For our 59th Episode of Bogleheads on Investing Podcast, host Jon Luskin interviews William Sharpe.
William F. Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business. He was one of the originators of the Capital Asset Pricing Model, developed the Sharpe Ratio for investment performance analysis, and has published articles in a number of professional journals. In 1990, he received the Nobel Prize in Economic Sciences.
This episode of the podcast is hosted by Jon Luskin, CFP®, a long-time Boglehead and financial planner. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.
Jon Luskin: Welcome to the 59th edition of the Bogleheads® on Investing podcast. Today our special guest is Dr. William Sharpe. I'm Jon Luskin, and I normally host our Bogleheads® Live show for the folks of Twitter. I'll be taking over for the normal host Rick Ferri, while he takes a summer sabbatical.
Please allow me to introduce Dr. William Sharpe. He was one of the originators of the Capital Asset Pricing Model, developed the Sharpe ratio for investment performance analysis and developed other methods for the evaluation of options, asset allocation optimization, and investment return analysis for evaluating the style and performance of investment funds.
Dr. Sharpe has published articles in a number of professional journals and is a past president of the American Finance Association. In 1990, he received the Nobel Prize in Economic Sciences for his work on the Capital Asset Pricing Model. You can learn more about Dr. Sharpe at wsharpe.com.
Some announcements before we get started on today's episode with Dr. Bill Sharpe. This episode of the Bogleheads® on Investing podcast, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit boglecenter.net where you'll find valuable information, including transcripts of podcast episodes.
Another announcement. Registration is currently open for the 2023 Bogleheads® Conference. This year's conference is on October 13th through the 15th in Maryland. We have some phenomenal personal finance and investing rock stars who will be attending as speakers, including Charles Ellis, Paul Merriman, Clark Howard, Jonathan Clements, Michelle Singletary, Barry Ritholtz, Wade Pfau and more. And of course, Bogleheads® favorites, host of this show, Rick Ferri, Christine Benz, Dr. Bill Bernstein, Mike Piper, Alan Roth, and much more. Go to boglecenter.net/2023conference to see the full lineup and to register. Also, you still have time to take advantage of the discounted room rate. Again, that's boglecenter.net/2023conference.
And finally, a disclaimer. The following is for informational and entertainment purposes only and should not be relied upon as investment advice.
And with that, let's get started on our interview with Dr. William Sharpe.
Bill, welcome to the 59th Bogleheads® on Investing podcast. Thank you for joining us.
William Sharpe: My pleasure.
Jon Luskin: In 1990, you jointly received the Nobel Memorial Prize in economics with Harry Markowitz and Merton Miller for your work on the Capital Asset Pricing Model (CAPM). Tell us about the Capital Asset Pricing Model.
William Sharpe: The idea is that the more securities you have in a portfolio, the less important is the risk that's specific to a given stock, whether it be from the company's activities or from the industry it's in. So, as you put more and more securities in a portfolio, what we call idiosyncratic risk, the risk that's attributable to the fact it's General Motors or the fact that it's in the auto industry, that risk tends to be diversified away.
And as you diversify more, the risk in your portfolio becomes predominantly due to what's going on in the broader market.
Jon Luskin: So, certainly, Bogleheads® are fully subscribed to this. We love diversification, and we love those low-cost index funds. We want the return of the market. We're not necessarily putting all our money into just one individual stock, and that helps manage risk.
Let's jump to one of our questions we got from Twitter. This question is from username “Levi”, who writes: “Do you still fully subscribe to the Capital Asset Price Model?”
William Sharpe: Well, it's a model, and models abstract from reality in various ways and get results based on what goes into the model, what you assume in the model.
The CAPM, the original version in the dissertation, assumed that all stocks had risk that came from “the market” and then idiosyncratic risk that was unique to them. And not correlated with anything else going on. So, in that sense, it assumed something that was not perhaps surprising and got the result that expected returns would be related to beta values, that is sensitivity to the market.
The broader model uses just the idea that the more diversified your portfolio, the greater would be the component of risk in that portfolio that was attributable to the market as a whole. And so, in a sense it did not assume that the market was the only source of returns. It in some sense got that result that the market portfolio was predominantly, I should say, to be careful, the risk for which there would be rewards in higher expected returns.
There was a radical difference between the two. And some people who knew the first work had thought that the second result, the CAPM resulted from assuming the “single index” model – that is, that only market risk was a correlated risk in securities – it did not. Again, if you have enough stocks that will diversify away and be of much less importance and therefore not rewarded. The non-market part would not be rewarded in higher expected returns.
Jon Luskin: This question is from David from Twitter who writes: “It would be great if Dr. Sharpe could comment on CAPM assumptions and the degree to which the model's value has changed as markets have evolved.”
William Sharpe: It's hard to describe to somebody in today's world how irrelevant the stock market was for most human beings. Back in the fifties and sixties, relatively few people had individual stocks. There were not 401(k) plans, and there certainly weren't as many securities as there are now, or as many different exchanges, et cetera.
At the time, the idea was that the market as a whole could be sufficiently dominant in expected returns, that it would be a high, high, high percentage of the influence on expected returns.
There was the idea that only the beta of a security would have an impact on its expected returns. That was a pretty far out assumption. Now, there are so many securities, so many markets for that matter, and so many people who own securities if nowhere else in their 401(k)s or 403(b)s. I think it's, to me, at least a more comfortable assumption.
Jon Luskin: Let's jump to measuring risk next. This question comes from username “9-5 Suited” from the Bogleheads® Forums, who writes: “Should investors consider volatility to be the primary measure of risk when constructing financial portfolios?”
William Sharpe: I would say yes, if they have a bunch of securities or a mutual fund that has a bunch of securities or multiple mutual funds. Obviously if they have an investment portfolio of three stocks, there's a lot of non-market risk in that portfolio. But if they do what Bogleheads® might by and large do, I would assume so, yes.
Jon Luskin: Yeah, certainly. I wonder if “9-5 Suited” is referring to some other risks that long-term investors might face such as inflation risk. That's to say if you don't want to take volatility as a risk (the risk that your investments decrease in value), then you're not necessarily getting rid of all risk so much as you're trading that one risk, volatility, for another risk, which is inflation. If you're not going to invest in assets like stocks that have historically grown more than inflation, then you might be looking at your wealth decreasing over the long term.
William Sharpe: Well, I think there's a very strong argument that for most people, the returns that matter are real returns, inflation-adjusted. Now, you know, we can talk about how important is inflation for old people versus young people. But in a sense, I would favor thinking of returns not as nominal returns, but as real returns.
Pick your country and time period. Inflation may be dominant. It may, if you're lucky, for a short period in some countries, be sort of minimal, as we well know and as we're experiencing in most countries, in many times. Inflation is important. So, in some sense it's easy: you just do everything in real returns.
When I'm doing projections, Monte Carlo, what have you, I tend to like to do it all in real returns. Then the literature, there's an argument that for retired people, inflation may not be quite as formidable a factor depending on if they've bought their house and they paid off their mortgage, et cetera.
Property taxes in some places in California, for example, there's a limit on how much they can be increased once you bought the house, et cetera. My inflation may be different than your inflation.
Jon Luskin: There's some research by David Blanchett that talks about the spending smile of retirees, showing how retiree spending might not actually keep up with inflation. I will link to that in the show notes for our podcast listeners. David Blanchett, by the way, was our guest on Episode #14 of the Bogleheads® Live show. I'll also link to that in these show notes.
Let's talk more about measuring risk. This question is from The White Coat Investor from the Bogleheads® Forums who writes: "Risk-adjusted return calculators, such as the Sharpe ratio, use volatility as a measurement of risk.” Volatility is the change in price of your investment. The White Coat Investor goes on to say: "A long-term investor really shouldn't care much about volatility. Does that mean that they shouldn't care about the Sharpe, Treynor, or Sortino ratios?"
And before we answer that question, perhaps you can tell us what those ratios are.
William Sharpe: I can probably answer that part, what the Sharpe ratio is. And let me say, by the way, I didn't call it that. I called it the reward-to-variability ratio. And I think it was Gene Fama who started calling it the Sharpe ratio. The idea of the Sharpe ratio is to at least take two things into account: an average returns, and a standard deviation.
Jon Luskin: Standard deviation for those who aren't investing nerds is just a way that we can measure risk, how much our portfolio changes in value. This is the same thing as the volatility that we just mentioned, standard deviation, volatility, and risk are often all used interchangeably.
William Sharpe: The t-statistic or the Sharpe ratio, it gives you credit for higher average returns – that's on the top – and it gives you a discredit or it demotes your number or lowers your number for more risk, more variation. That's the number on the bottom.
And so this has in the numerator an average, and on the denominator, a standard deviation. So, you get a better number if you do better on average, and you get a better number – all other things equal – if you have less variability.
It's not unlike a statistical measure called the t-statistic, which again is saying, well, here's how you did on average, but how much variation was there? If you did this on average, and it was almost the same every single period, then using that number as a prediction makes me more comfortable than if it was that on average, but it was varying all over the place.
The original idea, as you know, it takes into account the risk-free rate. So, it's not just the average return on the top, it's average over and above the risk-free rate. That's because it assumes that you can borrow and lend at that rate. And, so you could take that portfolio and lever it up or down at that rate. That's the economics behind it. The Sharpe ratio, it's a useful number. I would not refuse to look at it if somebody offered it to me for an investment. And again, it's particularly important to understand that for a piece of a portfolio, the risk of that piece may or may not be important depending on how correlated it is with what's going on with the other securities in the portfolio.
I sometimes say when people ask about the Sharpe ratio, I say, "look folks, we have computers now. We don't need to put everything in one number." We can look at more than one number. You know, what was the average return and what was the risk, and what was the beta, et cetera. We can do things that are more sophisticated.
I serve on nonprofit investment committees. Very often, the consultant or the manager will show you Sharpe ratios for every investment in the portfolio, this fund, that fund, et cetera. That doesn't really help you much with what it was originally intended for. It does help you in the sense it's like a t-statistic.
t is interesting if a manager did not only well, but did it with quite some consistency. You have more reason to believe that you might get some good results in the future. Recently, some manager who was touting a Sharpe ratio, I don't know, it was five or something, this humongous Sharpe ratio and looked at it and said it was based on 14 monthly returns for private equity, for which there was no market value.
[t was just an estimate, and they'd put down these 15 estimates. And sure enough, there wasn't much variation and they'd done alright, according to the estimates. So, sometimes there are uses that I would not endorse.
Jon Luskin: For those folks who aren't investment nerds, why that is hilarious, for two reasons. Number one, a 14-month investment return is pretty much random. And then also, if it's a private investment, the manager can pretty much make up whatever price, whatever investment return.
William Sharpe: What do you want? What would you like it to be worth?
Jon Luskin: All that's to say how they used the Sharpe ratio in that situation is quite silly. And then for me, the Sharpe ratio is very special because I looked at how endowments did next to index fund portfolios for my master’s thesis. Hey, what happens with $600 million to invest? Well, the data already exists to show that those endowments would've been better off with low-cost index funds.
But what about risk? What is the risk-adjusted return? So, I used a Sharpe ratio and the Sortino ratio to show even on a risk-adjusted basis, considering how much risk you are taking, that the amount of return you're getting compared to that index fund portfolio is not that great.
William Sharpe: And of course, if you're comparing portfolios and you can borrow and lend at the riskless rate, then the portfolio with the highest Sharpe ratio is golden because with leverage up or down, that can beat anything below it.
Jon Luskin: Let's jump to the second part of The White Coat Investor’s question, who asks: “How can we adjust for the deep risks discussed by Dr. Bill Bernstein, such as inflation, deflation, confiscation, and devastation?”
William Sharpe: Let me maybe twist the question a little to a broader question. To what extent is it useful to look at historic returns of a security, a portfolio, the market, whatever, as a predictor of future returns and risks? And that's a very serious question you have to ask yourself. I would say I think it's incumbent upon you or your advisor to look at history to see how that particular portfolio would have done in the past.
I don't think you should say past is not a predictor of the future, so don't look at all. On the other hand, if a portfolio did well in the past, how likely is it that it's going to do well in the future? And I would say generally not very likely. Risk is a somewhat different matter. Past risk is probably a better predictor of future risk. In an efficient market, past expected returns that are abnormally high are unlikely to be repeated, as are terrible returns. If it's done really well in the past, the market knows that, and the price reflects that to the extent that it's predictive of the future. So don't expect with any kind of certainty abnormally high returns in the future.
Jon Luskin: Let's talk a little bit more about the risk-adjusted metrics that are out there. Username “Chiggy” from Twitter writes: “We should ask him if the Sharpe ratio is the best risk-adjusted return metric to compare index funds versus mutual funds.”
William Sharpe: In principle, the Sharpe ratio should be used for your whole portfolio. In many cases, it's used for pieces of the portfolio. It's useful, but in a different sense. And if you're using it for pieces of a portfolio, then it's more in the sense of the t-statistic. How did that piece do on average and how much risk (variation) was there getting to that average? If you got that average return almost every single month, then that's a very different story than if you got it ranging all over the place.
For a whole portfolio, don't just use the standard deviation. Look at the whole distribution. How many months, let's say over the last 20 years, did it lose 20%? Did it lose 19%? Show the range of things that happened and how frequently they happened. That's for the whole portfolio.
For pieces of the portfolio, even standard deviation, the typical risk measure, standard deviation of a portfolio X plus Y is not just the average of those two standard deviations. It depends on how they move together. So, it gets more complicated.
Jon Luskin: Thoughts on the Sortino ratio?
William Sharpe: My recollection is that for the Sortino ratio, for the risk side, uses downside risk on the grounds that the risk of that you'll do better than expected doesn't seem to be at something you should worry about.
And Sortino is certainly right. When you're looking into whole portfolio, what you care about is downside. Upside risk is fine. You know, the more the merrier. And there's the issue, if the distribution is symmetric around a middle point, you know when you plot it, it looks sort of the same on the downside as on the upside, then it doesn't matter whether you use standard deviation or the standard deviation of the downside.
Jon Luskin: Bill, I mentioned earlier that I used the Sharpe ratio to compare index fund portfolios to the very high fee portfolios of endowments to compare their performance on a risk-adjusted basis. I also used the Sortino ratio and the results were very similar.
William Sharpe: That's kind of my expectation. The probability of distribution is isometric, but they're typically of a similar enough form. Probably if you rank on one, probably rank on the other.
Jon Luskin: This question is from username, “Derek Tinnin” from Twitter, who writes: “Are the persistent flows to index funds changing the market structure?”
William Sharpe: Yes. There are two ways of looking at that question. One is, were there not those funds how different would things be? The other is given there are those now and there were not back in my early days, how different are things? And I'll skip the latter one because the world is so different in general. I don't even know how to start on that one.
I guess one difference if people generally stop using index funds would be they'd be poorer because they'd be paying higher fees. And as Jack Bogle has written about and talked about many times, that's not a trivial difference. That's a major difference.
One of the ironies of Efficient Market Theory, broadly construed, is this is a sort of a contradiction. We assume that people are really working hard to figure out exactly how much more General Motors is worth than General Electric. And that all those prices are taking into account information in very efficient ways, and yet we encourage investors to pay no attention to any of that and just hold them all.
And there has to be a point at which there aren't enough active managers, people doing research on securities to keep the market prices “right” as it were, to incorporate the information that's extant into security prices. That's a really interesting thing to worry about, and over the many years since we all started in this field, the question is how much indexing is too much?
[My hope at least is that if and when we got to that point, enough people will peel off and start doing security research and become active managers. Where that point is, I don't know. But it is a dilemma. So, you don't want to convince too many people to index. Unfortunately, the people who don't index are paying the price for that research through higher fees. It's a very strange kind of equilibrium.
Do I worry about it now? No. Do I index now? Yes.
When I started teaching the investments course at Stanford, and this would've been 1970 or thereafter, I would start the course by going into the classroom and writing on the board a phone number, and I would say, “this is the most important information you're going to get in this course.” And I'd wait for somebody to say, “Well, what is that?” I said, that's the new customer line at Vanguard.
This is true, and I'm not making this up just to please the Bogleheads®. Because they were at that time, the only place you could get an index fund.
It's an issue to think about, if not worry about, is there too much indexing? The answer is “no.” But, I can't prove it.
Jon Luskin: Certainly, to your point, if too many index fund investors means an opportunity to make some money, someone's
William Sharpe: Of course. And the question is, how much, if any, of that will the managers pass through to the shareholders of the fund.
Jon Luskin: To quote Rick Ferri, "If there is any alpha, it goes to the managers.”
Let's move on to another question on index investing. This one is from username “SB1234” from the Bogleheads® Forums who writes: “Are buy and hold index fund investors free-riding in the
William Sharpe: I think so. There are certainly managers who get rich by being, in some sense, superior and getting information and acting on it.
I have a general audience teaching the investments course at Stanford, and I will divide them into two halves. Left side of the room, right side. They're all money managers in this market, and they collectively are the market. I would assign half of them to be index fund managers and tell them what they did. They had to figure out how many shares were outstanding of each and by exactly proportionate amounts.
And the people on this side were active managers, and I would describe this one does research on this and that one does this. And you know, give them a sense of what active managers do. So, I'd say these folks own half the market and those folks collectively own half the market.
And the index managers, of course, each of them holds the same portfolio. But the active managers are all over the place. And then I would say, okay, before costs, the market has done 12%. Okay before costs, what did this passive manager earn? And they'd say, “12%.” What did that one earn? “12%.” Now over here on the active side, what did this one earn? “30%.” Brilliant. What did this one earn? “Minus 12%.”
What did the average dollar earn on the passive side before costs? And they think a bit. “12%.” What did the average dollar earn on the active side? It takes a little while. “It has got to be 12%.” Okay. Then, we take costs into account.
In general audiences, when you play that little game, they say, “wait a minute, what did he do? Hey, wait, that can't be right.” I mean, forget data and standard deviations and equilibrium and all that. Just that argument from pure arithmetic.
And the money managers hate to hear that because they don't want to have to have that discussion with their clients.
It's a paper, I've published a two-page paper of the arithmetic of active management.
Jon Luskin: Sharpe’s Math. I'll link to that in the show notes for our podcast listeners. They can check out that paper by Bill.
William Sharpe: There have been attempts by many managers writing articles to say, well, but there are new issues. We get them the good ones first, and there's this and there's that. Those are minor perturbations, realistically, and that argument for indexing, I mean, it's so self-evident. Virtually everybody in the Bogleheads® group knows it.
Jon Luskin: Let's move on to some questions on model portfolios next. This one is from username “Exodusing” from the Bogleheads® Forums who writes: “A general principle is that people who are much different from the average investor as weighted by portfolio size or trading activity, those people should deviate from the market cap weighting to take into account their special differences. Does Bill agree?”
And then we had a similar question from username “tomsense76”.
William Sharpe: Let me break that into two pieces. One is less risk, more risk. And in the theory, you can do that by borrowing and lending. And in theory, you can borrow and lend at the same rate. But those are very strong assumptions.
There's one market portfolio levered up or down. And of course, people don't just take one market portfolio and lever it up or down. They tend to shade a bias towards less risky funds, or a bias towards riskier, et cetera.
The real world is more complicated than the simple models that economists create. People cannot borrow at the same rate at which they can lend or risklessly invest.
There are arguments there, and I will not argue that life is as simple as in our simple models.
And again, you need to take your whole portfolio into account. Your assets, if you have a home – an owner-occupied home – that's an asset. If you have a mortgage, that's a liability, et cetera.
I think of that as more bond/stock issue. Now, in the simple theory, you know, there's the market portfolio that includes bonds and stocks. And you lever that up or down at the riskless rate. Well, let's face it, we really don't do that.
I think a lot of those issues can be addressed by changing the proportions of bonds and stocks. And that is the lever that I would prefer to see people pulling and pushing to get a balance.
Jon Luskin: And that goes back to that basic Bogleheads® principle, which is take the right amount of risk. And you can do that by adjusting that lever: how much do you want in bonds versus stocks?
William Sharpe: Yeah, that would certainly be the place to start at the very least.
Jon Luskin: I wonder if “exodusing” is asking about factor investing in this question.
William Sharpe: Some people's favorite strategy of overweighting small stocks, for example. You can do the outward index funds. I don't advocate overweighting small stocks because you think they're underpriced.
Jon Luskin: More risk for the chance at higher return. Those higher returns are not guaranteed when overweighting small caps. Let's talk about TIPS, Treasury Inflation Protected Securities. These are inflation adjusted government bonds. We have another question from the Bogleheads® Forums. This user writes: "Now that TIPS have positive real yields, should individual investors who have enough space in tax-deferred accounts be using them exclusively instead of regular, or nominal, Treasury bonds?”
William Sharpe: It's certainly nicer now that they have positive, if not so nice for those who need to sell them. Yeah, definitely in an important sense, TIPS for somebody in the US are the riskless security. They’re as riskless as you can get in terms of consumption.
Jon Luskin: Let's return to a question that we touched on earlier on factor investing, such as those factors found by Fama and French. Do you believe in those factors?
William Sharpe: Well, “believe” is perhaps too strong a word. Are they useful? Yes. For some things they are, but do I believe that it is clearly true that people should overweight exposure to a small factor or the growth factor or whatever factor of your choice because there's something wrong with the markets? Uh, no.
Jon Luskin: What are your thoughts on international diversification? Should investors be only investing in the US total stock market? Or, should we be investing globally?
William Sharpe: I'll have to tell a story here: I was on a nonprofit investment committee, and one of the members was a semi-retired private equity guy, and we had a consultant who was helping us, the usual story. And at one point we were discussing a foreign investment.
And he gave a little speech – as far as I could tell, was not kidding –said, well, if he had his druthers, we wouldn't have any foreign investments because they don’t know how to run businesses over there. And I thought, “well, surely okay. Haha, this is a joke.” It wasn't. He was serious. That's one view. It's not mine.
My view is that international diversification should be a good thing in theory, as long as people can without too many problems in terms of repatriation and all the rest and divergent tax systems. I believe in globally diversified portfolios. There is a sense of diversification.
That said, there is an argument for investing at least more than market proportions at home, because that's where a lot of your consumption originates. You know, if in fact the company that you have traditionally purchased goods at the grocery store does very well because they raise their prices a lot, you at least have a balance. Well, I'm paying more, but my stock went up and that's a trivial and sort of silly example. So, I think there is an argument for home bias, but I don't think it's totally offset by the advantages of global diversification. So, there's a happy point in the middle somewhere there.
Jon Luskin: For those who aren't investment nerds, know that the global cap weighting is roughly 60/40. That's to say roughly 60 cents of every dollar invested around the world is invested in US companies, and the balance of those 40 cents are invested outside of the US.
So that is the global cap weighting. If we have a home bias, we'll invest a little bit more than that, roughly 60% compared to international. For example, Rick Ferri, the normal host of this podcast, frequently suggests two-thirds, one-third in favor of US stock markets, giving us a little bit of a home bias.
He talks about that in Episode #1 of the Bogleheads® Live podcast. I'll link to that in the show notes for our podcast listeners to check that out.
Bill, what do you think is a reasonable mix for home bias?
William Sharpe: Whether or not you go to world market proportions – which is what I would favor as a default – ask yourself, I don't buy only companies in California. I buy companies in the US. And I don't buy only companies in the US. I think you need to really think a little bit about what are your other holdings. You obviously have a disproportionate holding in the US if you own your own home. So, if you take your overall portfolio, including things like equity in your home, then that gives you a difference.
Jon Luskin: Certainly, if you've got real estate, your primary residence, maybe even some investment properties, then that further tilts you towards that home bias, even if you've got that global cap weighted portfolio for your liquid investments. That is a phenomenal point.
William Sharpe: There is a time. There were some investors who would say, I only invest in things that are close to home. You think, no, wait a minute. That's from a diversification standpoint, you have a lot of stake in California or what have you from your property.
Jon Luskin: Let's talk more about bonds, Bill. I'm curious about your thoughts on the following. The risk of equities shows up in corporate bonds. Therefore, if I'm trying to manage equity risk, I don't want to hold bonds that are subject to equity risk in my portfolio.
That means opting exclusively for US government bonds for the bond portion of my portfolio, as advocated by David Swenson, the late Chief Investment Officer over at Yale’s endowment.
William Sharpe: I haven't thought of the issue that way. Why should it matter in what manner you invest in the company? It's out there. It's part of the market, broadly construed.
There is obviously the risk issue. If you take the simplest of a theory, in theory, you should deal with combining the overall market with riskless securities to deal with your risk aversion, and you should get everything that's out there in the market if you can get it at reasonable expense.
Now, kinds of issues you're raising are more subtle. Theory is not subtle enough to deal with it. My first impression would be whatever the company has issued, we’ll buy our proportionate share of everything and then leverage to move the overall risk of the portfolio up or potentially down.
Jon Luskin: “BurritoLover” from the Bogleheads® Forums asks, “Is chasing higher yields via a lower duration bond in the current environment a viable strategy.”
William Sharpe: Well, I would just say generically, anything that assumes that you can exploit somebody who's smarter than you would not be recommended if you believe in efficient markets.
Jon Luskin: What are your thoughts on changing bond maturity over time? That's to say right now, short-term yields are really attractive. Therefore, I'm going to hold a short-term bond portfolio and then maybe when rates normalize, I'll update my bond portfolio going farther out on that yield curve.
What do you think about market timing your bond portfolio with respect to interest rates?
William Sharpe: Yeah, in general, I don't think much positively about market timing because market timing means the other people in the market are stupid, or at least not as smart as you are, and there are a lot of smart people in the market.
It's not at all clear that you know significantly more than is embedded in the market. Maybe you do think you know more about the future than the average investor. And you have to think of the average investor as dollar-weighted, not the average investor, you know, down the street with a small portfolio.
The average investor is pretty informed and pretty smart. If you're going to underweight or overweight anything because you think the market has “got it wrong”, then you're betting against a bunch of folks, many of whom in terms of dollars invested, know a lot about some of these things. I do not play that game and I would not recommend it to the average investor.
Jon Luskin: What are your thoughts on foreign bond holdings? This question is from username “McQ” from the Bogleheads® Forums who asks about just holding the US bond market on the bond portion of their portfolio.
William Sharpe: Well, there's an argument you should overweight that which you eat. In other words, you live in the US; you buy things from the US predominantly, although not exclusively of course. There would be an argument for doing things that are closer to your consumption basket, to put in economist terms. I think that's an argument we're thinking about.
Of course, we consume a lot of things that in whole or in part come from it elsewhere. But, home bias maybe makes some sense. But you have to think about it that way, I would argue, as you make the decision.
Jon Luskin: Let's talk a bit more about real estate. This question is from username “abuss368” from the Bogleheads® Forums who writes: “What are his thoughts on private real estate investing such as Fundrise and Grant Cardone as an alternative asset class to invest in alongside a diversified low-cost total market index fund portfolio?”
William Sharpe: I think you should certainly get market proportion. Think about market proportions of real estate in the sense of things that are traded on security markets, where you've got liquidity, et cetera. Not in the underlying asset, but in the security.
When you start talking about direct investment in real estate, that raises a number of other conditions. I mean, you're not going to try to get a piece of every shopping mall. I think as a practical matter, there are traded securities on major markets, that's definitely something worth considering in proportions on those markets.
Jon Luskin: “abuss368” goes on to say, these funds typically have high fees, such as 1%, and are illiquid. Does that illiquidity increase the probability of achieving alpha?
William Sharpe: Well, I would not argue that anything with certainty increases probability of increasing alpha. I think there's a pretty good argument that the truly average investor should consider liquidity.
You obviously don't do it when you buy your own house. You buy real estate. That's illiquid. Because you can live in it. But to buy an illiquid asset as an investment period, I think you should give some thought before you do that.
Jon Luskin: Let's talk about publicly traded REITs investible using Vanguard's low-cost rate index fund VNQ. These were highly recommended 10 to 20 years ago by Burton Malkiel and David Swenson.
William Sharpe: I think you should consider investing in them in market proportions in the risky part of your portfolio. Again, if they're highly liquid and they're traded reputably and such, yes.
Jon Luskin: When you invest in VTI/VTSAX, that low-cost Vanguard total stock market index fund, you're already getting everything in VNQ to your point.
Let's pivot to annuities. This one is from username “Afan” from the forums who writes: “Can you discuss the role of annuities versus bonds in a retirement plan?”
William Sharpe: Annuities versus bonds. Well, there's a really big difference. When you die, your kids can tell there's a difference or your universities in that when you die holding annuities, there's nothing for anyone else.
[00:42:04] That's a major difference, and the whole issue is should you annuitize, should you partially annuitize, is one that takes an awful lot of thought. There are very, very important things that transcend investment discussions on whether you should annuitize or not.
One of the questions is whether or not you can even make it to a very old age, which you have some probability of reaching. And, do you want to play the probabilities? Or just say, I'm not going to bet that I'm going to die soon. It's a very complicated decision that involves many issues that transcend or at least overwhelm the economics involved.
Jon Luskin: A single premium immediate annuity. That's the type of annuity you described just now.
William Sharpe: Yeah.
Jon Luskin: Let's jump to some questions that you suggested about asking artificial intelligence, AI, how to invest.
William Sharpe: It's pretty interesting. First of all, of course there's as you well know everybody now, well, knows – the answers, it's astounding what kind of answers you can get. The answers do differ. I asked the arithmetic of active management: can the average dollar invested in a market portfolio after costs outperform the average dollar invested in active strategies, and one of them said “no, period”.
One has to think about what the role of AI will be in investment advice, whether it will replace some humans or if it will just give advice to people who otherwise didn't get it and what the impact of that might be. We need to find a way to make sure that the AI reads some of the things that you and I are talking about and such.
Jon Luskin: Certainly, at least for the short term, it’s buyer beware if you're using those AI platforms for investment advice.
William Sharpe: Amen. Yeah.
Jon Luskin: Bill, thank you so much for your time. I really appreciate it, as I'm sure do all the Bogleheads®. Any final thoughts you'd like to share with the Bogleheads®?
William Sharpe: My guess is the Bogleheads® are on pretty much the right course if they're truly following Jack, that's a very good thing. I appreciate your interest and I appreciate their interest, and I appreciate anybody who listens to whatever the edited version of this will be for spending the time.
Jon Luskin: And that wraps up our interview with Dr. William Sharpe. Don't forget you've still got time to take advantage of the special room rate for the hotel for the 2023 Bogleheads® Conference. Go to boglecenter.net/2023conference for more information.
I'll be back next month, returning as guest host for the Bogleheads® on Investing podcast.
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Until that next show, have a great one.