Episode 408: Elroy Dimson – Investing & Optimism

Introduction

0:00This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, Chief Investment Officer, and Brayden Warwick, Financial Planning Product Architect at PWL Capital. Welcome to episode 408. I love the conversation that we just had, Brayden, and it's an episode that I have wanted to do for a long time. Professor Elroy Dimson is a busy man. I was on another

0:31podcast in the UK, and that person, Damien, is the Damien Talks Money Podcast, has a relationship with Elroy, and so he made an introduction, which finally got the connection made. We would have done this one sooner if we could have, I guess is the point of my long preamble, but I'm super excited

Guest Introduction

0:49that we got to talk to Elroy Dimson. He is a professor of finance and research director at Cambridge Judge Business School and Bi Fellow of Gonville and Caius College, Cambridge. He is also Emeritus Professor of Finance at London Business School. Listeners will likely know his name, Elroy Dimson, which is the D in the DMS data, which we've talked about many times because we use it a lot in our own research at PWL. We also did an episode, I can't remember the episode number, but we did an episode a while ago, something like Lessons from 100 Years of Stock Returns or something,

1:22where we went through a bunch of their past reports. They do something called the Global Investment Returns Yearbook that they've been publishing for many, many years now.

Global Investment Returns

1:32Right now, it's sponsored by UBS. Formerly, it was sponsored by Credit Suisse, but it's this just incredible book that they publish annually that details stock, bond, and bill returns for a whole bunch of countries all around the world. They also publish indices, which we, PWL, subscribe to. We purchase them every year, purchase a license to use them. And in their yearbooks, in the Global Investment Returns Yearbooks, they also, and he mentioned this during the conversation, they also do a couple of essays where they take a topic and they use their historical

Historical Data Analysis

2:04data to analyze it. So an example would be, what is the historical relationship between economic growth in a country and its stock returns or industry growth and stock returns? But they've got tons of these different essays over the many, many years that they've been doing this. And it's a wealth of incredible analysis and information. They've also got a very famous book called Triumph of the Optimists, which we also discussed. That book was the culmination of their work using historical data to reconstruct indexes for a whole bunch of different countries. And we talked about

2:37this during the conversation too. It really changed our knowledge of what is the equity risk premium?

Equity Risk Premium

2:42How much should you expect in stock returns relative to bond returns, which prior to their work had been heavily influenced by the US historical record, which we all know has been incredible, exceptional. And so their expansion to international markets really gave us more knowledge about what it might be reasonable to expect as an equity risk premium going forward, which was great. We're super fortunate and grateful to be able to talk to Elroy. We talked for about 90 minutes. Braden, any comments? What do you think of the conversation?

3:13Well, I think it was just so cool from my perspective as someone who's used the DMS data

Industry Growth and Stock Returns

3:18for years now. I use it all the time to just hear the origin story about why he decided to collect the data and all that went into it over the course of time. And then it just really brought the data to life to me to hear his perspective on it. Yeah, it was just such a cool conversation. Really a pleasure to talk to Elroy. He's got his academic experience, but he's also done lots of interesting investment committee work, including with Norway's sovereign wealth fund. It's the biggest single investor in the world. And he helps to form their whole setup and investment policies and all that

3:52kind of stuff. He's not just an academic, he's got real world experience dealing with people. And he talks about some of those types of issues during our conversation, people in committees and just making

Investment Committee Experience

4:03real investment decisions. An incredible wealth of wisdom that comes from both tons of time with the data and doing analysis, but also tons of time working with real humans, trying to make investment decisions based on the data and other inputs. That's a good introduction from Professor Elroy Dimson. Let's go ahead to our conversation.

4:27Elroy Dimson, welcome to the Rational Reminder podcast. Thank you for having me. It's a very pleasant afternoon here, but other people who are tuning in will be all over the world. Weather may be different where you are. It's actually a very nice day where I am as well. So that's good. Real quick, Elroy, super excited to be talking to you on the podcast. This is something that I've wanted to do for,

Studying Financial Market History

4:47we've been running the podcast for eight years now. You're someone that I've always wanted to have on. Super excited that we're talking to you. Well, it's exciting for everyone. Yeah, that's good. To start with the first question here, can you talk to us about why it's important to study financial market history when thinking about the future? It's extremely difficult to think about the future without knowing where you've come from. It's an integral part of a journey. If you don't know where the journey started, you can't start thinking about where you're going to end up.

Assembling Data for Triumph of the Optimists

5:17So what was the process like to assemble the data for your 2002 book, Triumph of the Optimists? That's an interesting story because when Paul Marshall, Mike Staunton and I, we all did our PhDs at London Business School, early on in our academic lives, textbooks all made very heavy use of American data and a little bit of British and a tiny bit of Canadian data. But basically, if you had what then was a standard textbook of Bradley and Myers, which now has

5:49another couple of co-authors, you would see some indications to what returns you might expect. But there was very little choice other than to recite what had happened in the United States. And so there was heavy reliance of the long-term data which had come out of the University of Chicago. Paul Marshall and I had done a bit on looking at the long-term for

Biases in Historical Index Data

6:12the UK. And there'd been one or two snippets of not very satisfactory research on the UK. But that was about it. And even Canada didn't really play a part. We, at that time, distributed our research. We began at the very end of 1999. We distributed it through a firm which sort of changed hands a bit. We had not changed sponsors much, except when there's been a corporate event amongst the sponsors. It became clear there was a demand to go beyond the American and British

6:46data that we had. And we were moving into a period of internationalization. Money was kind of free at the end of 1999, expecting 2000 to come along. And the global head of our own knowledge of the research that others were doing and of a practitioner who was thinking globally. And we liked that idea. And we worked through the run-up to New Year 2000 on producing a book which was privately published. First, we had a number of countries. But as we reached the end of 1999, we found that it was creeping up

Conclusion and Final Thoughts

7:23towards 10. The 10th was actually at quite a late stage. 10 countries for which we had accumulated 100 years. And we thought, that's a millennium of data. And so the millennium year came along. Our work got a great deal of publicity. But one of the things which nobody had noticed at the time was, when do you celebrate a birthday? So people were talking about the new millennium. It's a 1,000th birthday. Actually, you have a birthday. You are one year old when you're into your next year.

7:57So birthdays actually are calculated differently. And so people pointed this out. And by that time, we discovered data for lots of other countries. And the suggestion was, well, we should have Millennium Book 2 for the real millennium. And the real millennium was once there were 1,000 years behind us. And we were in the 1,001th or 2,001th year. So the story was one of evolution. And that was a big success. Millennium Book 2 then was an idea that Princeton University Press thought would be

8:30something worth bringing to people. And the book that you know, Triumph of the Optimists, a fiercely expensive book, which was released by us, building on something which we had already done in a private publication. There's still a few people around who've got the original millennium book, the millennium book too. It pops up on eBay from time to time. The little beginning was once we were into the current century. And we've had 25 years of running with it. It's been an amazing journey. When you're assembling the data, like when you say you got to 10 countries and you keep

9:02adding countries, what are you actually doing? Where is the data coming from? Our data set is primarily a compilation of data. So let me go backwards in time. What would we like now? Nowadays, we have high quality indices. And so if you start a particular period, we'll go back where there's a good quality capital gains index with an income series. Nobody would dream of telling you what the return is on treasury bills excluding income because it's a dollar. The value every year is

9:35a dollar, a dollar, a dollar, a dollar, a dollar. Equitas people would manage without income. And that's really strange. So we wanted data which cut us a longer period. We presented our data. I can tell you a bit about our very detailed data in a moment. Once we'd got that first book done, there was so much interest in it. We were presenting it all over the place to academics and practitioners. And every so often, we'd be in a large room. Question time comes along and somebody would say, you know, I've been collecting data like this for my country. It never occurred to me that anybody

10:09would be interested. And so we grabbed. By the time we had our first 10 countries, we had accumulated some long-term return series. But that rapidly went up after that. We used data which has often been assembled by other people in more recent decades commercially, before that, academics who were doing this job. They've been kind to us and we've been kind to them. We credit their work in great detail. And often we were able to extend it a bit. So for example, for South Africa, there was somebody who had done a study like the famous Ibbotson-Sinkfield,

10:45long-term return studies for South Africa. It was starting in 1940. But before 1940, South African shares were traded heavily as well in London. And so it was possible to use data to infill missing data. And so we've worked in a number of cases with people from other countries to extend the data sets and produce a series, which starts at a common date. So primary start date is a new year, 1900. It's drawing on contributions from scores of academics and scores of commercial data sets.

11:22Yeah, it's incredible. You mentioned excluding income, having just a capital gains index. Other than that, what are some of the biases and other issues that can affect historical index data? Well, when we first launched our research, we made some remarks about our predecessors' work. That really illustrated some of the challenges that you face. So early on, we reported on the premier index series for the UK. That was prepared by a predecessor of Barclays Global Investors,

11:55who you know of, although they've also changed ownership. That started with a stockbroking firm in the 1950s, hiring some general economists that weren't financial economists in those days, to produce a long-term history. And they wanted something which would represent the UK stock markets. The FT, the Financial Times Index, had begun in 1935. And they were going to go back further than 1935 to an earlier date. They wanted their series to look similar to the standard FT series. We wanted the

12:35pre-1935 data to be reflected with reference to the companies which were in the Financial Times Index after it launched. So we had companies from 1934, 1933, 1932. And as you went back in time, what the Barclays Global Investors Index or Barclays Capital Index contained was a set of companies that had done well enough to be big, and it left out the companies that had died. That index got replaced

13:09some time after our own series came out. But at the time, what we were doing was replacing an inadequate index with one that was adequate. This is all ancient history, and I dare say loss can live with that. But if he wants me to rephrase anything, he'll tell you. That was great on survivorship bias. I'd love you to talk also about easy data bias when it comes to country indices. The term easy data bias is one that we coined. The easiest data to collect is data which is readily

13:41accessible, which is well known. The easy data that people had, including this data series for the UK, started after a period in which markets had become unreliable, had less information behind them. So for example, the Barclays Index, which is still used by some people, it began life at the beginning of 1919. Why not 1918 or 1917 or 1916? It was a war on. People couldn't trust prices. So the series began

14:16after the wartime turmoil was out of the way. That was easier to do. The data was more reliable. You take a more extreme case, there was a Barclays publication of a similar nature, looking at Germany, which waited until after the turmoil of the Second World War and the succeeding events were out of the way. And so if you look at Germany, and you include the recovery period after Germany recovered, but leave out what happened in the war, you again have a misleading number.

14:50And so we discovered that almost everywhere, almost every country was one where if you used the standard index over the standard period, that was easier to do. You didn't have so much in the way of data collection, but performance was very overstated compared to what happened if you imposed a common start date on all of the different markets that you looked at. I would say that that is the most important of the biases that we eliminated, but there are others as well.

15:22So what about stock markets that don't survive or succeed? What happens in that case and how does that affect global average stock returns? If you take markets which are important at the date you're compiling data, you're more likely to incorporate ones that had done well and more likely to leave out ones which had started tiny and got smaller still. But it's a bias there in terms of choosing markets which is similar to the choices you

15:53have to make within a stock market looking at individual stocks. There are relatively few markets that simply didn't succeed, leaving out a couple of major geopolitical casualties. The demise of the Russian stock markets was important, the acquisition by the state of not only Russian but Chinese resources when China moved towards a communist framework. But mostly there aren't markets which start up, do okay,

16:28and then just completely disappear. There have been one or two, and I could give you anecdotes along those lines. We make sure that we include everything. And so our histories now cover significantly over 98% of the market capitalization of global equity markets in 1900, and they're equally comprehensive today. So missing countries is not a problem. What is important is how you do the calculations.

17:00So if a market loses some of its assets, for example, Austria lost the Hungarian assets, but the Austrian market continues, we want to make sure that we're using the right index and reflecting what went wrong. If we're looking at the world index, we need to include the Russian or the Chinese stocks that became valueless. In just the same way as if you were looking at a conventional single country index, you take in those companies which became valueless, and they're part of the index calculation. The same is true for the

17:37global series. That's crazy. It's a lot of really looking at what actually happened in that country to figure out what should be included in the calculation. Well, the back histories, I think, are tricky. And if you look at the early attempts at back histories, which were typically done by general business economists or economic historians, they were perhaps less critical of the data that they were using. Nowadays, financial history is a big thing. People are much

18:08more aware of the dangers of finding ways of losing data and inadvertently having misleading results in the index history. So we go from US market data, maybe some UK, upward biased UK market data being the norm, what everybody knew. How did your work on long-term global returns change our understanding of expected stock and bond returns? Well, let's go back to the book that we were talking about. We call it Triumph of the Optimists. We thought that book times of the Optimists. We did that because we have a century of data.

18:44If you looked at the beginning of 1900, and you asked who was investing in financial assets, there would have been a small number of optimists who thought the commercial and industrial companies would do well, and a much larger group of people who were cautious. If you look at US endowments, a hundred years before, you would find that the endowments were full of bonds. So the 20th century was one in which optimists, that's the people who bought common stocks, did well. That does mean that

19:19you can now look at out of sample data because we put into the market data for the last complete century, the 20th century. We've now got a quarter of a century out of sample rolling forward, which has been quite good, but not as good as the 20th century. We can also go back in time, and so some people have been looking at evidence that predates 1900. There's papers by a number of individuals. The National Analyst Journal has become a popular location for talking about these historical issues.

19:54And it's clear that if you start in 1900 and you go back in time, performance of equities wasn't quite so good either. Our data changed the way people think about the reward for risky investment, for the equity risk premium. And it's still changing because people are now saying, well, it was a good century, but it wasn't quite so good before that. It's difficult going back in time. We've done that using British data, which goes back further. The attempts at doing the same

20:26comparisons for the United States are more difficult because if you want to cover the 1800s, then you can't find a history for government bonds. Essentially, you can find government bonds for part of it, and that's because there were no government bonds and you would have to settle for corporates or state securities. Interpreting history also gets to be more difficult the further back you go and requires more and more care. Preston Pyshko In 1900, the optimists end up triumphing,

20:57as the title of your book suggests, thinking about how people feel today about the state of the world. Do you think people in 1900 thought that stock returns would be as positive as they were in the future? Steve McLaughlin No, I think they had a pleasant surprise. It was really in the second half of the 20th century. People would have expected, I think, extrapolating from their experience before and in the early years of the 20th century. They would have extrapolated from a world in which

21:29companies did business, generated income, the income was paid out as dividends. Pretty much everything was income driven. We then moved into the 20th century proper. At that point, people were making capital gains. In part, they were making those capital gains because expectations for the future look rosy and what you would get from investing in common stocks was more than just the dividends that were paid out. You had rising valuations and that must be something which you

22:02talk about and write about in your own business. Steve McLaughlin Absolutely. It comes up all the time, especially today where the US stock market has obviously had lots of capital appreciation on presumably very, very rosy expectations for the future. Steve McLaughlin The United States in all of this is very tricky. I mean, one other form of survivorship, perhaps, is that in the global equity markets, although America was one of several large markets back in 1900, fairly rapidly, it became the biggest one in the world. And it stayed that way with the exception of a very brief period where the

22:36Japanese equity market was bigger than any other markets. And so the US has had this amazing history. People who are psychologically attuned to the United States have often said that they think that can only continue. Our expectation was that with 100 very good years from the US, you couldn't expect it to continue. And Paul and Mike and I were wrong. It did continue. It continued till about a year and a

23:08half ago. Robert Leonard I've been saying the same thing for a long time now with US valuations being so high, just saying that the expected return on the US market must be lower based on where valuations are. But as you said, returns up until recently continued to be higher than expectations would have suggested. Steve McLaughlin I mean, once you buy markets which represent more than all the others put together, you can't imagine anything else which is as big. Extrapolating to the history that was going to be

23:39used for the future, that's a very difficult extrapolation and yet we really must look at long-term stock market histories in a variety of different circumstances. So we can learn by looking at the differing experiences of markets around the world and not just relying on the US. Robert Leonard At the beginning of the status series back in 1900, can you describe what the composition of the country weights looked like back then? And then how did that evolve over time to get where we're at today?

24:10Robert Leonard Well, the biggest market in the world by market cap in 1900 was Britain. There were others that were large, Germany, France, and so forth. What did those stock market valuations reflect? Well, part of it was the growing network for communications, physical communications, in different countries. So the majority of all of US common stocks, the majority of all British common

24:41stocks by value, was railroad stocks. We had previously had a canal frenzy. Canals did very well, but they found themselves underwater. So within a few decades, railways had come along. And although canals were very efficient compared to lousy ground transport being pulled by a horse and cart, you had the same sort of thing where trains were much better than travelling on canals.

25:16Robert Leonard Trains were very important. I don't think it would have been obvious at the time, once there was a railway boom, that there would be alternatives like trucking or road transport, might be alternatives. But nevertheless, there was a longer period of success for trains. And in the end, if you stuck with it, railways did quite well, but they went through some very, very difficult periods in the middle of the 20th century. Robert Leonard Trains You have data in one of the yearbooks, comparing the performance of railway stocks from, I want to say 1900. I don't know. I don't remember

25:50the timeline now. We look at railway stocks from 1900 going forward. And then as soon as there is an industry sector for road transport, which is not as early as 1900, but as soon as that's available, we take that sector index and we start it at the same level on the start date as railways had. And we do the same thing once there's a listed sector on the stock market for airplanes. So we can have a number of series. And what you find is railways did much better than the alternatives,

26:26even though nowadays, nobody would think of railway stocks as a growth stock in any sense. Robert Leonard Trains You show in the yearbook that the market capitalization of railway stocks decreased from being massive to being tiny, but the returns outpaced all of those other sectors and the market as a whole. That's just mind blowing stuff. I love that one. Robert Leonard Trains It's fun. We periodically update that work. Typically what happens when we write these books is we produce an essay or two of particular topics. Some of those you have acquired because they found their way onto the internet. But we also bring in

27:02the long-lived pieces of research. And so the book would increasingly grow to having more and more topics. We never realized that if we had this long-term history where we could simply ask the history, what was the equity risk premium? But instead we could look at all sorts of other questions over time. It's the richness of that data, data which we license you to use in your own research as well. It can answer a whole variety of different questions, whether you are focused on inflation,

27:37emerging markets, and sometimes more esoteric investments, precious metals, artworks, and so forth. Robert Leonard Has the railway analysis held up since you first did it? Robert Leonard Yes, the story has made the same. When you see these graphs of different asset classes or indices moving up over time, so we've got the horizontal axis, which is for the years, and the vertical axis, which is a value. But that vertical axis is always plotted in a logarithmic

28:07form. So if you move one inch up the vertical axis on a page, and let's suppose that over that inch on the page, you've got values going up tenfold, then the next inch on the page will be the ten becoming ten times as big as a hundredfold and so forth. So when you see a series, and you're asking me about one particular series, and you see one is winning a great deal compared to others, it needs quite a lot to send them to the back of the queue.

28:39Robert Leonard You had another chart in one of the yearbooks comparing developed market returns to emerging market returns. The fact that emerging markets underperformed, to me, was just mind-blowing the first time that I read the analysis. The reason that I think it's related to this question is because emerging markets tend to have high economic growth. Can you talk about the historical relationship between a country's economic growth and its stock returns? Robert Leonard Absolutely. If you know in advance that a country is going to have high economic growth, if you've got a crystal ball, you can foresee

29:10these things accurately. That would be a good case for buying the stocks. But unfortunately, we don't have a reliable crystal ball. We typically extrapolate from the past. And so when we first started looking at emerging markets and comparing them to developed markets, there was a wave of interest in emerging markets as being the future, the growth opportunity. And we don't really argue with that. The question is whether, as a shareholder, you will benefit from that. And as a shareholder,

29:42a stockholder investor, if you know there has been a lot of growth in the past, everybody else knows it'll be in the price. And so you will pay more for a growth opportunity. And so people who buy into an emerging market, which has done well, are coming along too late. So the long-term record of emerging markets is surprisingly disappointing. They've got left behind. What with big disappointments, if you lose a global war, that can wipe a great deal off your stock market. So the history of Japan,

30:21for example, is one in which a huge amount of financial value disappeared during the Second World War. If we stood back from that and we asked, well, what happens if we begin our index series, not in 1900, not in 1940, but in 1960 or some point in the 60s? Emerging markets have broadly moved in line with developed markets, but they've actually done a little bit better. But if you look at the entire series, there were some very substantial losses. It's a warning, really, that there's no

30:57guarantee, particularly based on extrapolating from the past that an investment strategy will pay off going forward. We talked a lot about that analysis and about Japan in a past episode. And one of the comments that I made was that it's kind of like a reverse lottery. You might expect higher returns from emerging markets, but you have these occasional big events where one country just gets completely wiped out. And that causes the long-term record for emerging markets not to be so great, even if the expected return based on something like valuations is high. I think there's another twist on this. And that is that you focus on the individual investor,

31:38and you focus on people who are using institutional products. So you might want to ask yourself, this is entirely hypothetical, what would happen if you were selling a global fund, let's suppose it's 1948. And you say, we think Germany looks really good. We suggest you stick a quarter of your assets into Germany. They would have been boning out for men in white coats to take you out. But afterwards, we see that if you bought into an emerging market like that, you would have done

32:13very well, but you would have had to be ever so brave. It would not have been a saleable proposition to retail investors, and would not have been something which if you were managing a pension fund or some other scheme institutionally, you could have pursued. So being counter-cyclical, focusing on cases where there is scope for a very substantial recovery, you've just got to be awfully brave. As part of the dilemma, we have looked at the impact of strategies where you systematically buy into

32:48stock markets that have done poorly or sectors that have done poorly. The outcome afterwards is two things. First of all, if you've done poorly in the past, it's a more volatile market. So you're more likely to do very badly. You're also more likely to do very well. In the long term, if you buy into markets that have collapsed, you will be ahead of the game. But typically, what most investors will do is then lose them. They may like that story. They've got to stick with it for a long time, and that mostly

33:20is beyond their patience. That's super interesting. We talked about railways already, but more generally, what's the historical relationship between industry growth and stock returns? It's a similar story to where I was talking about it earlier, but if you've got good economic conditions in a country and you know in advance, that's a good idea, the same is true for an industry. But historically, I'm going to caveat this in a moment, but historically, if you bought into industries

33:53that were cheap, cheap defined, for example, with an aggregate price to book or cheap in relation to dividend yield, historically, buying into cheap markets or cheap industries outperformed a little bit. But we've just been through a period where that's been a difficult strategy to sustain. So if you have been convinced that buying into sectors that are cheap and avoiding or even shorting ones that are expensive, that's not something which would have done very much good for your business.

34:27Definitely a tough period. We do have a bit of a value tilt in our portfolios, which has been not as good as a growth tilt over the last, I don't know, 10 or so years. Although recently, a little better. Last year or so has improved. Yeah, yeah. The evidence on country economic growth and industry economic growth with respect to stock returns, it seems like it's just kind of noisy. There's maybe even a negative relationship, but it just seems really messy. Why is that? Why doesn't economic growth

34:58translate into higher stock returns? Yeah, that's because economic growth benefits all sorts of categories of people. So if you think back to people who are buying into China, for example, there were people who a couple of decades ago, clear-mindedly could see that China was going to do well. But that does not mean that you necessarily do well buying listed stocks. Those listed stocks will already have a price that reflects what's going on. So the big beneficiaries will be the equity partners in joint ventures,

35:29or maybe individuals who start up their own business. So economic growth can help a country, it can help the people, it can help sectors and so forth. The benefits get spread around. Everybody can, to some extent, benefit except those who go into the stock market, where prices will already reflect the consensus as to what the future holds. It's super interesting, it makes a lot of sense. What impact has global diversification had on long-term risk and returns? I think that's been very important. Again, if you go back a long way, almost every country

36:06had a small number of sectors which were important, sometimes a very small number of stocks that were important. It was difficult to get a broad portfolio. Over the years, two things were happening. One is that there were more and more industry sectors. So if you were to look within one large market, such as the United States, there was much more opportunity to create a diversified portfolio because businesses that used to be private by them were listed. And if we think about investing globally,

36:42then you could spread the risks that are associated with particular countries or are associated with the resources that particular countries have and diversify those much more effectively. So there's a lot of risk which you might have thought is inherent to investing. And it turns out a lot of that could be diversified away. You can spread your money around in a way which eliminates many elements of risk which you would not recognize as diversifiable in the middle of the last century. Diversification has been

37:20important and it's been important as there's been a growth in varied investment opportunities. Some people would say that now, because of the very largest companies, there's a little bit less opportunity to diversify. About a quarter of the global equity market is represented by just 10 companies. Of those 10, nine are in one country, the United States, and one is in Taiwan. You would like to diversify. There are

37:55some sorts of diversifications which are a little bit more difficult. You've got to be brave in the way I was describing it earlier. If you're going to move away from having exposure to those growth companies, we really don't know whether we are in the middle of an upward momentum or whether those stocks have become so expensive but there'll be a collapse. We don't know whether we are in early year 2000s confronting a collapse of the technology companies of that era or whether we're in the middle of

38:31continued ascent by technology companies. I can't know the future. In your data, for example, we can look and see that there has historically been a quantitative diversification benefit to global stocks. I picked this question up from reading one of your yearbooks. What effect could frictions like foreign markets being less accessible to investors historically than they are today have on the perceived quantitative benefits that we see in the data of diversification? Well, trading costs can impair performance. Performance over the long

39:07history that we examine has been helped by trading being cheaper. Cost drag became something people talked about. Although the lower the costs are, the more people are willing to trade. While I don't have numbers to share with you, my hunch is that if we looked at the aggregate of costs drag, that is what it costs to do a transaction and the frequency with which they happen amongst investors as a whole, then I think the jury for me may still be out. It's much, much cheaper to

39:45invest globally. But so many people are doing it in aggregate across all investors, there may be less of a benefit than you might anticipate. So on that note, how have the benefits of international diversification evolved over time? International diversification involves spreading your money across different markets, different jurisdictions and so forth. There's a lot of resistance amongst American investors to investing in markets which are less promising than the US in the eyes of individuals. But on the other hand,

40:18it cannot be the case that for everyone, it makes sense for them to avoid diversifying out of their home market. And so what we can see is that if you had moved into a market which turned out to do well, you prosper and like that. But people who are in the United States who bought foreign stocks may have been persuaded by people like me and my co-authors, risk reduction was worth having and therefore they

40:51would be better off if they spread their money into other countries. People did do that from the United States. It was a little bit more difficult to do from Canada, but those impediments were lifted because people were convinced that global diversification was worthwhile. There were opportunities like that, but it cannot be the case that there is a strategy which makes money for everyone. So in other words, when Americans put their money outside the US, they were buying stocks which were destined

41:23to underperform American stocks. What that means also is that if Europeans or Asians had moved out of their home markets and bought more in the US, they would have bought more. The average return experience is across all of them has to be zero. You can't create returns out of nowhere. So the role of international diversification is risk reduction and that you can promise. On international diversification, why do you think, and I will note that we do have a home

41:56country bias in our portfolios. We weight more than the Canadian market capitalization. We have about a third of our portfolios in Canadian stocks and we have reasons for that, which we can talk about if you want, but why do you think investors, and actually one more note on that, our home country bias in our portfolios, which we think is reasonable, is much less than a typical Canadian investor's home country bias who might have 60% of their portfolio in Canadian stocks. Why do you think investors continue to exhibit home country bias when the benefits of international diversification that you just

42:27described are so well known? Some of it may, of course, be not rational, just warm feelings. But there may also be other attributes to that. So my answer to some extent is covered by taking an institutional investor perspective. I'm employed by one of the wealthier universities in Europe, which is Cambridge. And Cambridge, when it hires people, has a mix of paying salaries which are the going rate

42:59locally and will stay that way, and some where the going rate is essentially determined globally. The decision as to how much you want exposure to foreign markets compared to local markets, it is something where there isn't a rule that applies to everyone. I think there are individual circumstances which will finesse what you ought to be doing. I do understand home bias. For those who have a heavy bond component, I think the story is more compelling. That is,

43:31being able to diversify out of your home bond market into foreign bond markets is taking a view on how exchange rates are going to change. I'm in favour of diversification however it comes, but I can see how for fixed income investors, it's a little bit more important because you can hedge more effectively. When it comes to the stock market, I still have some sympathy with people who want to stay at home. But I think the proportions you describe are not high enough. I think back to the

44:06time when I was more heavily involved with the Norwegian sovereign funds, I chaired the strategy council for Norway for about a decade. And early on when I was working with the Norwegians, they had a strong Nordic tilts, because they were buying and selling goods and services in Scandinavia and nearby. And then over time, they came to appreciate that if they bought something which came out of Scandinavia,

44:37came out of an IKEA store, they weren't really too exposed to the Swedish currency, because some of that would be made in China. And if you look through that, China was quite heavily linked to the US dollar. There was a gradual realisation that a strong geographic tilt is not in the interests of the Norwegian people compared to being well diversified globally. I would be saying the same thing in Canada. But there are these geopolitical issues which are being wrestled with now. How much do you want to be

45:12self-aligned within a particular country? The world is so complex now, you can probably run another session like this focusing on geopolitical risk. You'll get a lot of listeners. Yeah. That's one of the things that we had Gene Fama on this podcast years ago. There's a tax efficiency, cost efficiency, local currency argument for home country bias, which I think are fine. But Fama brought up that more geopolitical expropriation risk of investing in

45:42foreign stocks that I hadn't thought about before. But when he described it, it gave me another reason for a bit of home country bias, I guess. Early in my career, when hedging currency was in its infancy, we used to focus on back-to-back loans. In other words, a business, rather than taking exposure through setting up a subsidiary in another country, would borrow in that country and then invest the money. And it was for exactly those sorts of reasons that you could end up with expropriation of assets you

46:16thought you had. My wife's family come from Germany. They were refugees at the outbreak of the Second World War. My late mother-in-law remembered that the first bit of savings that they had took to Switzerland. They put a small amount in a bank and she wrote a number, which is an account number. And in her final years, my wife's mother was keen to get these savings. So these were put there,

46:51they were run to money in case they had to run again. We went from bank to bank, none of them recognised the number. It had been inadvertently expropriated. We went to the banking ombudsman in Switzerland. And several years later, he wrote that they had identified this deposit. There was no explanation as to quite what happened to it, explanation as to how it got the money. But this money which the young couple who had escaped from Germany at the end of the 1930s was eventually

47:26available much more than half a century later. This expropriation risk is a real dilemma. And it's one which as a family we've seen. That's a fascinating story. Yeah, crazy. How important would you say that industry diversification is relative to country diversification? I'd say it has become more important. That's because companies find somewhere to list their shares. And so you end up with a listing in locations which are not naturally where

48:02they do their profit creation. We had quite a number of years of resource companies being listed on the London Stock Exchange. There's not much in the way of resources that comes out of the ground in Britain. When you diversify across markets, you're diversifying different sorts of things. The reality of diversifying across industries now is more compelling than it was. What do people say to you? That must be something which you talk about? Oh, it's a tough one. We look at different papers and writings, including yours and some of the

48:35yearbooks. And it's a tough one. It seems like it changes over time, which I guess you were just describing. It really comes back to that big question of how important is international diversification. I think it comes up a lot for US-focused investors and investors in the US who look at, well, look how diversified our industrial base is in the United States. We don't need to diversify outside of the country. And that's one of the main reasons that I've looked at this is, is a well diversified market sufficient diversification relative to being diversified

49:05across countries? I think I've landed on international diversification is still important, but it's not a super easy question to answer. It is much, much cheaper to invest globally than it was. It may be less important, but it can also be a great deal less costly. The burden in terms of costs for investing in a passive global fund is remarkably low. The burden, therefore, for active investors to compete with that is very difficult.

49:36We've mentioned dimensional briefly, but you've looked at longer term historical data than even dimensional would have had when they started their business. Can you talk about how pervasive the size and value effects have been in historical data around the world? It's kind of curious that because when dimensional was quite young in the London market, they supported us collecting value and size data, value data had previously not existed. I coordinated several PhD students to do that. The work largely was done by year one, year two,

50:15year three PhDs collecting data manually and coordinated by a year zero PhD. You might ask, what is a year zero PhD? It's somebody who we have given a place on the PhD program, and he just seemed very well organized. This is a man who subsequently became editor of general finance, so he was my PhD student. We ended up collecting data, publishing this in financial analyst's journal. I think it probably could be published somewhere better, but we were in a hurry to get

50:49that out. That was the first attempt at a time when, I think in the early years, dimensional was much more keen on factor effects within the US and thinking globally, and that was still to come. The paper on the value and growth in the UK was complementary to other stuff. We've looked at performances, you have these checkerboard charts which are popular in the hedge fund world, but we also look at them

51:20year by year, seeing for each year what the best middling and lowest performance was for different factors. We also do this decade by decade because we've got some data which goes back quite a long way, some of it a bit further back than the Farmer and French material which Dementiton so kindly made available to researchers as a whole. The small firm effect was the premier anomaly. It seems to be that value became a premier anomaly in stock market performance, but that's kind of gone away,

51:55jumping around for the last handful of years. The value sort of got left behind quite a lot. The one that was most striking is momentum. What's striking about momentum is there's a big contrast between momentum investing and size and value investing. For size investing, you buy small caps and you hope that they will outperform. At the end of the year, you can reformulate your strategy, and if you are really lucky, your strategy will have been messed up because some of those small

52:29companies won't be small any longer. But basically, you're fairly doomed. You buy small companies and they'll stay fairly value-ish. But you can't do that from momentum because from momentum, you're buying stocks which are trended up, avoiding or shorting stocks which are trended down. There's actually no reason why one which has trended up over time should keep doing that so the galaxy would explode. I mean, that can't happen. It's a high-cost strategy. Size and value has been, I think,

53:05overwhelmed by momentum returns, but it's high cost. And so whether you do that effectively, if you can control costs very well, then size and value are pushed down as the relatively unpopular factors now. But for a long time, and after Paul Mosh and I created the first small cap index in the UK, which mirrored what Rolf Bantz had done as Dimensional was being set up, he had done that for the US. The astonishing

53:35performance of small caps which continued over a very long period up into about two-thirds of the way into the 1980s. That all evaporated. That's a fact, and I think we now recognize that there are factors and premia. There are attributes which are associated with differential performance, which may be good or may be bad. Attributes which may be associated with a premium because they are giving you exposure to stock characteristics that people don't want to be exposed to and therefore makes those stocks more cheap.

54:12Do you think the size and value premiums are still worth pursuing today? No, I think they should be monitored. If you were looking at institutional active portfolios, then you'll often find that there are inadvertent factor tilts. For example, some charities are constrained to spending income. What that means is that they run the danger of influencing their asset manager to buy high-yielding stocks. If you are aware of those factor effects, you can discover that,

54:51in my example, the fund manager buys too much of the high-yielders because that's the only way that the charity can actually access the money that it's making. There are other similar things. People, after small caps have done well, want to buy small caps, and if they do that through a pooled vehicle, mutual fund or an ETF, small caps are expensive to trade. Those strategies can be expensive and so you need to understand some of

55:25these subconscious influences on the way a portfolio gets constructed. I would argue that an active manager that is not particularly persuaded by your sort of dislike for passive management, is not persuaded by your interest in factors, should still be looking at these attributes. That kind of reminds me of Mark Carhart and Fama and French both have papers looking at active mutual fund performance through the lens of factor exposures. Is that kind of the line of

55:58thinking that you're talking about? Yes, although what I'm talking about is traditional active managers primarily who accidentally end up with factor tilts. Those factor tilts are essentially bets being made through the portfolio where they didn't actually intend to make those bets. They were doing something which they thought was more innocuous and more geared towards the objective plan. I've been on a lot of investment committees for pension funds and endowments and I've seen that multiple times over.

56:32I had a call with a reporter earlier who wanted to talk about equal weighted index funds and this is one of the things I explained is that you're putting significant factor exposures into place by having that equal weights, but it's sort of a naive tilt. And so I was like, if somebody wants those factor exposures, there's probably a lower cost and more efficient way for them to get there. Yeah. I mean, the journalists should be aware that if this is a good idea, it would have been a good idea two years, four or six years ago, which would mean that every time any of the magnificent seven

57:05do well, you would reduce your exposure. At the end of the decades, you would feel much poorer. Yeah. I alluded to that too. We talked about the negative momentum exposure that equal weighting is always going to have, which is what you were just talking about. I want to move on to the equity risk premium. Can you talk about what history tells us about the size of the equity risk premium? The size of the equity risk premium is very important. If you were trying to build a modern building, you will have steel pillars that support it. But if you were trying to do that in such a way

57:40that the ratio of the diameter of those pillars that support a skyscraper, the ratio of the circumference to the diameter, if you wanted to be anything other than 3.14, 159, 635, et cetera, you can't do it. So we have a number in investment, which is just as important as the equity risk premium. The trouble is that while we know what the value of pi is, we have no real idea as to what the equity premium is. It's even worse than that because there are lots of different estimates that come out.

58:15They seem to vary a lot over time. We think of these as being long-term attributes, but there are sell-side advisors who are constantly changing their minds and that have got limited opportunity to do their business if the equity premium never changes. So we see lots and lots of calculations. In the academic world, this has been a source of discussion for 20 years. So it started out with Goyal and Welsh,

58:47Welsh being based in the US, Goyal nowadays being in Switzerland, who looked at what happened if you didn't peak into the future, but just chose as you went through time to make an investment based on information that at a particular date you've got based on the past. The equity premium that you get if you use long-term data is still varies depending on whether you look at the 21st century, the 20th century or the 19th century. The sort of numbers that we come up with nowadays are much lower than the

59:25spending rules that are followed by many endowments. We could live with 3% as the equity premium, the amounts that equities will throw off relative to safe assets. But 4% is, you have to be quite lucky, and in many cases you find endowments and other long-term investors who think that sustainable spending can run at 11.5%. Sustainable spending means money that you can spend without destroying the future

59:56of the fund. It is not to do with rain forests or climate change. What we're talking about is how much you can take out of the fund and still leave it in a good shape for the future. Lately premium estimates that we have are, I think, lower, and the consensus is much smaller than it was. I think there's been gradual agreements that even the most optimistic of individuals, so you might think of Jeremy Siegel as an optimist amongst commentators, have brought down their numbers. In other cases, their estimates of

1:00:32the reward for equity risk compared to short-term risk-free investments or long-term risk-free investments, it's a smaller number than we used to talk about. Lately, historically, that's the risk premium. How does that correspond to the real return on equities? Well, we can look at the equity premium as the difference between the expected or the realized return on equities, the return on the safe asset. We can do that in real terms or nominal terms.

1:01:06The number will be exactly the same. If you've got a numerator and denominator which is nominal, you divide one by the other. It doesn't matter if the top half of that fraction and the bottom half of the fraction are scaled by inflation. The equity premium is fundamental. It's fundamental whether you are an investor that's focusing on real returns, focusing on the purchasing power of your portfolio, or whether you are focusing on the nominal risks and what a nominally straightforward low-risk

1:01:43alternative would be. Lately, I think that's already getting high. Lately, 3%. Lately, there are still plenty of institutional investors in the US who would be talking about 5%. I think to get to numbers like that, you've got to be claiming that you can not only get the equity premium, but that you can identify clever managers who will outperform the pack. That's hard.

1:02:13Lately, 3%, that's a low number. If we switch from thinking about the equity risk premium to just real stock returns without adjusting for risk, what does the 3% equity risk premium look like in terms of just a real expected stock return, not a risk premium? Lately, I would take the view that over a 10-year period, a plausible real return from bonds might be 2%. If that risk premium is relative to bonds, the equity bond premium of 3% would give rise to a 5%

1:02:53return above inflation. Lately, that's a number that I think makes sense. Is that pretty close to the historical real return on stocks? Well, it will leave you a lot happier than if you've been asking the same question four years ago when the long-term return on bonds would have been zero in real terms or less. Moved not all the way back to long-term history, but the sort of numbers that people could plausibly use now are not quite as discomforting as they were. This is actually the heart of what financial advisors who you're working with

1:03:30think about. And I think there's another way of considering what individual savers ought to be doing. So the traditional way would be to look at how much wealth there is and say, well, this is what you can afford to be spending over years into the future. There is another way, which is to say, hypothetically at least, you could take out a contract which would cover all of your needs from 800 to 101. And let's assume that you don't expect to live beyond that. But that's something which you

1:04:06could price. It's an annuity. You could also work out how much would be needed to help you live from 99 to 100 or 98 to 99. Bill Sharp calls this a lockbox. It's working back from the end of your life as to how much you need, rather than stopping where you are now and having a plan which will take you forward. But then, when you're, say, 82 years old, you'll have nothing left. The reason I like that is that it helps you focus on

1:04:36how long you should be working for. Some people have a job like mine, which they just enjoy. But for other people, they would quite like to stop working. And I think the stage at which they will be able to stop working is something which they could do with guidance. Flash advisors don't think about it that way around, usually. That is a good perspective to take. So looking at markets today, with wars, high valuations, and the fear of AI, and so on, how should investors remain optimistic?

1:05:09Steve McLaughlin Your listeners will be a range of ages. Because you're young, you have some young listeners, but you also have some people who've got quite a lot of wealth. I think part of the story is for them to know who they're investing for, what chances they can take. And the optimistic ones will be ones who have the good fortune to be able to invest for their children, their grandchildren, for charities or whatever. In the end, they'll spend their money on. How can they be optimistic? It is through living modestly and investing for a future which stretches out a long

1:05:46way beyond their life if they're fortunate enough to be able to afford to invest that way. Preston Pyshko What do you think are the risks of being pessimistic about future stock returns? Steve McLaughlin Well, if you're pessimistic, you're still going to put your money somewhere. So that means that you are not like the optimist invested in the stock market. You're going to stick your money in the bank. Over any reasonably long period, you are likely to lose purchasing power from doing that. So if this is money you don't need

1:06:17for the near future, then you should be investing for the long term. You still need some liquidity. Steve McLaughlin I came to New York at one stage in 1999, the peak of the TMT bubble. And at that stage, there were taxi drivers who would tell you that they are planning for their daughter's wedding or their son's bar mitzvah or whatever it was. They put some money to one side and within five or six years time, they were going to be in a position

1:06:48to spend the money that they needed. They did not understand that the projections in growth for the long run, which the Wharton School Professor Jeremy Siegel had popularized, there's still a sign-scape for people who are not such optimists. They are not going to become as wealthy, but the downside is less as well if you really need the money. My world is also in downs. If you look at

1:07:19Oxford and Cambridge colleges, some are terrifically wealthy and others are not. If you are worried about whether rain will come through the roof and ruin the organ in your college, you don't stick the money into the stock market if you might need it in a few years' time. That's the cross-subsidy, if you like, between long-term investors and shorter-term investors. Long-term investors will do better because short-term investors can't afford losses. That was a great line.

1:07:52We talked about the equity risk premium and that 3% number being fairly attractive, especially once you consider the risk-free rate and inflation. How do you think about the role of bonds and portfolios? The extent to which bonds have co-moved with or been a diversifier for equities is quite important in all of this. We went through a period for the first two decades of the current century in which we had become used to

1:08:23bonds having a role in the portfolio of being a safe asset. Then 2022 came along, all bets were off. I think there is a role to bonds, but I'll give you the personal view because our tastes, I'm talking personally, are fairly modest. We don't need to spend an awful lot. There's a big benefit from being heavily invested in equities for somebody who thinks that way. People sometimes ask me for

1:08:55advice. I'm not a financial advisor and I don't like giving advice. But I think you need a clear idea as to how risk-averse you are, how much you might need money for an adverse event. And if you can manage it, if you can invest for the long-term, that is the second best investment you can make. The very best is investing in yourself. That's getting an education. That would be where I rank highest. After that, I'd look for long-term financial assets.

1:09:28I love that. Make yourself the safe asset. Live modestly so you can invest in stocks. I love it. I share the same philosophy. Confirmation bias, that's why I'm so excited. Last two questions here. We've talked about US exceptionalism and how the US has just had this incredible performance. How do you think investors should think about expected future returns in the context of the US market? It's never a good idea to be a market timer. People who ask themselves,

1:10:00what should I be doing now because it looks as though I could invest in risky assets now but lose a lot and so I could stay out of the market. That's market timing, which is not something which any advisor would urge you to do. The reason for that is that it's easy to make a decision now to sell your common stocks because you think they may fall. Then you may never get the opportunity to buy back. What people should be doing is focusing on a long-term strategy. That long-term strategy should be as

1:10:36diversified as possible. Costs should be as low as possible. There are instruments for doing that where the platform fees and the asset management fees are incredibly low. That should be the starting point, I think, for many investors. Great answer. Our last question, Elroy, how do you define success in your life? That's easy for me. We've got four children. I have four children involved, so we've got eight children and there are 10 grandchildren and the success is happy people.

1:11:10That is a great answer. I've got four children too, but no children-in-law and no grandchildren yet. It will be a while for that still. But if they're happy, you've got a winner. Great answer to the question. This has been a great conversation, Elroy. I mentioned to you that this is just, it flew by for me. I can't believe we've been talking for 90 minutes. Really appreciate you coming to the podcast. This has been fantastic. That's great. Thanks very much. It's time to start.

1:11:38All right. That's it, Elroy. Thanks so much. We appreciate you spending the time with us.

1:11:47Hey, everyone. It's producer Matt. Thank you so much for tuning in to this week's episode. Before we sign off, here's the disclaimer you've been waiting for. Portfolio management and brokerage services in Canada are offered exclusively by PWL Capital, which is regulated by the Canadian Investment Regulatory Organization and is a member of the Canadian Investor Protection Fund. Investment advisory services in the United States of America are offered exclusively by One Digital Investment Advisors, LLC. One Digital and PWL Capital are affiliated entities and they mostly get on really well with each other. However, each company has

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