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Okay. Good evening. This is a great honor for me to be asked by the Economics Department to introduce one of their lectures. I used to be in the Economics Department until I was summarily dismissed by the likes of Jackman. Anyway, it's a great pleasure to have John Kay with us this evening. John's very well known to most of us through his writings both academically and of late as a college contributor to the esteemed Financial Times. John's actually got a pretty long career. I first saw John give a talk at the LSE in 1976. I don't think he knew I was there, but I was. He was at that time, I believe a very youthful looking Fellow of Economics at St John's College, Oxford where he spent quite a lot of his career. John spanned the world of practice. He was the founder of London Economics, one of the major consultancies in London that brought serious economics to bear on the world of economic practice at times of fairly radical change in the industrial structure of the country. He for some time was a professor at the London Business School. He was the, I think the founding head of the side business school at Oxford. Of late he's been a visiting professor here at the LSE linked to our esteemed Economics Department. It is esteemed still and he participates in the activities of the Centre for Economic Performance. However, you're not here for me to sort of go on like that. So what we're going to do is give the floor to John who's going to talk about the long and the short of it, which apparently is the first serious attempt to really get what finance is all about into the mind of the common man so that he doesn't make foolish mistakes with his money and can live a happy and long prosperous life. So this is more kind of philosophy lecture, I guess, of a kind. So John's going to speak for roughly three quarters of an hour and then he'll take questions and the more demanding the better.
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Okay. We were talking on the way down here suggesting that perhaps this is the first lecture ever to be given in the history of London School of Economics that is intended to provide some practical advice. And I'm not sure whether or whether that's true or not, either that there have been no such lectures in the past or that this one will. But at any rate that is the motivation in large part of what I want to say. And it's about the book or its focused run book which I've written along the short of it, subtitled Finance and Investment for normally intelligent people who are not in the industry. And it was written after about 20 or 30 years of people asking me the question, what should I do with my money? And it was designed to enable me to say, well, if you only lay out a few quid, you can stop bothering me and contribute to my royalties and my own income. There's a story, actually that Karl Marx's wife said after Marx died that she wished Karl had spent a little bit less time writing about the accumulation of capital and a bit more time doing it. I suspect that story is apocryphal, but one that I believe was apocryphal but actually turns out to be true, is that the man who can pretty much be regarded as the founder of modern financial economics, Harry Markovitz, who invented modern portfolio theory. And I don't know how many of you in this audience have done serious finance courses, but you will know that that is what takes you to efficient frontiers and the like, to the whole ideas behind efficient portfolio allocation. And indeed the ideas behind that form the basis of a value at risk modeling that serves their banks so well until they ceased to serve banks very well in the summer of 2007. But Harry Markovitz was asked late in his lifetime what he'd done with his retirement funds. And the answer was, well, of course, half in equity is half in bonds. I think there's a disjunction there that is rather characteristic of a majority of economists, which is the disjunction between what they teach, what they talk about, even in what ought to be practical subjects like finance theory and the ways in which they live their lives. And I've tried a little bit to try and bridge that disjunction. And that's really what I want to talk about this evening. I want to try and tell you, some of you will know it already, some of you won't know it, but I want to refer you to 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 from it the couple of investment strategies which I think it's possible for individuals to follow. I want to focus on one of them and I want to talk in the the last part of what I have to say about what that actually how you can actually implement this kind of strategy and practice. Because one of the things which I learned, really, which came home to me writing the book which I was describing, is that the opportunities which you have to do things yourself have been transformed over the last decade or so, partly by financial innovation, but rather more by the arrival of the Internet. That means a whole variety of things that you used to have to employ a financial advisor of some kind or some intermediary to do for you, you can now actually do yourself. And I'll argue that you should. So that's what I'm going to talk about this evening and that's the sense it in which it's intended to give you some practical advice. Now I'm going to talk, as I said, about the theories which you need in order to do this. But I'm also going to suggest, and this is the consequence of the disjunction which I talked about between what economists do in their academic work and how they actually live their lives, that you need to know something about the basics of finance theory. But you will make a mistake if you take that finance theory rather over seriously. And I think there are very few economists who have actually made money for themselves using their economic theories. There have been rather interesting, rather more who have made money selling their economic theory theories to other people, but there have been very few who have actually made money applying them. There are two conspicuous exceptions to that. One, but that's rather a long time ago is David Ricardo and the other is Maynard Keynes. And Keynes described the way he thought about economic theory in Keynes rather witty and stimulating usual style. But I think the quote here gives an important key to the way we all should think about the application of these kind of theories to practical affairs. And Keynes described an encounter with Planck, the great Nobel Prize winning physicist, in which he said that Planck had told them that he'd once thought of studying economics but had decided against because he thought economics was too difficult. And as Keynes pointed out, it was not that Planck couldn't have done the contents of the average MSc course which is delivered at LSE Keynes Planck could have mastered the whole corpus of mathematical economics in a few days. It's probably expanded enough that it might now take taken a few weeks, but it still wouldn't have taken someone like that very long to get through the course material and that sort of course. But what Keynes said Planck did mean by that was the following. The amalgam of logic and intuition and the wide knowledge of facts, most of which are not precise, which is required for economic interpretation in its highest form is quite truly overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of a comparatively of comparatively simple facts which are known with a High degree of precision. And I think that quotation is particularly particularly insightful one, and it's one which ought to be in all of our minds, both in the issue which I'm raising tonight, that is how should we apply theory to practical affairs and in understanding what has gone wrong in the last few years in terms of the mistaken application of economic theories to everyday events in our financial system. So let's bear that quote in mind and I'll talk a little bit about the theory which I think you need in order to work on, in order to manage your own investments, in order to make money for yourself. I think there are three main elements to it. Firstly, you need to know about efficient markets. Second, you need to know about principles of asset valuation. And thirdly, you need to know about approaches to risk. And I put at the bottom of that slide what I think is a key issue in interpreting all of this, which is my summary of what Keynes said on that previous slide. Economic theories, we should treat in this kind of context as being illuminating rather than cruel. It's important that you know about these theories. It's important that you should know, particularly that other people are committed to these particular theories. You will make mistakes if you don't understand these theories, but you will also make mistakes, perhaps even more serious mistakes, if you make the error of believing these theories. Theories are true. So know about these theories, but don't take them too seriously. Now, let me go through these three elements. Efficient markets, principles of asset valuation, and approaches to risk. In turn, let me begin with efficient market theory. An efficient market theory is the basic idea that prices incorporate information. That's in a sense, the very nature of an economic system, far less a financial system, that prices incorporate information. And one of the economic roles they serve is as a means of handling and disseminating information. They also make it possible to economize that information. So prices in this sense acting as sequence, is one of the basic aspects of the way in which a market. Now, those of you who've learned a bit about efficient market theory will have been told that of course there isn't just one version of the efficient market theory. There are basically three. There's a weak version, there's a strong version, and there's something in between, which is the semi strong version. And the weak version of the efficient market hypothesis says essentially that that historic price information conveys no useful information about future prices. That prices follow what is described in economics as a random walk. They follow what physicists call Brownian motion. The random walk analogy is Actually, a more striking metaphor, it's like the drunk who wanders round in random direction and the direction he's taken in the past gives you no information about the direction he's going in the future. And that means when you look at a share price in the newspapers and you see high and low for the year, you should disregard that column. That's irrelevant. It means that when Chartists, who are often called technical analysts, who are popular in the finance community but extremely unpopular in the finance departments of all reputable universities, they're unpopular in the finance departments of all reputable universities because they are regarded as the equivalent essentially of astrologers. They came to see patterns in what all of us believe are essentially random series. And rather like astrologers, they can find these patterns in any series you throw at them. The weak efficient market hypothesis says that Chartism is bunk and that you can't get any information about the future from looking at past prices. The semi strong version of the efficient market hypothesis says that all publicly available information is already in the price. So that when I tell you that Tesco is a well managed company, I'm not giving you any useful information that will help you make investment decisions, because everyone knows that Tesco is a well managed company and therefore the price of Tesco shares will already reflect that particular information. The semi strong version of the efficient market hypothesis, however, allows the fact that there might be private information that is not yet known to the public, or bits of analysis that you've undertaken on this information that is original, which might enable you to know more about an activity or the value of a security than is already there in the price. So the semi strong version of the efficient market allows for the possibility of investment skill of some kind, but requires you to have either investment skill or inside knowledge of some kind in order to act profitably on that kind of information. And the strong version, put simply, says that everything that you could know about the value of a security is in the price. And of course, if you believe that there would be little point in any of the things these guys, the City of London or Canary Wharf do at all, because everything you could possibly know about about market prices is already out there in what the market price is. You can probably already see that there's a bit of a logical problem about that. If that was true, then there wouldn't be any of these guys in the City, in Canary Wharf doing any of the things which they're doing if all information was already in the price. In short, there would be no incentive to acquire the information that is supposed to be already in the price in the first place. And therefore the substance in which the strong version of the efficient market hypothesis could not logically and literally be true. And that's what takes me to saying that all of these theories we should think of in the way I described earlier as being illuminating, but not. We learn something from each of these ways of thinking about market prices. But we shouldn't take what we learn too seriously. The weak version of the efficient market hypothesis tells us that chartism is bunk and most mechanical rules for trying to make money on the stock market won't work. So that there are all kinds of theories. There's a kind of dogs of the darrow sell in May and go away. You'll be given all kinds of conventional wisdom of the financial services industry. And even the weakest version of the efficient market hypothesis says forget about these kind of rules, they're not going to make you any money. And almost all the investigation of these kind of rules that has been conducted shows that either they don't make any money at all, or they make so little money that they don't offset the transaction's cost of actually acting on them. The semi strong version, so the weak version tells us chartism and these kind of mechanical rules are nonsense. The semi strong version tells us that you can only make money through some kind of originality, either original analysis or superior information of some kind. And that's something we should cling to and will use in what we're going to talk about later today. And the strong version of the efficient market hypothesis, as I said, if that were literally true, you could shut everything that is done on the city and Wall street down and it wouldn't make any difference. And there would be something to be said for shutting at least most of the city and Wall street down. And there's a lot to which it wouldn't make a great deal of difference. But nevertheless, the strong version of the efficient market hypothesis is itself an exaggerated story. But the thing you should learn from it is the truth is these guys over there don't know a lot more about anything than you do. And not only do they not know a lot more about anything much than you do, but actually you can free ride to a very large degree on what it is that they do do. Because actually a large part of the information which people in the financial services industry have is already out there in the market prices. So you can learn something from each of these parts of the efficient market hypothesis, but you should not take the efficient Market hypothesis too seriously, Warren Buffett, someone I'm going to come back to a bit later, who's the most successful investor in history, having made a fortune of 50 or 60 billion dollars out of relatively modest sums with which he began investing nearly 50 years ago, Warren Buffet has said, realizing that markets were mostly efficient, finance professors and some people on Wall street concluded that they were always efficient. The difference between these two hypotheses is night and day, he said, and that difference between night and day is the difference that has made Buffett a fortune of $50 billion. So we shouldn't knock that particular insight, Right? We should bear in mind then, that the efficient market hypothesis is mostly true, but is not completely true. Let me turn to my second bit of theory. And this bit of theory is how you actually value an asset. And there are two ways of looking at asset valuation. The first I'll call the mark to market principle, and that says an asset is worth what someone is willing to pay for it, pure and simple. That's. You can see that that's something that might be taken to follow from these various versions of efficient market hypothesis that has been I've been talking about. And the second is the fundamental value principle, which says that the value of an asset is the present value of the cash flows which that asset is going to generate over its lifetime. Now, in the long run, one would expect, though there's nothing that conclusively demonstrates that one is going to come in line with the other. But at any particular point in time, it's likely that the market price of an asset is going to differ from its fundamental value. Now, if I'm a real believer in efficient markets, I will want to argue that the market price is the best estimate of any particular time that you can make of fundamental value, but never even in that world. You have to accept that it's possible that fundamental value and mark to market can generate can differ. So these are essentially two distinct ways of thinking about asset valuation. But there's one thing that you can probably notice right away, which is if you have these two principles in mind and you're a relatively patient investor, then the value of an asset is the higher of these two. Because if it's the money, you have the option of selling something at its market price. And if the fundamental value is higher than the market price, then you can sit and wait for it to generate the cash which is underlying it. So that the mark to market principle and the fundamental value principle are two alternative ways of thinking about asset valuation. They underpin accounting Theory. These principles underpin most of what goes on in terms of professional asset valuation, and they're two different ways of thinking about investment. I'll come back in a moment to the ways in which they map into alternative investment strategies. The third bit of theory which I need to talk about is approaches to risk. Now, if you look at modern finance theory, as it's mostly taught in schools like this and business schools, there's one way of thinking about risk which people basically focus on. It's a way of thinking about risk that I'll call subjective of expected utility. And it says you need to compute expected utilities using subjective probabilities. And I learned about this way back in the 1970s when I was a graduate student. And it was thinking about that in a highly disciplined way that underpinned the first investment, the first stock market investment which I ever made. And it was a very strange investment. It was a little Scottish shipyard which was called Rob Caledon. And this shipyard was essentially bankrupt. In fact, it was bankrupt, but there was a special consideration about it, which was this was 1976, and there was a bill to nationalize the British shipbuilding industry, which was going through Parliament at that particular time. And I discovered that if that bill went through, the shares in Robb Caledon would be nationalized and the government would pay the shareholders of robbcaladon an amount computed by compensation formula, which would give the shareholders about a pound a share. If the shipbuilding nationalization bill didn't go through Parliament, then the shipyard was bankrupt, the shares were worthless and the shares were worth nothing. The shares were selling at the time for about 40 pence. And I thought, well, I know a little bit about politics and I reckon the probability that this shipbuilding bill, the shipbuilding bill will go through Parliament is a good deal higher than 0.4. And that was the sum which I'd been taught to do. You look at the alternative payoffs, you look at the payoff of pound, you look at the payoff of zero, you estimate your own. You make your own estimate of the probability. And I thought the probability was not 0.4, it was more like 0.8 or 0.9. And on that basis, Rob Caledon shares were a pretty good buy. Now. So I went decided I was going to buy some Rob Caledon shares. What was further interesting to me was I found that quite difficult. I called up a couple of stockbrokers attempting to buy this and they told me, first of all, they told me that shipbuilding nationalisation was an extremely silly idea, which was true. They told me that the Labour government which at the time was attempting to pass this nationalization bill was incompetent, which was also true. And they told me various things of that kind of things you would expect stockbrokers to say, but on this occasion they were right. But although the shipbuilding nationalization was stupid and the Labour government was incompetent, neither of these facts seemed in any way relevant to my investment decision. They also told me that the shares had been selling a few months earlier for 20 pence. Indeed, before people thought the shipbuilding nationalisation might happen, they were selling for even less than that. And that, I discovered, was true also. But once again, it didn't sell seem to me anything that had any relevance to my current decision. There was a lesson there that took me a long time to realize the significance of which was that even if I thought about risks in terms of the way I'd been taught in my graduate courses, in terms of subjective expected utility, that wasn't the way people in the market mostly filter pipe risks. They also told me that it was very unwise for me to make an investment in which I might lose all of my money. And if I had indeed been planning to make an investment in which I might lose all of my money, they might well have been right. But I wasn't planning to put all of my money into Rob Caledon. I was planning to put the small amount of spare cash I had at the time in my in Rob Caledon. And also I anticipated that my earnings were going to rise fairly rapidly after I finished graduate school, as indeed they did. So the extent to which I was exposing my lifetime earnings by investing in Rob Callaghan was pretty small. So I bought some Rob Calledin shares and you will always be all be pleased to hear that the shipbuilding nationalization bill did indeed go through. That I got a pardon a share. And I've never looked back actually in my life and investing career from that particular exercise. But what I didn't realize then was actually quite how special the circumstances of that Rob Calladon purchase were. It was a simple binary event. Either within a year or so of my purchase, that bill went through or it didn't go through. And in terms of the outcomes of that binary event, I knew exactly what the payoffs would be in these two circumstances. There are very few situations in real life which are actually like that. And that takes us back to the ways in which people think about risk. Because this subjective expected utility method of thinking about risk has actually dominated the way economists and finance theorists think about risk since the 1920s. But in the 1920s, there were essentially two different schools of thought in the ways people, in the literature of the ways people think about risk. One of them was a way of thinking that led to subjective expected utility that we now associate with Frank Ramsey and Chibi Savage. Interestingly, one Cambridge, one Chicago economist, because on the other side of the debate there was also a Cambridge economist who interestingly was Keynes, and a Chicago economist who was called Flagdyne Knight. And Keynes thought about risk and uncertainty in a rather different way. They emphasized uncertainty rather than risk because they were skeptical about the extent to which one could actually define the range of possible outcomes in ways that lended them themselves to being described in probabilistic terms. Keynes wrote that when it comes to thinking about the rate of interest 20 years from now, the only sensible answer to that we can give is we simply do not know. Now that's an interesting kind of observation because actually people in financial markets today think of what interest rates will be in future as precisely the kind of risk which you can think about usefully in probabilistic terms. But I think what gives a particular twist to Keynes formulation in that way was that he published that particular book, the book that contained that quote, in 1921. Now add 20 years to 1921 and the date which you get to is 1941. And actually in 1941 you could not have known whether if you held British government bonds, they would be repaid in sterling in Reichsmarks, or indeed repaid at all. Keynes was absolutely right to say that when we thought about interest rates in 1921 and what they would be in 20 years time, the right answer is to say we simply do not know. The truth is most of us don't think about risk in subjective expected utility terms. And one way you have a thinking. One way I found helpful in formulating this is this is one of a standard problem in behavioral economics literature which some of you may have encountered before. And the story runs something like this. It's widely called the Linda Problem. And it says Linda lives alone. She read social history at Anglia Polytechnic University and she was active in organizing demonstrations against Shell over the Brent Spa affair. Okay, we've got that background information about Linda. Now, which of the following do you think is more likely? One is Linda is a bank manager. Two, Linda's a spokesperson for the Animal Liberation Front. And thirdly, Linda's a bank manager who is an active feminist. Let me take a vote on it, see what we get. How many people think Linda's a bank manager? How many people think she's a spokesperson for the Animal Liberation Front. And how many people think she's a bank manager and an active feminist, Right? And I've got what I find is a fairly typical response when I give this kind of question, which is about 1/3, 1/3, 1 third. People are pretty much equally willing to sign up to these three options. Now, if I'm brought up, as I was, and still to some degree am on subjective expected utility, I say to everyone who voted for 203, don't be silly, you can't vote for two, I say, because you're victims of what is called the base rate fallacy. You haven't taken account of the fact that there are tens of thousands of bank managers in the country and only about two spokespeople for the Animal Liberation Front. So the probability that anyone is a spokesperson for the Animal Liberation Front is extremely low, while the probability that even in Britain today a randomly selected person is a bank manager is really quite high. So nobody can sensibly vote for 2, and nobody can sensibly vote for 3 either. Because if you think about probabilities, it can't be more likely that someone is both a bank manager and a feminist than a bank manager alone, because there are quite a number of bank managers, indeed a very high proportion in my experience, who are not active feminist. So why is it that people go for alternatives two of three, and the answer is they don't think about risk in these probabilistic kind of terms. People think about risk not in terms of subjected expected utility. It's only people who've been subjected to years of finance courses, we even start to think in these terms. And they don't really, when it comes down to it, I bet there are some people in this audience who've been through finance courses and went down the second and third alternatives. The way people actually think about risks is in terms of plausible stories. And the reason lots of people went for two and three is two and three kind of cohere as a story that given the way I describe Linda, you can easily imagine that someone like that would be a spokesperson for the Animal Liberation Front. If she is a bank manager, you can imagine that she's a bank manager who's a feminist. But if I confront you simply the idea that Linda's a bank manager, people rebel against that. And in a way, they're right to think of. Of these issues in terms of likelihoods and not probabilities. Because actually, if you ask if I made the introduction, which I've made all Right. I gave you the information, which I did give you, and then introduced you to Linda, saying casually, as I move away, Linda's a bank manager. You would say, did I hear that right? And you would start in the non committal way we do when we talk to someone and we don't quite know who they are, which is to ask questions that generate more information about the person. Whereas if I tell you two of three, you think these kind of things make sense and you start talking to the person concerned, they're stories that make sense. If you're confronted with a first, it doesn't make sense, you don't act on that. You need to get more information, it'll order to do it. And you need to build up the confidence you have in terms of the narratives you tell. And that's actually the way people typically think about risks. And the truth is, it's the way the stockbrokers whom I talk to about Rob Caledon were thinking about risk when I rang them up and asked to buy these shares. And mostly they were right to think about risks in that kind of way. It's just I was confronting them with a rather peculiar problem. That was one in which the best way of thinking about it really was the one I'd been taught in my graduate courses. And it took me at least a couple of decades to realize that the very first time I'd bought a share, I'd been faced with a peculiar problem to which the theory which I learned and then subsequently taught fitted rather well. So these are the bits of theory which you need to know in order to think about finance. Now let me go on and translate that into the two broad kinds of investment strategy which you can follow. If we go back to these principles of asset valuation, you can see that the idea that we're going to. We've said you can value assets by reference to the mind of the market. That is, you can follow the mark to market principle or you can follow the fundamental bond principle. I've already mentioned Warren Buffet, who's the most successful investor there has ever been. And he's pretty much associated with the fundamental value principle. Buffett has always taken the line as described by Buffett's mentor, Benjamin Graham. As there is this guy called Mr. Market who comes along every day and he offers to buy and sell you assets at essentially randomly selected prices. And these are opportunities for you because you have an idea in your mind of fundamental value. And if he's offering the asset to you at something lower than your conception of fundamental value, that's an opportunity for you to buy it. And when you've bought it, then you just lock it away. You rely on the second principle of asset valuation, which is you're going to get the stream of cash flows that that generates over its lifetime. The other way of thinking about investment strategy is to go to the first one to say that an asset is worth what someone is willing to pay for it. And therefore, if you're able to anticipate the mind of the market, to judge what other people are going to think about asset valuation, not necessarily on any rational basis, but what they're going to think about it ahead of them. Forming that particular view, you will be able to buy and sell assets in ways that will make money for you. And if I was I meant to describe Buffett as the most successful investor that has ever been. I doubt if George Soros is quite the second most successful investor there has ever been, but he comes fairly close to it. And if you associate the fundamental volume strategy with Buffett, you can associate the mind of the market strategy with Soros. And he's described, both Buffett and Soros have described their investment strategies in quite considerable detail. And what Soros is doing is essentially believing that he can anticipate the nonsense that people in financial markets are going to respond to rather more quickly than they can do it themselves. So there are these two broad strategies which you can apply as an individual investor. But I'm going to make the point that it's a almost a no brainer which one you should focus on as an individual investor. Because unless you're willing to spend all day, every day being in the market, you are not going to be able to anticipate the mind of the market better than people who actually do it. In terms of the first strategy, the mind of the market strategy, in terms of applying the mark to market principle, you're worse placed than most people in the financial services business. But as far as the second principle is concerned, the fundamental volume principle, you actually have an advantage over most people in the financial services industry. And the reason you have an advantage is that most of them are benchmarked by relative performance. They are in effect, precluded from doing things that are very different from what the bulk of people in the market are themselves doing. Because the only way you can do well, if you are out of line with a market for more than a small number of quarters, you as a fund manager are going to find yourself out of a job. And that's why most fund managers employ a practice which is called Closet indexation, which is you buy essentially a random selection of securities of the market. But you don't tell people that you're doing that because you won't get paid a lot of fees for that particular exercise. But that is the reality of what you're doing. And it's only by following that reality that you can meet your relative performance figures. Every fund management firm in the city has people who are doing risk analysis for their fund managers. And what they mean by risk analysis is what they call tracking errors. How large an error are you making relative to the performance of relative indices? That's what they mean by risk. But what you mean by risk as an individual investor is not that. What you mean by risk is how much money are you going to make and how much money, not how much relative performance are you going to lose, Lose or make. Relative performance doesn't pay the investors bills, it pays fund managers bills, it doesn't pay your bills. Absolute performance is what matters to you. So there are these two strategies you can follow. But as a private investor, the only one which in my view is any relevance is the fundamental value story. Now this is then how you start building an investment portfolio. I've already talked, emptied it the way in which I believe the Internet has changed the possibilities available to a private investor. And this is a simple way of doing what it is a professional investment advisor will do for you. Anyway, you can go on the Internet and, and you can open a personal stockbroking account. It'll take you five minutes to find what the average asset distribution of a British pension fund is. And these are the most conservative, well advised, professionally advised investors, which there are. You can then essentially replicate the portfolio of that particular institution. You can buy a UK index fund, you could buy, I'll tell you in the book exactly how you find these, but it's not very difficult. You can buy a global index fund, you can buy a global bond fund, you can buy a real estate investment trust and essentially with four clicks of a mouse, you can buy a portfolio which will mirror very well the performance of the average UK pension fund. Of the average well advised, expensively advised UK professional investor, that will take you an hour. And the great advantage which you have of doing that is you're not going to pay large fees to any investing adviser for doing so. If you invest professionally in the uk, if you trust your funds to fund managers, it will typically be the case in Britain that you will pay about 2 or 3% of your assets a year in the total of charges which you incur now, the most spectacular sum I think I've ever done in investment analysis was one which I did in the course of preparation for this book where I've talked about Warren Buffett as the most successful investors. I've asked myself, suppose instead of investing for himself, Buffett had divided himself into two elements. He thought of himself as investor and he thought of himself as fund manager of his investment. And he paid standard investment industry charges to himself for his fund management activities of his own funds. So after the end of the 50 years, Buffett in 2008 had accumulated $62 billion. At the end of his period of investment, how much of that money would have belonged to Buffett investor, and how much of it to Buffett the fund manager? And the answer to that question is 5 billion would have belonged to Buffett the investor and 57 billion would have belonged to Buffett the fund manager. There's an old joke about in the financial services world which goes Back to the 1920s, when someone visits Newport, Rhode island, the home of American plutocrats, and someone points to him and points out the yacht's moored there and says, that's Mr. Mellon's yacht and that's Mr. Whitney's yacht, pointing out the great names then of the financial services industry and that's Mr. Morgan's yacht. And then says the visitor, so where are the customers yachts? And that there's a lesson for us all that the clear risk free way of increasing the returns on your investment portfolio is to pay the financial services industry less. What I've described is how you can simply implement that strategy and you can do what a professional investor advisor would do for you at relatively low cost. But I suggest you should follow two other basic principles as well. The first is to diversify more. That is actually the portfolio which I've described, which is the portfolio of the average British investment institution, lost something like 50, 30% of its value in 20072008 and lost a similar amount of its value in 2000, 2001. That's a lot riskier than certainly I'm inclined to take in my investment decisions, or I think you should be. It's not a sufficiently diversified portfolio. And the second key element of investment strategy one, which goes right back to that initial investment in Rob Caledon, is to say diversify more. And above all, when you think about risk, mind your overall portfolio. Risk is a property of your investment assets taken as a whole, not of the individual assets in it. So although Rob Callard had taken on its own was a risky investment taken as part of an overall portfolio, it was not actually a risky investment at all. What would have been risky is if I had plunged most of my expected net worth into Rob Caledon, and I certainly wasn't going to do that. The third element is to be contrarian, which is to say that we've learned that market volumes revolve around go up and down around fundamental values. In the long run, there's some degree of reversion towards fundamental values. Indeed, when I said that past prices tell you nothing about future prices, there's an important mild exception to that, which is to say that there is what we call short term positive serial correlation in most markets. That is things that went up yesterday are slightly more likely to go up again tomorrow. But also those long term negative serial correlation, that is things that have gone up in the last five years are less than averagely likely to go up in the next five years. So prices move in the same direction in the short run, the opposite direction in the long run. Now, if you knew exactly when the short run became the long run, that would generate a rule that would make us all rich. But I don't have to explain that. We don't know exactly when the short run becomes the long run. But if you follow that principle, you can stay out of these momentum effects in the short run and you can benefit from mean reversion in the long run. And that's the benefit essentially of being contrarian and following that kind of strategy. So what I suggest individuals do is they begin with a simple pay less strategy. You can replicate what it is the best advised investment institutions do. But over time, as you gain confidence, you can get a little bit of ability to think for yourself and to lean against the accumulated wisdom of the financial services industry. Because if we didn't know it before, we've learned in the last decade with the madness, first of all, of the new economy boom and bust and the madness of the credit expansion of the last five years that are characteristic of people in the financial services industry is that they all think much the same thing at any particular time. But from time to time, and for no very good reason other than the force of reality finally breaking in, they frequently change what it is that they all think you have an advantage in not being part of that particular conventional wisdom, of being able to stand back and make your own particular decisions. So these basic principles, pay less, diversify more, mind your portfolio, be contrarian, are the basic ideas which are ultimately grounded in real theoretical analysis of the way we approach these financial issues. Which I think are the keys to managing money as a private individual. But overall, what I've told is, in a fundamental way, a depressing story that we have in the financial services industry, one of the largest and most profitable industries in Britain and the world today. And yet, if you ask what is the honest advice one can give to people as private individuals, it is to say that the best way to manage your money is to have as little to do with the financial services industry as possible and to take as much control over your own destiny as you possibly can. As I say, that's a deeply depressing conclusion. But if we look at what has happened in the last couple of years, if these people are so bad at managing their own money, why on earth should you think they will be good at managing yours?
- [55:41]
A
Well, thank you, John. So we'll take some questions. Okay. Perhaps you could say who you are and this young lady here first. Are we.
- [55:56]
B
Any microphones?
- [55:57]
A
Yes. Okay, there's one here.
- [56:00]
B
Okay.
- [56:01]
A
Perhaps we could just let the people that are exiting clear the room first. And then we can. Can have a slightly uninterrupted question session.
- [56:18]
B
Okay.
- [56:19]
C
I'm afraid I have worked in the financial services industry. Guilty.
- [56:22]
B
That's.
- [56:24]
C
And actually for a fund of which you were a director, so you sound.
- [56:26]
B
As if you're reformed.
- [56:29]
C
Feels like an AA meeting. I just wondered how your book compares with David Swenson's work in the U.S. you know, the Yale endowment man who wrote a book called Unconventional Success where he puts forward his theories for private individuals saying that they should buy ETFs or very, very cheap products. My second question is, I know you were talking about private individuals, and therefore hedge funds are not really relevant, but your thoughts on the new fashion for UCIT's three absolute return funds, which are being marketed towards private individuals in this company.
- [57:05]
B
Yeah, there's obviously a lot in common with what I'm saying and what Swenseness has been saying. And when you say, how does what I've written differ? I think one important respect in which I hope it differs is I think I will write rather better than Swiss. But if we put that to one side for the moment, I'm also rather less enamored of paying people 2 and 20 than Swensen was with private equity investments and hedge funds which he engaged in. Although there's an issue which we could explore there, which is the extent to which hedge funds and private equity rather change their nature from the time in the 90s at which Harvard, Yale, and some of these other US and institutions went into them and what they became when they were aggressively marketed widely to institutions in the last. In the years after 2000. But broadly speaking, I think in this sense there's a lot of similarity. And Swensen's more recent book, rather Aimed at the private individual, is kind of almost about obsessive in the way it attacks the US mutual fund industry. But I think the degree to which a lot of these funds have charged people very large amounts for is essentially what I've described as closet indexation for following the bench very close to the benchmarks, which you could have followed yourself without paying any amount. These fees at all is indeed a scandal. And some of the other abuses which parts of the fund management industry have perpetrated on private individuals are also scandal. There are very few of these people who are worth what they've been charging and it's quite hard to work out who the ones who are worth what they've been charging actually are. So this is all I'm saying is entirely about absolute return that I've said. And it's a kind of basic mantra that relative performance doesn't pay the bills. But relative performance is what fund managers are aiming for and are incentivized to aim for. But it ought to be irrelevant to you that your fund has only gone down 15% when the market has gone down 20%.
- [59:48]
A
Here in the front row, number three.
- [60:01]
B
I can see there's a row of people in the front. I know David has these instructions here for what you're supposed to do in the event of disorder in one of these lectures. A couple things actually.
- [60:16]
D
Just on your last point, I guess hedge funds out there at the moment, who made, you know, targeting at.
- [60:24]
B
Absolute.
- [60:25]
D
Returns and so to hedge them down perhaps fairly cheap options where you put huge upside if there's some catastrophic event, wondering if it is possible if the technology is there for invest and private individuals to actually view that at the moment. You know, I may get why short ETFs, but that really doesn't view this. Perhaps you know, the optionality risk that you know, sophisticated institutional. And another question, just your views on the den of brackets perhaps you've seen and threats common is uk, US and Japan. And if you think that will have a bearing on stock markets going forward because obviously, you know, as you grow Asian populations, perhaps there could be some sort of downward valuations in markets in those countries because, you know, cash, which is coming out of pension funds, perhaps net.
- [61:26]
B
Right. I'm going to decline to answer the second question because one thing I really want to do tonight is to avoid anything that might resemble stock tips or investment advice. I should have said right at the beginning that anyone who's come here to be told what shares to buy should have left right at the beginning. I'm sorry if you've stayed for an hour in the hope of getting that. In relation to the first question, I take the view that private investors should almost always avoid kind of structured products of various kinds because there is very little you can do with a structured product that you can't do more cheaply yourself. You were saying there are some gaps in what is available for insurance.
- [62:19]
A
Really?
- [62:20]
B
Yeah, you can construct quasi portfolio insurance in effect for yourself. But you're right that cheap access to more complicated versions of optionality is something that's not really available for private investors at the moment. But that's a kind of complex strategy, you know, for the kind of people, you know, which we're whom we're whom we're talking about in general, you know, people will do better simply with broad spectrum diversification, I think from that kind of portfolio insurance.
- [62:58]
A
The young lady on the side over here, box eight rows back, she's got.
- [63:15]
B
What do you attribute the common investors reluctance to invest in bond markets over stock markets. And do you think this is a misstep for the person who's trying to manage their own funds? Yeah, I think people. There's a very simple story which is people get a lot more commissions and particularly in the past for selling people equities and particularly equity funds than have ever been generated for selling bonds and bond funds. And indeed even such bond funds that exist, you know, are typically overpriced relative any reason even compared with equity funds. It seems to me paradoxical but true that it's probably cheaper for most people to buy exchange traded funds that invest in bonds than actually to buy bonds themselves. And that at least for the moment, until that particular aspect of the technology improves, probably what most private investors investing in bonds should do. And I think it's what all private investors should do to some degree.
- [64:37]
A
There's a chap on the blue top here.
- [64:43]
B
I was wondering, would you agree that not just CEOs or being executives of companies that they obviously look at relative performance, but also that the incentives for them is to have high risk, high returns because if it does flop, which it can do, they still have a base salary of six figures. So you know, they're still going to be all right, but if they don't get the returns, well, it doesn't really matter, does it? Yeah, I mean, you're talking in a way about different. We've been talking with people towards the front really about the incentives that fund managers have which are very much benchmarked to quarterly performance. You're talking about the kind of incentives which CEOs had, which typically, interestingly have mostly been related to average, to absolute stock performance. So that they've created both the phenomenon which we've seen over most of the last 20 years, that since stock prices have basically been rising, they've amounted to a way of paying CEOs quite a lot more because whatever the performance of your company, your stock price tipping typically went up and typically also generating the asymmetric incentives which you describe. So you took out a lot of the upside, or you made a significant profit on the upside, but you didn't make a corresponding loss on the downside. What I think may be more relevant to the basic subject we're talking about tonight, however, is the way in which the quarterly benchmarking incentives that are on pressures that are on fund managers get translated into a process of managing investor expectations and investor relations at the corporate level, in which particularly finance officers of companies are managing investors expectations. A combination of generating smooth streams of rising earnings and of trying to manage investors expectations. So your results are always kind of slightly ahead of what it is the market has been expecting. And analysts will typically reward you for doing what they describe as what you say you'll do, which typically means giving more reasonably reliable earnings guidance. And I think that's created for public companies in Britain and the United States a whole kind of dysfunctional structure in which both companies and the analysts and the fund managers who follow them are all locked into a kind of cycle that focuses on quarterly returns that becomes increasingly divorced from long run strategic issues for the company that determine the underlying fundamental value. And I think that's one of the real problems of the way public markets and securities in active stock markets now operate.
- [68:08]
A
Okay, down here at the front.
- [68:13]
B
Mio Silvester I'm a private investor. First Gay Is there no such thing as alpha? In other words, if you look at people like Peter lynch in the Fidelity Med, Gap Fund, Buffett in Berkshire Hathaway, Soros in the Quantum Fund, these seem to run counter to the homogenization of investment that you're talking about, much of which I actually agree with. But I'm just wondering, is there anything, Is there such a thing as alpha? No, there is such a thing as alpha. It's just not very many people can do it right. And even given the ridiculous Sum which I described for Buffett. It would actually have been worth your while paying Buffett to get the 5 billion for you. 5 billion is not to be sneezed at, as it were, but you have to recognize the fact not just that the bulk of the fund manager, the bulk of the money would have gone to the fund manager, but that is not actually a property of the fund manager having done so well, more or less, regardless of that kind of period of compounding of what the underlying return on the investment had been, the fund manager would have ended up with more than the underlying investor. These charges are just high for the small number of people who have genuine alphas. They're ridiculous for the large group of people who are doing in effect one version or another of closet indexes. And we described it talking earlier about how hedge funds changed over the 10, 15 years from when big US endowment started to invest in them to when they became widely marketed popular investment. And part of that change was they migrated from being people who had genuinely idiosyncratic investment styles, some of which really did generate a lot alpha, to people who were just fairly conventional fund managers who were charging enormous 220 hedge fund fees for no particular investment skill of any kind. I think there is a role in a contrarian private investor's portfolio for some actively managed funds, but I think they should be relatively idiosyncratic funds, firstly to get diversification and secondly to stand a chance of getting someone who really does have genuine investment skill of some kind or something distinctive to offer at least.
- [71:08]
A
Okay, at the back, just behind you on the right or your right.
- [71:15]
B
When talking about diversification, how important would be the role of investments in different currencies and maybe commodities? I think all of these can play a role. But when we talk about investments in different currencies, you find that what people tend to mean by that in when they start is investing in different equity markets. But the truth is large multinational companies in Japan, in the United States, in Germany and Britain are selling to much the same customers in much the same countries, regardless of the country in which their head office is actually located. So that kind of diversification may actually provide less diversification than you think on commodities. I talk a little about that. I find it quite difficult to see for a long term fundamental value investor how investing in commodities is going to have much appeal relative to investing in companies that own commodities or companies that mine commodities, because the truth is, paying for them already having been dug out of the ground, in effect is something you don't actually need to Do. That's a more technical part of the argument. But that kind of diversification is part of any genuine diversification portfolio.
- [73:00]
A
At the back.
- [73:04]
B
With the shifting sands of accounting standards and other ways of reporting assets and moving them off balance sheet and on balance sheet, etc. I do find it difficult to know exactly what an earnings number is. Is this a problem? Yes, it is. And there's a simple starting point there, which is if the company report and accounts are hard to understand, then shut them and move on. And that will rule out a very high proportion of potential investments. But you're not going to buy more than a small, small proportion of the available of the shares that are potentially available to you anyway. Another good rule is to say as soon as you see the complicated calculations which you get in many companies about pro forma earnings, adjusted earnings, etcetera, you know that's another signal to move on to something else. If they're making it hard to understand, it's probably because they don't really want to tell you what's going on. The rule if you don't understand it, don't do it, is one that would have saved an awful lot of people an awful lot of money over the last decade. And not just amateurs and the financial services industry, I would say professionals, even larger amounts.
- [74:44]
A
Yeah, this young man here. Yeah, the microphone's coming your way. The chap in the black shirt and fancy pattern on the front. Did you have your hand up? Sorry? Clearly you didn't. Over here, about five rows from the back.
- [75:04]
B
Pardon? Ask a question.
- [75:07]
A
Oh, sorry, I didn't see you. I haven't got my glasses, I can't really see much.
- [75:13]
B
But I once read a book by Peter lynch and he was arguing for fundamental value assessment, just like Buffett and he said, invest in what you know and for like normal person, takes quite a long time to assess the fundamental value. And he said, don't go for something you don't know. Why isn't it a bit contradicting with the idea of diversification? Because if you only invest in what you are sure about, you are certainly not diversified. Yeah, I mean, lynch said a lot of strange things. Lynch said invest only in what you know. By which he seemed to me, certainly from the examples he gave you invest only in companies whose products you use or are familiar with. The truth is that narrows the scope of companies you can invest in quite a lot. And yet at the same time, his funds had extremely large numbers of stocks in them, many more than the vast majority of of investors have. So despite Saying what he said to you, what you described, which he did indeed say, he absolutely, massively diversified, incomprehensibly diversified, in fact, because you can get most of the benefits of diversification by owning a relatively small number of securities. So long as these securities are genuinely diversified, that is, so long as they're not strongly correlated with each other. As you can see in any of the kind of mathematical demonstrations of the benefits of diversification, there are quite rapidly diminishing returns to diversification of assets, assets that are genuinely uncorrelated. Over here, I just wanted to pick you up on a quote that you gave recently and that was that banks became a blur between a utility and a casino. And that wasn't obviously the words that you used, but I think it was to some extent, and I was just wondering was whether there was like a defining landmark point when the bank became a utility to a utility and a casino or were they always a mixture of the two. But then the casino bit just got bigger recently? I think the answer to that is the casino just got bigger. I mean, it was always true that even the narrowest of narrow banks had to have a Treasury operation for the day to day management of its cash. What happened was that the treasury operation was eventually turned into a profit center. The scale of money market activities increased. You know, what was once described as a Treasury operation exploded into what people called proprietary trading. As the hedge funds we were talking about earlier operated not just as standalone hedgehog hedge funds, but became a large part of the operations not just of investment banks, but of what were predominantly retail banks. And it was the kind of gradual explosion of these kind of activities. And people sometimes talk today about the separation of retail banking from other kinds of banking, which, as you know, I favour was writing in favor of there as being a new Glass Steagall which separates investment banking and retail banking. Glass Steagall no longer draws the line in quite the right place for the reasons we've been describing. In terms of treasury, there's no difference, there's only a difference of size, not a difference of kind between treasury activities and prop trading.
- [79:33]
A
Okay, behind you.
- [79:38]
B
Do you have a view on the rating agencies? I have a view on rating agencies that says that rating agencies should not be regulated and should no longer have any role in regulatory supervision either. I think the primary mistake we made was in giving them a kind of formal official role that created the world in which people had. Not only did people have incentives to get particular ratings, but everyone had an incident incentive essentially to collude on the over rating of underlying securities. And that was the product of regulation, not the result of regulation's absence.
- [80:33]
A
Over here.
- [80:46]
B
I think that's going to violate my rule against talking about individual securities and individual transactions. And beside, if I was as good as Buffett, I would have $62 million too. We'll have to put up with a bit less than that, as I do.
- [81:04]
A
Okay, there's a young chap here.
- [81:08]
B
Do you not think it's time difficult to know exactly what you're buying with a particular stock or share these days since everybody invests in everything? When you sum it all together, obviously shares outperform each other, but it's very hard to know what's underpinning that price. Yeah, right, right. Indeed, there are a large number of businesses that are very difficult to understand, which is why my rule, if you don't understand it, don't do it, knocks out most of the things you might invest in. But there are actually so many things you might invest in that you can do an awful lot of knocking out. And there still is quite a lot left.
- [81:57]
A
Are there any questions? Okay, just feel like an auctioneer trying to sell you to the audience.
- [82:11]
B
Do we have any final offers going, going, going.
- [82:13]
A
Oh, we do. Over here. Okay, we're going to stop at 8 o', clock, so we have four minutes.
- [82:19]
B
Keep it quick. Two questions. Firstly, if you have it, could you tell us what percentage commission you achieve attributed to Warren Buffett when you were calculating his fees? Isn't that fascinating? The answer is in that sum. I gave him a 2 and 20 fee. A standard hedge fund, private equity kind of scale. Thank you. Second question is, do you think the existence of hedge funds is bad news for retail investors as a matter of principle or is it neutral? Do I. Is it bad news? Well, nobody has to invest in them so that there are very few people I would think would be inclined to pay 2 and 20 to. And as a typical small private investor, you'll be lucky to get into hedge funds even for that. I mean, more in the sense, do they reduce returns for other funds? I'm not sure they do. And that they're all right. And that leads one into, you know, is short selling a bad idea? And the like. And I must say, the degree to which Enron was brought down by short selling, the extent to which there was voluble objectors to short selling, were the managers of banks at a time when it was perfectly clear that the hedge funds or at a time when it became perfectly clear that the hedge funds knew more about what was going on in banks than the managers of banks themselves did. They were also revealing more about what went on in banks than the managers of banks were. I think, I feel what we've seen in the last two or three years, the hedge funds, the short selling hedge funds are the better of that particular argument.
- [84:19]
A
Did you. If you run the average hedge fund's performance against the 2 and 20 strategy for 50 years, how does the balance of the two accounts work out? Does one end up empty?
- [84:32]
B
You mean if I ran the S.
- [84:35]
A
And P index, the average performance of a hedge fund, but I don't have.
- [84:40]
B
A 50 year record for hedge funds. No, no, true.
- [84:43]
A
No, you extrapolate it. You take the current performance and run it for 50 years. You wouldn't end up with much, would you?
- [84:50]
B
I haven't done a particular sum and as you know probably better than I do, there are some hedge fund indices that are hell of a problems about these hedge fund indices and a large survivor bias of the hedge fund.
- [85:05]
A
We had a wonderful presentation from Victor Hagani on that. It was amazing how many ceased to exist in the course of a relatively short period of time. So survivorship bias is quite important when you do the calculation. One more question, do we have any? Yes. Okay, back to this chap who almost started us off. So it would be a suitable guy to finish with.
- [85:28]
B
We have a gentleman at the back who hasn't had a go before, so.
- [85:31]
A
We'Ll give him.
- [85:34]
B
Both.
- [85:37]
D
It's actually pretty time consuming for a private individual to come up with a diversified, you know, truly diversified portfolio. You know, talking about your Rob Caledon example, is it actually quite difficult to find stocks like that which really are idioting and you're kind of. I don't know, I'm thinking of maybe sort of biotech stocks who are betting on one certain drugs or. And that doesn't require quite a rigorous analysis and to actually come up with, you know, a broad portfolio of stocks like that.
- [86:09]
B
Yeah, I mean that's why I'm not suggesting that anyone who's starting off investing for themselves should start looking for stocks like Rob Callida. Indeed, it was a kind of freak that that turned out to be my personal first investment. And indeed it was at a time when I wasn't basically thinking about investment at all. Now that's why I've talked about the initial strategy for someone managing themselves to be using a small number of ETFs essentially to achieve quite a lot of diversification quite quickly.
- [86:46]
A
There is one final question at the back. John seemed to Identify somebody I didn't see.
- [86:52]
B
Yeah. My question goes back to the Linda story and the point you were trying to make about distinguishing uncertainty from risk. I just wondered if there are any specific techniques that you know of or you use yourself to do that. I think the basic idea, which I could give an entire lecture on in its own right, and I won't since I can see 8 o' clock on the screen at the back, is the way in which we think about uncertainty in terms of narratives and storytelling, rather than the kind of Bayesian approach to probabilities and the whole analysis of subjective expected utility. And I used to think, because I think most people in finance and economics still do, that this kind of SEU structure was really the only way of thinking about risk, and anything else was some sense irrational. I now take a very different view and think as I do about a number of the other issues I've described tonight, that fundamentally, to understand them, we have to take a view of the world that is eclectic. We have to have a kind of toolkit of ideas and theories, and different tools will be. Or different sets of tools will be the most important, appropriate one for particular problems. And I think that's a kind of fundamental note on which to end. 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 theory or group of. Of economic theories is completely descriptive of the world. And while put like that, no one will say they do it, in fact, in the way a lot of people in the business, finance and economic world behave, that is what they do.
- [89:11]
A
Thank you very much.