Episode 248: Prof. William Goetzmann: Learning from Financial Market History
William N. Goetzmann is the Edwin J. Beinecke Professor of Finance and Management Studies and Faculty Director of the International Center for Finance at the Yale School of Management. He is an expert on a diverse range of investments. His past work includes studies of stock market predictability, hedge funds and survival biases in performance measurement. His current research focuses on alternative investing, factor investing, behavioral finance and the art market.
Professor Goetzmann has written and co-authored a number of books, including Modern Portfolio Theory and Investment Analysis (Wiley, 2014), The Origins of Value: The Financial Innovations that Created Modern Capital Markets (Oxford, 2005), The Great Mirror of Folly: Finance, Culture and the Crash of 1720 (Yale, 2013) and most recently, Money Changes Everything: How Finance Made Civilization Possible (Princeton, 2016). He teaches portfolio management, alternative investments, real estate and financial history at the Yale School of Management.
How the financial system works and how we interact with it has grown in complex ways and is a fascinating but nuanced topic. To guide us through the history of the economy is Professor William Goetzmann, who is an expert in finance, economics and art history, and whose research has been featured in top publications. As a highly respected scholar, he's authored numerous books on topics such as real estate and behavioural finance. It is fair to say Professor Goetzmann's work has left a significant impact on both academia and the world. In our conversation, we dive into financial market history and explore more than just broad market returns. We unpack the fascinating phenomenon of economic bubbles and booms, and how they have evolved and shaped the financial system. He also shares crucial insights from the past and advice for investors looking to leverage the market. And to wrap things up, Professor Goetzmann shares his views on money after digging deep into its historical roots. Tune in to unlock the secrets of the past and gain valuable insights for the future as we journey through the fascinating world of economic history. Tune in now!
Key Points From This Episode:
Why is it important to collect and examine long-term historical returns data, and how useful the findings can be for today’s market. (0:03:21)
The furthest back in time that Professor William Goetzmann has looked at equity returns and how much of an issue survivorship bias is in long-term historical data. (0:05:44)
Reasons for the United States market trends concerning equity risk premiums and his approach to forecasting long-term returns of both stocks and bonds. (0:11:02)
Whether current discount rates are better for estimating future returns than long-term historical returns. (0:17:08)
How the markets of today compare to the markets of the 1900s, and whether investor behaviour has changed. (0:18:42)
Learn how global finance changed after the First World War and how likely a global financial meltdown is. (0:23:35)
What to consider when investing internationally and whether Canadian investors should be biased towards their home country. (0:28:23)
Hear Professor Goetzmann’s definition of an asset price bubble and his approach to studying economic bubbles and booms. (0:32:44)
Overview of the economic bubble and boom trends and crucial advice he has for investors regarding a market run-up. (0:36:18)
An explanation for negative bubble behaviour and how well market crashes align with investor expectations. (0:41:46)
The role of media in influencing investor behaviour, and whether long-term investors should ignore news from the financial media. (0:47:35)
What Professor Goetzmann has learned from studying bubble dynamics, and his advice for investing in transformative technologies. (0:52:50)
Professor Goetzmann’s book Money Changes Everything, his definition of money, and if money pre-dates trusted authorities. (0:57:47)
The role of money in finance and a brief outline of how finance played a role in the development of modern civilization. (1:02:13)
Professor Goetzmann’s definition of success. (1:06:08)
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, Portfolio Managers at PWL Capital.
Cameron Passmore: Welcome to Episode 248. Ben, another week, another phenomenal guest that you found. So, kudos to you. We welcome today, Professor William Goetzmann, who is such a fascinating guy. He is a professor of Finance and Management Studies, and Faculty Director of the International Center for Finance at the Yale School of Management, where he teaches portfolio management, alternative investments, real estate, and I think most importantly to him, financial history, which I find so fascinating. And that's what we've talked about, with his book, Money Changes Everything: How Finance Made Civilization Possible. So, you’ve got to tell us, Ben, how did you discover Will?
Ben Felix: I mean, it’s the same story, as always. I had come across many of his papers, in many cases on very long-term returns, that I'd referenced his papers and some of my YouTube videos, like his paper on negative bubbles, which we did talk about during this recording. At a certain point, you've read so many of someone's papers, and it's like, “Oh, yes, well, I mean, we have to have him on the podcast.”
And then, his book, too, if I needed any pushing over the edge to get in touch with Will, the book, it’s just phenomenal. We didn't even scratch the surface. When I was preparing questions for Will, there’s so much that I left out, so much of his research that I left out, because there's too much. Anyway, we still covered a lot of ground, and I think it was a really interesting conversation. I love his perspectives on how, despite the world being maybe different hundreds of years ago, there's still a lot of information in financial market history for investors today.
Cameron Passmore: Even the ability. You talked about the ability to invest globally, you know, in the early 1900s, incredible.
Ben Felix: People were doing it, and some people were advocating for it at that time. And markets were fairly global, but then the contraction of global finance after that, and that whole part of the discussion, I just found very interesting, because the discussion around global diversification is good, which I think is generally true. But I've always got FOMO on my ear, talking about maybe a lot of home-country bias is not so bad. And we talked about that with Will as well.
Cameron Passmore: How even with the two huge shocks are the two World Wars, the returns for the 1900s were pretty good.
Ben Felix: Yes, great conversation on financial market history, historical returns, and not just broad market returns, but we also talked about the historical technology bubbles. We think about technology bubbles as a modern phenomenon, but we talked about the 1700s technology bubble with Will. Yes, incredible. And I mentioned his book on money, we finish the conversation with some discussion around money and Will's views on money after having looked at so much of money's history.
Cameron Passmore: Cool. Anything else to add?
Ben Felix: No. That’s as probably a long introduction, anyway, we can go ahead with our conversation with Professor Will Goetzmann.
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Cameron Passmore: Professor Will Goetzmann, welcome to the Rational Reminder Podcast.
William Goetzmann: Yes, well, thanks. I'm looking forward to our conversation.
Cameron Passmore: Will, why is it important to collect and examine very long-term historical returns data?
William Goetzmann: A lot of what we read about in the press, when we're thinking about the economy, or the stock market is really pretty short-term, but if you want to understand the deep rhythms of markets and society, you really have to take a long-term historical view. In particular, when you have big shocks, crashes, technological innovations that happen only occasionally through time, and you want to study them and see what their effects might be, you have to take that long trajectory, even over centuries, sometimes, in order to get a sense of how things change, how does the world respond to big events.
Ben Felix: Okay. We are going to get into bubbles and innovations later. But before we progress on this, how informative do you think data from hundreds of years ago are about expected returns today?
William Goetzmann: Well, you're asking a real financial question, expected returns, which means what kind of growth or benefits do I expect from owning a share of stock or a part of the stock index today, on average, over months and years? So, that is a puzzle for many people, and the reason for that is that the returns you get from investing are not stable. They vary quite a bit. With that volatility, that volatility creates uncertainty. And it could take you 20, 30, or 40 years to really understand what the expected return or what the average historical return is. But we'd like to think that once you've discovered something that makes money, it's going to keep on going before you can really put any kind of boundary on it at all.
So, as financial historians, and financial economists, were plagued by that uncertainty about what the expected return is. But history helps you because what I found in my research is that, over very long stretches of time, the stock market returns some amount in a relatively narrow band once you can control for things like inflation.
Ben Felix: What's the furthest back in time that you've looked at equity returns?
William Goetzmann: Well, equity returns are the returns of owning companies, or investing as a shareholder. So, I've looked at some data with my co-authors for very early companies that were created in France, in the 1300s and that's fascinating. Nobody knows that companies existed that far back. Or what's even more miraculous is that somehow in the city of Toulouse, people save the documents of these ancient firms.
That was fantastic. We have good measurements of the returns to shareholders from about the middle of the 1500s, and early 1500s. Those things, for at least one of the companies, go all the way up into the 1940s. So, that was very exciting to see.
Ben Felix: That's fascinating. So, the returns going back that far are still in that sort of narrow band that we see in more modern times?
William Goetzmann: Okay, so we've studied one company that stretched the whole time period, it was about 5% real returns between 4% and 5%, on top of inflation. So, that's not too far different than what the US has experienced over the last couple of 100 years.
Now, sometimes the stock markets go up faster than that, 5% or 6% per year, inflation-adjusted. And then, sometimes you run into periods like a whole decade, where there's no return at all, on average. That's the variation. But the 5% real return for an equity investment is surprisingly modern, even though it comes from looking at this ancient company that lasted over centuries.
Cameron Passmore: How much of an issue is survivorship bias in the very long-term historical data?
William Goetzmann: Well, I will say this company disappeared in the late 1940s. So, it didn't survive. But it did survive over centuries. There are a lot of – well, there are a few other corporations that when they began to appear, then they also eventually disappeared. The Dutch East India Company, for example, is a company that was braided to trade with the Spice Islands in Southeast Asia. And that lasted for quite a bit of time and then disappeared.
In general, companies have a lifespan. We have to imagine an investment approach that doesn't just hold one company from beginning to end, but basically invests in a portfolio of companies as they appear, and then just lives with the fact that they could also go bankrupt and so forth.
So, when we're thinking about the equity premium, we typically imagine an evolving portfolio of companies, they're capturing the growth at any given time of the economy.
Ben Felix: What about at the country level? If we're looking back and saying, “What has the historical equity risk premium been? How much of an issue is survivorship bias at that level?”
William Goetzmann: Well, survivorship bias is a really interesting situation. It means that you have a lot of different ways to look at it. But if you're only studying companies or processes that have survived the test of time, or if you're only looking at the stock market of countries that won wars rather than lost wars, that tends to skew your estimate higher.
So, let's just take the perspective of an investor that might have invested in the stock market in many different countries in the 1920s, after the First World War but then before the Second World War. And you could have, at that time, a lot of stock markets had sprung up around the world and you could have invested of course in the United States and the UK and you could have invested in Germany, Austria, Japan, and China. The Shanghai stock market was going great guns at that time. And then along comes this massive global war and a fundamental change in the politics of many of the countries that you could have invested in, particularly in Eastern Europe, after the Second World War, the stock markets that were in Poland and then Czechoslovakia and Romania and so forth. Those markets closed for decades, because of what used to be called the Iron Curtain, the division between East and West.
So, when you're thinking about a strategy of investing globally, you have to be careful not to just look at the winners, you have to imagine that your global portfolio is going to have some big shocks going forward in the 21st century, just like we had in the 20th century. I know that is saying something really pessimistic, but you at least ought to put some weight in your expectations, on the fact that we will have those kinds of disruptions, those kinds of market disappearances, those kinds of winners and losers in the global equity market.
Ben Felix: I want to come back to those parallels in a bit. I want to ask what the US market though, for a moment. You mentioned earlier that the US equity risk premium has been pretty good, relative to other countries. How do you explain that?
William Goetzmann: Well, there are a couple of ways to explain it. Or at least from an academic perspective, there are questions that you try and answer about that. We can test some hypotheses. By doing some things like simulations, or even doing some kind of mathematical analyses, we're able to make some predictions about how much survivorship may have affected, looking in the rear-view mirror at a very successful ride through the 20th century.
But that's an easy explanation. Another possibility is that the United States became a particularly successful economy in terms of generating innovative processes, ideas, companies, and the genius of a particular economic setting is what led to high returns. That's certainly possible. It's hard to distinguish those two. Also, you never can tell. Maybe there's a bit of a feedback going on. Once you have a successful capital market that can fund new ideas, that might be something that perpetuates itself. All these things are things that as a professor, it's fascinating to figure out ways you might be able to test these different hypotheses. But another thing that's interesting about being a professor is you have to live with uncertainty. You never like to say, “We've solved that problem” because just like the banking crisis, you might think you've solved the problem of bank runs, and all of a sudden, you haven't.
Ben Felix: So, speaking of uncertainty, Will, if you were in our receipts, so we help households make financial decisions. How would you estimate the expected long-term returns of both stocks and bonds?
William Goetzmann: You're right to differentiate the two, although they do share some characteristics. For stocks, the starting place, for me has always been the historical performance of the markets, both looking at the US market, but also comparing it to a world equity portfolio, which would take into account the failures as well as the successes.
People often ask me, “Don't you think that the expected return has really changed, because technology has changed?” Strangely enough, it doesn't seem to have really ramped up the expected return particularly or changed it that much. So, I think, at least the basics are that you look at returns, but you really have to adjust for inflation, because inflation has been a great shock since the First World War. So, for 100 years, we've experienced the kind of inflation that was only episodic in the world before that.
So, you have to adjust your perspective and you have to think about why are you investing. You're investing because you want to take the fruits of that investment sometime in the future, and be able to live off of it, or buy stuff and buy real things. So, those things are going to be affected by inflation. That's one big important issue. I would look at inflation-adjusted returns as my metric.
On the bonds side, bonds are theoretically less risky than stocks, although sometimes they can be very volatile themselves. But you have to realize with bonds you're not getting an upside. Occasionally, something will happen where interest rates suddenly go down and bond prices go up. But that's not why you're investing in bonds unless you're a short-term speculator. You're investing in bonds because they basically take your money from today, and ship it into the future. And unless it's an inflation-protected security, you're getting future dollars, which are going to be affected adversely by big inflation shock. So, bonds are sensitive to the potential for future inflation in the long term. And in the short term, they respond to variations in the interest rate.
Now, that's easy to say in one word. It's impossible to really explain all the complexities of what goes into causing variation in the interest rate. Today, more so than almost any time I can think of in the past, everybody's watching the Federal Reserve and the Treasury Department and trying to figure out what branches of the government or even something's, Federal Reserve is not exactly a government institution, it’s independent. What are those decisions that the Fed will make? And how are they going to affect my bond portfolio?
Those are human beings making decisions and thinking about what effect on the economy those decisions will have. So, there's a lot of speculation about what's driving them to do this, that, and the other thing. And that, in turn, makes it difficult to really forecast bond returns, at least in the short term very well.
So, those are the two different ways you think about stocks and bonds. However, one of the things that stocks and bonds both share, is their promises of future cash flows. That means both stocks and bonds are affected when the interest rate goes up or down. We've seen this recently because when the stock market went down after the Federal Reserve decided to start raising interest rates, a lot of that is probably due to the discounting of the future cash flows from the stocks in the same way you discount the value of the future coupons that you get from the bonds. So, the present value suddenly changes when the discount rate is raised.
Ben Felix: Again, similar question, if we're estimating future returns for financial planning and decision-making, how much weight would you give to current discount rates versus long-run historical returns?
William Goetzmann: Well, that's an interesting one. I was thinking about that a bit. I got my MBA in the middle of the 1980s, and that was about five years after interest rates had been peaking in the United States really close to double digits, if not just over. There was a secular decline in interest rates from that time until this time, until last year. I mean, there were a few ups and downs. But if you think about that, I mean, imagine what you would have done if you had seen the beginning of a decline and said, “Oh, now, boy, I can take advantage of that.” So, the bond prices just kept going up and up, and you kept getting capital appreciation from bonds because interest rates are going down.
So, I don't think you should expect that to happen again, all of a sudden. I mean, we may be at, I don't know where we are in the long bond, which is the 30-year bond. Maybe it's 6%, but I'm not quite sure. I haven't checked. But should you expect that value to double over a three or four-year period? I don't think so.
So, you ought to think about the bonds as kind of a safe haven from shocks. When I say bonds, I mean, US government bonds, as a place to squirrel away some money when things get really bad.
Ben Felix: You earlier brought up international or global stocks. How comparable today was the global financial world of the early 1900s?
William Goetzmann: It's really kind of interesting. We're still living in a period of extreme evolution of the financial markets, and the financial markets at the end of the 19th century and in the early part of the 20th century, we're also undergoing rapid and interesting changes, both in terms of where securities were being issued, and what kind of companies were being funded, and what kind of financial products were being developed and a lot of stuff.
But if you're just doing it sort of in terms of the role that the stock markets played in society. At that time, the stock markets in Europe and North America, and to some extent, South America, even in China and Japan, were funding a wide range of different kinds of enterprises. At first, in the 1870s, it was railroads and infrastructure and electrification and the basic foundations of technological development. But then by the 1880s and nineties and early teens, and 1920s, they began to be a source of money for industrial enterprise, manufacturing, and then particularly twenties, speculation in venture capital, really, and that was a period of, television, radio, airplanes, all of these companies were being funded.
Today, actually, those kinds of enterprises do get funded in the public capital markets. But maybe after they've already been funded by venture capital dollars, and then after that, perhaps taken public. But by the 1920s, those markets in the US and also globally would be very familiar to investors today. You'd feel right at home. The only thing you'd be doing is you wouldn't be looking at a screen to look at the stock prices, you'd be looking at a ticker tape machine, and being able to see the prices as they were coming through on an intraday basis.
Cameron Passmore: That's so interesting. So, were investors back then encouraged to actually diversify their portfolios globally, like we often are today?
William Goetzmann: That's a good question. It depends on who's doing the recommendation. There are kind of two strains of investment advice and research that you might have seen in the early 20th century. One of them became what you might call value investing. Well, you might call it as exactly value investing. Graham and Dodd, Benjamin Graham, was an advocate of carefully selecting individual companies by looking at their fundamental performance. Kicking the tires, trying to understand their cash flow, trying to understand their debt coverage ratio, trying to understand whether they had a competitive advantage. So, we still see that strain today.
The whole other side of the coin is what you describe, which is, did somebody tell people they ought to be diversified? And who was telling them and why and how could they do it? It was not as easy to be well diversified in the United States at that time, but it was very possible to be well diversified in some of the big money centres in Europe before the Second World War, particularly before the First World War. But London was the dominant global equity market. Well, global equity and debt market from about 1870 until the First World War, but it continued until about 1930, to have that pre-eminence.
In that market, in the 1920s, you could have invested very broadly in companies that were doing business in Africa, Southeast Asia, Oceania, and China. Many countries in Africa, you could have invested in. You could have had an amazingly diversified portfolio.
A famous economist, John Maynard Keynes, ran this portfolio for his college at Cambridge. And they thought, “Well, he's the economist, we’ll let him manage our portfolio.” The kinds of things that he was able to invest in included shares of gold mining companies in South Africa. So, that was where, at times he had made a killing, and at times, he'd nearly gone bankrupt. But that gives you a kind of a flavour for how easy it was, sitting in the UK, to be able to access investment opportunities, not just all throughout the empire, British Empire, but even in many other countries. The British invested in the railroads of the United States, and their capital helped build our railroads.
Ben Felix: So, it kind of paints a picture of pretty easy access to global markets back then. You alluded to this earlier, how did global finance change after World War One?
William Goetzmann: World War One was, you could say, the greatest catastrophe of the 20th century until World War Two came along. It was something that was unexpected in its scale and impact, of course, in human terms, and also in political terms, in changing the borders of the countries of the world. But it also was such a costly war, that many countries just had a hard time economically, and what had been a globally integrated capital market to a large extent, suddenly, the needs of government trumped the needs of investors in terms of trying to refund themselves.
I mean, the United States played some role in that, because we were less affected. The war wasn't on our territory. But the death that Germany had, for example, as a result of the reparations payments after World War One, created extraordinary tensions for that country. And it took a long time for those tensions to work their way through both into the political geopolitical consequences, but also in terms of how do you build markets that channelled capital into productive enterprises, and into employment for people, and into them being able to plan a life for themselves by investing when you're trying to repair the world order, and that's a costly thing to do.
So, that shock really set the British Empire back a lot. It's set the London capital market back a lot. It meant that the markets in some sense, were less free and open and willing to respond to the basic economic needs, and had to respond more to the needs of government.
Ben Felix: Fascinating.
Cameron Passmore: How plausible is it that the root causes of global financial contraction back then could actually resurface today?
William Goetzmann: Well, don't scare me like that. I think, when I look back at the 20th century, those two big wars were really important things or important shocks. There's sort of good news and bad news about this.
My prediction is that if we go forward, and we don't have the wars at that scale, then the markets will have a better opportunity to develop in practical, useful, beneficial ways. So actually, even though it feels like the war that's going on in Ukraine, or the war that recently ended in Afghanistan, or other kinds of conflicts, even though they feel so terrible, they're nothing compared to the scale of a global war, and the disruption of economic and human.
So, I think if we skip through and glide through and don't have to face those kinds of massive shocks, I think that the capital markets are going to be wonderful for investors. They're going to have their ups and downs. They're going to have their inflation shocks and that kind of stuff. But I think that there will be less worries about survivorship because there'll be more survivors.
Now, on the other hand, when I look back at the 20th century, the thing that stands out to me is the fact that despite those extraordinary disruptions, a portfolio that you constructed in 1900, actually didn't do so badly if it was an equity portfolio. Boy, that tells you something. It's like, boy, you get hit with these giant, unprecedented shocking wars that changed the world. And yes, some of your investments disappeared and went bankrupt. But when you average out the good and the bad, you did get quite a reasonable real rate of return, inflation-adjusted rate of return by investing in equities, diversified investment in equities.
If you were a Japanese investor in the 1920s and you'd only invested in Japanese stocks, guess what, you probably wouldn't have done so well. You might well have lost close to 100% of your portfolio, even if it was diversified in Japan. However, if you had taken a portfolio that was diversified across both the successful countries in World War Two, and the unsuccessful, yeah, you would have taken a bit of a hit, but your capital would have been reasonably well preserved over the long term.
Ben Felix: When you look back, take in historical perspective, like you gave the example of Japan would foreign and domestic investors have been treated the same in terms of the poor returns that they got?
William Goetzmann: That's always a concern. Cross-border investing is always a concern for the foreign investor. One of the benefits that the people enjoyed in investing in the London capital market is the UK was fairly hands-off when it came to the treatment of foreign investors. And it still basically is. But you can imagine expropriation being the tool of the state when the state needs that kind of money.
For example, when you're thinking about investing in China, you kind of have to ask yourself, “What's going to happen to us investor or a non-Chinese investor, if there's an escalation in not just rhetoric, but escalation in political disputes?” And getting your money out of China is something that requires the ability to take money cross border, ultimately. And that's something that China allows for investors to some extent, but it's always at the pleasure of the state at this point.
Ben Felix: Do you think that there's an argument for some home country bias in there?
William Goetzmann: You mean, should a US investor invest a big proportion of their equity? Should they buy US stocks? Right, mostly.
Ben Felix: Yes. Or more US stocks than the capitalization weight of that? Well, we're in Canada, for example. So, in Canada, our market is like 3% of the world. Should a Canadian investor be a little bit more biased toward their home country?
William Goetzmann: We always used to think about home country bias as some kind of mental problem that the investors had. I don't think that's the case. If you're going to be spending money in your own country, you might want to also buy securities that generate future value in terms of the currency that you're going to spend.
So, that's one argument. The home country bias, we can pat ourselves on the back and say, “Oh, well, we did pretty well after these wars. So, we should do well, again.” Well, you never can actually tell. So, that's the diversification argument.
One of the things that I've been working on and have a long time worked on with my colleague, Geert Rouwenhorst, is whether or not diversification across industry versus across country makes sense. And which of the two? Are you better off holding, let's say, just car company stocks, right? But holding car company stocks from China, Japan, South Africa, from Brazil, and compare that to what if you put all your money in one country, but diversified across industry?
So, it turns out, you're much better off, when I say much better off, you have lower risk, without giving up too much return. You're much better off having diversified your portfolio across countries, even if you have to hold only one industry, like cars. That's a pretty interesting result. Why is that? Is it due to the fact that we have these political borders? And we have different macroeconomic policies in each one of the different countries? How come a car company in Japan is not going to be highly correlated to a car company in North America? Right? Why?
I mean, there are forces that should drive the two of them together, since after all, when we decided to buy cars, we go, “Oh, maybe I'll take a Japanese car. But I heard that Kia is good, and blah, blah, blah.” The product markets are integrated, how come the equity markets aren't integrated? I don't know that's an interesting problem. But that's the finding that we have that Geert has found before with other people. But we've been studying and particularly in that early time period from 1870 to 1929 because we want to see if that holds true in the past. And whether it's due to trading in different markets, as opposed to just having cross border differences.
Ben Felix: Let’s shift to your work on bubbles. How have you defined asset price bubbles in your work on the topic?
William Goetzmann: I've defined asset price bubbles, in the most naive manner possible. I'll tell you what it is. But I'll tell you why first. Some of the most sophisticated and interesting financial theory has gone into trying to define a bubble in the asset market. Is it based upon overlapping generations of beliefs about the stock market? Is it based on some behavioural biases? My colleagues through the years, have gotten very clever at designing mathematical expressions of what a bubble is, and then studying those.
So, I said, “That's not my comparative advantage. I mean, I'm not a sophisticated theorist.” So, I'm going to start with a definition of a bubble that most people can relate to, which is, I think, it's a bubble if the stock market doubles in one year, and then gives back that return, or more in the next year. I mean, come on. That's got to be a bit of a bubble. And we troffer inflation, right?
Once I do that, the world is simple, then I can study bubbles, and you can tell me whether they're due to one bias or one problem, or the Federal Reserve, whatever you want. But at least I got a simple definition of bubble that I can study in.
Cameron Passmore: How do you differentiate a bubble from a boom?
William Goetzmann: Well, it's really simple. A bubble starts with a boom, and then it's followed by a crash. That's it. Followed by a bust. So, we take the bubble, and we say one side is the way up, and the other side is the way down.
Cameron Passmore: Okay. So boom is – the run-up without the way down afterwards.
William Goetzmann: Yes, the good news without the bad news.
Cameron Passmore: Now, you've looked at this a ton of data. Can you just briefly describe the data that you've used to look at booms and bubbles?
William Goetzmann: Sure. I guess over the last, I don't know, maybe 15 years, a lot of people have been able to collect stock prices, and stock returns in many different countries, and I've been guilty of that myself because I've been interested in this historical data collection. So, we're getting to the point now where you can get access to stock indexes for more than 100 countries, 120 countries probably. Some of them start really early like the UK starts in the 1600s.
So, if you have the world's stock returns at your fingertips, and so one of those databases is called Global Financial Data, then you can really study the many different paths that markets have taken. You can deal with the survivorship issue and things like that. Then, another database that I was able to look at is a database collected by Dimson, Marsh, and Staunton, and that is a database that starts in 1900, with about 20 odd countries. And then lately, I think they've even been expanding it annually. So now, we got over 120 years of very clean data that those scholars have constructed.
Anyway, that's the data that I said, we can use that to study booms, crashes, and the combination of the two, which are bubbles.
Ben Felix: Therefore, what was the relative frequency of these booms in bubbles?
William Goetzmann: Well, the good news is that bubbles don't happen very often. Thank goodness. And since what you mean by a bubble, I mean, even in the United States in 1929, the run-up to 1829, and then the crash thereafter, it didn't happen in one year. So, even to capture that idea of that bubble, and also, the crash of 1987, for example. I kind of had – or 1990, in the tech bubble. I kind of had to expand the definition of what a bubble was to include a run-up over three years and a crash over the next three years.
In any case, in my data that one year up and one year give back, that bubble happens, not much more than 1% of the time, if I can remember correctly. Very rare. Booms were, if you just separated the first half of the second half, the booms were, of course, more frequent. But even there, not too many markets doubled in value in inflation-adjusted terms in one year. But when it does, that's when you want to know, “Oh, my God, what's going to happen?”
So, when it happens to you, you want to be able to figure out, “Is it going to crash the next year? Should I be selling out my stock position and patting myself on the back for doubling my money?” That's when you want to know what happens. I'm going to keep you in suspense.
Cameron Passmore: I know.
Ben Felix: I want to know the answer.
William Goetzmann: Okay. For this one year up, one year down, what we found is that you doubled your money in one year, it's 50/50 whether or not you're going to double it again the next year, or give it all back. It's like a coin flip.
So, that's risky. But here's why it's that risky. Because any market that has doubled in one year is a very volatile market. By definition, we have sorted – I've sorted on the most volatile markets that can double. So, you can look at that and say, “Well, I don't know. I just made a bunch of money. But I don't want a coin flip on whether I can give it back or double it again.” That's up to you. But there's no evidence that I found that the market has a tendency to reverse. In other words, it doesn't follow the old story of what goes up must come down. It's not a Daedalus and Icarus situation. That's really pretty comforting.
Now, when you extend the horizon out, if you say to yourself, “Well, what if I hold on to my stocks for another three to five years?” Then the story gets even better. You're much more likely to have long-term returns that are positive, even after a boom like that. So that's kind of extraordinary.
Cameron Passmore: What would you say are the lessons for investors who may have become concerned about a run-up in a market or are maybe thinking about timing that market?
William Goetzmann: Well, right now, wouldn't it be nice to have that luxury? It’s like, “Whoa”, what we would love to see is another kind of super stock market that we had in the early 2020s, and so forth. But when that happens, if you're a taxable investor, you have to think, “Do I sell out now and then pay my capital gains tax, but sleep comfortably at night?” Okay, well, the capital gains tax can be really expensive. That's expensive insurance for a good night of sleep. So that's the taxable side, I would say, the statistical data suggests to us to coin flip, whether it's going to keep on going up or go back down. Now, the penalty you pay, you have to trade off that risk aversion versus the cost of insurance.
What's interesting on the other side is, suppose that you saw something which we saw in, let's say, 2020. The COVID crash, scared the heck out of everybody, right? And then you want to know, should I bail and go into something safe, or even something like gold, which is not even future dollars? It’s just a commodity. I should throw Bitcoin in there, too.
Anyway, there, when we look at that pattern, we find that if it's a really big crash, the probability of a rebound is actually pretty high. That's exactly the opposite story, though, from what we found with the boom. So, if it's a big crash, if it drops by 50% over the course of one year, in real terms, then we find that 50% or 40%, we find that there's sort of a gain of a third to a half back in terms of value over the next year. And well, we've looked at different horizons as well.
So, there tends to be a rebound when there's a crash. Not all the time. If it's only a 10%, or 20% decline in value, it could keep on going down. But there's this sense of recovery from the most extreme of the stock market crashes that we've been able to document.
Cameron Passmore: What explains the negative bubble behaviour?
William Goetzmann: Well, we didn't test it. We tested a lot of theories about it. Those theories include, is it due to passing geopolitical shocks, internal turmoil, banking crises, and that kind of stuff? To some extent, the decline is associated with those problems. With a banking crisis, you might see a flight to liquidity, a need to sell risk assets, and for banks to be able to buy safe assets. That could be associated with a drop. But we don't really have any good fundamental explanation for the rebound, other than just the notion that whatever caused the crash was temporary, and non-permanent.
So, it's a little bit unsatisfying to say, “What condition?” Because I can't tell you, what conditions should I look for that will help me predict a rebound, which is sort of what a real investor would like to know.
Cameron Passmore: Does it suggest that big crashes like that are more discount rate related than cash flow related?
William Goetzmann: It certainly does to me, because a sudden shock is more likely to be related to these pretty frequent variations in the interest rates, or even just the discount rate that you would apply to future cash flows. Earnings and dividends seem to be a little bit slower to evolve. Although, again, let's look at COVID. Suddenly, businesses that had a healthy expectation that people would be doing their holiday travel, suddenly, it was just gone overnight. So, you can never really have a complete story.
But I agree with you that a lot of variation in asset prices is likely due to variations in expectations and tied to the discount rate. I think that that's probably something that is driving the temporal nature of a portfolio of stocks.
Cameron Passmore: To keep going on crashes, how well does the frequency of actual crashes line up with investors’ subjective crash expectations?
William Goetzmann: Well, that's not easy to test, because subjective crash expectation means that you got to be asking people about what they think is the probability of a stock market crash. The good news is we've been doing that for more than 20 years.
It all started with my colleague Robert Shiller, who's a Nobel Laureate, and one of the creators of behavioural finance. Right after the crash of 1987, Bob had the idea to mail out questionnaires to individual investors and institutional investors and ask them like, “What do you think is the probability of a stock market crash of the magnitude of 1987 or 1929? Or where do you think the Dow index is going to be over the next six months or a year? Or is this a good time to be in the market?” I mean, he asked them lots of questions and they answered them a little bit more than 20 years ago, our center at Yale Law, I say ours, it's the International Center for Finance, we started doing this on a monthly basis with exactly the same questions. And this was for Bob's research, and now we have this rich set of data about people's views on the market.
The big takeaway for me, once we started looking carefully at it, is that people thought that the probability of a catastrophic stock market crash in the next six months, tended to be somewhere between, I don’t know, between 10% and 20%. So, imagine that. Imagine the anxiety of walking around thinking the 1929 crash could happen in the next six months, one in five. One in five chance it could happen. I mean, it's amazing.
So, either people didn't understand the probability assessment of the 20% chance of this happening in the next six months. Maybe they didn't understand probabilities. But maybe people that were answering these questions had a dark view of what the future will bring on a systematic basis over decades. But by definition, there are only two crashes of the magnitude of 1987 and 1929. In the US market over the period since 1929. So, almost 100 years. Two times that happened in 100 years. That means it's a 2% chance. Now, we could fiddle with that to be more realistic about volatility, this and that. But if it happened twice, in 100 years, now, I'm asking you if it's going to happen in the next six months. Your answer should be, “Well, the probability is about 1% and it shouldn't be 20%.”
So, the thing that worries me when I look at these, oh, and by the way, institutional investors as well as retail investors had very high probabilities. Institutional investors were a little bit more practical, but they were still pretty elevated. It kind of makes you worry that people are so frightened that a crash is going to eat up their savings, that they're leery of putting their money in the stock market. And then, that means they're going to give up that equity premium, just for the safety of avoiding a crash, that probably isn't going to happen in the next six months.
Cameron Passmore: What role do media narratives play in investors’ beliefs that will be a crash, do you think?
William Goetzmann: Well, media narratives – first of all, Bob Shiller, he had this idea about narratives being the essential means by which people pass along economic ideas. They can be very short narratives. I mentioned, what goes up must come down. We all recognize that. And then if I tell you, if I said, “The market operates the same way, what goes up must come down” you're suddenly thinking, “Well, that just makes so much sense. A lot of things are like that.” That can be misleading because I just told you what goes up doesn't necessarily come down.
But that narrative can be very powerful for a lot of people. Once they start spreading it around the Internet, or once journalists start to say, “How am I going to tell a story that's going to really get people – will help them understand things or will sell newspapers?” Telling a story is the way that we humans interact with each other.
I've done work on this with Bob and also with a co-author Dasol Kim. We started by looking at all the newspaper articles in The Wall Street Journal and in the New York Times that mentioned something about the stock market. And 20 years ago, you couldn't do that. But now, with natural language processing techniques and big data methods, you can do it. That allows us to see whether there's some relationship between negative news about the stock market on a daily basis. So, we can figure out what the — we call it, sentiment. But is it a negative article about the market or a positive article? That allowed us to test the theory that you're describing, which is, well, how does the newspaper affect people's beliefs?
What we found is that let's say the stock market went down yesterday, then comes a negative news article, people really changed their expectations about a crash. They think that the crash is a lot more likely if they've just got a negative news article. So, then what's also interesting is suppose the stock market went up, suppose then some journalist writes a positive article about the stock market, you think that that would have the same kind of effect on people?
Well, it’s not as big. The good news is, good news situations only have a moderate impact on their optimism. But the bad news, the bad news really makes the pessimism shoot through the roof.
Ben Felix: So, is there a lesson here about long-term investors and that they should perhaps ignore the financial media?
William Goetzmann: Well, I will say that what I've just described to you is about the individual investors, but the institutional investors are pretty savvy actually on this. So, they're less influenced by the media. So, I think that it's important to step back when you're thinking about investment decisions, it's important to step back from the flow of daily news. To go back to some basic principles that you base your investment decisions on, not everybody's going to have the same principle because not everybody's going to have the same needs. But you say to yourself, a basic principle is the reason why stocks generate a higher return than bonds is because, basically they're riskier, and that higher rate of return is because it's a compensation for the risk that you're bearing.
So, you say, okay, the stock market went down yesterday. What does that tell me, with respect to the principle on which I'm investing? I'm in the market because I'm getting a premium for uncertainty and risk. Yesterday, there was a realization of the market, that just tells me that it is risky as I expected. And that I have to be in the market for the long term, to take advantage of that risk premium.
So, instead of thinking to yourself, “Oh, it's suddenly risky. I'm frightened. I don't like risk.” Actually, you do like risk as long as you can tolerate it over the long term, because that's where your benefits are coming from, for investing in the stock market. Sometimes it's a bitter pill to swallow, because you think, “Oh, my God, I've got to sell”, but the investors that sold after the biggest stock market decline in US capital market history, and by that, I mean, 1987. In October, the market in the US declined by 21%, 22% in a day.
The people that sold after that were sorry forever because the stock market over the next year or so climbed back out of that hole. The people that sold out on that day never were able to benefit from the recovery that that market had.
Ben Felix: Will, I want to come back to bubbles, as we come near the end of our questions here. What did you learn about bubble dynamics by hand-collecting data from the 1720s?
William Goetzmann: I love that question because I love history. There was a great bubble in 1720, that was tied to the excitement about the Atlantic trade, and also the excitement about how it was possible to use the corporate form to create corporations, to do all sorts of different kinds of businesses. And that happened in London, Paris, in the Netherlands. So, there was a cross-border boom in stock prices, that was as high as eight times to 10 times the price. You could have bought a stock in 1719 in Paris, or London, or Amsterdam, and then seen that thing just grow, double and double and double.
Here's what we learned. First of all, in that case, we call it a bubble, because as you might imagine, all the prices of these stocks dropped. So, in the next few months after they boomed, they crashed. On the economic side, my colleagues and I who studied this figured out that the bubble had some rational basis, which is that the economy really had changed at this time and that it allowed investors in all those countries really, for the first time to participate in this potential giant engine of growth, which was the Atlantic economy. That was one driver.
My lesson learned there is that when you see a boom in asset prices, or if you see a bubble, go and look for some kind of innovation, financial innovation, technological innovation because that's probably what's describing this sudden shift in expectations about the stocks. We can think of a lot of bubbles through time. I always think back to the tech bubble of a couple of decades ago, as a time when suddenly people thought, “Well with personal computers and other electronic devices, we're going to have huge gains in productivity and things like that.” Now, we know that did transform our economy, but not all stocks benefited from it. But nevertheless, that enthusiasm drove a lot of people to invest in these new stocks. And sometimes those stocks did bubble.
The other thing I learned is that when the stock market has crashed, everybody's looking around for whose fault it is, and they're also making fun of those people that had the belief that the economy had changed. There's a little bit of schadenfreude or the sense that somebody else, not you, was in trouble. And we saw that after the great financial crisis in 2008, we saw people saying, “Okay, who are we going to throw in jail for this? Somebody has to be punished. The financial system is at great fault.”
So, after the 1720 crisis, just like after the 2008 crisis, there was a backlash against financial innovation, and against investing in equities. The equity markets really kind of dried up in France, and in the Netherlands. I mean, they didn't completely go away. But suddenly, the world turned in many countries, they kind of turned against stock investing for about a century. So, we had this lapse from 1720, almost till about the middle of the 19th century, when there wasn't a lot of investment opportunity in equities.
Cameron Passmore: Interesting. What are the lessons for investors who may be compelled to invest in so-called transformative technologies?
William Goetzmann: You should understand that along with innovation and novelty comes uncertainty. And you don't know which of those stocks is going to really be the one that pays off. You don't know whether you're going to buy the next Apple, the next Tesla, or whether you have put your money into something that was going to go bust, even though it was an interesting or good idea. That's been true for a long time, particularly, let's say with mining stocks. This is a good example. There is always going to be a mining industry. There are always going to be discoveries of new gold sources or new mineral sources. But which of the companies is going to find that, you're never going to know in advance. So, you have to think about investing in the new economy stocks a little bit like that, even a diversified portfolio of them is going to have a lot more uncertainty than buying stocks of companies that are tried and true and have been basically, making the same thing for decades.
Ben Felix: That's a good analogy.
Cameron Passmore: All right, Will, our last set of questions for you are related to your book, Money Changes Everything, which is fantastic, and we've mentioned it to our listeners a few times. How do you describe what money is?
William Goetzmann: Well, money is actually pretty recent in human history. Actually, pretty recent, even in terms of the time since writing began. Money, the way we think about it, we think about coins as money. And coins were an extraordinary invention because they're a system of transferring value that has nothing to do with accounts. It's memoryless. Once I hand you a dollar and then you use the dollar to spend, nobody knows where the dollar came from. So, it doesn't require a system of keeping accounts.
Now, when I say keeping accounts, when you use your credit card, when I use my credit card, what happens? An account somewhere in the ether is debited and another one is credited, and it all comes back together at the end of the month, and somebody gets a bill and all of this stuff. That's money that's based on accounting. But coins are money that didn't require that. But money actually in a more abstract sense, actually, I shouldn't say abstract, it's very solid. Money goes back, at least until about, I don't know 4,000 years ago, in the ancient Near East, in the Tigris and the Euphrates area. The Babylonians had money, they just didn't have coins. Babylonians would use silver as their money, and they'd weigh it out.
So, you'll see in these cuneiform tablets, there'll be a description about somebody lending somebody some money. And they'll say, “Well, this is pure silver. This is silver that hasn't been measured.” They were using silver. Now, silver is interesting, because it really doesn't have any practical value at that time. Now, we can use it – it has some other things we can use it for, like for a while, photography. But silver was sort of a pure good that could be stored, and transferred, and it was rare, it was mined. So, the Babylonians started to go and trade for silver, just so they could have an injection of money into their economy. That notion of suddenly in an economy, you had to have something more than goods and services that were real things. You had to have this kind of abstract way of valuing and storing that value. That was really the beginning of what we think of as money.
So, it wasn't really until about 1,500 years after they started to use silver, finally, we start to see coins that appear in Mesopotamia, in Greece, and actually, in China as well. So, it was a financial revolution when we started to see coins, but money in terms of silver, started long before that.
Ben Felix: Interesting. When you go back through history, would you say that money precedes trusted authorities or that trusted authorities precede money?
William Goetzmann: Well, the way I think about your question is, is there money without a government that says that money has value?
Ben Felix: I agree, yes.
William Goetzmann: With commodity money with silver and gold, even today, we think about that as a store of value, that if the government disappears, it will still be something that one could use to buy goods and services. So, which came first, the chicken or the egg? Those early Mesopotamian societies that were collecting silver so that it could be used to pay for things and so forth, there wasn't one big country that was doing it. They were a set of trading cities and agricultural cities that sometimes were at war with each other, and so forth. There was a common monetary unit that existed, even though there was no common government.
So, I’d say that money preceded the government. But since governments figured out how important and useful money was, they started to figure out ways of controlling it. Creating money themselves. Controlling it to the extent that they set up systems of taxation, where they demanded that you pay in hard currency and so forth. Well, I mean, I don't have to describe it, because that's the way life is today.
But you see, with early Greek coins, back to 300 or 400 B.C, a lot of times they'll have a face on it, that will tell you that it's from this city or that city. It’s became something – it was connected with the state in a way that just unstamped silver was not.
Cameron Passmore: What role does money play in finance?
William Goetzmann: Well, I think that money is really a financial instrument. A lot of people might not say that. But here's why I think money is a financial tool. Finance, to me, is something that requires that you're passing money into the future, passing value into the future. Your investments in stocks are really about, you pay for it today when you buy it, and then you're going to get dividends in the future, or you can sell it in the future. If you don't have that dimension of time, you probably not talking about a financial transaction. A contract is something you agree on today, then there's delivery, or some consequence in the future for the different parties.
Anyway, long story short, I think money is a financial instrument, because it is a store of value, that you get it today, and you can hold it as long as you want, and then spend it in the future. It doesn't generate interest. It is subject to inflation shocks, but it's a way to preserve wealth through time. Now, it has other values as well, because it's kind of a – well, it's a unit that you can use to measure relative values. You can decide whether two sheep might be worth one cow because you can figure out how much it costs to buy the sheep and to sell the cow. That's another benefit of it. But that fundamental technology of storing value by putting it into something that doesn't deteriorate, and something that will be acceptable by society in the future as valuable. I think that's the essence of what money is.
Ben Felix: Very interesting. This is a question that I understand if you give a short answer because it's literally the topic of your book. So, I don't expect the full answer. What role do you think finance played in the development of modern civilization?
William Goetzmann: You're asking a really big question, which is what's the role of finance in the development of civilization? I think about finance as a technology, and it's a tool that has evolved since the first cities at least, as a way of making things work better. So, the most important thing for me is that without finance, you're not able to have big cities. People couldn't live in one place without a technology for storing value, of transferring value, agreeing upon value, and paying for services. And even today, cities survived by borrowing money and issuing bonds.
The first cities that really couldn't live without finance were the first civilizations where you had a lot of people living in one place. But as finance developed, new kinds of cities evolved. Cities that couldn't grow had their own food but could go and finance ways of getting grain and bringing it to Athens. Or getting grain and bringing it to Rome. Finance made those possible. And when we think about what the future is, we're trying to imagine what cities might be like going forward, and the only way those cities are going to be built is through some financial arrangements either through stocks and bonds or other forms of financing, are able to bring a lot of capital together into one spot, and build a lot of buildings or construct a lot of things for people to live in. Break the infrastructure, and so forth.
So, without finance, we wouldn't have that. We wouldn't have the infrastructure. We wouldn't have a density of settlements. We just wouldn't have the kind of advanced methods of getting along with each other and growing without it.
Ben Felix: Great answer.
Cameron Passmore: That's a great answer and that's why I love that book. Our final question for you, Will, and it's a bit of a different one. How do you define success in your life?
William Goetzmann: I have had a great opportunity really, to pursue my research and my teaching. So, I am thrilled with having been able to do both of those two things. Yes, I'm just blessed to be in a situation where I can pursue these questions that you've been asking me, I can explore them as a scholar, and then I can try and produce things that are useful to people, and meaningful to people who are investing. So, that has been a wonderful success for me.
I also spend a lot of my time, mostly teaching about finance, sometimes about financial history, and that's a rewarding experience to be able to engage with students, and to learn together with them. I guess, I should say that I would define success as making more money. But that's always been a bit secondary. Being able to make things and experience things has been the greatest reward for me.
Cameron Passmore: Incredible. Well, thanks so much for joining us. This has been a very fascinating experience. Thanks, Will.
William Goetzmann: Thank you.
Ben Felix: Thanks, Will. Thanks for all of your research. It really is incredible.
William Goetzmann: Yeah, I appreciate your interest in it and this has been an interesting chat.
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Prof. William Goetzmann on Twitter — https://twitter.com/wgoetzmann
Prof. William Goetzmann — https://som.yale.edu/faculty-research/faculty-directory/william-n-goetzmann
'History and the Equity Risk Premium' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=702341
'The present value relation over six centuries: The case of the Bazacle company' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X18302836?via%3Dihub
'A Century of Global Stock Markets' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=225683
'Will History Rhyme?' — https://jpm.pm-research.com/content/30/5/34
'New evidence on the first financial bubble' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X12002541
'Bubble Investing: Learning from History' — https://www.nber.org/papers/w21693#:~:text=History%20is%20important%20to%20the,sample%20size%20for%20inference%20small.
'Negative bubbles: What happens after a crash' — https://onlinelibrary.wiley.com/doi/abs/10.1111/eufm.12164
'Crash Beliefs From Investor Surveys — https://www.nber.org/papers/w22143
'Crash Narratives' — https://www.nber.org/papers/w30195