The Power of Data Podcast
Episode 66: The Statistical Revolution
Guests: William N Goetzmann, Edwin J. Beinecke Professor of Finance and Management Studies & Director International Center for Finance at the Yale School of Management
Interviewer: Sam Tidswell-Norrish, International CMO, Dun & Bradstreet
Welcome back to The Power of Data Podcast. And I'm delighted to be joined today by Professor William Goetzmann, the Professor of Finance and Management Studies, and Faculty Director of the International Center for Finance at the Yale School of Management. Wow, what a mouthful. Welcome. Will.
Thanks very much, Sam. Happy to be here.
It's great to have you on and you and I were introduced through our friend and colleague in common Stephen Daffron, and he teed this up with a number of different superlatives, saying that you're one of the smartest men he's ever met, particularly in the financial services industry. And having read some of your studies and research, I've been looking forward to this for a very long time. You've taught at the Yale School of Management since 1994. And you're an expert on a number of different areas of finance, from alternative investing to behavioral finance, and an area which I'm also going to peruse a little bit with you today is the art market. Would you perhaps like to start off by giving our listeners a little overview of your career in history, by way of introduction?
I'd be glad to. You know, Steve Daffron and I go way back, because we both went to the Yale School of Management together and so Steve knew me before I got into finance. And so maybe some of the things he had to say about me reflects the fact that when we first met I was more interested in archaeology, film, the arts, than I was in academic finance, so it's been a long journey since then. But I discovered while I was taking my classes in business school, that finance was a really interesting tool; an interesting technology that was in some ways like other kinds of infrastructure or analytical approaches that we use. And so it kind of got me absorbed into the amazing ways that you can analyze problems, like how do you invest your portfolio? Or was there sudden shock of information that caused the bubble? And so that that hooked me, and so I enrolled in the doctoral program at Yale, and then that evolved into a career focusing mainly on studies of the markets. So you can think about me as a financial archaeologist in some ways. I've been very interested in collecting long term stock market and bond market data, and trying to understand what it tells us about the role of markets and society about the risk and return of investing, and the spread of this unusual technology of investing across the world over the last couple of 100 years.
I absolutely love that descriptor, a financial archaeologist and having spent some time with you previously, that sounds really quite apt, bringing together both data and the insights of data, but also physical artifacts. And we're going to talk about those physical artifacts a little bit later. What that descriptor does tell me is that you are a shoo-in for your recent appointment. Congratulations on that appointment as executive editor of the Financial Analysts Journal, which is a publication of the CFA Institute, if I'm not mistaken.
Yeah, so financial analysts journal is the lead publication of the CFA, and it's got a distribution of something like 130, or 140,000 professionals in investment management around the world. So it was a opportunity I just couldn't turn down. As a journal, it's been one of the key conduits for new financial knowledge, ways of doing things, best practices in investment, well, since the 1950s at least. It was also the place I published my first academic journal article, so I have a close affinity for it.
I love that, taking you right back to your publication roots. And exactly what I was gonna say, from my desktop research, it seems to be a kind of leading forum for knowledge sharing about investment management, and always trying to help the industry improve by introducing new ideas, research and practices. When you took the role you said that finance, particularly asset management is an important domain of research and practice for the ultimate benefit of society. So let's dig into that for a moment. What does it take to be a great asset management firm? And where does the social responsibility element come into play today? And are the two intrinsically linked, or can you have the former without the latter in today's world?
Well, one thing that's important to recognize is that asset management companies great and small, are firms that manage other people's money. They're intermediaries, and when I say manage their money, typically, a large firm would offer opportunities in portfolios, actually, that invest in companies that they don't manage themselves. So it's funny, they don't have the ultimate ownership of experience, and they don't have the final management say. So that intermediary role is an important one, but somewhat of a subtle one. They have to really think about other people's needs and concerns and they're always at arm's length from managers of companies where they might not completely understand what's going on, and that barrier of knowledge and information between the companies that they invest in, and the goals of their clients is something that demands real skill, and let's face it, a lot of data and analysis and research and in depth understanding of really both sides of that equation. So you asked about ESG - environmental, social and governance factors in the world of investing - that has become such an important topic right now for investment managers. Actually, for asset owners, for people that invest with those managers, people that invest in mutual funds and ETFs, and even people who have investment in their own pension funds. Even though they may not have much of a say, they're still sort of exposed to issues that ESG highlights as socially important, but also perhaps important to them as people. So you know, are there companies that really have to take ESG into account, you have to take the concerns of your clients into account, and also the challenges of understanding ESG from the company perspective into account. But what this all is mostly about is the impact on society and the environment of corporate activity. Not just corporate activity, national activity, because of course, countries issue bonds, and debt and so forth. And the concern that many people have, who are investors, they don't want this corporate activity to adversely affect the future of this world. So that's the intermediary role. How do you take that demand by many of your investors, but not all of your investors, and turn it into a reasonable thoughtful policy for investing in companies that you don't have ultimate control over? It's a big problem, and I see most of the major firms in asset management today working through this thinking about it setting up organizations within their company to explore this, and then to do what they think might best match their client's desires and society's needs. So there's a lot of investment on Wall Street, or throughout the world of finance in trying to solve this problem.
And it's not just the public markets, I mean, if you look at the UN PRI signatories, there's something like $87 trillion of assets under management from their signatories. And a large portion of those are from the private equity industry, and the private markets. And a number of those things that you talk about those forces at play, are prevalent in the private markets, just not in the same way. And it's not necessarily just asset ownership either. Could be supply chain risk in the ESG space, wanting to understand what the person you're doing business with practices are like. So I see this space as being a super important part of the future of the industry. But you and I discovered in a recent conversation that we have a friend in common, a chap called Mark Makepeace, who was the founder of Footsie and is the CEO of Wilshere, a data analytics and investment solutions business on the west coast. And I read earlier this week about their new partnership, an iconic partnership - I should add with the Financial Times - what's your view of the future of the indices and benchmarks business?
Well, first, I have to say Mark Makepeace was really a visionary CEO of Footsie. And so it's great to see him take his ambition for the future finance into this new arrangement and the connection with Wilshere. So I'm curious to see what he's going to do with it myself. But you know, indexation and benchmarking and measurement have become prevalent through the last 30 or 40 years in asset management. There's a good reason for it, because the uncertainty about whether your manager your mutual fund manager, your hedge fund manager, your pension fund manager is providing adding value is a big question. How do you ascertain whether or not the performance of your portfolio is commensurate with the fees that you're being charged for that performance? Well, the only way to do that is to look at alternative opportunity, kind of a benchmark passive portfolio that one could have invested in at lower fees. So that concept began with a few benchmarks such as the S&P 500 index, and then has grown dramatically. Wilshire is famous for introducing this idea that a very broad based index of many, many, many equities - 5000, if I'm correct - is a useful benchmark, because it doesn't leave out smaller firms and firms that might have different kinds of opportunities compared to the largest companies. So for asset manager evaluation alone, this benchmarking has been extremely important, but the ETF revolution also showed us that a benchmark could be something that could be used to create securities that people can buy and sell - very liquid securities that track passive indexes passive benchmarks. And for me, the important thing about that is many of these benchmarks have been broadly diversified, so the risk return profile is quite advantageous for smaller investors. We've since understood that we could also use these as very focused instruments to capture particular kinds of industries, strategies, risk exposures, and so forth. So that technology, that possibility of not only having broad based indexes for everybody to invest in, but also focused indexes that capture and articulate specific risks and potential for return in the global economy is also something has great promise. And so I see movements like Wilshire’s as something that may lead to even better tools for everybody from individual investors up to sophisticated institutional managers.
There's never been a more important time for better tools and better solutions. And you're right, that's I think it was even company narratives. But in 2020, the world went through one of the biggest upheavals in modern day history, and it caused incredible uncertainty. And it doesn't matter if you're an individual, you're a family, you're a business of any size, everyone's been affected. But this isn't the first time the world's been turned on its head. And at D&B, at Dun and Bradstreet, we pride ourselves on being there for businesses throughout times of crisis and throughout the better times too. So as a professor and a financial historian, what are some of the parallels that we could draw upon looking at the previous events? And how can we apply lessons from those experiences to today's climate to help us navigate and rebuild?
You know, there's a lot that we can learn from the past. There are two ways to think about this learning from the past. One of them is to say, are there episodes that are like today that we can identify historically, for example, we all know that the last great epidemic was in 1918-1919. And it was a global epidemic and it was very disruptive in all sorts of ways. And so we've been trying to figure out, I say we, economists and historians and researchers, is there anything that that can tell us about what we should be doing. And of course, the answers are fairly obvious, which have to do with hygiene and care about interaction, social interaction. But also, you know, there was a recession that followed that event, not immediately, but shortly thereafter, within about a year or two. And so right now, we're sort of wondering whether or not that is a model for what will happen going forward now, or whether that was just a one-off event. The other way that we can look at the past is instead of focusing on a few terrible shocks, and what might have happened, after all, we don't have that many epidemics to compare our analyses to, we can look at the rich data of the past in a statistical manner, and not just focus on a few things that frighten us. And there, it's actually pretty interesting, it will overturn some of your presumptions about stock markets. I took a look at all of the extreme booms in stock markets over the period from 1900 to the present at one point, because I was interested, you know, what happens if we see a stock market that really goes up quickly? Does that mean that there's going to be a crash that follows are bubbles inevitable once we see rapid expansion in asset prices? And what I found was kind of interesting. First of all, it's fairly rare in the history of all the world stock markets. And in this case, I took 42 markets that were around in 1900. And I found that only about 2% of the time, were there events where the market prices doubled in inflation adjusted terms. So it's rare to have a boom, and rightly would ask you to say, well what happened last time there was a boom. But when you take all the data, the chance of a crash in the next year, or the next five years is actually pretty small, less than 20%. And the chance of the market continuing going up is equal or greater to that probability. In other words, if you just focus on the booms, and asked whether that a crash is inevitable, the probability of a crash is actually quite small, which is a bit of a surprise, it kind of tells you better think twice before yanking your money out of the stock market when prices go up, so that's one example. Another example which is actually hits quite close to home in terms of our recent experiences. When you look at situations where stock markets dropped in half, in other words, their prices plunged by 50%. What tends to happen after that? And there This is work with my co-author, Dasol Kim. There, what we found is that for extreme crashes like that like dropping by 50%, there was a significant probability of a recovery, a big recovery in the next period, maybe not taking back all of the loss. But there tended to be a kind of a bounce as if this crash itself was a kind of a liquidity shock or a narrow crisis that was temporary. So that was an interesting discovery as well. Now, it wasn't true for all declines and crises. But taken together, it tells you look, if you go back and gather the data, you can actually make some reasonable probabilistic predictions about what would happen from extreme events. But if you don't have rich sources of data for that, and you only focus on one or two things that might be in your memory, or sort of the collective memory of the markets, you may be reacting incorrectly to a big change in prices.
This is fascinating stuff. Having started my career on the trading floor, I could talk about this all day. But let's talk for a moment about the world we live in today as it relates to the stock market, there have been some incredible events in recent times. If you think about the dramatic increases, we've seen in some companies stock prices, on the one hand, you've got Apple, that took 43 years to get to the trillion dollar market cap, and then just another 12 months, in fact, less than that, I think, 10 months to get to the $2 trillion mark. It shows you the exponential opportunity in singular stocks, and certainly technology as well. And I was reading one of my favorite quotes the other day, Warren Buffett's quotes, and it’s only my favorite because it makes me laugh. “If past history was all there was to the game, the richest people would be librarians.” And you could almost replace that word with Reddit readers, I think. What's your view on GameStop, AMC and these other explosive stock price trajectories?
The case of GameStop is a remarkable case, it's really going to be one for the history books. It seems to be a classic case of a short squeeze. And that just means a lot of people bet against the stock by borrowing it and somebody or some group of people figured out that this had happened and bought up stock in such a way that the short sellers would have to purchase it from them very high prices to hand it back to the people that they borrowed. That is a classic kind of example of failure of capital markets, or at least failure of the short sellers to understand that they could be exposed to this kind of squeeze. Now why is it remarkable? Well, we don't have that many historical examples of short squeezes to look at, I mean, this doesn't happen very often. And the reason it doesn't happen is because our capital markets are fairly well regulated. And we've got good rules for this kind of thing. For example, trading on the New York Stock Exchange, there were specialists that when they saw something weird happening with a stock price, they could shut down the trading until they figured out what strange things were going on. So we kind of figured out how to get the capital markets to work fairly regularly and price discovery became something that you could rely on in most cases. Now, why is this so weird? Well, it turns out that the coordination for this strategic short squeeze happened through social media and the organization of it, which you might think would take massive amounts of capital by one or two big institutions. That's not how it happened. It was, it was the deployment of massive amounts of capital through the vehicle of social media coordination that allowed this short squeeze to happen. That is a big warning sign, as if we didn't already have a warning sign that the ability of social media to coordinate events that can be destructive, is quite large. So I think our new administration is going to have to reflect on whether or not this requires further regulatory action or whether the existing laws that we have about manipulation of asset prices might simply serve to stop this happening again.
Let's talk for a moment about human flaws, not just human behavior, but human flaws. There's a rising awareness of the human flaws, the cause chaos with our investment decisions, and can often explain a number of those anomalies in the market due to those irrational behaviors. How can data help to mitigate the impact of these and play a role in making smarter investment decisions?
Well, you know, we're in the midst of a statistical revolution that is being driven by access to vast amounts of data. This revolution began in about late 1970s but has ramped up in the last decade so that it's affected almost every kind of business and human activity. I mean, the one I think the most about is the Human Genome Project. Where strings of 1000s and tens of 1000s of data points somehow could be analyzed computationally, to create some kind of picture of the human genome. Now, instead of genomes, we've got data that includes vast amounts of stock prices and dividends, and underlying liabilities, and names of the people that work at organizations, and the weather that happened to prevail at a given time in a given place that might have affected human decisions. We've got so much data that we have to have tools to organize it and make sense of it and lead us to useful decisions. That's where this new data science comes in - big data. And the innovations that are taking place in the application of big data tools, the flow of it is just amazing. So I'm very excited about it. I use it when I have occasion to. But you know, imagine this in the last decade, we've been able to take all of the text from newspapers and magazines in the in the internet, and so forth, and then turn it into bits and bytes and numbers that then can be analyzed to find patterns in people's discussions. And those patterns can be analyzed to see whether it might help forecast a stock by security to go up or down or identify some risks that we might not have known about, but with advanced warning, we're able to protect ourselves against. You asked about whether or not human behavior might be misguided in some ways, or whether or not the foibles that people make in their decision-making processes might be mitigated by the analysis of data. I'm going to give you one interesting example I've worked with two colleagues, Dasol Kim and Robert Shiller, who's famous for really spearheading the whole behavioral economics movement over the last 20-30 years. And what we've been able to do is look at the forecasts that individual investors have made over the last 20 or 30 years really, about the stock market returns. In other words, we would send somebody a questionnaire and among the many questions might be, what do you think the Dow Index will be in the next one year? So how much will the stock market grow over the next year? We've also asked them an interesting question about crashes, which is, what is the probability of a stock market crash in the next year, or in the next six months? And that one is extremely revealing, people tend to think that the chance of a stock market crash in the next six months is extremely high, something like on the order of 10 to 15, to 20%. So imagine that, when I say stock market crash, we asked them about a crash on the magnitude of the crash of 1987, or the crash of 1929 in the United States. So the thought that twice in a century crash might happen with 20% probability in the next six months is crazy. It means if people acted on that kind of probabilistic fear, nobody would invest in the stock market. So there's an example where the interaction of history, selective history and fear about a crash will keep you from investing in in the stock market in the equity portfolio that historically has had a great return not just over the century beginning in 1900, and extending up until now 120 years, but also over the prior century. So if there's one area that we can say, with some confidence is a long term profitable, if slightly risky investment, it's the stock markets of the world. On the other hand, fear about a crash, maybe keeping people from investing some of their savings in that opportunity. So the data that we need, which is to look at the performance of the markets over many years, that's data we're now beginning to collect. We don't have all of it, we don't have the whole history of all the markets, which we really have been working to generate. But at least we have some statistical evidence that should give people pause, and they can use it to compare reality to the fears that they might have about disaster.
Will, we talked about looking back and looking forwards, and one of the phrases I love in your book, Money changes everything, you explain the finance is like a time machine. It’s a technology, ultimately, that allows us to move value forward and backward through time. And this innovation has changed the very way we think about planning for the future. What do you see as some of the most important opportunities to innovate in the future of finance? And also, what are some of the challenges you see during the process?
Well, if we go back a generation, the future of finance might have been expressed in terms of option pricing theory and derivatives that we could use to hedge against exquisitely detailed kinds of outcomes. So it was a in some sense, an innovation in insurance. 2008 taught us that those innovations depended crucially on the smooth operation and the provision of liquidity in the capital markets and sometimes that would just blow up on our face. So, you know, we had a period of great hope for the future in terms of just financial technology. My particular hope now for the future of finance is the expansion of investment opportunities to people around the world. In the most industrialized societies, or at least I shouldn't say industrialized now, the most financialized societies, UK, US, continental Europe, we have mutual funds and ETFs, that are progressively becoming more broadly accessible, so that people can save for the future, through diversified portfolios with low fees. But those cut opportunities are not available to everybody in the world broadly. So I think innovations in providing access to equity are going to really step up. The key areas for me are areas of technological innovation, you know, it's easy to invest in a big portfolio of mature stocks. But how do individuals how to pension funds, how do pools of capital access promising new technologies? Right now, I don't think Kickstarter really does the job of providing that opportunity for us. But I'm hopeful that new channels for directly accessing new ventures will become increasingly organized in such a way that we can all participate in the next Tesla, in the next Amazon, in the next corporate venture that promises to take the world in a new and productive direction. Right now, that's not as possible as we might like, but I think because of FinTech, you know, because of the ability to create some hard wiring and soft wiring that allows people to invest comfortably and safely in small amounts, that's something that will lead us to kind of a new access to global equity.
Well this is a conversation that honestly, if we could talk for hours, Steve did warn me. But as we come to the close of the podcast, I want to touch on something a little bit lighter. You're, of course a financial expert, and academic, but you also have a fascinating collection work across a number of areas. You and I have spoken about art before at some length, but also your collection of financial securities artifacts. Can you tell us a little bit more about it? And perhaps which one your favorite artifact is?
Yes, indeed, I've collected old security stocks and bonds that extend back into the I guess the earliest one I have is from the 1500s. But they are reminders to me that the technology of finance was a technology, mostly of paper and printing. The ability to write a contract or for that matter, print a contract that many people would also be a part of made financial markets possible. And for much of the history of modern finance, you would be actually trading and transferring physical documents, pieces of paper that represented your claim to let's say, a fraction of a corporation or claim on the sovereign debt. We've entered into a period called dematerialization, where it's rarer and rarer to have somebody's portfolio being represented by stacks of old bonds with coupons in them. So I guess what I've been able to do is to acquire examples throughout capital market history. And those have helped me study and understand how financial contracts worked in the past. We sort of think we know what a stock is or a bond is, but actually you go back another 100 years, and these contracts are somewhat different. For me, it's an area of research as well as collecting. My most exciting artifact of the whole collection is actually a weird rock that I was able to pick up in this remote area called Frobisher Bay. And Frobisher Bay in Canada, far north in the in the Arctic is named after Martin Frobisher, one of these dashing early entrepreneurs, a captain that convinced a bunch of investors to back an expedition to find the Northwest Passage to China during the 1500s. You know, it was a venture that was as much a financial venture as it was a voyage of discovery. And it was a venture also that collapsed in catastrophe. This strange rock was something that Frobisher and his partners thought might be gold ore. They thought they'd struck gold in northern Canada. They brought it back to Britain and it turned out that when the assayer’s in London looked at this stuff, there really wasn't any gold in it at all. Of course, by that time Frobisher had raised a bunch more money and had headed back to Frobisher Bay. The whole thing eventually ended in financial collapse because of course, lugging all this rock across the Atlantic turned out to be nothing more than delivering some materials that were ultimately used for roads and some highways in England. Frobisher himself sort of escaped the financial disaster, but his backers including Queen Elizabeth lost a lot of money. So having a physical artifact of something that lived in people's imagination as perhaps something that was an amazing treasure, but then turned out to be what essentially looks like a lump of coal is kind of a cool thing to have in my collection.
I can imagine, there's many people that have bought stocks with that same outcome has occurred. Thank you so much for being on the Power of Data podcast today, Will, it's such a pleasure as always to talk to you, and thank you for your incredibly interesting insights.
Yeah, Sam, thanks I really loved the opportunity.