Episode 399: The Boring Asset That Outperforms Most Stocks
On this week's Stansberry Investor Hour, Dan and Corey welcome Hendrik Bessembinder to the show. Hendrik is a business professor at Arizona State University. With more than 40 years of teaching experience and 25 years of consulting experience, he joins the podcast to impart some of what he has discovered over his decades of work.
Hendrik kicks things off by introducing himself and sharing how he got involved in teaching. After that, he talks about his breakthrough research studying the performance of stocks versus Treasury bills, why investing over a long time horizon is crucial, and the importance of finding a competitive advantage in the markets. Hendrik then compares stock picking with professional athletics, as both are rare skills that only small portions of the population excel at. And speaking about his research findings, he notes...
It's not just that most stocks underperform Treasury bills... [it's that] most stocks actually lose money compared to cash. The majority of stocks have negative returns in the long run. So when I found that, I was surprised.
Next, Hendrik reveals that he's skeptical of any system that alleges it can make you wealthy, because the markets are competitive and constantly evolving. He says it all comes down to probabilities – and trying to gain an advantage that will nudge those probabilities in your favor. Hendrik also explains why he believes now is "the best trading environment ever" for retail investors in terms of cost and reliability. And he gives his thoughts on passive investing, the Magnificent Seven stocks, and diversification...
If nobody's being a fundamental analyst or technical analyst – if nobody is looking for misvalued securities – then why should we have correctly valued securities?... On the other hand, as we get further in that direction, it'll be easier to be a skilled manager. If the prices are less efficient, it should be easier to spot the misvalued securities. There are some self-correcting tendencies built in here.
Finally, Hendrik discusses which assets he personally has in his portfolio, his concerns about inflation, the benefits of Treasury inflation-protected securities ("TIPS"), and the downfall of meme stocks. Plus, he responds to popular criticism about the value of a Master of Business Administration degree...
You not only need to understand the formulas, but you need to overlay judgment and common sense. So I think when people criticize what we teach... it's because sometimes people come out knowing the formulas but not necessarily having the judgment or common sense.
Click here or on the image below to watch the video interview with Hendrik right now. For the full audio episode, click here.
(Additional past episodes are located here.)
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm Dan Ferris. I'm the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Daily Digest. Today we talk with Arizona State professor Hendrik Bessembinder.
Dan Ferris: We will talk with him about a very particular paper of his that has been very successful. It's been downloaded and read and cited many, many times over the years. We'll also talk about other areas that he has focused on in his many-decade academic career. So let's do it right now. Let's talk with Hendrik Bessembinder right now.
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Dan Ferris: Hendrik, welcome to the show. Thanks so much for being here.
H. Bessembinder: Thanks, Dan. It's my pleasure.
Dan Ferris: Well, Corey and I have some questions about various things, some of your work that we've read over the years. But you're a new guest to our listeners.
H. Bessembinder: I am, yes.
Dan Ferris: And I was wondering if you couldn't give us a little bit of your background and how your career started and how it got where it is today.
H. Bessembinder: Sure. I guess it depends on how much detail you want, but I grew up in a working-class family in northern Utah. I attended state universities. I'm a big fan of higher education, because I know it opened doors for me. As far as becoming a professor, which I am now, a research professor, research-oriented professor, it was one of those cases of unforeseen event, which I think for a lot of us, where we end up can be a matter of unforeseen events. But I was in my MBA program at Washington State University, and I had an assistantship there, helping professors grade, that sort of thing. And I'm sitting in my office one day, minding my own business, when the department chairman walks in and says, "We just had an unexpected resignation, and we need somebody to teach introductory courses next year. Are you interested?" And until that moment, the thought had never crossed my mind. But I said, "Yeah, that would be good for me." Gain some more insights, gain some skills.
I did it for a year, it went great, and changed everything in terms of my career path. So I've been a professor for decades, longer than I might want to admit, doing research and teaching, and I've enjoyed it. It's a great way to make a living.
Dan Ferris: So now you're still doing that to this very day, decades later.
H. Bessembinder: To this day. As a matter of fact, I've been working on research projects this morning, and after we finish this podcast, I'll be driving into Arizona State and teaching an evening MBA course tonight.
Dan Ferris: All right. Sounds good. A man of focus. On this show it's surprising how many people I find – to tell the truth, like myself – who they started someplace completely differently than finance, and they wound up running a hedge fund or working on Wall Street through some convoluted pathway. So it's almost reassuring to know that there are people who do the same thing for decades and decades. Like my father did, he was a lawyer for 60 or 70 years. It was forever. [Laughs]
H. Bessembinder: Yeah, maybe it was just that one random moment, maybe it would've happened anyway by another path, but I somehow ended up in the career that was just right for me. So that's a good situation to be in, to be able to say that.
Dan Ferris: Hendrik, I feel the best way to start off is just to ask you what seems like a provocative question, but which you know to be something else, which is do T-bills outperform stocks? [Laughs]
H. Bessembinder: [Laughs] Well, clearly you're referring to the title of one of my papers. And I'll freely admit, I have before and I will again, that I chose that title – literally it was "Do Stocks Outperform Treasury Bills?" but I chose that title because I kind of thought, if people see this, they're going to have to have a look to see what this guy's talking about. So the paper you're referring to, I kind of stumbled into it, and we can talk about how I stumbled into it, but ultimately it's kind of a statistical paper. It's about economics and finance and investments, but about a statistical phenomenon: positive skew.
And most of the people who hear this will be familiar with skewness, but just in case, the nature of a positively skewed distribution is that you've got a few really big positive outliers, and those pull up the average. And because of that, the average is actually higher than most of the individual outcomes were for forward-looking, the average is higher than most of the possible outcomes. So the paper was really about positive skewness in the distribution of stock returns in the long run, but I've got a hunch – maybe the word would have gotten out eventually anyway – but I've got a hunch that if the title of the paper had been "Stock Returns Have Positive Skewness" it might've taken a while before people noticed it. So I think the title was successful in getting people to pay attention. But I think it was a good thing. I think the paper has some lessons that people should be aware of.
Dan Ferris: Absolutely. And they are lessons that we have witnessed on this show through several guests who reported things like – one friend of mine I'll mention manages portfolios of very, very small capitalization mining exploration stocks. And he'll say, "I had 10 stocks in the portfolio and half of them were zeros and I made all of the money," which was like 55% a year for 10 years on maybe five or 10 of this, some small amount of them like that. So we are familiar with certainly the practical application of skewness. And you can look at our newsletters. You look at my newsletter, I've been doing it since 2002, and I've recommended hundreds of stocks. My whole career is based on about 20 of them. It just works out that way, doesn't it?
H. Bessembinder: Yeah. There's kind of an analogy to baseball, where if you succeed one time in three, you're doing great. Investing isn't about batting average, it's about how does your portfolio do. Anyway, that's one of the lessons that comes out of the skewness.
Dan Ferris: Right. And I'll just – since I have mostly – I have practical examples, you have the theoretical knowledge, but I'll name one more, which is Robert Kirby's Coffee Can portfolio, where he described putting $1,000 or $5,000 into all the stocks that the adviser recommended and never taking their sell advice, and having one of them just dramatically outperform the others and split and spun off. I think it was the original Xerox. And several of them did pretty well, and then a bunch of them did really poorly.
H. Bessembinder: That's the nature of the game. I've come to the viewpoint – let me just back up a little bit – forecasting the future is always hard, right? Picking which stocks are going to win is hard. But this point that over long horizons, like say 10 years or more, most of the gains are going to come from a relative handful of stocks. Telling you which ones are going to be the stocks is hard, but telling you that it will be a relative handful of stocks, I just feel like that's hardwired into entrepreneurial investing. One way I sometimes describe this is that if I just started from scratch and I said, "Look, I'm going to tell you about an asset class, and in this asset class most investments lose money. As a matter of fact, the most common outcome is to lose all your money. But there's a few really big winners sprinkled out there, and those are so good that this is actually a desirable asset class." You might respond to me, "Yeah, I knew that about venture capital."
Dan Ferris: Yeah. That's right. [Laughs]
H. Bessembinder: Except, of course, I'm talking about publicly traded equities once you look at longer horizons. So I think it's just fundamental to entrepreneurial investing. It's the way the world works.
Dan Ferris: Yeah, the world's working that way in kind of a big, notable way right now, with the incredible outperformance over the past several years, decade or so, of the Magnificent Seven, the top seven really. And sometimes I talk about the top 10 S&P 500, top seven, whatever it is, they've accounted for quite a bit of the return, as we ought to expect, having read your excellent paper from years ago.
H. Bessembinder: Yeah. I did the first draft of the paper with data through 2015 and I thought it was kind of eye-opening. Then the published version had data through 2016. But now we've got a few more years of data, and far from the phenomena disappearing. If anything, the phenomenon has gotten even stronger since I first circulated the paper.
Dan Ferris: And I have to say, too, I came away from it thinking maybe I should just buy T-bills. [Laughs] Because the prospect of losing most of the time is not attractive to a lot of people. When you describe that asset class in the abstract, as you did, you wind up saying, "Do I really want to lose money most of the time? I don't think I do." And yet, the performance of T-bills described in the paper is comparatively pretty darn good, isn't it?
H. Bessembinder: Yeah. I've heard a few people with that reaction, or to put it differently, I've heard some people say, "Look, your paper is going to scare people out of the stock market." I don't think it should. For one thing, remember, I focused on individual stocks. And even the stock pickers among us are not picking just one stock. Things get better when you start to form portfolio, but there have been really diverse reactions to the paper. You probably know of the psychologist whose name I'm about to slightly mispronounce, Rorschach – the notion of a Rorschach test. I think my paper and what I found really did comprise kind of a Rorschach test. Because some people look at that and say, "Well, if most of the wealth creation is going to come from a few firms, what are my odds of picking them?" And the only way I can be sure to have tomorrow's Apple and Microsoft and Nvidia in the portfolio is to buy everything. And that reasoning is not wrong. [Laughs] The only way to be sure is to buy everything.
But other people look at the same data and come away with the opposite conclusion. They say, "Well, this just shows that if I have some skill, or if I can find a money manager with some skill, you can beat the market by so far." [Laughs] And I can't disagree with that either. Of course, hinging on that somebody really does have the skill.
Dan Ferris: Right. And to be fair, even though we all know that most actively traded funds don't beat the market, a lot of folks have. A lot of folks have worked very hard and had the skill. And I wonder, do you think it's all skill? Because statistically, there will be a Warren Buffet regardless. Right? Is he just lucky? He seems highly skilled to me. Maybe I'm just sort of letting the appearances influence my thinking here, but there must be skill over a long period of time to do so well.
H. Bessembinder: I'm actually with you. I do think there are skilled investors. The difficulty – or actually, back up just a little before I go to the difficulty – somebody trained as an economist, I tend to use econo speak – economist speak, but we use the phrase "comparative advantage," which in layman terms is just what are you good at? What are you better at than your competitors? And there's a lot to be said for figure out what your comparative advantage is. It's just another way of saying figure out what your niche is in life. Figure out what's your passion, assuming you're good at your passion.
Dan Ferris: [Laughs] Yeah.
H. Bessembinder: But anyway, comparative advantage is important. And I'd like to think that I found my comparative advantage in being a researcher and teacher, but I believe there are people with comparative advantage in finding misvalued assets, finding the long run winners ahead of time. But the problem is the signal-to-noise ratio, to use the engineering term. Now the signal-to-noise ratio is not very high because there's a lot of noise – there's a lot of randomness. So Fama and French, names that I think most people watching this will recognize, have a nice paper talking about, if you just go with the statistical evidence, how long does it take and how many years' worth of data do you need before you can reliably decide who's skilled and who's lucky? And their arguments are hard to dismiss, so I think they're both true at once: There are skilled investors out there, but there's a lot of randomness out there that makes it hard to identify them, particularly in advance. If somebody invests for 40 years, maybe, but the 40 years has passed.
Dan Ferris: Yeah. Your mention of Fama and French reminded me, one time I was at a breakfast with a few investors, and Joe Greenblatt was hosting the breakfast. And he told us about a study, I think his firm had done it, where they studied a bunch of investors. I think it was over a 10-year period. And the worst performers after five years – it was a complete flip. They were the best performers after 10 years. So after five years of poor performance, you knew nothing. You knew nothing about their 10-year results. I've always been fascinated by that.
H. Bessembinder: Yeah. As I said, the general point is the markets do have a lot of randomness, so the skill I believe is there. I believe, by the way, that that skill is also concentrated. An analogy I've made before, but I think it's apt, if we think about being a professional athlete, it's a great way to make a living if you've got the right skills. But what percentage of the population actually has the right skills that it makes sense to put their time and effort into trying to be a professional athlete? Most of us should keep our day jobs. So I don't know the exact percentage of would-be money managers, would-be investors that have the right comparative advantage, but it might be a small slice.
Corey McLaughlin: Hendrik, thanks for being here, first of all. I want to go back to something that you said earlier: you kind of stumbled into doing this particular paper. What's the story behind that? And then we can get to it, but like when did you realize you had discovered something maybe you weren't expecting or whatever you were expecting?
H. Bessembinder: Sure. Sure. So I'll go back again. I'm trained as an economist, a financial economist. I've read hundreds of research papers, and sometimes we kind of – there's the danger of getting tunnel vision. If the prior researchers have done something a particular way, the prior people who study the markets do things a particular way, there's a tendency to do things in generally similar ways. And so that was true of me for much of my career. Now in fairness to myself, I didn't actually spend most of my career even thinking about risk and return. Those are really important things, but I was focused on some other things that are also important: microstructure, trading strategies, trading costs, rules for trading and such, for much of my career. And those are perfectly good topics.
But in any event, I did, again, in some sense, stumble into something. I was working on a paper with a couple of colleagues, Mike Cooper and Feng Zhang. We were looking at outcomes for companies in the years after important events, like dividend initiations or stock splits or spinoffs or the IPO or secondary or seasoned offerings. Anyway, we were looking at their returns in the years after those events. And you might be aware that the literature, the studies have shown that there tend to be abnormal returns after those events. Anyway, we were digging further into that. We had a pretty big sample of stocks, not as big as I ultimately ended up studying all the stocks since 1926. We had a pretty big sample of stocks. And for some techy reasons that we don't really need to get into, we were studying logarithmic returns, continuously compounded returns.
Anyway, I'm looking at just our summary statistics for this pretty big sample of stocks, and the average continuously compounded return was negative. Now again, it's kind of techy, but one of the techy facts in the back of my mind was you can add up log returns. You can't do that with regular returns; you've got to compound them, not add them up. You can add up log returns. So if the mean is negative, the sum is negative. Anyway, it's a little techy, but it just suddenly jumped out at me, it looks to me like a lot of these stocks actually have negative returns. And that started me digging into let's see what these returns actually look like in the long run. And so just started digging into the data that eventually led to the paper.
Just one more observation, and maybe it'll seem odd at this point, but when I started to find that actually it's not just that most stocks underperform treasury bills – I just thought that was a catchy title. Most stocks actually lose money, you know, compared to cash, zero. Most stocks, the majority of stocks have negative returns in the long run. So when I found that, I was surprised, but I'm thinking other people must already know this, because this database that I'm looking at – CRSP is the acronym, Center for Research in Security Prices – literally thousands of people have combed this database looking for any interesting pattern. And so I'm thinking to myself, "OK, I didn't know this. I'm surprised. But other people must know this." And for that reason I almost stopped. But a few people I talked to, some of my colleagues said, "You really should circulate that paper, because we're not so sure that people know this."
Now in fairness, there had been a couple of studies by people in industry, not so much academics, that had shown findings along the lines of what I documented, but they hadn't been widely distributed, They weren't as comprehensive. Anyway, that's how I stumbled into it. Circulated the paper and was pleased to see that people found it interesting.
Corey McLaughlin: Yeah, I would say so. I was one of those people that when I read it I was like, "Oh, I did not know that." And you're right, a headline.
I would think that by far, or you could tell me, this is the kind of the paper of yours that has been most widely circulated, or that sort of thing? Or what do you think about that?
H. Bessembinder: Yeah, it depends a little bit on which audience we're talking about. Among academics, we pay a lot of attention to citation counts, because when other people are citing your paper, it's an indication that you've had an impact on other researchers. And this paper has a pretty good citation count, but it's not my most cited paper. But moving out of the academic world into the real world, this paper has received far, far more attention than anything else I've done. It's not even close. Talk about number of downloads from the repositories where I place my papers or the amount of press coverage or the amount of discussion, it's received far more attention than anything else I've done.
Dan Ferris: Yeah, it's a revelation. It really is. it's quite – well, it's a valuable finding, I think. It's something that you ought to know if you really think that you're going to go out and pick a bunch of great stocks.
H. Bessembinder: Exactly.
Dan Ferris: The typical sort of novice mindset, and presumably the three of us have all had it at some point, is that you go in and you've got this sort of available data bias, which is the price. You see the price on the chart, you think, "That's everything, right?" You just want to buy at the point where the price goes up, and you're sure there's a system that tells you that with perfection every time. And then you sort of get beat up and you lose money, and then if you're smart – or humble may be just all you need to be – you pay attention and realize that it's a game of probabilities, not one of certainty.
H. Bessembinder: Yeah. Yeah. You might not be surprised to hear that I'm skeptical of systems. I'm especially skeptical of systems that somebody wants to sell you for one low subscription.
Dan Ferris: Yep. [Laughs]
H. Bessembinder: It's a competitive – I don't know if the markets are efficient, right? The market efficiency theory is controversial, and I don't know the final answer on that. What I do know is it's competitive. If you're trying to find the undervalued stocks, so are a lot of other smart people, and it's not going to be easy, no matter what. And even if something worked, again, the signal-to-noise ratio is hard to say. Did it work because you were smart or did it work because you were lucky? But even if it worked the last three years, there's no guarantee it'll work the next three years. It's a dynamic world. Competition catches up, the reality changes. So again, I think some people have the right comparative advantage, at least a few, but it's never going to be easy.
Dan Ferris: No. And it's never going to be what people – people think it's about finding winners and having great entry points into the market, and virtually every single trader, and some of the longer-term investors too – I think of them as medium-term traders – but every single trader, people who show up in the Market Wizards books by Jack Schwager, we had a few of those, and a lot of people like them. They all say, "That's nonsense. The really important thing is your discipline about the position size and when you sell, when you're you know, selling your losers." And they say, "Well, I make money 40% of the time." [Laughs] And people don't want to hear that.
But your point about the systems is well taken, because people who sell the products in our industry, they'll say, "Look, Dan, all you've got to do is tell me how what you're doing is a system and how it works every time." [Laughs] And so you know two things there, and one of them is it's human nature, actually. That's really it, it's just human nature to want that. And unfortunately, that's what people want to buy. So, over the years all the marketing people, they look at me and say, "Oh, you're doing great, Dan. You've got a great track record and everything. But the product is so hard to sell." [Laughs] Which you get to be proud of that after a while.
H. Bessembinder: [Laughs] So people do like to hear, at least some – we don't want to use a broad brush for everybody, but at least some people like to hear that there's a simple system that can reliably make them wealthy by next Friday. But the world is more complicated than that, and [crosstalk] used more than once, you know, it's probabilities. Even the skilled traders, all you're doing is nudging the probabilities a little bit your direction.
Dan Ferris: Right. Even my father, who I considered a very wise man, he'd call me up and he'd say, "What can I do that'll make me a quick $5,000?" I'll say, "Nothing. Go play tennis. Go to the club. Go out with Mom. Just don't do anything." [Laughs] Yeah.
So having spent your career on things like trading costs and market structure, maybe we ought to talk about some of that. When you say trading cost, I think to myself nowadays, "What trading costs?"
H. Bessembinder: [Laughs]
Dan Ferris: Right? [Laughs] I mean –
H. Bessembinder: I'm glad you brought it up that way. There's a writer who at the big picture level I have tremendous respect for, Michael Lewis. I've really enjoyed his books over the years. But when I read his book about trading, Flash Boys –
Dan Ferris: Flash Boys.
H. Bessembinder: – and his blurbs that say the market is rigged against investors.
Dan Ferris: Yes, I had the same complaint. Yes.
H. Bessembinder: Where did this come from? I don't trade all that often, but when I do, I can trade without a commission, the bid-ask spreads are tiny, and I usually get price improvement and get executions within the bid-ask spread. How badly rigged can the system possibly be given those facts? [Laughs]
Dan Ferris: Yeah, and I think there was a passage I remember, a paragraph saying, that was talking about stealing people's retirement. I thought, "On a one-cent spread? You're kidding me." We do decimal points, we don't do eights anymore. And the decimal points sometimes go out to four of them. [Laughs] Where is this theft? I don't get it. I don't see it. Of course, he was talking about HFT.
H. Bessembinder: [Laughs] Well, I would say that today, for individual investors, it's the best trading environment ever in terms of being able to get your trades done at minimal cost, high reliability, get in and out of positions. It does get a little trickier if you're institutional and you're trying to do $10 million trades. You know, one of my pet peeves is when people talk about a class of traders as though they were all identical. "Short sellers do this." Well, there's a lot of short sellers and they do a lot of different things. So any statement that's supposed to apply to a whole class of traders should be taken with a grain of salt.
But high-frequency traders, there's room to talk about them. I think this tremendous liquidity and ease of trading for retail traders, I think high-frequency traders should get most, if not all of the credit. On the other hand, there's high-frequency strategies other than liquidity provision, and some of them are more controversial, so-called front-running or some people have called it back-running – order anticipation or order detection strategies. There's room to debate those things, and maybe the interplay between the institutional manager and high-frequency traders can be complicated. There's room to discuss and debate it. But this idea that it's a bad environment for retail traders, yeah, I just don't know where that came from.
Dan Ferris: Yeah, I agree, better than ever. Better than ever. Of course, better than ever, technically speaking, in terms of the monetary cost, now it's more seductive than ever, though, isn't it? [Laughs] It's–
H. Bessembinder: [Laughs] Well, I really appreciate that the platforms I use can get me zero commission, low bid-ask spread, price improvement. But for whatever reason, the platforms I use don't show me fireworks after I complete a trade.
Dan Ferris: [Laughs] Right. That's funny.
So I asked an earlier question about where I just made – maybe I made one of my rambling comments about the Mag Seven and how they represent an example of a few stocks garnering most of the return over a significant period of time. But some people say, well, this is part of a greater market structure issue in which so-called passive investing, which is arguably not passive, maybe that's a separate conversation – but so-called passive investing is attracting massive, massive sums of money into the largest cap stocks based on nothing else but their market capitalization, completely regardless of fundamental attractiveness, valuation, future prospects, etc., etc. That has alarmed some people, and it has at least made me start to wonder about it. And in the extreme, even Jack Bogle, the guy who is credited with making so-called passive investing more popular, even he said, "When this gets to be too much of the market," I think he said more than 50% or more than some big percent, it'll start to break down and it'll be a very bad thing. And I think we're about there.
Do you see this as a real market structure problem that could create problems in the next, I don't know, decade or however long?
H. Bessembinder: I think there's real issues to debate here. I feel like I have some insights about various pieces of the debate, but whether I have a final answer is another question.
Dan Ferris: That's OK.
H. Bessembinder: The basic point if we think – sometimes it's simplest to see things if we go to extremes. If everybody's an indexer, who's going to keep the prices efficient or close to efficient? If I go back to putting my economist hat on and say, "Why do the financial markets exist? What do they accomplish for society?" Well, we just talked about one of them: liquidity, providing liquidity, allowing people to get in and out of positions. But another really important one is price discovery, or valuing things. It's important for somebody managing a company, their share price determines how much dilution there is if they sell more shares. So it's going to guide their decisions or affect their decisions to issue shares, and that's going to affect their real investments. This stuff matters for the whole economy working.
If nobody's being a fundamental analyst or a technical analyst, if nobody's looking for misvalued securities, then why should we have correctly valued securities? So for sure, if it tips too far towards too many people indexing, we're going to have problems with the efficiency of the prices, so that's a big issue. On the other hand, as we get further that direction, it'll be easier to be a skilled manager. If the prices are less efficient it should be easier to spot the misvalued securities. So there are some self-correcting tendencies built in here.
You mentioned the evidence about most active managers underperforming. One of my follow-up papers to the original paper is about mutual funds over longer periods, and we found – you know, what we did that was different in that paper is looked at compound returns over long horizons. But we came to the same conclusion that others have come to, that in aggregate, active mutual funds have delivered negative alpha after fees. We have some indication of positive alpha before fees, but the fees more than ate it up. Anyway, what that says to me is that in the past there was some combination of fees that were too high and too much active money. Because I think of it as an economist, how did we come to this situation where we're on balance, money was lost compared to a passive benchmark? You know, either too much money tried to do it, or fees too high.
But now there's less money doing it, and fees are lower than they used to be. So it's not so clear that we still have too much money inactive. It's even possible that we now have too much money in passive. But if we do get to a point where there's too much money in passive, the evidence should start to tip the other way, that we see that active managers are outperforming, which would pull some money back out of passive. So it is a real concern, but there's also, I think, a self-correcting tendency built into the system, as there should be. In a well-functioning capitalist system there should be self-correcting mechanisms.
Dan Ferris: Hendrik, I hope you're right, because I know a whole bunch of value investors who are waiting for the self-correction moment. They're sitting here going, "OK, Hendrik, that sounds really good. But according to my watch it's been about 11 years since I could do this." [Laughs]
H. Bessembinder: Yeah. Yeah. I hear you. It has been a long wait for the value people.
Dan Ferris: Yeah. And actually, all the people. Like the growth versus value or foreign versus US is another one. Or, commodities versus stocks, those kind of things. All of those – the other side of all of those – we're all sitting around here going, I'm tired of posting the same chart that shows the relative performance going down and down and down and saying, "This has to be the moment." [Laughs]
Corey McLaughlin: Right.
H. Bessembinder: I hear you. I hear you.
Dan Ferris: I've been posting that chart for three years. [Laughs]
Corey McLaughlin: Right. Which brings me to – but then you think about that with the Mag Seven or whatever stocks you want to say, and then I go to like Hendrik's work here and I'm like, "Well, this is what has happened over 100 years. So should we be surprised by it?" But like what you said, you can make different conclusions, I guess, based on your preference.
Dan Ferris: Yeah.
H. Bessembinder: Yep. Yep. There's more than one way – different people see the evidence and interpret it differently, and in some sense two things can be right at the same time.
I'll just throw out one more thing about the Mag Seven and the concentration of the indices. I do think it is the norm that we will get concentrated outcomes. It's, of course, a different thing to say that the ones that are current, today's Magnificent Seven will be 15 years from now when people talk about the Magnificent Seven and Magnificent Eight, will they be talking about the same firms? That we're much less sure of.
But the point I actually wanted to make, diversification is a powerful argument. The fact that you can reduce risk by diversifying is powerful. Now of course, you also reduce skewness. So if you wanted skewness, or if you think you can exploit skewness because you're skilled, diversification also reduces skewness. So keep that in mind.
But anyway, diversification undeniably reduces risk by most measures. And as I said, I'm a finance academic and I teach this material in my courses, and something that's often said is that the most diversified portfolio is the market portfolio. It's either said explicitly or it's said implicitly, and the market portfolio is value weighted. I mean we really do live in a value-weighted world. But I'm not sure that that really follows, that the market portfolio is necessarily the best diversified portfolio. The Magnificent Seven has a big weight in the portfolio, and portfolios with less weight in those stocks might arguably be better diversified.
Dan Ferris: Mm-hmm. Yeah, we've definitely –
H. Bessembinder: And, you know, index fund –
Dan Ferris: Go ahead.
H. Bessembinder: I was just going to say value-weighted index funds is the easiest one probably to create. But there are other ways to build index funds, and this might be an opportunity for people to consider offering some index funds with alternative weights. And maybe the smart beta people are already doing that.
Dan Ferris: I was going to mention Rob Arnott from Research Affiliates, who they are, you know, smart beta pioneers. And we discuss fundamental weighted indexes, and I think even just good old RSP – that's the ticker for the ETF – of the equal-weighted S&P is interesting.
H. Bessembinder: Yeah. Yeah, the equal versus value-weighted thing is very interesting. People should be aware that equal weighting does require more trading, because your weights drift and you have to rebalance again. But I think it's worth considering the alternative – value-weighted is not the only way to go. In aggregate it is. If we look at all the investors out there, all the investors together have to hold things in their market weights. That doesn't mean every investor has to.
Dan Ferris: Yeah. I want to see a line of ETFs that do the – I don't know what the technical term for it is, but just the snapshot S&P 500, possibly equally weighted. Like the thing constantly changes – they're constantly adding and changing names in it. But there's been some work to suggest that some of the better performance has come from not doing that, from just buy the 500 and then forget you own them for however 20 or 30 years, rather than constantly believing you have to have the index as most recently updated.
H. Bessembinder: Right. Yeah.
Dan Ferris: I don't think I'm going to see that, but I would like to.
H. Bessembinder: Well, I think there's room. We should be thinking about these things collectively, thinking about the alternatives to just tracking an index that somebody created.
Dan Ferris: Right. So do I dare ask, Hendrik, Do you own T-bills? Do you pick individual stocks? Do you want to talk about that at all? If you don't, it's perfectly fine.
H. Bessembinder: No, I don't mind talking about it. I am not a stock picker. I've never bought an individual stock. It's a comparative advantage thing. I like to think I'm good at researching the data sets and teaching. It's also related to just once you're spending most of your time on one thing that you seem to be good at, how much time do you have to free up? But anyway, for whatever set of reasons, I've never been a stock picker. I tend to use low-cost index funds or low-cost funds and low-cost ETFs. That doesn't mean I'm a completely passive investor. I have at times sensed that there were some opportunities. And then, we're not all identical, and we're not all at identical stages of our life cycle. There are some things that I think potentially make sense at some points in your career that might not at other points. So big picture, I have used broad index funds, but I've made some strategic moves.
I've been concerned about inflation for a long time, more than some investors are, and I remain concerned about inflation. And you know that personal perception of mine led me to do things like buy single-family homes for investment purposes in the wake of the financial crisis. And I feel good about saying that I got into that before the big institutions got into that, but I did. And that did turn out well, and I'm glad it turned out well, but I did it mostly for inflation protection.
Corey McLaughlin: You were concerned about inflation that long ago, coming out of the financial crisis?
H. Bessembinder: Yeah. I've been concerned about inflation ever since QE2 kicked in. And for those who want to point fingers, they could say, "Well, there was a good 10 years in there before we actually had any substantial inflation." And they're right. But sometimes you like to be insured, even if the event doesn't happen. [Laughs]
Dan Ferris: Right. That's right.
H. Bessembinder: With that in mind, I've also – I've built a TIPS ladder recently. I'm getting closer to where I might think about retirement. You can get 2.5% real on TIPS these days. So Government Guaranteed Inflation Index, 2.5%, could be worse. So I've locked in some of that. It seemed like an opportunity to me.
Dan Ferris: Yeah, 2.5% real is great, too, just for our listeners' sake.
H. Bessembinder: Yeah, historically 2.5% real with inflation protection, I think is by historical standards a pretty good deal. It's harder than it should be to get into a TIPS ladder is one of the things that I've learned. [Laughs] It seems like institutions should be facilitating making this easy for people to do should that be something that they think makes sense for them.
Dan Ferris: Yeah. Did you actually find someone to help you, or did you have to sort of do the work yourself?
H. Bessembinder: I kind of had to do the work myself. There were actually hurdles that – I won't mention individual institutions or organizations, but in some places, it was way harder than it had to be, and I had to get around those hurdles to get it accomplished. I had one case where a retirement fund, they would let me buy stocks and ETFs. So if I wanted to buy a triple inverse ETF I could have, but they would not let me buy individual Treasury securities. So I'm wondering who made these rules. [Laughs]
Dan Ferris: Isn't there something out there called the Prudent Man Rule? Maybe they're not under that because they're not advisers – I don't know. But yeah. [Laughs] It's not good. That's not in the best interest of the client, for sure.
H. Bessembinder: Yeah, I've also tilted recently towards dividend-paying ETFs. And I can't predict the future.
Dan Ferris: That's [crosstalk]
H. Bessembinder: I can't predict the future, but I can say that valuations are not cheap. And my thinking is that should there be a downturn. I'm at least optimistic that dividend-paying ETFs will be less affected than some other possibilities. Anyway, these are things that just seem to work for me, but I'm not completely passive, but I'm not a stock picker either.
Dan Ferris: All right. Just sounds wise to me. It sounds like something a lot of people should do. I think a lot of people go in and they treat the market like it's some sort of a lottery, and they think they're going to really crush it really fast. And we've seen – speaking of passive effects and other sort of market structure issues, I'm still – I remain fascinated with the meme stocks and the persistence with which people maintain that they were never going to sell them and they were going to go to the moon and stay there apparently, when really what they were was these enormous short-covering episodes. And one should think that, well, once they cover, it's kind of over.
H. Bessembinder: Yeah, I hear you. The meme stocks – interesting, puzzling.
Dan Ferris: Yeah, puzzling.
H. Bessembinder: I haven't looked recently, but I don't think GameStop has ever gone back to its pre-event price, which – puzzling. I teach the market efficiency theory in my classes, as I should, but I present evidence pro and con. GameStop and the other meme stocks are now my exhibit one against the efficient markets theory.
Dan Ferris: Right.
Corey McLaughlin: Yeah, I would say, "What's up for class tonight? What do you got going on? What was the topic tonight?"
H. Bessembinder: Well, I'm just teaching an introductory MBA course, so it's really basic stuff. The firm's objective – actually, I get a little philosophical, because the textbook says the firm's objective should be to maximize shareholder value. But of course, much of the world says otherwise. So I try to get out there for them, where the textbook author is coming from or why is this not a ridiculous idea, which some people might say it's a ridiculous – or might react "That's a ridiculous idea." So I try to get out for them what do the textbook authors have in mind? But then the people who criticize that, what do they have in mind.
So I'm not trying to tell them the answer. I'm just saying, "Let's understand where the textbook authors are coming from. Let's understand where that could be criticized." So we'll talk about that tonight, and then then we'll just get started on discounted cash-flow valuation. We'll do some bond valuation, calculate some yield to maturities, fun stuff like that.
Corey McLaughlin: Yeah.
Dan Ferris: Oh yeah, good, fun stuff. A common criticism by lots of – by Warren Buffett no less – a lot of what you learn in your studies as an MBA doesn't really apply. What do you say to that?
H. Bessembinder: Well, first thing I'd point you is the market test. I've been teaching MBA students for, OK, I'll go ahead and confess, about 40 years. And demand has grown, not shrunk during those 40 years. And I know the Wall Street Journal ran a couple articles in the last week that demand is down a little bit relative to the really high levels, but as a secular thing, demand for the degree has grown by leaps and bounds over the last 40 years. So I think there is a market test there. You can't disrespect Warren Buffett for the obvious reasons, but there is evidence that there's something valuable there, or that the market perceives as valuable.
Dan Ferris: What do you think that is?
H. Bessembinder: One of – well, what I try to get across in my class is we give you a structure for thinking about things, microeconomic theory, financial theory, portfolio theory, discounted cash-flow valuation. We give you a structure, but then I've also got this quotation, and gosh, I'm embarrassed, because at the moment I'm forgetting the name of the person whose quotation I draw. He was a Goldman Sachs analyst, very well respected. But the quotation in its essence says that you not only need to understand the formulas, but you need to overlay judgment and common sense.
So I think when people criticize what we teach – I know my own side of the MBA degree best, the finance side – when they criticize it, it's because sometimes maybe people come out knowing the formulas, but not necessarily having the judgment or common sense. So the really successful people – one way to put this sometimes, I say net present value analysis to decide whether to make a real investment, and occasionally somebody will say, "Well, I know this entrepreneur, and he doesn't really use spreadsheets. He just goes with gut feel." My reaction is, "Well, some people have really good intuition for figuring out what situations are going to give rise to a positive net present value, even if they don't personally do the calculations." Because there are certain circumstances that allow for, again, using economist speak, the economic profits. If you're computing a positive net present value, you're assuming there's economic profits, rates of return above the normal in your field. Some people have a nose for finding those intuitively. Other people can use the spreadsheets to help them at least do a reality check.
Anyway, I think good financial management, whether it's deciding whether to do a real investment, deciding what to do with your financial portfolio, it's a combination of the models and common sense and judgment.
Dan Ferris: Judgment. Yeah, it's hard to teach that one, isn't it? You can't really teach it, can you?
H. Bessembinder: [Laughs] Case studies are useful, but when push comes to shove, you're right, it's hard to teach common sense. [Laughs]
Dan Ferris: And as far as the definition of the firm, what the firm should be, as soon as you said it should be about maximizing shareholder value, basically the textbook definition, I thought, "I wonder if you could go through one of these books, like The Outsiders – the book about all the great investors – and just ask each one of those people who built these amazing companies that compounded at enormous rates over decades and decades, what would they say? What would Steve Jobs say? What would he say is the purpose?" I think he'd say, "Well, it's to make insanely great products and thrill your customers" or something like that.
H. Bessembinder: Mm-hmm. So I agree. And actually, it would be wonderful to have been able to pose that question. There must be somebody out there who has tried to create an interview series along these lines. But circling back to your point, maybe Steve Jobs would've said the goal is to create incredibly good products.
Another one of the points I like to make is that the goal of maximizing shareholder value and some other goals that are sometimes stated, other stakeholders, people sometimes call it, but your customers, your employees, you can't be ruthless towards your customers and your employees and expect to maximize your shareholder value. You've got to treat your customers and your employees well to maximize your shareholder value. So the conflicts are not as great as some people make them out to be. And I think Apple is a great case study in how putting out world class products is really good for your shareholders. Really good for your shareholders.
Dan Ferris: Every now and then we hear about a CEO who's a real hard-nose type. But the real hard-nose types I hear about are the traders. I was reading about Bill Gross today, and I've read about Steve Cohen a little bit, and some of these people, they're just absolutely brutal. I do know one entrepreneur named – he's a very famous guy named Robert Friedland, who's a friend of Steve Jobs, and has a bit of a reputation as a rough guy to work for. And I don't know, maybe they're the exceptions to the rule, and you just get so much out of being with them that it's to your benefit. But, man, I'll tell you the few times anybody's gotten rough with me over the years I thought, "Well, maybe I should quit now." [Laughs] You know, if that's the way it's going to be. So yeah, point taken.
H. Bessembinder: [Laughs] I don't know, the thing about traders, we talked about how the signal-to-noise ratio is not very high. Even the best traders have some bad days and bad months, maybe bad decades. [Laughs]
Dan Ferris: Right. Well maybe – Hedrik, maybe the key to getting rid of the noise is just to like throw objects at your traders on the floor. Maybe we've got it all wrong here. Just be more brutal than anybody else, and that gets noise out of the room.
H. Bessembinder: [Laughs] I don't know, I'm not a human resources expert, but I have certain doubts creeping up here.
Dan Ferris: Yeah. Me, too. All right. We have come to the time when it's time for our final question, which is the same for every guest, no matter what the topic.
H. Bessembinder: I know I should've reviewed some prior videos. [Laughs]
Dan Ferris: No, no, no. I believe it works best when you don't anticipate it and don't know what it is.
Corey McLaughlin: Right.
Dan Ferris: Others have said that, too. But here's the thing, if you've already said the answer and you'd like to repeat it, feel free to do so. That's great. And the question is simple – it's for our listeners. If you could leave them with just one takeaway, if you could leave them with one thought today, what would it be?
H. Bessembinder: You know, this is a little bit like asking, "What's your favorite movie?" Because there's so many good movies, or what's your favorite book.
So I'm going to answer, and this is a little bit outside of say my research or the papers we've been talking about, but it's something I've always tried to do, and I think it has paid off in a big way in the long run. And it's nice and simple. Deliver more than people expect.
Corey McLaughlin: Oh, I like that.
Dan Ferris: Yeah.
H. Bessembinder: I think that'll pay off in the long run.
Dan Ferris: Perfect.
H. Bessembinder: And the flip side will come to bite you.
Dan Ferris: Yeah. Although you could argue that the flip side is something a friend of mine's father told him, which is that in life you always get out of something what you put into it, or a little less.
H. Bessembinder: [Laughs]
Dan Ferris: So always give a little more than you expect to get, right? Very wise words. Hendrik, thanks so much for being here. I've really, really enjoyed talking with you.
H. Bessembinder: It's been my pleasure, Dan, Corey.
Dan Ferris: All right. Thanks a lot.
Corey McLaughlin: Thanks.
H. Bessembinder: Certainly.
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Dan Ferris: Well, I enjoyed that. I enjoyed talking with one of our academic heroes, if you will. I think I wrote an issue about that paper that we discussed many, many years ago. Because it's such an unexpected finding that most stocks lose money and you've got to be really good at this if you're going to pick individual stocks. I found that interesting. I found Hendrik interesting. He does all kinds of things.
Corey McLaughlin: Yeah, it was nice. That's an academic with common sense, right? [Laughs] And he's trying to teach that way, too, which is nice, which is what you would want if you're going into an MBA program, or what I would want.
Dan Ferris: Yeah. We trust him a little on the MBA, the value of the MBA, and he had good, reasonable answers.
Corey McLaughlin: Yeah. Like yeah, you want to learn the fundamentals and learn the textbook but also have some judgement. And you're right, you can't teach that, but it's kind of the way he ended up writing this paper in the first place. He thought he was done after he was working on one thing, and said, "Oh, turns out a lot of stocks have a negative return over a really long period of time" and then it sounds like he mentioned that to a colleague or two and they're like, "Oh, I didn't know that." And then you say that to a lot more people and they all didn't know it, including me. And I know a lot of people didn't.
So again, if you go to Arizona State's website you can find all of his research. The one we were talking about, "Do Stocks Outperform Treasury Bills?" you can find it. You can download all the data he was talking about, too. So it's interesting. Essentially it said 96% of stocks are basically returned the same as one-month T-bills over 90 years is what it was.
Dan Ferris: Wow.
Corey McLaughlin: And 86 stocks accounted for $16 trillion in wealth creation, which was half the stock market total during that time. So it's really mind-blowing when you get into it, and it was cool to hear the story behind it.
Dan Ferris: Yeah. Yeah. The nuggets in that paper are, I agree, truly mind-blowing. So that's another interview, and that's another episode of The Stansberry Investor Hour. We hope you enjoyed it as much as we really, truly did.
We do provide a transcript for every episode, just go to www.investorhour.com. Click on the episode you want, scroll all the way down, click on the word "Transcript" and enjoy. If you like this episode and know anybody else who might like it, tell them to check it out on their podcast app or at www.investorhour.com, please. And also, do me a favor, subscribe to the show on iTunes, Google Play, or wherever you listen to podcasts. And while you're there, help us grow with a rate and a review. Follow us on Facebook and Instagram, our handle is at @InvestorHour. On Twitter our handle is at @Investor_Hour. Have a guest you want us to interview? Drop us a note at Feedback@InvestorHour.com or call our listener feedback line: 1-800-381-2357, tell us what's on your mind and hear your voice on the show.
For my co-host, Corey McLaughlin, till next week, I'm Dan Ferris. Thanks for listening.
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