Stephen Foerster is an award-winning author, investing blogger, and professor of finance at the Ivey Business School at Western University in London, Ontario, Canada. Foerster’s most recent book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest (with Andrew Lo, MIT Sloan School), Princeton University Press, 2021, was featured in The Wall Street Journal’s Bookshelf column and won the Axiom Business Awards silver medal in Personal Finance and Investing. Foerster has also written two textbooks and over 100 case studies and technical notes in the areas of investments and financial management. He has published over 50 articles in journals such as Journal of Financial Economics, the Journal of Finance and Financial Analysts Journal. Foerster has served on pension and endowment fund boards as well as not-for-profit investment committees. He received a PhD from the Wharton School, University of Pennsylvania and has obtained the Chartered Financial Analyst designation.

Have you ever wondered how the world's top financial thinkers shaped the way we invest today? In this episode, Ben and Cameron sit down with Professor Stephen Foerster from the Ivey Business School to explore the evolution of modern investing. As a distinguished financial expert and co-author of In Pursuit of the Perfect Portfolio, Professor Foerster dives into the groundbreaking work of financial pioneers like Harry Markowitz, Bill Sharpe, Gene Fama, and others, unpacking their remarkable contributions to portfolio management, risk assessment, and market efficiency as we know it today. Tuning in, you'll gain a deeper understanding of Markowitz's revolutionary diversification theory, Sharpe's introduction of beta as a risk measure, and Fama’s Efficient Market Hypothesis, as well as each of their perspectives on the “perfect portfolio,” tying together the history, theory, and practical application of modern investment strategies. Whether you're looking to sharpen your strategy or build your investment knowledge from the ground up, this conversation with Professor Foerster is packed with actionable takeaways and fascinating stories that could change the way you approach your financial future. Don’t miss this opportunity to learn from the thought leaders who shaped the market!

Key Points From This Episode:

(0:03:29) Contrasting the historical art of investing with the modern science of investing.

(0:04:44) Markowitz’s diversification theory and the importance of balancing risk and return.

(0:09:39) Sharpe’s capital asset pricing model (CAPM) and his contribution to measuring risk.

(0:16:13) Insight into Fama’s Efficient Markets Hypothesis and the joint hypothesis problem.

(0:19:13) The rise of factor investing and the significance of Fama-French’s three-factor model.

(0:23:26) Unpacking Shiller and Fama's main point of disagreement on bubbles.

(0:26:50) Bogle’s perfect portfolio and persistence about the index fund, despite resistance.

(0:29:37) How the Black-Scholes-Merton (BSM) option pricing formula changed the world.

(0:34:37) Ways that Merton contributed to portfolio theory and his take on TIPS.

(0:36:20) Key takeaways from talks with Martin Leibowitz, Charlie Ellis, and Jeremy Siegel.

(0:37:35) An interesting analogy for Professor Foerster’s take on the “perfect portfolio.”

(0:40:53) Correlation vs. causation in stock pricing and how it applies to factor investing.

(0:46:38) Examples of masterly inactivity and investor lessons from Madoff's Ponzi scheme.

(0:52:07) The dangers of FOMO, a SPACs cautionary tale, and lessons from value investors.

(1:00:43) Winning at tennis vs. investing and risks of over-reliance on automated decisions.

(1:06:02) Long-term lessons from pioneers in finance to improve investment strategies today.

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 328. And this week, Ben, we welcome another Canadian, super great guest, great communicator. Kudos to you for getting Professor Stephen Foerster on. I love this conversation. Great communicator. Great storyteller, and so many practical takeaways from work that he’s done in these two books, which I know you want to talk about, that are so applicable, so understandable, and so relatable for any investor. Stephen is a Professor of Finance at the Ivey Business School at Western. He also has his BA from the University of Western Ontario, M.A. and PhD from the Wharton School at University of Pennsylvania. He has written a couple of textbooks, which he talks about, and now, or over the past few years, has written other books in this field, which – what a career, what a communicator.

Ben Felix: He does have published academic papers too, but unlike with a typical guest, that's not what we focused on. He's co-authored with Juhani Linnainmaa, quite a few papers, but he's got other research out as well. He's got these two books that we focused on. One of them is co-authored with Andrew Lo, who's at MIT, and a lot of listeners likely know Andrew Lo's name, that book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest. They go through a bunch of the people who created the modern field of academic finance, also some practitioners who really shaped the way that we invest today. The book is many biographies, but it's a biography that gives you the context for how these people came up with their academic theories, or their contributions to finance. Really interesting to read. Pleasure to read.

Cameron Passmore: Many past guests, too.

Ben Felix: Three past guests, I think. Ellis, and Fama, and Merton. Pretty cool. That book is a pleasure to read. They also go through the technical contributions to finance. They explain in plain language what Markowitz contributed and what Fama contributed, and they go through all these people. We talked to him about that one. Then he's got a more recent book, and as he explains during the conversation, in writing the first book with Andrew Lo, there were so many stories that they came across doing that research that just didn't fit into the first book. Stephen wrote this second book telling these other just interesting stories that have valuable insights about financial decision-making. We also talked about that one. I think it was a great conversation. He speaks very well. He does a really good job making this information, whether it's historical information or theoretical information, he ties it back to how is this practical for an investor. How does someone use this to make a good financial decision, or to form their own investment philosophy. It's a nice combination of stories, history, theory, and what does it mean practically speaking for investors.

Cameron Passmore: Pretty good tee-up. You good to go?

Ben Felix: Let's go ahead to our conversation with Stephen Foerster.

***

Ben Felix: Stephen Foerster, welcome to the Rational Reminder Podcast.

Stephen Foerster: I'm delighted to be here.

Ben Felix: Now, we're delighted to be talking to you. You've written two incredible books. We're going to ask you about them. They really are both incredible collections of stories. Your first book, like the way that it takes the stories of the people, but also their contributions to academic finances is just really neat. To kick this off, how do you contrast the historical art of investing with the modern science of investing?

Stephen Foerster: We kick that off in our book, In Pursuit of the Perfect Portfolio, which is co-authored with Andrew Lo. We talk in the first chapter about a brief, very, very brief history of investing that goes back over 10,000 years, which we call it the art of investing, which was really risk-reward decision-making, and that goes back to long-distance trading. These were a lot of risks that these traders had to take on in order to try to profit.

When we talk about the science of investing, that's much more recent, going back to the 1900s. There were a number of investment theories being developed and really was bringing together investments, money, and mathematics. It's really culminated with Harry Markowitz, and I'm sure we'll talk about his contributions and his seminal work around the early 1950s.

Ben Felix: What are Harry Markowitz's main contributions to the science of investing?

Stephen Foerster: He really presented a very simple framework, simple, in retrospect, just really identifying the only two things that should matter to an investor, expected return and risk. What he was able to show, and this is where the math comes in, and again, it seems simple now, but he was able to show that when you bring securities together, this is the one and only true free lunch that we can get through diversification. In somewhat mathematical terms, if you have, let's say, two securities, and as long as they're not what we call perfectly correlated and not moving in lockstep, then by combining the two, the riskiness of the portfolio has to be less than the average risk of each of those individual stocks, and that's what he meant by the only true free lunch.

His contribution was highlighting the importance of how stocks are correlated and tend to move together, but not in sync. Therefore, by being diversified, while one stock might be up, the other will be down, and that will counterbalance.

Cameron Passmore: How did Markowitz change the practice of portfolio management?

Stephen Foerster: Before the 1950s, and even for probably two decades afterwards, until his model and others really were taken into account in the industry, it was more like a gunslinger approach to investing, and everyone's on their own, and each investment professional would have their own approach. “I think I like this stock, and I think I don't like this stock.” There was really no identification of expected returns and risk. The idea that really what you wanted to get from an investment was return that's really commensurate with the risk that you're taking on.

It became increasingly important to recognize that diversification matters. Diversification across securities, also diversification across assets. Then, and I'm sure we'll talk about his protege, Bill Sharpe, then where we had a different way to measure performance, that’s when things really started to change as well.

Ben Felix: One of the things that you do in the book that I found really enjoyable is you interviewed these guys, as I understand, and talked to them about their perception of the perfect portfolio. What was Markowitz' idea of the perfect portfolio?

Stephen Foerster: That's really been what tied together is because we asked everyone the same question that we tried to bring everything all together, because the answers were so different. For Markowitz, not surprising, it was all about diversification. His perfect portfolio contained some traditional asset stocks and bonds. What's interesting is that there was nothing really special in terms of what eventually became index funds and the market portfolio. It was nothing special about any market portfolio for him.

Markowitz also recognized, and this is a common theme as well, that the perfect portfolio is often going to be very dependent on you as an individual, what risk tolerance is, taking into account taxes, and so on.

Cameron Passmore: Can you talk about Markowitz's concerns about the misuse and misrepresentation of modern portfolio theory?

Stephen Foerster: Markowitz shared a number of examples of some unsavoury financial advisors who, in their advertising, would claim that their particular approach was based on the work of Nobel Prize winner, Harry Markowitz. Especially in the late 1990s, what we now recognize as the so-called dot-com bubble era. A lot of these investment advisors were putting their clients in a portfolio that was heavily tilted toward tech stocks. Then, of course, we know the rest of the story that the bubble burst and these stocks really tanked. Markowitz's point is there was nothing in so-called modern portfolio theory to suggest that you need to really load up on tech stocks in that particular era.

The other thing that had been a critique of his model and others as well was the erroneous assumption that these models relied on an assumption that stock returns follow a normal distribution. Think of the bell curve. There's nothing in modern portfolio theory per se that makes that particular assumption. That's something that Markowitz wanted to really set the record straight.

Ben Felix: You mentioned his protege, Bill Sharpe, earlier. What did Bill Sharpe do to build on Markowitz's work?

Stephen Foerster: That's actually my current book project is writing Bill Sharpe's authorized biography. So, happy to chat about Bill. Going back to Markowitz, Markowitz's framework became known as what we call the efficient frontier. Markowitz was able to show that among all the different securities, there is a subset of risky portfolios, and they share the same characteristic for a given level of expected return, they have the lowest amount of risk, or put another way, or a given level of risk at the highest amount of expected return.

What Sharpe did was take that model as a starting point and add in one additional wrinkle, what if investors could either borrow, or lend at a risk-free rate? Think of a T-bill. Either you could invest part of your money in a T-bill, or you could borrow at the T-bill rate. That was his really big contribution that shifted the focus in terms of how we measure risk. Now risk became a matter of relative to the overall market portfolio.

Cameron Passmore: What were Sharpe's main insights with the capital asset pricing model?

Stephen Foerster: I'll venture to say hundreds of thousands, of millions of students know the model by the short form of CAPM. Almost everybody calls it the CAPM model. Almost everybody, except Bill Sharpe, who always refers to it as the C-A-P-M. I'm going to use the C-A-P-M just in the spirit of Bill Sharpe. Essentially, what Bill Sharpe showed through this capital asset pricing model was that all that matters in terms of pricing and security, or all that matters in terms of the expected return of security, is the riskiness relative to the overall portfolio.

It doesn't matter how risky a security is if you just own it by itself. But all that matters is how risky is it to the overall market. We operationalize that by thinking of the market as something like the S&P 500 index, and that relative risk measure has become known as beta. That is a huge contribution that Bill Sharpe made. All that matters is a stock’s beta, a stock that has a beta of 1, then moves closely tied to the overall market. If you have a beta greater than 1, let's say 1.5, when the market is up by 1%, you'd expect the stock to be up by 1.5%, and vice versa down by 1.5% if the market is down by 1%.

A second key insight is that it's really not good enough for a portfolio manager to say, “Look at me, I helped you get positive returns last year.” What they really need to do now is to think differently in terms of, have they provided a sufficient risk-adjusted return? Risk-adjusted in terms of how risky the portfolio is based on the average beta. You can outperform the market just by loading up on high beta stocks, for example. Sharpe would say, that's not enough. You've got to do better than what the beta risk would suggest.

I think the important third implication, and this took a while, and we'll talk about other contributors, I'm sure, and particularly Jack Vogel, but the CAPM world really suggests that everybody should buy what then became known as index funds.

Ben Felix: There's a paper from Fama on the CAPM, and he says in there that Sharpe took Markowitz's mathematical statement and turned it into a testable prediction about the relationship between risk and expected return. I always thought that was a really elegant way to explain what Sharpe did with Markowitz's work.

Stephen Foerster: I like that as well. It's very nice.

Ben Felix: How did Bill Sharpe's work with the CAPM change the practice of portfolio management?

Stephen Foerster: This comes back to the whole performance measurement. Now it's ubiquitous that we have this ratio known as the Sharpe ratio, which Bill Sharpe didn't initiate. Others gave it that name, which is the Sharpe ratio captures the relationship between a portfolio's return above the risk-free rate compared to the riskiness of that overall portfolio. Just a funny anecdote, so Sharpe ratios are everywhere now.

One time, Bill's wife, Cathy, was watching the Showtime TV show Billionaires. All of a sudden, she lets out a shriek, because one of the characters was bragging that his algo had a Sharpe ratio of 3.64, so she was just all excited about seeing Sharpe ratio in practice.

Cameron Passmore: Too funny.

Ben Felix: That is funny.

Cameron Passmore: You have to share, what is Sharpe's perfect portfolio?

Stephen Foerster: Of all the 10 luminaries that we interviewed, his was closest to his research. It was really simply buying four index funds, or well-diversified portfolios, one US stocks, another global stocks. The third one, US bonds, and the fourth one, global bonds. There you have it. That's his perfect portfolio. Obviously, depending on how much risk you want to take on, you might overweight, or underweight some of those portfolios. It was very straightforward.

Ben Felix: It's funny to see the simplicity of – it was in your book, and I've heard it before about Markowitz that he didn't really know how to split up between stocks and bonds, so he just did 50-50.

Stephen Foerster: He initially did. He did admit that he evolved over time. That was when he had to make a decision in terms of his pension allocation and stocks and bonds. Again, for emotional reasons, he didn't want to have too much regret of buying all-in in stocks or too much in stocks. That's where he naively landed.

Cameron Passmore: So powerful though. The simplicity is beautiful.

Ben Felix: Some of the smartest guys in the world. That's one of the other things in this book that's so interesting is that you get an appreciation for how incredibly brilliant these guys are. They didn't just have some big discovery in finance. They're absolutely brilliant. I think Markowitz had a paper, or was it Sharpe, that had a paper in a different field, in English literature or something? Crazy stuff like that.

Stephen Foerster: Bob Merton wrote about Sullivan's Travels. Yeah.

Ben Felix: Well, that's what it was. That's right.

Stephen Foerster: Gulliver’s Travels. Yeah, sorry. Yeah.

Ben Felix: Then these absolutely brilliant guys have the simplest portfolios. How does Gene Fama's work on efficient markets fit in? We have Markowitz, Sharpe. How does Fama fit into the story?

Stephen Foerster: Fama is known for coming up with what's known as the Efficient Markets Hypothesis. I'm sure Gene shared this with you. His definition of market efficiency, a market is efficient if prices fully and immediately reflect all relevant information. Very simple definition. Where the nuance comes in is what exactly do we mean by relevant information? He came up with three different categorizations if we're going to test whether or not a market is efficient. He called it a weak form of efficient market if it captures all past prices. Just the past security prices. He called it semi-strong if it captures all public information. Finally, he called it the strong form of the efficient market hypothesis if it captured all information.

That third test of the efficient market hypothesis isn't really one that he expected necessarily to hold up because imagine if you're an insider, you could theoretically trade on non-public information. You might have an advantage there. A lot of the research provided strong support for both the weak and the semi-strong form of the efficient market hypothesis, but not perfect in every particular test. What's important and this is something that Fama points out, in some ways, if we're testing this notion of market efficiency, you also have to have a model. The common model is Bill Sharpe's capital asset pricing model. Really, our test is what's known as a joint hypothesis test. We're testing both, whether market is efficient and whether or not the model holds up. That's an important distinction he made as well.

Ben Felix: Can you talk a little bit more about the joint hypothesis problem and why it's a bit of a challenge?

Stephen Foerster: Let's suppose we are trying to test whether a particular phenomenon, a particular strategy outperforms on a risk-adjusted basis. Well, we have to have a way to adjust for risk. One way would be to use the capital asset pricing model and identify what the securities betas were. Let's suppose we then find that this strategy, even adjusting for beta risk, outperforms. Is that necessarily proof that a particular market is not efficient? The rub here is that, well, what if we have the model wrong? What if there are other factors in addition to the market factor, which goes into the capital asset pricing model? Then, maybe markets are still efficient, we just have missed some factors.

Ben Felix: Yeah, it's so interesting. You're always testing market efficiency and the model for what an efficient market should look like jointly. So, you can never really know whether your model is wrong, or the market's inefficient if you find inefficiencies.

Stephen Foerster: Exactly.

Cameron Passmore: How impactful was Fama and French's three-factor model to portfolio theory?

Stephen Foerster: Here's where we talk a little bit about the evolution that Fama has made in terms of his thinking. He initially wrote his famous efficient market hypothesis paper, or his first efficient market hypothesis paper in 1970. That was way before he and his co-author, Ken French, came up with what became known as the Fama-French three-factor model in 1992. Bill Sharpe's capital asset pricing model is based on theory. He was able to derive his particular model in an equilibrium setting. Fama and French were really empiricists, and not theorists as it pertained to stock prices. Their model, they looked at what other factors might be associated with, or driving stock returns.

Based on not necessarily unique studies that they had done, but studies that others had done, they found that there were two other factors in addition to the market, as we would expect being a driver of returns. Those two other factors, one was looking at the returns on small stocks versus large stocks. Small stocks historically have outperformed large stocks, and also value versus growth stocks. Think of value stocks, for example, in their world as those that had low price-to-book ratios, versus growth stocks having high price-to-book ratios. By adding those two factors, then they tested various models and various portfolios to see what was driving the returns.

What was really amazing at the time is that once they added these other two factors to Sharpe's capital asset pricing model, they found that the market portfolio itself really didn't matter. It was subsumed by these other two factors. Fama famously, in a quote to New York Times reporters, said that their results meant that beta is dead. That got a lot of attention. I'm not convinced that beta is dead, given that we still rely on the capital asset pricing model now. Going back to the practical terms, what this implied is that investors certainly should be diversified. No question about that. You should probably start off with some overall well-diversified portfolio. According to Fama and French, you would want to tilt your portfolio to small stocks and tilt your portfolio to large stocks.

Now, that being said, as we're chatting in 2024, we know that in the last five to 10 years, the reverse has been true. That large-cap growth stocks, the so-called magnificent seven, mainly large growth-oriented tech stocks, have done much better than small stocks and value stocks. Based on data, going back to the 1920s, Fama and French, their case is still pretty solid.

Ben Felix: It's interesting to think too about with the CAPM, all of a sudden, active managers, they had to add value over the risk they were taking. Then with FAMA in French's three-factor model, and now their five-factor model and all the many other factor models that are out there, it gets harder and harder for active managers to show, “Look, we're doing something special.” It gets easier and easier to say, “Well, no. You just took a little bit more risk.”

Stephen Foerster: You're absolutely right. I think the analogy is, I think of men's shaving razors. We started out with one blade and then three, and I'm not sure where this is going to end, really.

Ben Felix: Does the sixth blade get the shave any closer? I don't know. That's pretty funny. What's Fama's view of the perfect portfolio?

Stephen Foerster: Again, Fama has evolved in his thinking. If you asked him in the 1970s, the 1980s, his perfect portfolio would have been, buy and hold an index fund. Now it's more nuanced and that his perfect portfolio would tilt towards small stocks and tilt toward value stocks as well. Perhaps, his other factors that are part of his and Ken French's five-factor model.

Cameron Passmore: What is Robert Shiller and Gene Fama's main point of disagreement on bubbles?

Stephen Foerster: It's quite fascinating, because Fama really detests the term bubbles, in almost all of his work. I've gone back to even the 1960s. Almost every time when Fama has to write the word bubble, he does it in quotation marks. Shiller tells a really funny story. As you know, both Fama and Shiller were recipients of the Nobel Prize in Economics in the same year in 2013. I think it's almost like the committee was having a good chuckle, these two individuals who had very different perspectives in terms of whether markets were efficient or not and whether bubbles made a thing. Shiller really delighted by sharing that as they were doing this tour as part of the Nobel Prize time in Sweden, Shiller would see Fama just squirming every time he used the word bubble.

Fama wouldn't even refer to it by name. He just called it “that nefarious term,” like actors referring to Macbeth as “the Scottish play” to avoid some curse. Fama's whole point was that there's no such thing as a bubble because we can't identify a bubble before the fact, whereas Shiller thinks we can.

Ben Felix: Yeah, it's really interesting. The difference in their views, or their interpretation of the same data is super interesting.

Stephen Foerster: Yet, they seem to have a lot of things that they would agree on, but it's just this bubble thing is really a subject.

Ben Felix: It's like a different theoretical interpretation of what's happening. How do Shiller's views on asset pricing – he has that different, more behavioural view, I guess, than Fama. How do they inform his view of the perfect portfolio?

Stephen Foerster: Unlike a lot of the other luminaries that we interviewed, Shiller wouldn't be a passive buy-and-hold and index fund person. He doesn’t believe in diversification. But he believes that the perfect portfolio would change over time. As you point out, in terms of whether he feels that the overall market might be overvalued, or undervalued because of some of the behavioural biases, the emotions that we might bring into play. Shiller is well-known for his measure known as the CAPE ratio, which stands for Cyclically Adjusted Price Earnings. Price earnings common metric to capture potentially, whether a stock, or whether a market as a whole is overvalued or undervalued. Stocks that are trading at a high price-earnings multiple, it's suggestive that they might be right for being overvalued and vice versa.

With Shiller's measure, his big adjustment to get around some of the cyclicality is to, rather than what's commonly used as looking at last year's earnings, he takes an average over the last 10 years, and so that normalizes things. Shiller would say that if you're in a market, let's say, it's the US market that is at a very high average over 30, which is where I believe it is today compared to a long run average, which is closer to 17, then that would suggest that that particular market is overvalued, and you might want to look globally for a different market that has a much lower CAPE measure.

Ben Felix: I think it’s at 37 right now. I was just looking earlier today.

Stephen Foerster: That's pretty high.

Ben Felix: That's pretty high.

Cameron Passmore: I'm curious, what was it about John Bogle that allowed him to be so persistent with the simple idea, the index fund, while it took so long to gain traction?

Stephen Foerster: Not only did it take so long, I think, for the index fund to really be accepted, but the whole premise of the capital asset pricing model and Harry Markowitz's work, those really didn't get a lot of attention until years and years, if not decades after they were initially published. John Bogle, Jack Bogle, as we know created the first mutual fund index fund. That was in 1976. But even Bogle himself would claim that initially, it was a huge block. They tried to raise a lot of money. It was a very underwhelming offering, but he stuck with it.

Bogle didn't start out with this notion that, “I want to create an index fund.” It actually came from when he was forced out of the Wellington Management Company, and so he had to come up with some new approach for a new fund. He was partly inspired by some writing Paul Samuelson, the first American Nobel Prize in Economics winner, who was really pleading for the creation of an index. Charlie Ellis, who I think we'll probably talk about later on as well, who we feature in our book, who in 1975 wrote an article called The Loser's Game, and that was really a motivation for creating this index fund. There was a lot of resistance, and there were full-page ads taken out by competitors calling index funds un-American. How could you just settle for average? That is just so un-American, so a lot of resistance.

Bogle had this drive, and he really didn't let anything get in his way. He had many health issues related to his heart, and yet, he seemed to keep coming back. I think it was just, he had this natural persistence to him.

Ben Felix: What was his view on the perfect portfolio?

Stephen Foerster: Not surprisingly, his perfect portfolio would heavily be involved with index funds. He was more focused on the US than others in terms of taking a global perspective. His included stocks and bonds. It included a small portion of emerging market stocks, so not a lot, but a small portion. There was one surprising thing, and this was his notion of putting a very small allocation, a 5% allocation into gold. His notion there was that there might be severe geopolitical risks, and that might be a bit of a counterbalance to it.

Ben Felix: I've heard that about him, that he likes that 5% gold allocation. Did he like some active management in there too, a little bit?

Stephen Foerster: I think the only active fund was the Wellington Fund. I'm a legacy from where he used to work.

Ben Felix: How did the Black-Scholes-Merton option pricing formula change the world?

Stephen Foerster: Where this whole notion of changing the world comes from, there's a book by a mathematician and author, Ian Stewart, called 17 Equations that Changed the World, and the Black-Scholes option pricing model was one of these equations. That's where that came from. Myron Scholes, Fisher Black had the seminal publication in 1973 that solved this long-time puzzle. How do we price theoretically a call option, a call option where you have the option to buy a stock at a particular price, and you've got a certain time by which you are able to exercise that particular option?

I think their main contribution went beyond solving this puzzle. But more, it created what they referred to, what Myron Scholes referred to as the technology itself. The whole notion of derivatives and how derivative securities, not just call option, but derivative securities more broadly, can help to manage portfolio risk by creating all kinds of products, futures, and swaps, and so on.

Cameron Passmore: What is Myron Scholes’ take on the perfect portfolio?

Stephen Foerster: Of all the luminaries, his was the most different. The way that he looked at a portfolio was through the lens of risk management. He started backwards with what an investor might be trying to seek, some goal. Imagine that you're planning to retire in 30 years. Let's start with what terminal wealth do you need to retire comfortably? Then let's work backwards to where we are right now. How can you choose a path that might lower the riskiness of achieving that particular terminal wealth goal? For Scholes, it was all about managing some of these tail risks, some of the disasters that really might set your portfolio back.

The other thing that Scholes liked to focus on is what the market can tell us. By that, we have a very well-developed derivatives market in so many different products. A lot that that then we can price based on the Black-Scholes option price above. Probably the most famous and one of the most important indices based on call options is what's known as the VIX, often referred to as the fear index, which tries to capture investors' expectation of the volatility of the overall market, like the S&P 500 over the next three months.

Scholes's point was that this is a priced market, so we should pay attention to the signal of what that market is telling us. Unlike many others, Scholes was a believer, there is a role for active management.

Ben Felix: Shiller and Scholes were a little bit more active and the rest were a little bit more passive?

Stephen Foerster: Yes, that would be a good way to put it. Some still a little bit of active, but they would have been on more of the extreme.

Ben Felix: What did Robert Merton add to the Black-Scholes model? Because we call it the Black-Scholes/Merton model.

Stephen Foerster: It was a friendly competition. This was academics trying to solve this – race to solve this very important problem. Colleagues and yet “adversaries,” trying to get there first. What was happening then is that we had Black and Scholes trying to derive different parts of their model. The key to deriving this model was to come up with what was known as a hedging ratio. That was part of the secret to solving this puzzle. The question was, what should this hedge ratio look like, where you would be buying stocks and at the same time shorting calls? Then there was a way mathematically, then you could back out what the price of that call option was.

What Black and Scholes had figured out is that this hedging ratio, if they got it right and they thought they did, would remove all of the market risk. In other words, back to Bill Sharpe's model, it would remove the beta risk. They delicately shared some of this with Bob Merton. He said, “I don't think that's right. I don't think you have it right. Let me stew on this and I'm going to get back to you on it.” Merton had developed a more sophisticated mathematical model for the capital asset pricing model in what's known as continuous time. He thought, “Well, I'll run it by my model.” He was all excited then. I think was on a weekend and he came back and he said to Black and Scholes, “You guys are right, but for the wrong reason. Not only does this hedge ratio eliminate market risk, it eliminates all risk.”

That was really the key insight. With that key insight, then Black and Scholes were able to come up with this model. That's why we call it the Black-Scholes/Merton model, because he was a real contributor to this key element that helped to really solve the mystery.

Cameron Passmore: What a time. Incredible. How did Merton contribute to portfolio theory?

Stephen Foerster: Merton is also known for what's called the Merton Model. taking these call option puzzles that were solved, applying it to not only call options, but thinking about a company as a call option. What he was able to contribute was using these models, there was a much better way to assess a company's credit risk. His contribution was really a different way to think about risk.

Ben Felix: We've talked on this podcast, including with Merton himself about his intertemporal capital asset pricing model too, which is pretty interesting stuff. What's Merton's take on the perfect portfolio?

Stephen Foerster: Merton has an interesting approach. It's a really simple approach, but one that not all of us could use. It's really a potential perfect portfolio. That potential perfect portfolio would simply be to buy TIPS or treasury inflation-protected security. Imagine you need, let's say, it's a million dollars and you need that money in 20 years. If you had enough money now to invest in these TIPS today that would then provide that future value of a million dollars, you're all set. Just put all of your money into these TIPS and you're protected against inflation. That's the end of the story.

In reality, for most of us, that's not going to do it. You're going to have to take on some risk. Still, he would have this anchor as these TIPS as the starting point in your portfolio. Then you're going to have to add some risk on top of that.

Ben Felix: We skipped a few in the questions that I wrote. We skipped Martin Leibowitz. We skipped Charlie Ellis, although we'll come back to Ellis, I think, in your second book, indirectly. We also skipped Jeremy Siegel, which was a tough one. We had to make decisions for time. We skipped those guys. We talked about a bunch of them. What are your main takeaways from talking to these guys?

Stephen Foerster: Martin Leibowitz, he really helped to show pension fund managers how to better manage risk. He was a real pioneer in helping understand the whole dynamics of bonds. He and his father-in-law, Sidney Homer, wrote a seminal book on interest rates. Charlie Ellis, we’ll come back to him. He wrote a bestseller called Winning the Losers Game. We'll talk more about him and a tennis analogy that is really important, and I tell that story in my most recent book.

Finally, Jeremy Siegel. Actually, my professor at Wharton back in the mid-1980s is best known for his bestseller called Stocks for the Long Run. His main contribution is providing a lot of long-term analysis of stock returns and risks and why stocks, if we hold them for a very long horizon, aren't as risky as we might think they are.

Cameron Passmore: What is your take on the perfect portfolio?

Stephen Foerster: I think asking anybody, what's your perfect portfolio? It's like asking the question, what should I do to be healthy? The answer of what I should be doing to be healthy, well, it depends on what my current medical condition is. It depends on when you ask me and how medicine has progressed, what tools we have today. Part of the answers might be diet and exercise and medicine tailored to my particular situation, or your particular situation. That's, I think, a good analogy in terms of what our perfect portfolio is.

I would say, our starting point should be developing an investment philosophy. That's really the theme of my most recent book, what you should be doing to try to come up with an investment philosophy. Really, some of the principles and what your beliefs are, whether you think you can beat the market, for example. That's got to be a starting point. Then you have to determine what your financial goals are and how much risk you're prepared to take on, how much you have in terms of saving and investing. Once you've figured those things out, you want to start with a foundation of what I call the traditional investment stocks and bonds. It really is then a matter of balancing expected returns and risk. You might have to circle back and adjust how much you're planning to save and invest each year and how long you're going to save and invest each year. As I tell my students, short answer is it depends.

Ben Felix: The health analogy is really good. There's more dimensions, too. Someone may have different preferences about what type of medicine that they'll take. You can't prescribe the perfect portfolio without a whole lot of information.

Stephen Foerster: Absolutely.

Ben Felix: I want to move on to questions about your second book. I also want to ask before we go there, how did writing this first book about those people that created this field of academic finance, how did that inspire you to write this second book, which is in some ways similar, but also quite different?

Stephen Foerster: A lot of the stories that we had uncovered in Pursuit of the Perfect Portfolio, particularly the first chapter when we were doing a brief history of investing, along with just talking to these luminaries, like Bogel and Ellis really inspired me then that there were more stories that we didn't include in the first book. Also, just through happenstance, happened to be listening to some podcasts, got some ideas as well.

Where I really have evolved in my writing, I started out writing textbooks and they were well received and students who had to read them claim that they enjoyed it, but the captive market. Textbook to me is like a lecture and you're just telling someone something. I think we learn better through stories, through narratives. Just by telling stories, my hope is that readers will then reflect and take away their own key messages, hopefully, some of the things that I would like them to take away as well.

Ben Felix: What edition is your textbook in?

Stephen Foerster: I've had two different textbooks. I'm looking to create a new version of it each year.

Ben Felix: Very cool. Maybe you'll jump into the story that inspires this question. What do investors need to understand about correlation versus causation when they're analyzing stock price movements?

Stephen Foerster: It's one of my favourite stories. It's the first chapter in the book called, Did Ronaldo Move the Stock Market? This is one of the most contemporary stories that I include in the book. It's set at a press conference in 2021. You might remember it, or some of your viewers might remember it, at this soccer championship, had a mandatory press conference. Ronaldo sits down, prominently displayed were two bottles of Coke since Coca-Cola was a major sponsor. He took the two bottles, immediately moved them out of camera sight, grabbed a bottle of water and said, “Aqua, water, no Coca-Cola.”

On that same day, and this was a big story in the Washington Post and elsewhere, the Washington Post headline said, “Christian Ronaldo snubbed Coca-Cola. The company's market value fell by $4 billion dollars.” If you look at Ronaldo and we think of him as an influencer, in fact, he's number one on Instagram in terms of the hundreds of millions of followers that he has, so it seems like a clear case of cause and effect moving the bottles and it cost Coca-Cola $4 billion.

Turns out, that's not the real story. That's where we get into causation versus correlation. Was there correlation? Absolutely. The same day that Ronaldo was at this press conference, snubbing Coca-Cola, the Coca-Cola stock value overall, fell by $4 billion. There's a technical explanation for it and it's a common explanation of any stock that pays dividends. It's what's known as the X dividend date. When a company pays usually quarterly dividends, they'll announce that in two weeks, we are going to be distributing this dividend. In two days, if you still own that stock on that day, you will get the dividend. If you buy the stock a day later, you will not. What do we expect to have on the so-called X dividend date, where you're not entitled to the dividends? We would expect the stock price to drop roughly by the value of the dividend. Coincidentally, that's what was happening on that particular day.

In fact, the major drop in Coca-Cola stock price came as we would expect rate at the opening price. This was just before, and it turned out coincidentally minutes before Ronaldo started his press conference. In fact, what happened to Coca-Cola the rest of the day, it went up. We could have had a whole different scenario and a different take. It's an important story that correlation does not imply causation.

I tell another story to really drive home the point. It has to do with what's known as the Super Bowl effect. The Super Bowl started, I think was around 1967. The champion of what was then the NFL versus the AFL. Now, they're the National Football Conference and the American Football Conference. What was observed after about 10, 20 years was that there was this major tendency that if an NFL team won the Super Bowl, that year the stock market did really well. If an AFL team won the Super Bowl, stocks tended to be down. It was pretty dramatic. In fact, in 1990, based on 22 years of data, in 20 of those 22 years, the Super Bowl effect worked brilliantly.

There was a famous study that was written up in the prestigious Journal of Finance. That got a lot of attention. What do you think has happened since 1990? Well, just as we would expect, it's been a coin toss, whether NFC or an AFC team wins, there's no predictive ability. I've asked students this and I haven't come up with any convincing answer. How could it possibly cause the stock market to go up, or to go down? That's really the story. You need to be careful and consider what the causation might be.

Ben Felix: The football factor performs poorly out of sample.

Stephen Foerster: That's correct. It's all about out-of-sample, which reminds me of another saying, I've never seen a backtest that I didn't like.

Ben Felix: Yeah, that's right. We talked earlier about Fama and French's factor models. I alluded to the fact that there are a lot of different factor models and hundreds of factors. How does this correlation versus causation thinking apply to the concept of factor investing?

Stephen Foerster: It really is quite important, because this whole notion of factor investing, the whole premise is that individual stock returns are driven by a number of factors. Back to the original factor model is really, Bill Sharpe's capital asset pricing model in which there is just one factor and that's the market then will drive, or cause individual stock prices to a greater or lesser extent, depending on this beta risk measure.

Fama and French and others have come along to suggest that there could be more factors and a lot of potential factors have been identified, dividend to price ratios, unexpected earnings, leverage, price momentum, volatility, all kinds of things. In fact, famously, John Cochran described these as the factor zoo. There are literally hundreds of potential factors out there. The important thing to keep in mind, this goes back to correlation versus causation. For a factor model to truly work, there has to be some causation. Yet, through backtesting, we can identify correlations, but we've got to make a convincing case that there is some causation. We have to just be really on the lookout for what might be so-called spurious correlations.

Cameron Passmore: What are some examples of masterly inactivity?

Stephen Foerster: This is based on a chapter of my new book, Trailblazers, Heroes, and Crooks. Masterly inactivity basically is the art of doing nothing. I give some examples before switching into an investing world. Going back to 200 BCE, we all have heard stories of the famous military master, Carthaginian Hannibal Barca, one of the greatest military commanders in history. There's this image of him going through the Alps with his army of elephants and wreaking havoc as he moves through the Roman Empire.

Quintus Fabius had the unenviable task of being appointed Roman dictator and having to try to stop Hannibal. What he did was he got an army together and he set a camp up fairly near where Hannibal was. When Hannibal found out about this, he was all itching for a fight, came out, and said, “Okay, let's fight.” Fabius did nothing. Didn't engage and just bided his time. The reason he was doing that is because he didn't feel the timing was right. He wanted to bide his time and basically, do nothing. Wait until he could get some reinforcements and be in a much stronger position. It really paid off and he had this huge military upset. This is where the term masterly activity, or Fabius victory was started.

In the sports realm, 1974, great example of masterly activity in Zaire Africa, now known as the Democratic Republic of Congo. Probably the greatest boxer of all time, most famous Muhammad Ali, who at this time was in his thirties, had been in the world championship, but was a conscientious objector in the Vietnam War, and refused to serve, and so was stripped of his title. He eventually worked his way back into the ring. He was coming up against this world champion, George Foreman, who many of your viewers and listeners might identify with George Foreman Grill, where he made more money after the [inaudible 0:48:53].

He was a stronger fighter. He had a longer reach. In terms of some odds makers, Ali was a 40-to-one long shot with this particular fight, which became known as the Rumble in the Jungle. What was Ali's strategy? It was really masterly activity, became known as rope-a-dope. Ali throughout most of the fight just protected himself, went against the ropes, let the ropes absorb some of the punches. Until after about six, seven rounds, Foreman had tired himself out, and that's where Ali came back and had this huge upset knockout. Classic masterly activity.

As it pertains to investing, we come back to Jack Bogle, who founded the Vanguard group in 1975. Really, this introduction of the first mutual fund index fund is a great example of masterly inactivity. If I buy and hold an index fund, then I don't have to do anything else. Bogle had a famous saying, if your broker calls up and tells you you need to do something, just reply, “Don't just do something. Stand there.”

Ben Felix: Such an important lesson for investors. It's one of few fields. Well, you gave a couple of examples there, I guess, that are not investing-related. But there aren't many things where you can do less and have a better outcome. Investing, if you try and do more, you'd probably have a worse outcome.

Stephen Foerster: Absolutely.

Ben Felix: What were the big lessons for investors from Madoff's massive Ponzi scheme?

Stephen Foerster: At the time this was happening, Bernie Madoff was actually a very well-respected professional in the industry. He was really a technology innovator. It also appeared that he had a really successful side gig. This side gig appeared to be a hedge fund that was purportedly able to provide these double-digit annual returns with almost no risk. Of course, as we know, as we found out later, it was just a huge Ponzi scheme, the biggest Ponzi scheme in the world. It had gone on for decades and investors lost billions of dollars. A lot of important lessons come out of this.

We want to be sceptical if anyone brings you a low-risk, high-return investment promise because usually, higher expected return comes with a higher risk. Of course, the classic, if something appears too good to be true, it probably is, especially if it purports to show a really high Sharpe ratio, going back to the Bill Sharpe metric. Other messages, you want to look for red flags in terms of investment advisors who overstate their credentials, which in retrospect is something that Madoff did, as well as lacking transparency.

Due diligence, I mean, for any investor is really important. I love Ronald Reagan's favourite Russian proverb that he used with Mikhail Gorbachev, trust but verify. It's going to be trusting and invest with somebody we trust, but you really want to make sure that they're above board. Another takeaway is that when we think about risk, risk is more than just volatility. The risk of fraud is something that's really important as well.

Cameron Passmore: How old is the art of FOMO investing into hot assets?

Stephen Foerster: Fear of missing out. We have documented evidence that it goes back at least three centuries. It goes back to Sir Isaac Newton, esteemed mathematician, physicist. He was an apparently, astute investor, because after he retired from his academic position at Cambridge, he became the Master of the Royal Mint. He knew a thing or two about investing. However, in 1720, he succumbed to a really bad case of FOMO. It involved the South Sea stock, and there's a whole story to be told, but we'll leave that aside in terms of the South Sea stock. What happened in 1720 is that South Sea stock went from, in January, around 100 pounds per share, up to 1,000 pounds per share by the summer, and then crashed back down to 100 by the end of the year. What happened with Newton, he was invested in South Sea stock. He watched the price go up, and he decided to sell it. He made the equivalent of what would have been millions of dollars.

After he sold, he watched as the stock price went up more and more and more, and this is where he got this FOMO. He went back in the market and not only what he had sold, but even he pushed all the chips all on red, and he went all in, and it was probably at the worst time, and he lost the fortune. Purportedly, he came up with this famous saying that, “I can calculate the motions of heavenly bodies, but not the madness of people.”

Ben Felix: What's the science behind FOMO?

Stephen Foerster: FOMO has been studied for a long time. There's a research paper that goes back to 2013. They had an interesting definition of FOMO. They called it a pervasive apprehension that others might be having rewarding experiences from which one is absent. Their context, I think, rings true today, was in a social media context. What they found is they conducted surveys and found that by their particular measure of FOMO, those that had high FOMO scores tended to have high levels of social engagement, but these individuals were less satisfied. It's one who is engaged in something, but it's not giving you that satisfaction, and you're always looking out for what you might be missing out on.

Cameron Passmore: How do you think investors can avoid losing money on FOMO bets?

Stephen Foerster: This is where I think we have to be aware of, our emotions when it's time for us to make investment decisions. I think the best thing that you can do, once you've sold a security, don't ever look at it again. That's one way to avoid FOMO. Don't try to time the market. Timing the market is very difficult. Be disciplined. Have some well-thought-out plan and then stick to that plan. Dollar-cost averaging is a great strategy, where each month, or on a regular basis, you invest a certain amount of money. Certainly, in this day and age of social media, really try to avoid peer pressure or somebody's claim that there's a hot tip.

Ben Felix: All good tips. Speaking of FOMO, a lot of people FOMO'd into SPACs, a few years ago now. What lessons from history would have suggested if people had read the history that SPACs may not have been the wisest investments?

Stephen Foerster: SPACs, first of all, are special purpose acquisition companies. They're also known as blank check companies. The way they work is you invest a certain amount of money, and there's someone who's promoting this particular fund. They say, okay, give me your money. Within the next, usually it's within the next two years, I'm going to invest it in something. This something is going to be really good. Just trust me on this. It's going to be really good.

The story I tell in the book, Trailblazers, Heroes, and Crooks, is set in 1720. I call this, partly tongue-in-cheek, the original SPAC. It has some parallels with the original blank check company. This was right around the time of the South Sea Company, where its stock was skyrocketing. New companies were coming to market. They later became known as bubble companies. There a crook, we don't know his name and lost the history, a promoter from Cornhill. His claim was that he had the company for carrying on and undertaking a great advantage, but he wouldn't reveal what the nature of the business was. Not for another month. Then in another month, he was going to reveal it.

He set up shop one day, and it really sounds like these blank check companies. Set up shop, took in, again, the equivalent of a million dollars. That night, he closed up the went to the continent and was never heard from again. Obviously, it didn't end well. I think it's a cautionary tale. Obviously, with today's SPACs, something that extreme wouldn't happen. Even if there isn't a good investment, or if it's even only a mediocre investment, you've got this two-year period where you've got a real opportunity cost of your money hanging around. We had this what in retrospect appears to be a bubble around 2021, 2022, I believe it was, where a lot of SPACs came to market. The investments themselves, once they acquired another company, for the most part, with a few exceptions having panned out very well.

Cameron Passmore: What do you think investors can learn from value investors, like Hetty Green, or Warren Buffett?

Stephen Foerster: Both Hetty Green and Warren Buffett appear in my stories as well. Her story, I call that chapter, Hetty Green, the Queen of Value Investing. It's set in New York City back in 1907. She's not as well-known but was a real trailblazer. At one point, was known as both the world's richest woman and also, the greatest miser, which I think really rings true from a value investing perspective. Really, she was a value investor before Ben Graham, who's considered really the first proponent of value investing, and obviously, his famous disciple, Warren Buffett She had this real knack out buying things when prices were low and nobody wanted something and then selling when there was some buying frenzy.

She was able to avoid a bank run. She identified a particular bank that she thought was not on the up and up. She claimed partly tongue in cheek that the men who ran that bank were too good-looking, and that's why she didn't trust them. It turned out, she got her money out before there was a bank run during the panic of 1907. At the time, New York City was almost going bankrupt. She provided some major loans that helped save the city.

In terms of what we can learn from Hetty Green and Warren Buffett and Ben Graham and other value investing is sometimes it does pay to be a contrarian investor. It's important to have a disciplined approach. It's interesting in anecdotes about both Hetty Green and Warren Buffett. They just didn't have this gut feel and say, “Oh, wow. This price is down, so I'm going to buy it.” They did a lot of research. I tell the story of Warren Buffett and American Express. He did a lot of research, where he saw this disconnect between Main Street and Wall Street. Wall Street had punished American Express, but he thought Main Street thought that its credit cards, its travellers checks were pretty solid. Really doing your homework can pay off.

Greed can get in the way of sound analysis. As part of the American Express story, Buffett really identified that long-term value can trump short-term profits. Short story is that it looked like American Express was trying to prop up a subsidiary that had got involved in a salad oil scandal. When they really didn't have to, they could have just let it loose. They felt their reputation was at stake. Other shareholders disagreed with Buffett, who was really supportive of what management was doing. This was a case of where long-term value can and did trump short-term profits. The last thing I would say is that it really comes down to a famous saying on Buffett, it pays to be fearful when others are greedy and greedy when others are fearful. Stocks might be overvalued when everyone wants them and then undervalued when no one wants them.

Ben Felix: Tough for people to do in practice, which is why those two are so special, I guess.

Stephen Foerster: Exactly.

Ben Felix: We briefly touched on Charlie Ellis earlier. What are the common threads between winning at tennis and winning at investing? Or I should say, not losing, I think, at investing.

Stephen Foerster: These stories are set around 1975. We really have two trailblazers here, both bestselling authors. One is Si Ramo, who was a really fascinating character. I think he passed the age of 100. He was the oldest person to get a patent in the US. He wrote on many areas. He was instrumental in forming a company that developed some of the first intercontinental missiles. Made a lot of money there. On a quirky topic, he wrote a book called Extraordinary Tennis for Ordinary Players. What he showed in this book, or what he claimed in this book, is that really, there are two different games of tennis.

There's the tennis that amateurs, like you and I play, and then there's the game of tennis that the professionals play. The professionals play this beautiful game, and they have these long rallies. They hit the ball in a very precise way after long rallies. They rarely hit into the net, and it's really a whole winning game. You win by being precise and just out-duelling your opponent. That's not the type of tennis that most amateurs play. Most amateurs will hit the ball into the net, or hit the ball wide outside of the court. Really, the way that tennis is played by amateurs is you end up losing.

The point that Ramo was making, if you want to be successful as an ordinary tennis player, then you should play to not lose. That's the winning strategy, is don't try to do these fancy shots. Just try not to lose. Don't try to replicate this game that is played beautifully by the professionals. When Charlie Ellis read this book, he really got inspired and saw the parallels with investing and ended up writing his own bestseller called Winning the Loser’s Game. His key message, and before the book, he wrote a paper in 1975, which really inspired Jack Bogle to come up with the index funds, because the best way to not lose is to try to not outperform and that’s simply buy and hold an index fund. Really, not losing is the key. By trying to replicate what the professionals are doing, that can lead to excessive trading, for example, and excessive trading has been shown to lead to underperformance.

Cameron Passmore: Index funds and target date funds have largely automated investing. What are the risks of over-reliance on automated investment decisions and platforms like that?

Stephen Foerster: This is a story I tell, called Autopilots Gone Wrong, which on the surface, doesn't appear to have anything to do with investing. It features a trailblazer called Lawrence Sperry, who back in 1912, invented the autopilot system. The main part of the story occurs in 1994, aboard an Aeroflot flight from Moscow to Hong Kong, where one of the pilots two children are invited in the cockpit. While the autopilot is on, they're invited to fly in the plane. Obviously, they're not really flying the plane, but get the feel that they are flying the plane, or so it seems.

One of the children sits in the pilot seat, everything is fine, and then the other child happens to override the autopilot. It's really 18 minutes of cockpit drama. The way the story ends, I don't want to give away everything, but it ends with the pilot saying, “Everything's fine.” Well, not everything was fine, and so we'll leave that for our readers to see what happens. The message here is that with an investing parallel, really things like index funds, things like target date funds, which based on your age, will move you gently from a portfolio that's heavily invested in equity, and over time, it becomes more heavily invested into bonds. Those are really autopilots. It's important for us to identify, there are benefits to these, but there are also limitations.

Let me use an example in terms of index funds. We think of an index fund for a particular country as being one that's very diversified, and it's very efficient from a low-cost perspective, but there are limits. A couple of stories, a Canadian story, a Finnish story around the late 1990s, again, what became known as the dot-com bubble. In Canada, one stock, Nortel Networks, represented over a third of the overall index. In Finland, Nokia was even more dramatic. I want to say, it was over 60% of the index. While you might think, great, I'm diversified. Autopilot. I'm buying an index fund. In fact, you were taking on a huge amount of risk.

Same thing with target date funds. Bob Merton is a real critic of target date funds, because target date funds make the assumption that the only consideration in terms of your risk is how old you are. Merton and others have argued that there's a lot more nuance than that. While these target date funds are on autopilot and have some positive features, they might not necessarily capture all of your risk exposure, what your risk tolerance is.

Ben Felix: Why do you think it's important to tell the stories that have shaped modern finance as you've done in your last two books?

Stephen Foerster: I love this quote purportedly, going back to Mark Twain who said, history doesn't repeat itself, but it often rhymes. I think we can learn so much from history so that we don't repeat the mistakes that others have made. I mentioned how I've evolved from writing textbooks that are some lectures to narratives. I really think we learn better from stories. Even if you're an office investor, hopefully by reading the stories, you'll have a good feel for some of the pitfalls to avoid. There are just so many fascinating people and fascinating stories, such as Bill Sharpe and his life and his times that are really important stories to tell.

Ben Felix: How do you suggest that investors take this information? They take all these stories about how academic finance came to be and all the other stories in your second book, how do you take that type of information and use it to form your personal investment philosophy?

Stephen Foerster: The problem that my book is trying to solve is really the need for individuals to develop their own investment philosophy. Many novice investors just take the plunge into investing and buy what others on social media are telling them they should buy, without really understanding sound investing principle and concepts, like the importance of diversification, like identifying the difficulty in earning returns in excess of the market. Really understanding the riskiness of investing and also, the common mistakes that we need. Really, this is where you need to develop an investment philosophy.

I would say that we don't always act rationally when it comes to investing. What I would like readers to take away after you've read my stories, ask yourself honestly if any of these ring true for you. Do you get excited and look at investment opportunities through rose-coloured glasses and not look at anything that might burnish your perspective? Are you overconfident in your stock-picking abilities? There have been all kinds of studies in psychology. One classic study asks individuals simply to rank your own driving abilities, above average, average, or below average. Well, I know for sure that I'm above average. I would guess, Ben and Cameron, that you're above average, or you would self-assess that you're above average as well. Yet, an 80% of individuals claim that they're above average. Well, we can't all be above average, and so that's where confidence comes into play.

The other thing that might bring true is we often think that if a company makes, let's say, its cutting-edge products, do we ignore how expensive the stock is? We can have a great company, but that might not be a great investment. The last one, coming back to Sir Isaac Newton, do we convince ourselves that if we bought a stock and we've sold and the price continues to grow up, are we going to regret it and want to hop in again? Lots of things that we can take away from this.

Cameron Passmore: Our final question for you, how do you define success in your life?

Stephen Foerster: Success is that if you contribute in some way to leave the world a better place, it could be anywhere you choose, it could be small, it could be large. The second thing is that to me, happiness is equated with success. If you can make others happy and be happy yourself, then in my books, you’re a success.

Cameron Passmore: Great answer. Great to see you. Thanks for joining us, Stephen. This has been an incredible conversation, and beautiful work that you've done. Thanks.

Stephen Foerster: Appreciate it. It's been my pleasure. Really enjoyed chatting with both of you.

Ben Felix: Great. Thanks, Stephen.

Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.
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Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-328-the-evolution-of-modern-investing-key-insights-from-financial-pioneers-with-professor-stephen-foerster/32770

Books From Today’s Episode:

Stephen Foerster Books — https://www.amazon.com/stores/author/B001KDO1L0

In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest — https://www.amazon.com/dp/0691229880

Trailblazers, Heroes, and Crooks: Stories to Make You a Smarter Investor — https://www.amazon.com/dp/B0DHLVYK1Q

In Pursuit of the Unknown: 17 Equations That Changed the World — https://www.amazon.com/dp/0465085989

A History of Interest Rates — https://www.amazon.com/dp/0471732834

Winning the Loser's Game: Timeless Strategies for Successful Investing — https://www.amazon.com/dp/0071813659

Stocks for the Long Run — https://www.amazon.com/dp/1264269803/

Extraordinary Tennis For The Ordinary Player — https://www.amazon.com/dp/0517511991

Papers From Today’s Episode: 

‘Efficient Capital Markets: A Review of Theory and Empirical Work’ — https://doi.org/10.2307/2325486

‘The Loser’s Game’ — https://doi.org/10.2469/faj.v31.n4.19

'The Pricing of Options and Corporate Liabilities’ — https://doi.org/10.1142/9789814759588_0001

Links From Today’s Episode:

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

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Rational Reminder on X — https://x.com/RationalRemind

Rational Reminder on TikTok — https://www.tiktok.com/@rationalreminder

Rational Reminder on YouTube — https://www.youtube.com/channel/

Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://pwlcapital.com/our-team/

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://pwlcapital.com/our-team/

Cameron on X — https://x.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Professor Stephen Foerster — https://stephenrfoerster.com/

Stephen Foerster on LinkedIn – https://www.linkedin.com/in/stephen-foerster-26b85319/

Stephen Foerster on X – https://x.com/profsfoerster