Podcast Summary: "The Long and the Short of It"

Series: LSE: Public lectures and events
Date: November 5, 2009
Speaker: John Kay
Host: LSE Film and Audio Team
Main Theme:
John Kay presents a practical and philosophical exploration of personal finance and investment, distilled from academic theory and real-world experience, aiming to empower individuals to manage their money more wisely and skeptically, independent of the financial services industry.

Introduction & Purpose of the Lecture (00:00–02:17)

• Host Introduction: John Kay, noted economist and FT columnist, is introduced as a leading voice in bridging academic economics, practical investment, and consultancy.
• Lecture Aim:
  The talk is based on Kay’s book The Long and the Short of It: Finance and Investment for Normally Intelligent People Who Are Not in the Industry, offering practical financial advice for individuals using core finance theories, while warning against overreliance on theoretical models.

“I want to try and tell you… the kind of body of finance theory that I think you need to know if you're actually to manage your money yourself. I want to explain what that theory is. I want to draw out… investment strategies… and talk about how you can actually implement this kind of strategy in practice.” – John Kay (02:17)

Philosophical Foundation: The Limits of Economic Theory (05:30–09:30)

• Kay recounts a story about Harry Markowitz, founder of Modern Portfolio Theory, demonstrating the gap between abstract models and real decisions.
• Keynes’s anecdote with physicist Max Planck highlights economics as “the amalgam of logic and intuition and the wide knowledge of facts, most of which are not precise.”
• Main message:
  Finance theory is illuminating, not definitive.
  Knowing the theory is useful, but literal belief and application may be misleading.

“Economic theories, we should treat... as being illuminating rather than cruel. It's important that you know about these theories... but you will also make mistakes if you make the error of believing these theories [are] true.” – John Kay (09:30)

Three Pillars of Finance Theory for Investors (10:20–28:00)

1. Efficient Market Hypothesis (EMH) (10:20–18:30)

• Describes three “flavors”:
  • Weak: Past prices don't predict future prices. Charting and mechanical trading rules are futile.
  • Semi-Strong: All public information is in prices; only private knowledge or atypical analytic approaches yield an edge.
  • Strong: All information, public or private, is in prices—an unrealistic version.
• Investing implication:
  Most “wisdom” offered by the financial services industry (e.g., rules of thumb, chartism) is bunk. Most people in the industry don’t have significant informational advantages.
• Warren Buffett recognized markets are “mostly efficient, not always,” and amassed a fortune operating in the exceptions.

“The truth is these guys over there don't know a lot more about anything than you do. And actually, you can free ride to a very large degree on what… they do.” – John Kay (18:00)

2. Asset Valuation Principles (18:30–22:00)

• Mark-to-Market Principle: An asset is worth what someone will pay for it at a given moment.
• Fundamental Value Principle: An asset’s true value is the present value of its future cash flows.
• Often, market price and fundamental value diverge; patient investors should choose the higher.

3. Approaches to Risk (22:00–28:00)

• Traditional (Subjective Expected Utility): Assign probabilities and expected payoffs, then maximize expected utility.
  • Illustrated by Kay’s own investment in Robb Caledon shares, based on careful probability and payoff estimation.
• Keynesian/Knightian (Uncertainty vs. Risk): Many future outcomes can’t be easily assigned probabilities (“we simply do not know”).
• Behavioral Economics:
  • “Linda Problem” illustrates that most people don't use statistical probabilities, but narratives and plausible stories to judge risk.
  • Investors often seek coherence in stories over mathematical rigor.

“The way people actually think about risks is in terms of plausible stories.” – John Kay (27:00)

Investment Strategies for Individuals (28:00–37:00)

• Two Approaches:
  • Mind of the Market (Mark-to-Market): Attempting to outguess other market participants—favored by traders like George Soros, but unrealistic for individual investors with limited time and resources.
  • Fundamental Value Investing: Buy when price < estimated true value; associated with Warren Buffett. This is more accessible and advantageous for individuals, especially since institutional investors are handicapped by performance benchmarking (“closet indexation”).

“As a private investor, the only [strategy] which in my view is any relevance is the fundamental value story.” – John Kay (36:10)

Key Takeaway:

• Individuals do best by imitating the overall asset mix of well-advised institutions, using low-cost index funds and basic diversification, not by chasing market timing or complex active strategies.

Practical Steps for Individual Investors (38:00–45:00)

• The Internet has democratized investing:
  Now anyone can mimic institutional portfolios (buying global/UK index funds, bond funds, real-estate trusts) with minimal fees—this would take minutes online.
• Fees destroy returns:
  If Buffett had paid “2 and 20” fees standard in hedge funds on his $62 billion fortune, only $5 billion would have remained for him as investor; $57 billion would line manager pockets.

“The clear risk-free way of increasing the returns on your investment portfolio is to pay the financial services industry less.” – John Kay (41:30)

• Three rules for individuals:
  1. Pay less: Minimize fees and commissions wherever possible.
  2. Diversify more: Institutional portfolios are still riskier than advisable; individuals should spread risk further across geographies, asset classes, and types.
  3. Be contrarian: Gradually develop your own view, avoid herd behavior; long-term returns mean-revert from extremes, so don’t follow crowd manias or panics.

“Pay less, diversify more, mind your portfolio, be contrarian… are ultimately grounded in real theoretical analysis… the keys to managing money as a private individual.” – John Kay (44:10)

Ultimate, “depressing” conclusion:

• The finance industry is large and profitable, yet the most honest advice for individuals is to avoid it as much as possible.

“If these people are so bad at managing their own money, why on earth should you think they will be good at managing yours?” – John Kay (45:05)

Notable Audience Q&A (55:41–89:10)

On Comparison to Swensen (Yale Endowment) and Absolute-Return Funds (57:04)

• Kay agrees with Swensen's critique of high fee mutual funds, observing both advocate for cheap, diversified products. But Kay is even more skeptical about hedge fund fees.

On Structured Products / Portfolio Insurance (61:26)

• Most structured products are unnecessary for private investors; broad diversification achieves nearly all the protection needed more efficiently.

On Why Investors Favor Stocks Over Bonds (63:15)

• Simple: More commissions for salespeople and higher visibility of equities. For individuals, diversified bond ETFs are preferable to buying individual bonds.

On CEO Incentives and Short-termism (64:43)

• Executive and fund manager compensation structures (benchmarks, options) encourage excessive risk and focus on short-term, smoothing earnings at the expense of long-term value.

On “Alpha” and Exceptional Investors (68:12)

• Alpha (genuine skill-based outperformance) exists but is rare. High performance fees tend to negate most of its benefit for investors.

On Diversification vs. "Investing in What You Know" (75:13)

• Critiques Peter Lynch’s advice (“invest in what you know”) as over-narrow—Lynch himself held hundreds of stocks, suggesting wide diversification is practically possible.

On Banks as “Casino vs Utility” (77:40)

• The “casino” aspect (speculation, proprietary trading) grew steadily inside banks, overwhelming the older, utility-like operations, especially as “treasury” became its own profit center.

On Ratings Agencies (79:37)

• Major error was granting ratings agencies an official regulatory role, creating incentives for collusive overrating of complex securities.

On Understanding Company Reports (81:08, 73:03)

• Simple rule: “If you don’t understand it, don’t do it.” Complex, “pro-forma” or “adjusted” earnings are red flags.

On Costs and Hedge Funds’ Effect on Investors (82:19, 84:18)

• Questioned about hypothetical fees for Buffett (uses 2 and 20 as example). Survivorship bias is a big issue in assessing hedge fund results.

On Practical Diversified Portfolios (85:36)

• Agrees it’s hard for individuals to build thoroughly diversified portfolios of single stocks—hence, advocates starting with a handful of simple, diversified ETFs, as in institutional models.

On Tools for Distinguishing Uncertainty from Risk (86:51)

• Emphasizes using a toolkit of approaches and narratives, not only Bayesian probabilities. No theory is universally or exclusively correct; eclecticism and skepticism are best.

“Economic theories are relevant in all these discussions, but we make a big mistake if we take any particular theory too seriously, and a disastrous mistake if we believe that any… is completely descriptive of the world.” – John Kay (89:02)

Memorable Quotes

• On Market Wisdom:
  “Most people in the financial services industry don’t know more about anything than you do.” (18:00)
• On Investment Fees:
  “The clear, risk-free way of increasing the returns on your investment portfolio is to pay the financial services industry less.” (41:30)
• On Contrarian Investing:
  "Be contrarian... If we didn't know it before, we've learned in the last decade... that from time to time... they frequently change what it is they all think." (44:00)
• On Embracing Uncertainty:
  “We make a big mistake if we take any particular theory too seriously, and a disastrous mistake if we believe that any theory… is completely descriptive of the world.” (89:00)

Key Takeaways for the Listener

• Understand but do not worship finance theory.
• Most professionals' apparent expertise is illusory—simple, diversified strategies are best for individuals.
• Keep costs down, avoid complex or high-fee products.
• Diversify more than professional practice; use the technology now available (online platforms, ETFs).
• Ignore most financial “rules of thumb”, stories, and trends.
• Build skepticism: in financial life, as in academic thought, hold theories lightly and prepare to act independently.

Recommended for:
Anyone seeking a deep yet accessible approach to personal investment, skeptical of industry salesmanship and eager to bridge theory and practice with common sense.

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