks that have ever existed in the crisp database and he has found that it's just 4% of all public us companies that give us the outperformance of US Stocks relative to treasury bills and the other 96% of stocks um just equal the return of treasury bills and so it really kind of makes

it apparent why stock picking is so difficult it's so difficult to match or beat the market when 96% of stocks are not are not doing that and of course John Bogle talked about this with his with his famous saying of um why look for a needle in the hay stack just by the Hy stack so with this with this idea of thinking about risk um as a cost or part of the cost equation we can think of risk we can convert risk into a fee so we could ask ourselves like okay we're looking at those

mutual funds and and they had about 1.3% higher risk um than the market risk um more concentrated portfolios would have uh a greater amount of of active risk relative to that so we can say look we could either uh we could have a return without paying any fees at all um but it's a concentrated portfolio so we have Market risk plus a certain amount of extra risk this active risk um let's say that we have a 5% expected Market return uh the market risk is 16% and we could have say 2% extra risk which would

be roughly what you'd get with just random portfolios of 25 to 30 stocks um and we could say we could we could try to reexpress that to help people to think about it more directly and tangibly we could say it is the same as owning the market portfolio and paying a fee uh but having the risk of the market portfolio so here we can say the equation gives us um a half a percent perom fee is the same as an extra 2% risk or like 35 basis points of extra fee would be the same as

the extra 1.3% risk that we had when we were looking at all of those Diversified mutual funds so um you know I I felt that by trying to um reimagine risk in terms of being a fee equivalent amount risk that that that would get my mom uh thinking a little bit more here's the just the formula that you would get if you solved the equation above that the fee the fee is higher the higher the return of the market is and the fee is um and of course the fee is is uh this uh risk

equivalent fee is higher the more active risk that you're taking um so how much does all this matter you know like is it is it a big deal you know how how should we think about this well you know we're kind of saying that uh that um active investors having concentrated portfolios I don't know maybe on average we we would say that the fee equivalent of that is a half a percent a year if on average investors were holding stocks maybe 25 stocks on average sometimes owning more Diversified portfolios very often we read about people

owning one or two stocks in their portfolio and having a lot more um going back to our slide on um on the professional Traders and how much money they're taking out of the market each year maybe there's a half a percent expected uh cost from the other side so you know trying to come up with a number maybe um maybe active stock picking investers are spending or are are getting 1% lower um returns than they should from these two components and and that could be a really big number I mean in the US market this

could be a couple hundred billion dollars perom that's that is um being left on the table with all of this active trading that people are doing that's like you know close to $2 $3,000 per household maybe it's $5,000 even per household that's invested in the stock market and you know maybe 1% doesn't seem like that much but if you think about um just what is the risk adjusted return of owning stocks to begin with that um you know that's probably only a couple of percent a year so people are losing half of the benefit of

being invested in stocks on average by not thinking about risk and all of the costs of active investing so um let me close with you know just a few ideas or thoughts or discussion on what we can do to try to um uh try to help with this situation try to help people to get uh better outcomes the first is that we need to increase awareness we need to get people to be aware of how much risk matters in their investing risk is not you know I mean as I showed with the slide of spending

40,000 PS a year risk has a really tangible impact on our outcomes um and and uh managing risk and keeping risk uh or trying to get the highest return you can for a given amount of risk is really important so getting people to think about not just return but risk and um is is really important getting people to think about their uh their outcomes as risk adjusted returns is very very important as well so my mom is basically looking at her brokerage account and she keeps telling me look at my brokerage account Victor I'm making

money right they're not showing her her risk adjusted return they're not doing anything like that they're just saying here's your and they're not even really telling her her um her true p&l because they're just giving what she's looking at is her realized uh profit so she has some unrealized losses over there she's like I'm not going to look at those I've made this is how much money I've made this year already so they're making it really tough for uh users of these brokerage accounts to see how um they're doing and then finally I think um

you know I think also just nudging people in the right direction where possible is also very effective um you know other people whoa sorry other people um you know might think that uh there are other Solutions in terms of uh regulation or a Tobin tax on transactions and so on I actually think that these um three responses to the situation have really taken uh seriously um will um will will do the trick and um you know in terms of awareness right there's there's books there's podcasts there's all kinds of ways of just making of trying

to help with um Financial literacy um and but in terms of the metrics I think the metrics is really where we can help people that it's it's you know you go to Vegas and I'm sure a lot of you have walked into a casino and there's these slot machines and the lights are flashing and it's going crazy and you really want to you know have a little have a little um flutter at the slot machine and and you can look everywhere you can look on that slot machine the one thing you will not find on

that slot machine is what are the odds um of you losing money or making money but when you put a dollar into that slot machine you put a dollar in that slot machine it cost you 7 cents on average 7% for every um from every time that you pull the lever why is that not required to be on the slot machine well I can tell you why that's the case it's because Nevada basically views its job as taking money from the other 49 states in America you know that's what they're you know I mean obvious

you know this is good for Nevada the more people that come and play the slot machines it's good for Nevada but it's unacceptable it's unacceptable to not disclose to people what they're getting into and just as it's in my opinion just as it's unacceptable to uh to not be disclosing the odds on these games of chance why is it did you go I mean imagine if when you went on to the sport betting site it's said to you by the way the only people that we allow to bet at this site are people who lose

money right like that's what it should say as soon as you go there right because if you are a user of a sports beding site and you make money you know what they do they shut your account or they limit you to a DI Minimus amount of um of bding why don't they just come right out and say it like hey you know you want a bet here well we only accept losers so you're you're welcome I mean why are we not requiring this kind of disclosure to help people make better financial decisions so here's

just a tiny mockup of something that uh that that that Brokers could be required to disclose so let's say that you know you were um you know you could have invested in Tesla or met or the S&P 500 well you know over the last 10 years Tesla and meta have done great making 25% or so returns double the return of the S&P 500 and and you would if you invested in Tesla you would have grown your money 10x and meta 7x and the S&P 3x right but the risk of these different Investments was really tremendously

different the Tesla bounced around by almost 4% a day 56% was the annual standard deviation of returns Meadow was over two times as risky as the S&P 500 so we have to have a way of showing people their results after the cost of risk we need to be able to show people the risk adjusted returns of their Investments well if the cost of you know the here's a simple formula for the cost of risk you know there's ways that the Brokers could easily do this um and um you can see that the cost of risk

of Tesla would have been huge if you had all this is assuming that you had all your money invested in one of these three uh Investments and so the risk adjusted return of Tesla was actually negative over that time whereas the P 500 was higher than than both of them or even it was higher than even uh 50/50 in Tesla and meta so I think there's so much more that we can do to help people um to get to better um decision making taking taking risk into account um and of course nudges have been really

successful there's a lot of nudging that goes on um in uh in defined um uh in defined contribution pension and and SA savings plans and so you know we have seen this is I think this is really encouraging that we have seen um you know market cap weighted and index funds lowcost index funds in general um actually overtake the amount that's in actively managed mutual funds um in the US and um and that's a trend that's going on um everywhere so um so in some what I have to say to my mom is obviously as

cost matter um you the other side of your trades matters a lot and uh and risk matters a lot and so um what I've come to um sort of um accept is that I've got these two moms I've got the bull market day trading mom on the on the right and I've got the market cap indexing mom on the left and I think that what I'm really hoping for and I think that my mom has accepted is that the market cap indexing mom has become the uh the predominant part of her uh portfolio um so

anyway happy happy birthday mom um and I'll stop here and we'll we'll have questions you know thank you thank you very much it's been really fun you can let my mom have a little more air time absolutely uh wow that was fantastic thank you so much Victor and so we'll take some questions from the floor we have plenty of time for for uh several questions I know there must be a lot of those out there so what we'll do is we'll collect them in threes uh when I recognize you please wait for the mic to

come to you we want to make sure we can hear you certainly before you begin your question state your name and affiliation so we know who you are and then of course uh try to keep your question brief and a question so uh let's let's begin uh yes gentlemen the person with the hand up there thank you uh Stefan Guta uh Alam and visiting fellow um Victor very convincing um how do you deal uh with global asset allocation and asset allocation between different asset classes for instance Alternatives or bonds versus stocks in this Paradigm okay

great um may we have another uh yes the person one two 3 four with the the gray code on the person yes right there excellent thank you so much um uh Victor for this insightful uh lecture I'm I'm a history student at Kings um so I had a small question about um Thomas Phelps books by um um 100 bager stocks and whether you thought it it had something consistent with what your theor is you're talking about the relationship between risk and returns of Investments okay and maybe one more uh yes the person in the the

Great coat there excellent thank you hi thank you very much uh ilar dlan from Hidden Valley gems newsletter private investor actually if I made two but you can pick one so uh there is a talk that the S&P is much more concentrated today than 10 years ago so how do you take this into account when you deal with risk uh concentration of the index and then secondly you mentioned I think Warren Buffett as well um would you not say that volatility is the price that investors have to pay so if you don't have to sell

tomorrow or in 3 years but you can hold a highly volatile stock for like 10 years you actually can achieve better returns if we have patience and long-term view thank you okay great Victor okay so um yeah the first question um from Stefan that's a great question is you know is okay um we need to define the market portfolio in you know in some way and um you know actually in Bill Sharps uh paper he says okay you know this arithmetic holds um you know given a reasonable definition of the market portfolio but um you

know I think that there are some real challenges with defining the market portfolio there's lots of things that are either um uninvestable or very difficult for people to invest in um you know in my my feeling is that um as a uh as an individual investor I want to invest in things that are uh that are liquid that are lowc cost to invest in um and uh and and that um represent really really big asset classes so for me you know I'm pretty comfortable limiting uh my family's Investments to the global uh public stock market

and maybe skewing it a little bit to also try to be a little bit representative of the private uh Equity markets as well um have a little bit of exposure realizing that commercial real estate is a huge asset class as well but is a is BAS is mostly privately owned so having a little bit of extra exposure for commercial real estate in there um and then uh you know kind of being willing to uh miss out on a lot of uh you know pretty big asset classes um but I think that the um you know

the idea is you know choose your Market portfolio depending on what kind of an investor you are if you're an Institutional Investor you might be able to Encompass more asset classes in in what doing but once you define what your Market portfolio is then you know invest accordingly you know from from that point onwards and yes there is segmentation between different markets you know I think that um you know it's reasonable to think about the expected return and risk of the US market as one thing that you could invest in and think about you know

European equities and their expected return in Risk is another Market maybe you know emerging markets and Asia developed markets could be others where it's it's a broad enough swath of companies and there's enough segmentation in terms of Home bias that you could actually have uh a reasonable expectation that returns expected returns could be different uh looking forward on those but you know I think also if you just um if you just treat the whole Global Market portfolio as one big asset class you're getting you know well over 90% of the way to a really efficient

good portfolio oh I have two other questions right um so the king's history student I didn't quite get the question fully that you were asking about hundred about stocks that go up 100x exactly yes and what do you think by in in what you talk about your book and the ideas communicated today what do you think about it in terms of risk and return like do you in relationship to a broader Market yeah so um so look I mean so you know I think what's what's interesting in these Bess binder results that that uh you

know where I was saying that 4% of the stock of 4% of stocks have represented all of the outperformance of us equities versus treasury bills is is there something like deep subtle or uh you know that that needs a lot of explanation there or is it simply the case that any stock can go to zero or it can go up 100x it can't go down 100x it can only go down 1X right so we know that stock prices are what we call log normally distributed so if stocks on average have a volatility per anom of

around 30 or 40% which is you know roughly what what individual stocks on average have we should see exactly what Bess and binder found which is that most stocks because of that volatility because they can go up as they can go up infinitely much but they can only go down to zero that we're going to see each individual stock having a distribution where most of the probability of returns is is is low and is bad and the higher the volatility of the stock the more is the median or most likely return going to be poor

and offset by a small probability of 100x um of 100x return so you know it's all very uh natural with regard you know what we see is actually very naturally explained simply by the um log normality of of stock price distributions but you know one of the things that we also talk about in the book is that um and this comes to this is going to tie into the third question that was asked is that um is that there are different kinds of risk right so if um if I am a long-term investor and what

I care about is the uh long-term uh uh income stream that my wealth can generate because that's what I'm going to spend you know I don't care how much is the present value of my wealth I care about how much can my wealth be converted into as a long-term cost of living adjusted annuity over my life my kids' lives or whatever um whatever the Horizon might be and so if I have this long-term Horizon I really don't care about changes in the discount rate right I don't really care about um changes in how future earnings

of stocks or future coupons on bonds are discounted back to today I just want those coupons or those those earnings or those dividends and with individual stocks so much of the risk is real risk is the risk of the company doing great or the company doing poorly whereas when I invest in the overall stock market and I diversify away a lot of each company's idiosyncratic risk what I'm left with is a larger fraction of the risk that I'm taking in stocks is actually coming about By changes from changes in discount rate which I actually don't

really care about that much so there's also that between you know individual and um individual stocks having these huge risks and huge potential Returns versus investing in the market index and then ilda your question was about um concentration you well you had two questions was one about concentration and the other was about volatility being the price that we pay for the expected return of investing in in the stock market so let me start with the second part of your question exactly that the um that uh that it is uh stock market risk uh it's the

risk of our economy um it's it's the risk of financial crisis Etc that are the risks that we care about as investors the risks that we care about as people that are trying to turn our wealth into future consumption so this is the risk this is the fundamental risk in our economy um which gives us a higher expected return for taking on those risks if we just think about a very simple uh you know in the simplest uh depiction of an economy with agents who are risk averse and with an economy that is expected to

grow but has risk the uh the um the assets that we're going to turn into consumption the risk of them that we can't diversify away from is that which gives us this higher expect return uh for for bearing that risk but um um but it's important to realize that that risk is is real risk and you can make your horizon as long as you want if you have that fundamental uh consumption risk that taking it for longer periods of time even though your probability of coming out on top uh gets higher and higher that the

um that the cost of that risk to you uh is not changing sort of perom as you go out that the cost of the risk is proportional to the variance of of the variance of the um of the riskiness of that outcome and so it's also going up with time in the same way as the return is going up with time so I think there's a lot of there's there's a lot of misunderstanding uh in the investor community that says well if I have a hundred-year horizon owning equities is going to is is um is

a no-brainer I want to own equities because to a 100-year horizon I have a 99% chance of making more money than on bonds but no in the simple in a simple framework you know in a simple framework that risk is aggregating with time linearly and it and um and we should want to that that the amount that we want to invest in stocks it should be invariant uh with Horizon in a in the simple in a simple model like that in in the simplest kind of model um the but the again the risk that we

care about is this real underlying economic uh risk that would hit our consumption that would put us out of a job um that would make our home prices go down you know Etc um and then on your other question about concentration um it's true that the biggest companies today are bigger relative to um uh um to other companies than they were in the last 10 or 20 years actually there was a time not that long ago go I think it was in the 70s when the amount of concentration in the indexes was similar to what

it is today but the only thing that we can all own is the market portfolio so to say that these companies that that the S&P 500 is too concentrated and I don't want that concentration and so I just want to have an equal weight uh investment in the S&P 500 is forcing somebody to be on the other side of that bet and why do we think that the person on the other side of that bet is making a Bad Bet and that I'm making a good bet so we have to live with that concentration it's

just of it's just the manifestation of these companies um having grown really large you could think of them as being multiple companies all wrapped up into one but I think that the concentration concern is is is somewhat misplaced in today's market and of course the concentration of these stocks is is half as big on a Glo in a global portfolio so yes um you know the biggest US stocks are a really big component of the S&P 500 but once you look at all 15,000 stocks around the world that you could invest in in a market

portfolio the concentration of those biggest stocks is a lot smaller as well okay great when we have another round of questions uh yes the person in the black shirt on the you are quick with your hand right hello can you hear yeah uh G I'm a Comm analyst firm a lovely lecture by the way uh just want to ask you have you ever investigated control so you looked at day trader returns but have you ever controlled those returns uh for level of sophistication so compared to your mother you would be a more sophisticated Trader and

be more I think as other mentioned be more willing to trade more exotic um assets like command compared to your mother and have you Incorporated that analysis in in your analysis I guess okay thank you um yes the person there with the pink shirt uh hi Habib joli uh class of 86 I guess um uh thank you that was fascinating as a practitioner I I do find this really interesting uh but and I can see we've seen the rise of passive and people just buying the mark market and that trend is increasing but as that

continues uh what about efficiency of pricing of individual businesses in in capital markets be fascinating to hear thoughts on that thank you thank you let's see um we take that one why not let's take that one great the man with the white lettering on a shirt thank you it was terrific to hear about your man I went to University with lots of young people I was interested to know what advice you would have for young people starting out on their careers and their saving strategies for their lifetime okay great okay I got them so um

so the first question was um whether um I don't know maybe the question was couldn't you know that what if my mom were um more Diversified with her day trading you know what would that what would that look like and you know I think that the um you know at the end of the day if my mom is swimming around with those mostly bald-headed guys um that were in that picture she's going to do worse than she should do she's not getting the returns that she should get commensurate with her risk so I think that

um you know until she's in the market portfolio and until she stops being uh you know an active investor in that way that her uh risk adjusted returns will be a little bit will be lower maybe a little bit lower if she if if um you know if the day trading mom stays nice and small relative to the index mom um that uh but that's kind of inescapable you know it's it's inescapable that she's um that there's this dead weight loss from not being as Diversified as she could be and also from swimming around even

if her costs are zero from swimming around from some people that are awfully good at consistently extracting a lot of money from the marketplace um and then um uh Charlie's question was about um the rise of indexing and and market efficiency and there's been so much talk about this question and you know people love to say you know what if we get to a point where um indexers own all of um all of stocks completely what's going to who's going to make prices anymore and um and by the way the um you know the chart

that I the chart that I showed of index funds versus uh actively managed mutual funds is really uh um is not even the whole picture that there's a lot there's um some recent research papers that is indicating that if we uh look at who owns different stocks in in in the US let's say you know we see Vanguard we see black rock we see State Street and we add those up and we're like wow look at that you know in general the market is like % owned by um index funds or indexers but actually you

know there's there's reason to believe that indexing is much bigger than that we could be close to maybe just under 40% of stocks are owned by um by pretty um diligent uh diligent index trackers and index funds um you know in the extreme if uh stocks were fully owned by by index funds I think that we would still have plenty of price setting by active investors who can run long and short portfolios they bet long on this stock short on that stock we're still really far away from it but I think there's this question out

there that gets asked and answered a lot our index is the growth of indexing making the market less efficient and uh Cliff asnes at aqr recently wrote a paper where he says that look you know I started I don't know he started in the early '90s I think in in the industry and he said he thinks that the markets are less efficient today than they were when he started and he puts some of it down to indexing but his def he has this interesting definition of market efficiency you know how should we measure market efficiency

the way that Cliff likes to uh to analyze it is Cliff says um that uh to what extent do prices represent or reflect reality or fundamentals well gosh how does anybody know what those prices are well Cliff says you know Cliff has valuation models for all the different stocks out there and he says the stocks are further away from Cliff's reality than they were um you know earlier on but from I would have a different uh definition of market efficiency to me market efficiency would be how hard is it to beat the market how hard

is it to to generate Alpha and you know in my experience and from what I see out there I think it's become harder to beat the market today than it was was when I got started coming out of the LSC in the in the mid 80s I think it's harder today I think the ante is much much bigger um I I think it's I think it's more difficult to beat the market today than it was back then I think so I I kind of feel like markets are more efficient and if you think about indexing

you know um you know what what Cliff says is like well who's moving to indexing if if the if people are moving to indexing um that we're making making the market less efficient than them moving to indexing would make the market more efficient or is it the other way around you know is it that he was kind of saying imagine we have Sharks and Minnows is it the sharks that are moving to indexing or is it the minnows if the sharks are moving to indexing then the market becomes less efficient if it's the minnows that

are moving to indexing the market becomes more efficient I mean isn't it almost abundantly clear that it's the minnows that are moving to indexing the sharks are doing well they're out there munching munching up a storm the minnows are the ones that are seeking uh asylum in index funds they're like get me out of here get me out of all this active stuff put me into the index fund where there's not much going on and be safe there so so I think that index funds you know probably making the market somewhat more uh efficient but

the craziness that we see in the market is coming from the stuff that I was talking about all this zero fee uh trading all these new ways I mean it's kind of like whack-a-mole when fees went down we thought oh you know um there's going to be less less flesh taken out of retail investors uh but no we found other ways to uh to do that and then um Jonathan you were asking about advice for young people uh or or uh Financial decision-making advice for young people and um you know I think that the main

thing that young people it depends on how young they are so first the the biggest decisions right that young people will make our education which in in the UK is not as um of is not as expensive as the decision as it is in the US where it's a really really big financial decision in the US but here a little bit much less so but it's your education uh career um and housing those are kind of the three really big financial decisions that you're making um the investing part of it I think is really easy

you know the advice to young people is get into the habit of saving and um you know invest in equities uh you know it's okay to invest most of your money in equities as a young person you have a lot of human capital and uh and your financial capital is relatively low so when you look at your overall portfolio human Capital Financial Capital depending on what you're doing I think if you're working at a in a Investment Bank you know maybe your human capital is looking a lot like equities anyway but for most people uh

their human capital is uh is is probably less risky and they can afford to be more inequities but I think the really big decisions are around career uh education and housing and I think in in those decisions you know really that risk is so Central to those decisions that particularly when is choosing a career and thinking about what's the risk you know you don't want to think about what's my expected compensation my expected reward in this career going to be but you really need to think about your risk adjusted reward and of course once you've

done that you can think about what you're attract Ed to where your passions are but I think thinking about career decisions in some risk adjusted way which generally will argue against taking lottery ticket type of career paths um you know I think is is is very valuable and I think with housing it's like you know housing is not really is not your best path to wealth generation you know buy your housing uh you know view your housing as a consumption item not as a wealth generation tool in general um and um and terms of Education

you know obviously come to the LSC on that note uh I think that's a good point to end I think I speak for everyone that has been a real pleasure to listen and to learn from you tonight Victor could everyone please join me in giving him a big round of applause [Applause]