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uh, and, you know, I owe it all to Warren Buffett, and on the cover it says, "This is a rarity—a useful book," Warren Buffett. And those few words helped sell a lot of copies. So, Howard, let's take a step back and talk about the most important thing in this book. You listed a lot of important things, but Market Cycles is the only book on the list that you wrote.
Yes. Why market cycles? Well, I think the book was called " The Most Important"...there are 21 chapters, and each one starts with the words " the most important is," and then something else follows. Because there is no one most important thing in investing; Maybe someone will object that there is no, uh, you know how it was, uh, Lombardi says, uh, "Victory is not..." let's see how many people in the room even know who Lombardi is.
Vince Lombardi, does anyone know? OK. Well, at least a third of them know. He said, “Winning is n’t everything. "That's the only thing that matters." And as I write in the book, I'm not exactly sure what that means, but I think the two most important themes in investing are risk and cycles. And they are linked because your place in the cycle determines your risk over the medium term.
The reason I think risk is so important is because, in my opinion , the main difference between a great investor and a not-so-great one is not just the amount of profit they make, but the amount of risk they take to get there. You know, today you can leverage the S&P using derivatives or ETFs. You can buy an ETF that rises or falls four times as much as the S&P, or maybe eight times as much.
And if you buy this and you get into a very positive market period, you'll have astronomical profits, but that doesn't mean you're a great investor because everyone will say, " Look at this guy." It has grown eight times more than the S&P.” Well, you know what? If this were a recession, it would have fallen eight times more than the S&P.
He didn't add any value. This is not a good investor. I think an exceptional investor is someone who makes a good profit that is disproportionate to the risk taken. Good profit with controlled risk. So I really think risk is the most important thing. The book has 21 chapters, and three of them are dedicated to risk.
Understanding risk, recognizing risk, and controlling risk. But I also believe that our place in the cycle has a huge impact on how much risk you will take. And I'm not thrilled with the title of this book. The publisher insisted on it because he believed that with the title “Mastering the Market Cycle” we would sell more books, because everyone would decide they were going to get rich.
But I like the subtitle: "How to tip the odds in your favor." We don't know what the future holds. I don't believe in predictions. Actually, Michael started with a quote from Galbraith. Another favorite quote of mine from Galbraith: there are two types of forecasters. Those who don't know, and those who don't know that they don't know.
And I believe in that very strongly. I firmly belong to the first camp. I don't know what the future will bring . And I don't think anyone knows. The future can only be rationally thought of as a probability distribution. What range of events can occur? What is most likely, what other options are likely, and which are unlikely?
And we have a great quote from Elroy Dimson of the London Business School. More risk means more things could happen than actually will. This is the source of risk— the future is uncertain , and if it could be predicted, theoretically there would be no risk . So let's take a step back, Howard, and try.
So, we're actually talking about risk-adjusted returns, right? And Howard said: is it possible to make profits with minimal or no risk at all ? And that's significantly different from someone who takes a big risk. When we think about the world we live in, we see a huge shift from active asset management to ETFs or passive management .
But it's easy to understand what happened. What happened was that the market grew significantly. And if you are fully invested , for example, in an ETF, you are by nature 100% invested in that asset class, unlike a money manager who might be 50% or 60% invested. So in a rising market, it is very difficult to outperform someone who is fully invested.
However, in a falling market, which we have not seen yet during the rise of passive investments or ETFs, what will happen? Of course, you will fall more because you are fully invested , not necessarily hedged, and you also risk facing a call problem. So, we did n't actually do that. So, Howard and I are strong believers in fundamental analysis.
Would you like to touch a little on the topic of passive versus fundamental investing? And obviously your experience at Wharton and Chicago -- we both lived through a period in our academic lives with the idea that markets are perfect. Yes. That no one can beat the market. People have received Nobel Prizes for our academic training.
They even won Nobel Prizes for claiming that capital structure doesn't matter, etc. So bring us back to this discussion. Howard. Well, I was a student at Wharton, where I studied the practical side of investing, and then I went to the University of Chicago for a master's degree, where I studied the theoretical side.
Financial theory , the key theories, were developed almost entirely in Chicago in 1963-64. This was the period when they appeared and we studied the things that Michael described. One of the most important is the efficient market hypothesis, which states that the market consists of a multitude of people who are highly motivated to get rich.
They are all smart. They all know how to count. They are all connected to computers. They are all trying very hard. And their search for bargains results in bargains disappearing. If there are any cheap stocks, they find them and buy them. Their purchases raise the stock price to full value. If there are any overvalued assets, they sell them.
This brings the price down to a fair level. So, all prices are fair. With risk taken into account, QED, you can't beat the market. This is the official conclusion of the efficient market hypothesis. And, by the way, we were empirically proven in Chicago that the average mutual fund did not outperform the market, but charged high fees.
It is clear that everyone together cannot beat the market, so on average all investors have average results, but after high commissions, the results are below average. And you shouldn't invest in a mutual fund that is actively managed and has high fees; you should, and they said back when I was a kid, why not just buy one share of each type?
Are you implying that we are both no longer children? We're both not kids anymore, but they said, "Why not just buy every stock in the S&P?" We didn't have a term for it, but about five or six years later, the concept of an index fund emerged, and index funds themselves began to emerge. And if the average active investor performs worse than the market, it is better to choose an index fund that simply tracks the market index.
Index investing started very slowly. In the mid- 1970s, Vanguard, led by Jack Bogle, launched the first serious index fund, but it still grew slowly because it had to overcome traditional resistance to handing over tasks to automated processes. You know, I wrote a piece, if you want to read about it, I wrote it in June called " Investing Without People," where I talk about the historical development of index funds, and it quotes Ned Johnson from Fidelity, who said, "No American would settle for being below average." This is , actually...I have nothing against Ned, but this is a great example of how, in my opinion, this statement lacks self-reflection.
Or, alternatively, maybe it's the salesperson's words, because of course you'll settle for an average result if everything else you can do is dooming you to a below- average result. And...and for many people it would be much better if they got an average result. Anyway, the bottom line is that expensive active management has obviously not been much worse for everyone than inexpensive passive investing , which is why over the past 10-15 years the movement towards index investing and other passive forms, as Mike mentioned about ETFs, has gained a lot of popularity. And now 37.
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