David Macchia: There’s a lot at stake for people as they approach retirement, many with arguably insufficient assets, or certainly not the optimum amount of assets. Making that money last as long as possible and protecting it as well as possible is an important goal. I’m wondering how you look at how the financial industry may respond as the financial need changes for millions of people — from accumulating retirement assets to generating durable, and hopefully, inflation-adjusted retirement income.Well, I’m very optimistic for the following reason. Sometimes a need arises, an important need or a social need or economic need arises, like global warming, and we don’t have the technology yet to address that need. But, in this area, namely the idea, the need for products, investment products, savings products, that offer adequate protection, there’s a huge need, but there’s also an available technology.
I mean, the last 30 years have seen a revolution in the science of financial risk management. Not just a science, but also the technology of financial risk management. The lives of derivatives markets, swaps markets, options markets, these are all, right at the moment, these are all markets where institutions are active, buying and creating risk management mechanisms, large banks, and so forth. But that technology is ripe and ready to be employed at the retail level, at the level of individuals. And so, I think that within the next year we’re going to see the rapid evolution of financial products that combine downsize guarantees against market risks with participation in the upside, or at least potential for upside growth. I’ve called those the consumer products, the financial consumer products of the future. But they’re actually here in many places. I mean, as you probably know, an example, a fairly simple version of such a product, is a mass market product over in Europe, and that’s the equity participation note.
It’s like a convertible bond. Basically, it guarantees you that you’re going to have, at the end, at least the value of your money back, maybe with some interest, and on the up side, you can get significant participation in the appreciation of underlying equities. So that, to my mind, is sort of the prototype for the consumer product of the future, and it’s even here in the present. It’s this entirely feasible technology. We see that these products are starting to be rolled out now in the retirement market. And the number of companies that are offering principal protection even with inflation protection, including rollover products for IRAs, will increase. In fact, at [Boston University], at my urging, we’ve adopted for our employees a class of rollover products that are available through www.incomesolutions.com. A retiree can go and get competitive bids on inflation-protected lifetime income from AA rated insurance companies, and you actually get to see apples-to-apples comparison between the picks. That makes me very optimistic.
I think that’s very important, and I know that you know of my interest in structured products. In fact, you recently provided me an opportunity to speak to your MBA class.That’s right. You did a great job.
Well, thank you. I’d like to get some of your vision about how you see the marketplace in the future changing, especially in the context of the debut of structured products in the retail market, which, I think, we both believe is going to happen on a broad scale, and probably will make a big impact.Well, let’s just take an example of how you can have standardization, transparency and a good deal of choice and customization in structured products. And, again, I like to use the principal protected note with equity participation as an example, because it’s very simple to understand. You can decompose it into a bond and a fraction of a call option so that it could be analyzed easily. That’s great for clients we’re teaching, but it’s also great for explaining it to ordinary people, as I do.
This is a chapter in Worry Free Investing, where I talk about these products. The beauty of it is this: Let’s say we’re standardizing, we’re saying what you’re going to get back is the minimum of your principal. OK? So you put up $100,000, or $10,000, or $1,000, and, at the maturity date — and you can choose the maturity date, let’s say it’s five years from now — the least you’re going to have is you’re going to get your principal back. Then there’s some standard equity index, let’s take the best known probably in the investments field, and that’s the S&P 500, domestic equity. There’s something we call the participation rate, which is, at the maturity date, what fraction of the increase in that index [you are] entitled to. Now, just like with the inflation-protected annuities that you can compare, it’s all apples to apples. You can compare the terms you’re getting on this investment because, you know, you’re getting downside protection. So you know exactly how much you had, the maximum you can lose, abstracting of course from the default risk. We need to somehow have a way of correcting for that, but let’s say these are all AA or AAA issuers, which typically they are with firms like Merrill Lynch, others. With banks this could even be FDIC-insured on the downside.
On the upside, you are promised some participation rate, let’s say it’s 90 percent of the appreciation in the S&P 500, right? So if the S&P 500 doubles, it’s twice what it was, at the maturity date, twice what it was when you put your money in five years earlier. You’re going to get 190 percent of your money back. That’s an investment product that is very easy to understand, especially if you compare it to, say, a target-date mutual fund or a value-oriented mutual fund, or a growth-oriented mutual fund. None of those descriptions of mutual fund strategy mean much to the average consumer. There’s a reason for that, and that’s because the mutual fund isn’t really promising anything. It’s trying to characterize the nature of the investments it’s going to hold, but even if you buy a target-date fund, say, with a target date of 2020, what exactly are you being promised in the year 2020? And the answer is nothing.
Or best efforts.Well, it’s not even best efforts. What they’re going to be doing is following a predetermined asset allocation strategy, the outcome of which is unpredictable. So it’d be like you’re buying a car, and they’re telling you here’s what the car is going to be composed of. It’s going to have these inputs, but we can’t guarantee that you’ll be able to even drive down the street in it because we’re not issuing any performance guarantee.
Well, you bring up another important point. In the course of my own experience of developing retirement income solutions since 2003, we’ve trained a lot of financial advisors, and we see that their tendencies are to try to port over accumulation logic into the distribution phase. And we see mutual fund complexes that are trying to maintain the accumulation mindset in distribution-era product development. How do you see that playing out?Well, I think the accumulation logic was wrong to begin with.
Does that make it doubly wrong in retirement?All of that was fallacious, the notion that all you have to do is hold on long enough and the risk goes away.
Okay, so, now here you have structured products emerging with a value proposition that is extraordinarily compelling — protection combined with upside growth potential.Yeah. Well, that logic applies whether you’re talking about the accumulation phase or the payout phase.
Right. But, you know, I saw the power of that with the equity-indexed annuity, which debuted in 1995, and although, regrettably, the indexed annuity business fumbled the ball through progressively ever more inferior product development, the underlying value proposition was so compelling it drove almost $30 billion worth of sales at the high point.Yes, that’s right. But the problem is cost. I mean the challenge for the industry, the big challenge for the industry, is to mass-produce these products, allowing some degree of customization, while maintaining transparency. They have to be sold for what they are and not hyped. We’ve got to do it through direct sales through plan sponsors to cut out the high selling expenses. Again, an analogy — automobiles for people in the upper income brackets were around for many, many years before automobiles became a mass market. You look at some of those early automobiles from the early part of the 20th Century, or even before that, and they are masterpieces, they are just gorgeous. That is the equivalent of private wealth management. Some of the most sophisticated financial engineering goes into solving the problems, the wealth management problems of multi-millionaires today. The trick is to find the model T that’s going to make this affordable for the masses.
And I believe that will happen.Oh, I’m convinced it will happen. And I do agree that it’s going to happen when the boomers retire, because that’s when they’re going to have to reckon with the fact that if they’ve got losses in their portfolio, they’re real losses. What happened in 2000, 2001 and 2002 is that boomers just stopped opening their statements, which is the equivalent of burying their head in the sand. It didn’t affect their standard of a living. But once you retire, it does affect your standard of living if you’re living off that income. So I agree with you, that is what is going to be the trigger.
I made the point at your class that technology has created an ever more transparent world and products that are opaque create friction. I do think that the boomers will not tolerate anything but transparent structured products and I think it’s likely that structured products will enjoy phenomenal growth, and it won’t take long.Right, and there’s also the advent of the Internet where it’s so much easier for people to compare, for consumers to compare. I mean now they talk about consumer empowerment; it’s still in its infancy, but it’s clear what way the trend is going.
Could you talk about your life, where you grew up, how it began for you?Sure. Well, I grew up in Brooklyn, was born into a working-class family. Both my parents were born in the United States. They were first generation, and their parents had come from Eastern Europe as immigrants. Actually in the 1800s from Russia and Hungary. I guess the best way to put it is to say that it was very similar to the upbringing that has been depicted in Woody Allen’s movies. But, you know, there are so many well known movies about growing up in families of Jewish immigrants, so it’s that kind of a background. My grandfather, who was really the most cultured member of the family, I mean, no one had gone to college, not my parents, not my grandparents. My grandfather, though, was a producer/director/actor in the Yiddish Theater. He had a repertory company in the early part of the 20th Century. His company toured all over North America, wherever there was an immigrant Jewish community, a Yiddish speaking community of any size. They performed plays and repertory, including a lot of Shakespeare. My grandfather knew all of Shakespeare’s major plays by heart, in Yiddish translation.
My grandfather was already retired when I was born. He was born in 1879, and he died at age 90, in 1969. He was an enormous influence on me, very theatrical, as you might imagine. He was a fascinating guy. My father was a plumber, and I, as a young person, would work with him on weekends. During the summers I was a plumber’s helper. And, so I grew up very much understanding the situation of working class people, having been one. We were never poor, but we were, never even remotely rich. I mean, my father never took a vacation. Never.
Actually, I do remember one. One summer we went away for two weeks, and that was the only vacation that I remember growing up. I even remember where we went. It was in the Berkshires, in Pittsfield, Massachusetts. Every time we’d drive past that lake I’d point out to my kids where we stayed. Anyhow, at age 13 or thereabouts, I got involved in a group. I was born in ’43, so this would’ve been 1956. I got involved with a Zionist group, and its orientation was towards getting Jewish youth to settle on the Kibbutz in Israel. And I was attracted to that. I just liked the idea of a cause, and, of course, when you’re that age, you think that socialism is the answer to all of man’s problems. You know, brotherhood. And, of course, a hypothetical society always works better than an actual society. So, I got involved in that for a number of years. Then, when I graduated in 1960, I went for a year to visit Israel, spending part of my time on the Kibbutz. I resolved that I was going to come back some day and settle there.
At that time I was 17 or 18, and a true believer. When I returned from that year in Israel my dad had a heart attack and died. All of a sudden things changed. I had a younger sister, who was only 8 years old. Mom was about 49 at the time. So I went to work. I had started college, and I worked and went to college at the same time. For about a year I really didn’t have much time for anything else. Then, my mother remarried. I got involved once again in the Zionist movement, and eventually, I settled in my Kibbutz in Israel, I was 23. By this time I was going with a steady girlfriend who also was involved in the Zionist movement. She was two years younger than me. She is now my wife of 40 years.
So, we’re living on the Kibbutz, and she got along just fine. But I became disillusioned with socialism for a variety of reasons. Well, with the Kibbutz, anyhow, which I guess is as good as socialism gets. It was a very democratic society, but people are people, and I just realized that living that life was not what I wanted to do.
So I went back to school. I went to the Hebrew University in Jerusalem and got a masters degree in Economics. I then went on for a doctorate in economics. By that time, I had gotten married, and we had our first child. In 1970, we came back to the states so I could work on my Ph.D. in economics at MIT. I arrived there at exactly the right time because, in 1970, MIT was the center of the new discoveries in financial economics.
Bob Merton had just finished his thesis under the direction of Paul Samuelson. They had already written their landmark papers of 1969 on Lifecycle Consumption and Investment Decisions over time, which are still sort of the watershed articles. Merton accepted a teaching position at the Sloan School at MIT, and I was in the very first class that he taught as a graduate student. I was 27, he was 25. So, I was sort of an older student among the graduate students. At that time Myron Scholes was on the faculty and Fischer Black was consulting, but he participated. He was working with Myron Scholes on the famous Black-Scholes paper, as well as other papers, and he was participating regularly in the finance seminar at MIT. Talk about being there, you know, at the right time.
And of course Franco Modigliani was there and also Stewart Meyers. They were in actually in the early stages of their careers. Not Franco though, Franco was a senior person, but, you know, this was 1970. Paul Samuelson said that he was younger than I am now. I mean he was in his 50′s. So it was quite an exciting place to be, and that is what sort of shaped, my, shall we say, introduction into the world of finance. I really considered that period the critical turning point in the development of finance as a science.
At what point in this process did you decide that you wanted to spend your life teaching others?Well, that happened a lot earlier. That happened even when I was on the Kibbutz. I worked as a teacher for a while. I was actually teaching science to kids who were in the high school. I always wanted to be a teacher. I loved being a student. I had gone to the best public schools. I had gone to Brooklyn Technical High School, which is one of the finest high schools in the country. It’s an exam school with free tuition, and then I went to Brooklyn College, which was part of the University of the City of New York which is also a very, very good school, and free.
So, I got a free public education and a very fine one, and had been an outstanding student. I had won all sorts of awards as a high school student, and I knew I wanted to be a teacher. That was a given from a very early age. I should say, even when I was in the Masters Program at The Hebrew University in Jerusalem studying economics, I was teaching economics in English to students who were visiting from abroad.
Was there something special about that MIT environment that made you a different individual today?Without a doubt, in terms of my intellectual development. The person who had the greatest influence on me, and there were a number of them among the senior group including Paul Samuelson and Franco Modigliani. But Bob Merton and Stan Fischer were my two thesis advisors, and those guys had a powerful influence as well, particularly Bob Merton. But Stan Fischer, who later went on to become the Vice-Chairman of the IMF, and now the governor of the Bank of Israel, was an important influence, too, and my principal thesis advisor. My thesis, which I completed it in 1975, was on the topic of hedging against inflation. Very much a finance topic that was linked to what was going on in the real world, because the early 70s was a period when, in the U.S., inflation reared its ugly head for the first time in a long time.
That period was called a period of stagflation, during the Carter era of 1976 to 1980. In the 70′s, there was something called the misery index, which was the sum of the unemployment rate and the inflation rate. The inflation rate, as measured by the CPI, was in the double-digits. Unemployment had been in the normal unemployment rate but was ratcheting up, and by the end of the decade, most of the economists were saying 6 percent is sort of the normal level of unemployment that we should expect. So, of course, everyone was surprised when it came back down to 4 percent some years later.
I remember that when I came to Boston in 1970, that that was the low point in the economic history of Boston, because that was exactly when the big turnaround occurred. New England in general, and Boston in particular, had seen its traditional shoe manufacturing and other manufacturing industries bought out, and it was before high tech developments in medicine and in computers starting taking off. It was the beginning of what later became known as the Massachusetts Miracle. Remember when Dukakis ran for President in ’88, and he was Mr. Massachusetts Miracle? So I do remember that.
I quote from Nassim Taleb’s book “The Black Swan:” “Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. The turkey reminds me how so often the past is used to project a vision of the future that no one can guarantee. Yet this tendency to project drives so much behavior in terms of how people invest their money. You know what I’m getting at.Oh, I do know what you’re getting at. And it’s one of the hardest issues, not just in finance, by the way, not just in investing, but it’s true in general. It’s how we deal with uncertainty.
Let me elaborate on it in theme, because there’s a very, very, very important distinction that I would draw between my approach and the approach of Nassim Taleb. Nassim, I would characterize as a kind of nihilistic figure. He’s rejecting everything more or less. In fact, if you look at the list of people who are in line for very rough treatment from him, it includes Paul Samuelson and all the Nobel Prize winners. I mean, virtually, all of them. I, on the other hand, believe in the progress of science, particularly in the field of economics. And so, all of those guys are my heroes, and they came to be Nobel Prize winners. Now, that doesn’t mean that the work they did is the final work, and that the Black Swan is not, if you will, a real phenomenon. Let me give you an example, okay? Let me give you the counter example that, at the same time, makes his point and makes my point.
Suppose you are studying really the basics of probability. Take something that we’re all familiar with, which is coin flipping. Now, you know, on each toss of the coin, we say, the probability of heads is zero point five. Right? Now, that may or may not be exactly correct, because any particular coin you pick may be out of balance.
But let’s say it’s in perfect balance, you make the abstraction that we got from the coin, then we can study the outcomes. In particular, you know, you can study binomial processes by coin flipping. In fact, I do this with my students in class. So in the very first class, I have every student pick out a coin and flip it ten times. And, then, they report how many heads came up. The number of heads has to be between 0 and 10. And what you’ll see, you should get a probability distribution that looks very much like the normal distribution. Okay?
But the zero and ten have very low frequency and the most common outcome is going to be five, right?
Now, all that can be studied, and has been studied scientifically. It is the basis for much of the science of and the laws of probability, without which we would not have made much progress in other fields of science. Now, it is possible for you to flip a coin and it lands, not on heads or tails, but because it’s got a third dimension, it actually winds up standing on edge. Okay?
Your Black Swan.Right. Now, would you therefore reject everything else about what we’ve learned about the coin flipping?
You would not reject binomial distribution, and a normal distribution. Of course not. Depending on the purpose, I mean, if you want to study rare events, then you’d want to study that phenomenon and understand it better. But frankly, it’s going to be very, very difficult to model. And one reason it’s going to be difficult to model is because, really, at the abstract level, you didn’t even want that to be a possibility. You would have liked the coin to be not three dimensional, but two dimensional.
But, of course, in the real world, you never get exactly what you want. Just like when Galileo was dropping objects from the leaning tower of Pisa, they weren’t going to hit at exactly the same moment, the feather and the steel ball, because he didn’t have a perfect vacuum. Do you see what I’m saying?
So what’s the point of what Nassim Taleb is trying to say? I don’t see that anything really spectacular comes out of that, except for something that we all knew even before he wrote his book, which is – who was it who said this – our former secretary of defense: “There are the things we don’t know we don’t know.”
The unknown unknown. And that’s why, if you’re ever going to run a financial firm, you’ve got to have some reserve capital there to back up the promises you make, because stuff happens.
But we all know that. I mean, it’s not as if the scientists don’t know that. But we build our models so that we can make progress, not so that we can reject everything. Now, having said all that, most of the arguments that I have made, which run counter to conventional wisdom, and probably the best known of those in the practitioner community, is my claim that it is fallacious to believe that stocks become less risky in the long run than they are in the short run. What could run more counter to conventional wisdom that that?
But that point is actually well established in the scientific community. You know, when I say that to a fellow professor of finance, they say, “You mean practitioners really believe that?”
In my experience, virtually all practitioners believe that. And it might be helpful to practitioners to understand the research or evidence that shows that the belief is not well founded.Okay. So, first of all, my first exposure to the proof that that is a fallacy was as a student of Paul Samuelson at MIT. He had written a number of papers. The one that was specifically targeted at this was his 1969 paper on lifecycle investing. Where he himself said, you know, he thought he modeled that (stocks become less risky over time) right? And he thought he was going to find that when he solved for the optimal investment strategy, he would find that the longer one’s time until retirement, the more the individual would get out of stocks and into fixed income.
But making some very reasonable assumptions about the nature of stock market uncertainty, namely random law, and making the assumption that people have very plausible, rational preferences, he discovered that independent of one’s age, one would always want to have the same proportional exposure to stocks, when you look at the individual’s total wealth, in other words, include human capital in wealth.
Now, Samuelson proved it, theoretically, making very plausible assumptions. So, you know, as far as most academics are concerned, we’re done. Okay. He’s proved that it’s a fallacy. Now, he rewrote that article in various forms consistently over the years. I mean I can send you a version of it that he wrote in the late 90′s, for the first issue of Bloomberg Personal Finance Magazine. And, again, you know, it was the fallacy of time, diversification, etc. But he was ignored. I did not ignore him, and, in fact, I took it very much to heart unlike most academics. But I think what is somewhat different about me, and if I had to single out what is my distinguishing trait as an academic, it’s that I really pay careful attention to what practitioners are saying and try to reconcile conflicts between the results of academic research, or scientific research, and the advice being offered from practitioners.
This is one area where the gap has never narrowed. In fact, it’s gotten wider, and why that is, is a matter of speculation in part. I think it’s because there are certain illogical traps that people fall into when they think about the risk of stocks in the long run, and I’d be happy to go into that in greater detail although I, too, have written about this now quite a bit. In fact, let me tell you my addition to the Samuelson proof.
What I did is say, look. Let’s forget about people’s preferences, because with Samuelson’s proof, you do have to know some economic theory to understand it. So I came up with a different one that doesn’t depend on understanding economic theory. I said look, if it were true that the risk of stocks essentially goes away or extenuates in the long run, then we should observe the following. Let’s say, you, David, invest $100,000 in a diversified portfolio.
Now, ask yourself what if you had invested, as an alternative to that, in a risk free asset? It would be accepted that at the end of your horizon, the equities are worth– and you’re reinvesting all dividends, right, and equity, to the extent that the portfolio of equities is worth less than the compound value of your risk free investment. We call that a shortfall. Right?
Consider an insurance policy that pays off whatever the value of that shortfall is. That’s a put option. It’s a put option where the strike price of the option is the value you would have had from your $100,000, had you invested it at the risk free rate. Okay?
Now, if it’s true that the risk of a shortfall gets smaller and smaller the further out you go, what should happen to the price of that put option? In other words, let me say it this way: if we’re talking about the S&P 500, what’s a reasonable price for that put option that pays off a year from now? So it expires a year from now, and because of a shortfall, you collect whatever the difference is. That would cost you roughly $8,000 on a $100,000 portfolio.
Well, if the hypothesis were correct, if the risk of stocks goes down the further out you go, you should observe something. That is as you lengthen the holding period from one year out to 25 years, what should happen to the cost today of buying an insurance policy that covers you against the shortfall at the end of that period?
It should be less.And the exact opposite is the case both in theory and in practice. You can actually verify this. You look at the cost of put options. Now this is a European type put option, and it pays off only at the horizon date, it can’t be exercised before that. The price of that put option is approximately proportional to the square root of the number of years amortized. So if a one year shortfall insurance policy will cost you $8,000, a 25 year policy would cost you $40,000. And this isn’t hypothetical. In fact, I once gave an interview to a woman who was writing an article about this for Institutional Investor Magazine. And I said to her, look, this isn’t just theoretical. Why don’t you call up investment banks and ask them what they would charge for options, put options of this sort, of different maturities. And guess what she found? I even remember her name – it was Debbie Galant who wrote this article. She was a freelancer working for Institutional Investment. What do you think she found?
Not only were they more expensive, she was told by just about every investment banking firm they wouldn’t even write them. That they wouldn’t even sell a put of that sort, that had a maturity of more than eight years, because it would be too risky for them.
We have a situation where a conventional wisdom, perhaps a marketing machine, a vested interest, has created a system of belief around the notion of investing that time reduces risk and that stocks are a reliable hedge against inflation.Right. Both are fallacious. Oh, and by the way, this is an important footnote, since you brought up the Black Swan earlier. This is true under normal assumptions. In other words, under the same assumptions that are made for the Black-Scholes model and all the other models that have won Nobel prizes. So, the phenomenon would be even more pronounced if you allow for extreme events to have, you know, higher probabilities, which is what the Black Swan assumption is.
Right. I’ve been in many practitioner’s offices, Zvi, and looked inside conference rooms, and have seen, so many times, impressive looking charts that hang on the wall that are, perhaps, are based upon the Ibbotson or some other source of performance statistics that show a very, I would say, comforting history of equities — that seems to have this long upward swing from, say, I don’t know, 1927 through 2006. This long, comforting upward climb accounts for a lot of people putting a lot of money into equities.Right. You know, when I was a high school student at Brooklyn Tech, I took a course in economics. I had a wonderful teacher, and he had us read all sorts of books, and there’s one that I will never forget. It’s a classic, actually, called “How to Lie with Statistics.” And, what this book did was, it showed how you can display data in different ways so as to get some desired effect, same set of data, but when you present it in different visual form, people reach different conclusions. So, let’s take the Ibbotson data, okay? First of all, recognize that when you look at the chart that shows the actual path of the stock market, in other words, how much you would have had for each $100 investment made back in 1926, you’re looking at one, as we call it, realization path out of an infinite number that were possible. Okay? So you’re looking at–
In other words, ask yourself, suppose we simulate the possible paths that could have been taken by stocks starting in 1926, right through 2006, 80 years, okay? The one that actually occurred was a very positive one, but there were many other possible ones. In fact, there were an infinite number of other possible ones, some of which had very bad outcomes at the end of their years.
Okay. So that, in and of itself, the fact that we, when you look at the plot for the United States, and you look at where the market was in 1926 and where it is in 2006, and it’s grown enormously, you say wow, that’s impressive. That, in and of itself, does not prove anything. In fact, let’s superimpose a graph of some other country, which, back in 1926, or even go back to 1900, looked just as promising as the United States did back then. What you’ll discover – for example, say, Argentina or Russia. I mean, there were over 30 major stock markets in the world back then. Some of them had no realization, because their economies were so unsuccessful, right?
So, let’s say in 1926, you were a global investor, and you were thinking, “Gee, I’m going to diversify my portfolio across all existing stock markets.” And then you look at your return at the end of 2006, it wouldn’t look anything like what you got in the United States, because the United States was an outlier, on the positive side. If you only look at the most successful realization of a certain stochastic process, you’re going to get a distorted view. And just in case people, you know, think well, he’s relating to more or less very old data, I want to remind you and all the people who will be reading this, that as recently as 1985, most investors thought the Japanese economy was the one that was going to outperform the U.S. economy in the decades ahead.
Well, suppose you advance this, you know, $100 in 1985, and you plotted, where the market would be, you know, your investment be in 2006. You’d see this bigger run up between 1985 and 1989, and then you’d see an enormous decline. And it’s still ends in recovery. Here we are in 2006.
But think of what the Ibbotson data is, okay? It’s a plot of how much your money grows instead of looking at the PE ratios or looking at any fundamentals.
So, my point is, you can’t conclude anything on the basis of a graph like that. The second thing is, there’s another Ibbotson graph, and it’s not just Ibbotson, I mean, you find this everywhere, although Ibbotson, perhaps, is the best known that shows a frequency distribution, simulates rates of return over holding periods of different lengths.
The one that I like to use in class to illustrate how to lie with statistics, is one that you can find at the Smart Money University website, which, by the way, is black labeled for a lot of sort of other educational websites, and it’s this applet ,a Java applet. If you go to smartmoneyuniversity.com , and you look at risk, time and risk I think it’s called, there’s this Java applet where you prepare the range of possible outcomes for holding periods of different length of stocks, large cap stocks, small cap stocks, bonds, and bills.
You’ve seen this in one form or another. Ibbotson has all of this in PowerPoint that they sell, and so forth. Now, this is really an example of how to analyze a statistic. What you’re looking at is the range of outcomes of the average compound rate of return annualized. Well, any student of elementary statistics can tell you that, because that’s an averaging process when you annualize, the standard deviation, the dispersion of the distribution has to go down. It isn’t proving anything; it’s just proving something about how you’ve chosen the wrong way to represent the data.
Because if you look at the distribution of annual rates of return, you get a certain spread. So, it can go from, I don’t know, a high of 50 percent to a low of minus 40 percent in any given year. Now you lengthen the time horizon, and you look at the spread of the average annual compound rate of return, that appears to be smaller. Now, this is used as evidence for what? I mean, it looks like an arbitrage book. You know, if you go to 20-year holding periods, it looks like an arbitrage opportunity. It looks like the lowest rate of return you can get with equities is higher than the rate of return you can get on T-bills.
I mean, it’s ridiculous, and it gets worse, because I’ve seen websites where they actually truncate the distribution, so they get rid of the worst five percent. They say, here’s the 95rd percentile up to the fifth percentile. But, you know, all the risk, or most of the risk, is in that bottom five percentile. Think about all the things that we insure against, fat significant cost, that have probabilities of less than five percent of return.
Well, such as your fire insurance.Yes. To me, it’s crazy. And then there’s the simple logical argument that says as follows: If you ask someone, why do equities have a higher rate of return? Theoretically, the answer is because they have a risk premium. But if the risk goes away in the long run, what is the risk premium?
And how do you get this message across?Oh, yeah, that’s a great question. The answer is I use every outlet available. I’ve written a great deal. First of all, the investments book gives me a good platform, and a certain amount of credibility.
The first one was “Investments.” Now, that book grew out of a course I was teaching at BU in the 80s. I was using a textbook which, at the time, I thought was a fabulous book, by Bill Sharpe, on the subject of investing. But it had one great disadvantage, and that was that the students hated it. You know, it was one of these books that professors love and students hate. Now, of course, not all students, but most of mine at BU didn’t like the book, and, so, the most popular books were books that I thought were really crappy. So I developed this set of teaching notes to supplement the Sharp book over a number of years. There were two other younger colleagues of mine who were also teaching the course, and, so, I had them, as well, helping to develop materials. At a certain point it was suggested to us that we write an investments book. Here’s an interesting story. This was in the late 80′s. I guess it was 1986 or1987, and I get a phone call from Steven Ross, who is one of the greats in the field. He’s now at MIT. My prediction was someday he would win a Nobel Prize, and he got it. He said to me, you know, I’m technical advisor or scientific advisor to a publisher who wants to start a new list of textbooks in finance. The name of the company was Times Mirror Mosby, a very well capitalized company, and they wanted to break into this business.
He said, I think you should write a textbook on investing. He said, my plan is to someday soon write a textbook in corporate finance. So the two books would be able to sweep the market, because he knew my thinking about the existing books. I thought he was exaggerating a bit, but, first of all, I was very flattered that he was asking me to do it. I said, well, I think it’s too much for me to do, but I have two other colleagues here who have been teaching the course. We’re all doing it pretty much from the same set of notes, so maybe the three of us would do it. He said, alright, well, why don’t we meet for dinner and we’ll discuss it? We met for dinner, we discussed it, and he talked us into it. Thus was born the Bodie, Kane, Marcus Investment text.
Now, from humble beginnings, the book was not an immediate success, but by the first few editions, we started getting adoptions at the top business schools, and, simultaneously, by the way, Steve Ross had taken as coauthor Randy Westerfield, at Wharton School. They wrote their book in corporate finance, which is now number one or very close to number one in corporate finance. Our book is number one in investments. Of course, the original publisher, Times Mirror Mosby, got out of it from before the first edition was out because there have been so many reorganizations in publishing, so eventually it became a McGraw-Hill book.
Both of them are now published by McGraw-Hill. But the Bodie, Kane, Marcus investments text, I’m very happy to say, is an example of a crossover book, one that has the lion’s share of the business school market, the university market, and is also highly regarded among practitioners. You see it on a lot of shelves of people who are investment professionals, so that makes me feel very good, because that is, really, my objective: to improve the practice of finance by subjecting each and every sort of hypothesis or proposition to rigorous scientific analysis.
“Investments” has been translated into numerous languages, hasn’t it?Yes, about ten foreign languages now. The Pensions book has a very limited market, extremely limited, because it’s considered a specialized topic. The other textbook that I’ve written is one that first came out in 1997, and that’s an introductory textbook in finance. It’s really principles of finance. It’s aimed at the university, the college marketplace, and is coauthored by none other than Bob Merton, my original teacher. When we completed the first edition, and it came out, I was at the meeting of the Financial Management Association in Hawaii. This was in October of 1997, and while I’m there to kind of talk up the book, it is announced on the news that Merton was the 1997 Nobel Prize winner in economics.
Yeah, that is a Black Swan. I like that. That’s a Black Swan. Of course, the publisher, Prentice Hall, immediately was swamped, right at the meetings, was swamped with requests for examination copies, and he had to send a message back to New Jersey to rush additional copies of the book. The bottom line, that book, has had less success in the U.S. college marketplace because it approaches the introductory course from a perspective of principle of finance rather than corporate finance. The tradition in the U.S., in most business schools, is that the first course in finance should be corporate finance rather than just principles of finance that cover all the subfields for the investments in financial market, and so forth.
So, that book has had much more success in foreign translation. That, too, has been translated into about eight languages. It’s widely used in China. We’re now coming out with a second edition. We took a third coauthor, and the second edition is going to be out in this country in another month of two. We’re hoping, you know, it will catch on a little bit better in this country, too.
“Worry Free Investing” has been somewhat of a disappointment for me. Worry Free Investing was my attempt to explain to the layman how to think about investing. Namely, start at the safe end of the risk/reward spectrum, decide how much risk you’re willing to take, then layer that on top of your safe portfolio. And don’t believe people who tell you that equities are safe in the long run. As you might expect, I thought it would catch on. It didn’t catch on; it was buried. Now a brand new edition is coming out, but in the U.K. We’re going to try the U.K. market, and so there’s a U.K. edition of Worry Free Investing that will be published by Financial Times Prentice Hall. I have believers at the Financial Times. It helps that the mother company is Pearson, the biggest financial publisher in the world.
Sometimes books that we know over history have been extraordinarily popular weren’t best sellers when they debuted.You know, it’s funny you should say that, David. I was listening to NPR yesterday in the car, and they had an hour long program on “The Great Gatsby” by F. Scott Fitzgerald, which was written in the 1920′s or 1930′s. It’s now regarded by many literary critics and professors of English as the greatest American novel ever written. You’ve probably heard that, too.
And, do you know how many copies of that were sold at the time of F. Scott Fitzgerald’s death, I think in the 1940s? He was in his early 40s when he died, and had written that book in his 20s, so it’d been out for 20 years. You know how many total sales? 25,000. Do you know that today, 25,000 copies of that book are sold every week, according to this radio show.
And here is book that you’ve written to help ordinary investors safeguard their assets and have a more secure retirement, and one of the things I’ve known about you from the very first time I saw you speak, Zvi, and one of the things that I deeply admire about you, among many, is that you hold a deep and sincere passion, in my judgment, for what you perceive as the best interests of ordinary people.But, you know, I think that’s common to most people in academia who are doing scientific research. You know, it’s true. We’re in it to search for the truth, but it’s also trying to improve life for everybody. Think about medical researchers, for example.
Well, one aspect of life is life in retirement. And, you’ve done a lot of work that’s very relevant to the boomer retirement opportunity and you were recently awarded a prize in lifetime achievement by the by the Retirement Income Industry Association, a well deserved recognition.Well, I don’t know whether it was well deserved, there were probably a lot of other people who deserved it as well. Certainly, I’m very grateful for receiving it because that is an organization that I, as you know, since you’re active in it, endorse, and, therefore, it means a lot to me to have that kind of recognition.
Well, like you, I, too, feel that there’s a lot at stake for people as they approach retirement, many with arguably insufficient assets, or certainly not the optimum amount of assets, and making that money last as long as possible and protecting it as well as possible, is an important goal. I’m wondering how you look at how the financial industry may respond as the financial need changes for millions of people.
If I could somehow convey to you a magic wand and by waving this magic wand you could affect any two changes you wish to make, instantly affect these changes, in the world of finance, what would they be?Well, essentially, we’ve been talking about it and that is- don’t think we need a magic wand, I think the magic wand is Adam Smith’s invisible hand- I think it’s going to happen. We’re going to see the evolution of a whole new generation of products just as we see in other areas of our lives. Again think about computers, think about all these things we didn’t have a decade ago. Pharmaceuticals, medicine, etc. That’s the hallmark of our age. I think the area where I wish I could wave the magic wand would be, somehow, to get people to have a somewhat greater respect for science. Even today, far more people believe in superstition than who believe in science. Not just in finance, that’s true in medicine. I mean I’m sure it is the case that far more people believe in astrology, than believe in astronomy.
If you were not the Norman and Adele Barron professor of finance at Boston University, but instead could you have any other career in any other venue, what would you be?Well, I once wanted to be a stand-up comic. Some people say that that a lot of my ideas qualify as jokes.
I do know that you have some of your grandfather’s theatrical flair.Well, it’s not surprising, since he loomed so large in my upbringing.
And given that you’ve thought so much about the issue of retirement, I’d like to ask you about your own retirement. In its own perfect, idealized form, where will you be and what will you be doing?Well, again, my heroes are people who never retired. I mean, just take Paul Samuelson, he’s now, I guess, 93 going on 94. He’s still going at it, and whenever he’s asked about it, he says, “When am I going to retire? When am I going to start work?” You know, how does the saying go? Find a job you like to do and you’ll never work a day in your life.
We’ve covered a lot of ground and I’m deliriously thrilled with this conversation, I think you’re going to be really happy with this, I know that I’m delighted already. Is there anything that we have not hit on that you would like to address?Well, not in the realm of things that are going to interest your readers, because I’m sure they’re not going to want to hear my views about, you know war in Iraq, Afghanistan, or other such things, so I’m going to refrain from making statements about any of those.
Do you have any heroes in terms of philosophers or scientists?Well, Adam Smith, for sure. I think his two books, you know, his first book on moral philosophy, which he regarded as his greatest book; and then The Wealth of Nations. It’s the embodiment of principles of Enlightenment, toleration, science, you know, it’s remarkable it’s hundreds of years old. The Wealth of Nations was written– it was published in 1776, and, I do believe, that the United States was the product of the Enlightenment. The founders of this country were all, to a man, great believers in Enlightenment. You know, in most of the world today you still find countries and regimes that I would describe as pre-Enlightenment.
Zvi Bodie is a professor of management at Boston University. His latest book is Worry Free Investing.