Andrew Lo: Finding the Perfect Portfolio--a ‘Never-Ending Journey’

Hi everyone. We’re taking the week off for the 4th of July holiday, but we wanted to use this week’s episode to honor Nobel Prize-winning economist Harry Markowitz, who recently passed away at the age of 95. Professor Markowitz is a giant of finance, someone who put diversification and Modern Portfolio Theory on the map, with his research transforming the way we allocate and invest our assets. While we didn’t have the opportunity to interview Professor Markowitz for the podcast, we were able to chat recently with someone who had interviewed him: author and financial researcher Dr. Andrew Lo. Dr. Lo recently published a book titled “In Pursuit of the Perfect Portfolio,” in which he profiled some of the leading figures in academic research and finance. None stood taller than Professor Markowitz, whom Dr. Lo discusses at length in this interview we aired in February of 2022. We think you’ll enjoy it. Thanks so much for listening and see you in a week. Have a happy holiday.

Our guest this week is Dr. Andrew Lo. Dr. Lo is the Charles E. & Susan T. Harris Professor, a professor of finance, and the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management. His current research spans five areas, including evolutionary models of investor behavior and adaptive markets, systemic risk, and financial regulation, among others. Dr. Lo has published extensively in academic journals and authored a number of books including In Pursuit of the Perfect Portfolio, which he cowrote with Stephen Foerster. He has received numerous awards for his work and contributions to modern finance research throughout his career. He holds a bachelor’s in economics from Yale University and an AM and Ph.D. in economics from Harvard University.

Background

In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, by Andrew W. Lo and Stephen R. Foerster

Adaptive Markets: Financial Evolution at the Speed of Thought, by Andrew W. Lo

History

"Thirty Maidens of Geneva," the Tontine Coffee-House, thetch.blog.com, Aug. 5, 2019.

"Why 18th Century Swiss Bankers Bet on the Lives of Young Girls," by Stephen Foerster, sfoerster-5338.medium.com, Sept. 2, 2021.

William F. Sharpe

"Keynes the Stock Market Investor: A Quantitative Analysis," by David Chambers, Elroy Dimson, and Justin Foo, papers.ssrn.com, Sept. 26, 2013.

Eugene F. Fama

"Algorithmic Models of Investor Behavior," by Andrew Lo and Alexander Remorov, eqderivatives.com, 2021."In Pursuit of the Perfect Portfolio: Eugene Fama," Interview with Andrew Lo and Eugene Fama, youtube.com, Dec. 15, 2016.

"Why Artificial Intelligence May Not Be as Useful or as Challenging as Artificial Stupidity," by Andrew Lo, hdsr.mitpress.mit.edu, July 1, 2019.

Charles D. Ellis

"Charley Ellis: Why Active Investing Is Still a Loser's Game," The Long View podcast, Morningstar.com, May 27, 2020.

Other

"7 Principles to Help You Create Your Perfect Portfolio," by Robert Powell, marketwatch.com, Nov. 10, 2021.

Christine Benz: Hi everyone. We’re taking the week off for the 4th of July holiday but we wanted to use this week’s episode to honor Nobel Prize winning economist Harry Markowitz, who recently passed away at the age of 95. Professor Markowitz is a giant of finance, someone who put diversification and Modern Portfolio Theory on the map, with his research transforming the way we allocate and invest our assets. While we didn’t have the opportunity to interview Professor Markowitz for the podcast, we were able to chat recently with someone who had interviewed him: Author and financial researcher Dr. Andrew Lo. Dr. Lo recently published a book entitled “In Pursuit of the Perfect Portfolio”, in which he profiled some of the leading figures in academic research and finance. None stood taller than Professor Markowitz, who Dr. Lo discusses at length in this interview we aired in February of 2022. We think you’ll enjoy it. Thanks so much for listening and see you in a week. Have a happy holiday.

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning at Morningstar.

Ptak: Our guest this week is Dr. Andrew Lo. Dr. Lo is the Charles E. & Susan T. Harris Professor, a professor of finance, and the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management. His current research spans five areas, including evolutionary models of investor behavior and adaptive markets, systemic risk, and financial regulation, among others. Dr. Lo has published extensively in academic journals and authored a number of books including In Pursuit of the Perfect Portfolio, which he cowrote with Stephen Foerster. He has received numerous awards for his work and contributions to modern finance research throughout his career. He holds a bachelor’s in economics from Yale University and an AM and Ph.D. in economics from Harvard University.

Dr. Lo, welcome to The Long View.

Dr. Andrew Lo: Thanks for having me.

Ptak: It's our pleasure. Thanks so much for joining us. In your new book In Pursuit of the Perfect Portfolio, you trace the history of investing and finance all the way back to the Neolithic era. But modern portfolio diversification really originated with three young girls in late-18th century Switzerland. Can you tell that story?

Dr. Lo: Well, it's actually 30 young girls, Trente Demoiselles, and it has to do with actually the American Revolution. So, as you probably know, France was involved in supporting us in that effort, and they had to pay for it somehow. So, the French government, Louis XVI, decided to borrow from private citizens. And in exchange for these loans what he promised in return were basically life annuities. So, if you lent the French government a certain amount of money, they would pay you back a certain payment every year for the rest of your natural life. But there was one really interesting catch to this, and that is that it wasn't necessarily just your life, you could designate somebody else, and as long as that person was alive, the payments would continue. So, naturally, what you'd want to do is to select a rather young individual to be able to keep on receiving payments as long as he or she were alive.

And so, this particular arrangement was taken advantage of by a number of Swiss investors in the town of Geneva. These Swiss bankers figured out that if you pooled a number of these loans in an investment portfolio, and you selected relatively young people to be the individuals on which these loans were based, you can actually extend the payments from the French government. And so, these interesting funds were called Trente Demoiselles de Geneve, because these Genevan bankers created so many of them. And typically, they had 30 individuals, generally young women from Geneva, hence the name, Trente Demoiselles. And so, these women were selected—they were actually girls—they were selected between the ages of 5 and 10. And after they survived smallpox, they would then be presented to the French government as the individuals to which the loans were going to be assigned. And so, diversification was clearly recognized at that time, the 30 young maidens from Geneva per fund, and shares in these investment funds were sold, they were transferred. So, the early form of securitization was part of this process. It was really quite sophisticated. And investors did very, very well until, of course, at some point, the French government ultimately went bankrupt, and a number of investors lost their money. So, not at all an unfamiliar story from our perspective.

Benz: You point out that serious investment theory didn't really emerge until the 1900s, which is when Irving Fisher, John Maynard Keynes, and several others published major academic treatises on economics. Why did it take so long?

Dr. Lo: That's a really tough question because there are many different factors involved. And I'm no expert in history, so I have to be careful about answering that. But if I had to hazard a guess, I'd say that there are probably two factors involved. One is that the motivation for having a systematic approach to investing really didn't develop until you actually had the need and the resources to be able to apply these kinds of mathematics. And so, that really didn't develop until the 1900s. Basic bond math, interest-rate calculations, even compound interest, those are things that are relatively modern from a mathematical perspective.

But I think there's another reason why it may not have become as popular as it did in the 1900s. And that was really because of cultural and socioeconomic factors. In order for investments to be considered a respectable profession, you needed to have a pretty significant middle class and a particular business class to take investments seriously. And so, I think it really took that kind of process to create a situation where enough people were interested in order to justify the kind of resources that ultimately went into creating an entire industry around the investment process.

Ptak: Christine just mentioned Keynes, who was not just a brilliant economic theorist, but also a very accomplished investor. As you point out in the book, he successfully managed the Cambridge University endowment for 25 years until his death in 1946. Yet, unlike in economics, where he made a huge and lasting impact, his investing legacy didn't live on. What lessons could investors have learned from how he managed the Cambridge endowment?

Dr. Lo: Well, there's a really interesting story about that that we describe in the book, which is that his track record was really quite impressive over the course of 20-some-odd-year period for investing for the University of Cambridge. He generated a compound return of something on the order of 14%, 15%. But the interesting part about that story is the fact that that return was really two components that are broken down into the returns from 1922 to 1932, where the return that he generated was about 1.3%, and from 1933 to 1946, during that period of time, he generated about an 18% return. And the difference, according to a paper by Chambers and Dimson, was the fact that he recognized somewhere in the process that his earlier investment style wasn't working, and that more of a bottom-up fundamental stock-picking value-investor style actually worked better.

So, he started out with a top-down kind of an approach and ultimately ended up bottom-up Benjamin Graham-type of investment style. First of all, that tells us that there's something to be said for value investing, and that Benjamin Graham does have some merit to his approach. But it also says that one needs to be adaptive because market conditions change, and when one discovers that the particular approach is not working, then it's time to adapt and change investment philosophies. So, I think that's probably the biggest takeaway that I got from the story, which is that even something as important as endowment investing is not nearly the kind of science that we would like it to be, and an economist of Keynes' stature, even he ended up engaging in trial and error to be able to achieve that kind of performance.

Benz: The book asks whether there is a perfect portfolio that offers the ideal mix of risk and reward. And to answer that question, you profiled 10 thought leaders who have come to shape the way that we think about portfolio theory and construction. Can you talk about those theories that you profiled and how you chose them?

Dr. Lo: Well, it's actually pretty easy. The book really grew out of what I would call a very thinly veiled version of hero worship. My coauthor, Steve Foerster, and I, obviously were trained in academic finance. And if you're trained in that tradition, there are just a very small number of absolute giants, both in academia as well as in industry, that have really transformed the way we think about investing. So, the people that we chose were simply the 10 giants, the founders of modern finance, both on the theoretical and academic perspective, as well as from the industry perspective. These are the individuals that have had the most influence in both the theory and practice of modern investing and ones that really changed the way Steve and I think about the field. So, from that perspective, it was a pretty easy set of choices.

Ptak: Something we've discussed at some length on this podcast and in other work we've done is the idea that investors shouldn't make perfect the enemy of good when it comes to building a portfolio. A portfolio isn't "perfect" if an investor is likely to misuse it. Did that come up in your conversations with the luminaries you interviewed? And, if so, did they think we need to tweak our definition of the theoretically perfect portfolio to reflect reality?

Dr. Lo: It definitely did come up. And, of course, we chose the title purposely. To be a little bit controversial, most people would argue that there is no such thing as a perfect portfolio. And yet, all of us seem to be constantly striving to achieve that level of perfection. And in a way, that's really what the book is about and how we end it. We basically point out that this is a never-ending journey, that we're constantly looking to improve the way we think about investing. And each one of the luminaries that we interviewed had their own version of what perfection means. And that's also part of our goal was to elicit the particular viewpoints of these individuals, knowing full well that they don't agree, but in a way, that's what we're looking for. We learn when we find other people who disagree with us. And so, just trying to understand the different kinds of disagreements gives us a much richer tapestry of the entire investment landscape. And in the end, I think that's what readers will benefit from, it's knowing the different perspectives and when certain perspectives are appropriate and applicable, and when others aren't.

Benz: There's a tendency to fight the last war, and that probably holds for portfolio construction, too. Thinking back to 2009 and 2010, it seemed like everyone was talking about risk parity and tactical asset allocation. But now that the markets have roared back, that's quieted down. Given this, what do you think constitutes a bona fide portfolio construction framework, especially knowing that different approaches can yield different outcomes, even over long stretches?

Dr. Lo: Well, a great example of that issue is the COVID pandemic. If we think about how things were looking, let's say, January of 2020, I think the markets were going great guns, we had a fantastic year the year before that. And then, of course, sometime around February COVID reached U.S. shores, and all of a sudden, financial markets panicked, we had a pretty significant drop in major indexes. And over a four- or five-week period, it really looked like there was going to be no end to this terrible affliction. But, of course, there is an end and markets take that into account. And a few months after the panic started in February, markets actually recovered. And so, I think that's a really interesting microcosm for the lesson that we learned from talking with all of these financial leaders is that a perfect portfolio is one that will adapt to both an individual's changing circumstances as well as market conditions. And so, what's perfect today may not be perfect tomorrow. And so, we constantly have to be thinking about reshaping our portfolio, and not only the portfolio, but the portfolio strategy, and trying to adapt those particular changes to the current conditions that apply. I think that's probably the biggest lesson. It's that among these 10 luminaries, we now understand many different ways of applying these tools to different market conditions. So, I would say that being forewarned is being forearmed. And I think that providing readers with all of these various different perspectives will give them an opportunity to apply each and every one of them as market conditions change.

Ptak: And I think we want to get into some of those different perspectives as we continue with our conversation. Before we do that, I wanted to talk about some of those luminaries that you profiled, the first of which is a giant in the field. All of these are giants in the field, but maybe he arguably looms largest, is Harry Markowitz. You explained in the book, in telling his story, that if it weren't for a chance encounter, Markowitz might never have gone down the path that eventually led to his research on Modern Portfolio Theory. Can you talk about that chance encounter?

Dr. Lo: It was a very strange story that Harry told about being in a, I think it was a waiting room, and trying to get some feedback on some work that he had done. And it turned out that that feedback ended up leading him toward thinking about portfolio optimization, which he would have never done had it not been for that occasion. And, of course, portfolio theory is such an important part of what we do in modern finance, that it's kind of hard to imagine that it was really due to that random event that got him down that path to think about how to apply optimization processes to this particular setting.

Ptak: It was a stockbroker in his doctoral advisors' waiting room, wasn't it, who said,

“Maybe take a look at the market.” And that eventually led him down the path he went down, correct?

Dr. Lo: That's right. And I think that he had very little experience with investing prior to that. He had no particular interest in it. But given the tools that he had at his disposal and given the problem that was proposed to him, it was just a natural application.

Benz: As you explained in the book, there had been little academic interest in portfolio management until Markowitz came along. Now there are whole journals devoted to the topic. But back then, the disinterest reflected attitudes toward the stock market, which was perceived as a bit of a backwater, right?

Dr. Lo: Absolutely. It's really quite a stunning change, because when Markowitz started applying these principles, nobody had any interest in portfolio optimization. And today, I don't imagine there's a financial analyst out there who doesn't know of mean-variance analysis. A very interesting story that Harry tells is at his thesis defense, when Milton Friedman, who was on his thesis committee, half-jokingly said, "Well, we can't really give him a Ph.D. in economics, because, of course, this isn't really economics, it's just math." And Harry Markowitz I think had the last laugh, when, as part of his Nobel acceptance speech, he mentioned this story. And he said that, "Well, at that time, Friedman was right. It wasn't economics or finance. But now, it is."

Ptak: In one afternoon—I think you recount this in the book—Markowitz had worked out the two major inputs to what became Modern Portfolio Theory: correlation and the notion of mean-variance optimization, as well as the notion of an efficient frontier. Can you talk about how those discoveries changed portfolio construction, maybe by contrasting with how it had been done up to that point?

Dr. Lo: This is really quite a stunning achievement, and it's one that most people aren't aware of, because they just take for granted that we now think about correlation, diversification, and portfolio construction the way we've always done it. But, in fact, prior to Markowitz, the way that people thought about investments was really from the perspective of the portfolio manager, the culture, and the personalities involved. They were often called gunslingers. Because these were larger-than-life celebrities that were able to pick stocks in much the way that certain art experts are able to pick the very best pieces of art. And so, that's the way that the investment industry operated until, I would say, the 1960s and '70s, well past the first decade after Markowitz's publication.

But something happened in that process, which is that portfolio managers began to see a different way of constructing portfolios, not by picking the best stocks, but rather by creating a combination of securities that had good properties overall. And correlation was a key feature. What you wanted to do was to put together a collection of securities that were not all highly correlated, not highly related. And the reason for that is you wanted to make sure that you had good diversification, not putting all your eggs in the same basket. And by managing the correlation, you're able to produce a portfolio that had better returns, lower risk, and therefore over time, would grow into a much larger nest egg than the traditional stock-picking approach. That was a combination of Markowitz and Sharpe and all of the other luminaries that had ultimately taken this academic idea, a rather dry set of mathematics, and really turned it into something practical and genuinely useful.

Benz: Markowitz is rightly credited as the father of Modern Portfolio Theory, but you call him the grandfather of behavioral finance in your book. What do you see as his contribution to this field?

Dr. Lo: Well, if you think about portfolio theory the way he looked at it, he made a behavioral statement. His statement was, individuals, they care about two things: risk and reward. They don't like risk; they do like reward. Those are actually behavioral assumptions. And based upon those behavioral assumptions, he derived tremendously powerful implications about how individuals would ultimately manage their money to achieve those goals. Since then, he's actually spent some time thinking about other criteria, other behavioral approaches. And so, in that respect, I think he really is the very first behavioral economist. He took human behavior seriously and then worked out the implications and ultimately developed a tremendously valuable framework for helping everybody manage their particular behavioral desires. And of course, since then, we've learned that there are many other kinds of behaviors, some of which are conducive, others of which are not, to wealth creation. And there's a lot more research that's being done on that today.

Ptak: I wanted to talk about Bill Sharpe, another luminary who you profile in the book. One of the many big advances that he made was in developing a measure of a security's non-diversifiable risk or beta. Can you talk about how well you think beta has held up through the years? I suppose on one hand, we can say it hasn't held up all that well, because there have been all these other factors that had been developed that now flank traditional beta. And so, in that way, it was an incomplete explanation. But do you think it's stood the test of time when you take a look at the way it contributed to our understanding of markets?

Dr. Lo: I think it's been transformational. And despite the fact that there are many other theories that have been developed that would argue that the traditional beta is insufficient, that there are multiple factors, the bottom line is that Bill Sharpe taught us to think about risk in a very different way from Markowitz. Markowitz said risk is volatility. And what Sharpe said was, "No, that's not quite right. Risk is the part of volatility that you can't get rid of by diversifying." And that was a really stunning achievement because it now provided a way for you to think about what investors require on their rate of return, what corporate managers should expect in terms of the cost of capital for doing their capital budgeting and for how performance should be measured based upon the amount of systematic risk that you're taking. So, it was really Sharpe's capital asset pricing model that gave us this distinction between systematic and idiosyncratic risk and where the rewards would come from, not from idiosyncratic risk, but from bearing systematic risk.

Now, since then, there have been other theories that have been developed to point out, well, there are multiple sources of systematic risk. It's not just market risk, but it's currency risk, credit risk, and so on. All of those are definitely advances from the original model, but it doesn't take away from the insights that Sharpe provided to us. And those insights are still being used to this day. And even though we do have other models with other betas, other sources of systematic risk, the fact is that we still take a look at the most significant source of risk as the market portfolio and that's all Sharpe.

Benz: Sharpe recalled that people were very slow to adapt the capital asset pricing model he developed because, in his words, "It went against everything people in the investment industry did." What do you think is today's CAPM, an idea or a model that is so counter to conventional wisdom that it hasn't caught on, but it has the potential to be transformative in the way that Sharpe's theories were?

Dr. Lo: Well, that’s a bit of a loaded question, because I—and I don’t want to seem too self-serving—but some of the work that I’ve been doing on incorporating principles of evolutionary theory to financial markets, I believe that that’s an area where we can make great progress. But I would argue that it certainly has not yet caught on. It’s something that people in the industry have an appreciation for simply because of their own experiences. But I think in academics, we still like to think in terms of formal mathematical models that are immutable and part of the physical law of the financial universe. I think that over time, we’re going to recognize that biology, especially evolutionary biology, is probably a closer approximation to financial market dynamics than physical theories.

Ptak: Since you mentioned it, maybe you can expand a little bit more on the key tenets of the adaptive markets hypothesis, or the AMH for short. You developed it to bridge behavioral and rational finance. I think you may have referenced some of those key tenets. But maybe you can elaborate a little bit more on how it forms that connection between behavioral and rational finance.

Dr. Lo: Well, the beginnings of it are really the "efficient markets hypothesis" that Gene Fama pioneered, and it was really a wonderful privilege to be able to include him in our book, too. In addition to being a giant in modern finance, Fama is just an incredibly dynamic and personable individual. So, it was really fun talking with him and understanding the roots of his ideas. So, the efficient markets hypothesis is really the foundation for a lot of the investment innovations that we enjoy today, things like mutual funds, passive versus active investing. And, of course, Jack Bogle credits a lot of what he has done to a combination of Markowitz, Sharpe, and Fama.

The idea behind efficient markets is that prices fully reflect all available information. And as a result, it'd be very hard for anybody to try to beat the market. So, instead of beating the market, may as well join it, meaning invest in a broadly diversified portfolio, and you'll benefit from the growth of the market as opposed to trying to pick the winners and get rid of the losers.

Now, the efficient markets hypothesis has been criticized by a number of behavioral economists. And I think that that's misplaced as well. The efficient markets hypothesis isn't wrong; it's just not complete in the sense that there are periods where efficiency breaks down. For the most part, it's an excellent approximation to most market conditions. Because, in general, markets tend to be very competitive, there are lots of very smart, highly paid people that are engaged in the process of coming up with the very best possible information. And so, it is really hard to generate value for investors in markets by trading, but it's not impossible. And periodically, when there are market dislocations, those who understand how those dislocations occur can take advantage of them and generate better value for their investors.

So, to be able to understand the dynamic of when markets are efficient and when they break down, you need to develop a different approach. And so, this is what I call the adaptive markets hypothesis. It's basically an approach that takes as its starting point the efficient markets hypothesis but then layers on top of it a more discreet and the specific description of investor behavior from the behavioral, psychological, and ultimately, evolutionary biology perspective. If we look at markets as not a physical system that never changes, but if we look at it as an ecosystem consisting of different species that are competing for survival, we see a dynamic that's much closer to reality. And that's really the idea behind adaptive markets. It's to take the principles of evolutionary biology and ecology, things like competition, innovation, and ultimately, adaptation and natural selection, to take those principles and apply them to financial market interactions among the various different stakeholders and use that framework to explain how markets change over time.

Benz: What are the implications for the perfect portfolio? If Fama and the efficient markets hypothesis hadn't come along, how might things have played out differently?

Dr. Lo: Well, I think eventually, somebody would have come up with that idea, because it is such a good and such a compelling idea. That’s true with most scientific discoveries. Obviously, the individuals who are credited with those breakthroughs deserve that credit. They were first. But if they weren’t first, most likely somebody else would have done it. Because the bottom line is that financial markets are highly competitive. And so, prices most of the time do reflect most of the information that’s out there. So, if we hadn’t had that theory at all, I think what we would be doing today is still struggling with the gunslinger kind of culture of investing. We would be trying to find that investment manager that would be able to generate superior returns—the next Warren Buffett, the next George Soros. The problem, of course, is that while many are called, few are chosen—we don’t know who the next genius investor will be. And so, the combination of Markowitz, Sharpe, Fama, Bogle and all of the luminaries, what they gave us is the means to create a very good investment portfolio without being a gunslinger. They essentially democratized finance. They gave finance to the people.

Ptak: We've gone from a single-factor explanation of the relationship between a securities risk and its expected return to a three-factor model. Now, we're up to five-factor models if you go off of Fama and French's five-factor model. It certainly is progress. But I suppose doesn't it also argue for a kind of humility? And, if so, how should that inform conclusions we draw about the best way to forecast risk and return and build a portfolio?

Dr. Lo: Well, if there's one thing that you can be sure of is that financial markets will humble any investor at some point. So, yes, I think that humility is the right word. In fact, if you take a look at the machine-learning algorithms that artificial intelligence experts have applied in other industries, people are now starting to apply those same techniques to financial modeling. And what we're coming up with is not just five factors, but how about 200 different factors. And the issue is that these factors change in importance over time. So, it may well be that there are only four or five factors that are the most relevant right now. But the problem is that those four or five factors are not the same four or five factors that were the most relevant a year ago, and they changed yet again a year before that.

So, what we're seeing today is because of these breakthroughs in AI, and computing, and information technology, we're able to create a much more complex array of factors. And we're going to see that over time, that's going to provide much better rates of return for all investors if they are able to be more flexible and dynamic. The key is whether or not they are able to allow themselves that flexibility, because it's so easy to get into religious convictions about what should work and what shouldn't. So, we do have to approach these issues with a certain degree of humility. But if we do, I think that's really what will ultimately help us to create value for ourselves as well as for our investment clients.

Benz: Fama has also done influential research on agency risk and the way incentives can create mismatches. There's now an entire cottage industry of advisors and consultants who specialize in things like risk management and portfolio construction. And to differentiate, they'll often recommend more complex solutions and techniques. How can clients ward against that risk?

Dr. Lo: Without a doubt, I think the principle of “keep it simple” applies in finance as well as in other endeavors. And there are certain people that love complexity and revel in it. And those are the portfolio managers that make a career out of investing. But for most individuals, they really just want to be able to plan for their retirement and know that they can retire in a lifestyle to which they’ve become accustomed. And for them, “keep it simple” is definitely the right operating principle. I think that this is a bit of a challenge with the various different service providers that you mentioned. But I think that with the right type of advice—and it’s one of the reasons that we wrote the book was to provide investors with a little bit of that in advance so they can be properly prepared.

It is possible now with the various tools that are given to us, we can create some very, very useful investment opportunities, whereas maybe 10 years ago, we would have needed much more hand-holding. It's very much like in any other endeavor, say, personal health. Nowadays, there's just so much information on the Internet about how to deal with hypoglycemia, dealing with obesity, various other kinds of medical challenges, we know to count our calories or watch our cholesterol, make sure we don't consume too many carbs, focus on a keto diet if we're trying to lose weight. So, there's a lot of information today that didn't exist 10 years ago about diet. But that also makes it much more challenging for the individual to figure out what the appropriate type of treatment is for a given condition.

So, in that same spirit, I think we have to be better educated as investors, so that we can manage through all of these various different opportunities and pitfalls. In some cases, having a financial advisor can be quite helpful. But we have to be careful about conflicts of interest. I've often thought that financial advisors ought to be required to swear to a kind of a Hippocratic oath that doctors do: do no harm to your investor, first and foremost. We don't quite do that yet. But I think that we're getting closer to thinking about incorporating those kinds of considerations into the fiduciary responsibilities that financial advisors and portfolio managers have. Over time, I think that that will get much better.

Ptak: You mentioned this idea of simplicity. And who better to talk about next than someone who, as you could argue, was an exemplar for simplicity, Jack Bogle. You were able to interview him before he passed away. Bogle boiled portfolio design down to a few basic ingredients, and you lay this out in the book. They were: reward, risk, time, and cost. Can you talk about this framework? And apart from his achievements in popularizing low-cost investing, what contributions do you think Bogle made toward defining the perfect portfolio?

Dr. Lo: Well, it's hard to overestimate the contributions that Jack Bogle made to the practical investor. I think that he really opened up investing to the entire world through Vanguard. Vanguard provided, at the time, a very, very different alternative to investing than the status quo. The idea of bundling securities, many of which we've never even heard of, into a pool of investments and then investing in that pool was completely radical, and at low cost. His insistence on keeping costs low is just such a remarkable ethic that to this day, I think, affects the Vanguard organization despite his passing.

And Jack often talked about not the efficient markets hypothesis or the adaptive markets hypothesis, he talked about the cost matters hypothesis. A very simple idea, which is that, if you end up paying for expensive advice over time, that’s going to eat away at your investment returns. And so, his notion of pooling a large number of securities benefiting from the correlation diversity that Markowitz talked about decades before and really reducing the risk and increasing the expected return for that kind of passive portfolio that created a multi-trillion-dollar index. But more importantly, it really democratized finance in that everybody—everybody from pharmacist, and the librarian, to the janitor, to the portfolio manager—they can all use his ideas to invest cheaply and effectively in a well-diversified index fund. So, it really is hard to really fully grasp the enormity of his contributions in allowing people to save for their retirement. And he was a champion of keeping it simple, and he put his money where his mouth is by creating the tools to allow us to keep it simple and yet prepare properly for our retirement.

Benz: Well, speaking of that, keeping things simple, Bogle thought it was OK to tie your bond allocation to your age. He frowned on frequent rebalancing, he stuck to investing in U.S. stocks, to name a few of the strategies that he evangelized about. Do you think we overrate techniques that more precisely calibrate the asset mix that we might own or seek to maximize diversification?

Dr. Lo: I do. And it really depends on the context. Someone once said that it's far better to be approximately right than to be precisely wrong. And I think that that applies to a lot of the financial theories that we academics have developed. We revel in the mathematics and statistics that we use. But the bottom line is for the typical retail investor who doesn't have the training or the patience to be able to use any of these ideas, they want to keep it simple. And in order to be able to get them to do the right thing for their retirement portfolio, we really have to keep it simple for them. So, I think that Jack Bogle is exactly right on that point, and the simpler the better.

Now, of course, I need to add Albert Einstein's warning that, when he was criticized at one point for the complexity of his ideas, he replied, “A theory should be as simple as possible, but no simpler.” And I think that that really bears repeating in the financial realm. There are certainly many things that can be made relatively simple, like diversification, index investing, and so on. But if you're engaging in a much more complicated corporate financial strategy, where you want to manage the risks of a pharmaceutical company, or you want to think about the impact of climate change on certain types of investments and captive assets, well, in that case, you really do need to have more sophisticated tools. So, like what most plumbers and carpenters would say, “You've got to pick the right tool for the right job.” And we just have to make sure that we understand what those tools are to be able to apply them to the appropriate jobs.

Ptak: We're going to talk about Charley Ellis for a moment. It's another leading figure you profile in the book. He's been an unflagging champion of indexing. For all of his accomplishments, what do you see as his biggest contribution to advancing our definition of the perfect portfolio?

Dr. Lo: Well, probably his biggest accomplishment is the creation of Greenwich Associates, which is a consulting firm that helps institutional investors think about investing in a systematic way. For years, Greenwich Associates has been helping pension funds, endowments, foundations, and very large pools of money, think systematically about reducing their costs, about the cost matters hypothesis according to Bogle and thinking about diversification and broadening their exposures not just to U.S. companies, but internationally, and really doing well by their clients who are pension plan participants. So, I think that Ellis' contributions are also enormously important when you take a look at the amount of assets he was able to affect with Greenwich Associates, before that at DLJ, and just a really impressive career.

Benz: Going back to the topic of adaptive markets hypothesis, how would a perfect portfolio designed per the adaptive markets hypothesis differ from what someone in the rational or behavioral finance camps might have come up with?

Dr. Lo: I think the main difference is that it provides an avenue for an individual to change over time as his or her circumstances change. I think back to the days before I had children. And at that point, I had no problem taking all sorts of risks, both financially as well as personally. In fact, I used to ride a motorcycle for a period of time. Once I had kids, that changed completely. I traded in my four-door sedan for a station wagon. I no longer rode the motorcycle. When I rode my bike, I started wearing a helmet. So, as our circumstances change, we change in response. And I think that has to apply to our investment strategies as well. So, I think that's probably the biggest impact of an application of adaptive markets, is to acknowledge that there's a lot of value in what the efficient markets proponents have described in terms of how to manage a portfolio. But there's also value in what the behavioral critics have leveled as critiques against the various different strategies. And so, ultimately, what we want to do is to be able to take the best of both. We want to be not necessarily devoted to any one school of thought but rather opportunistic and engaging in all of the above. And that's really where the adaptive markets hypothesis comes in. It provides the framework for thinking about how to do that and under what conditions does adaptation add value and under what other conditions could it actually hurt value.

Ptak: To build on that, imagine that my main retirement vehicle is my defined-contribution plan, and I dump all my money into a target-date fund that approximates my anticipated retirement date. I think of a target-date fund that probably reflects different rational and behavioral principles, in the way it's constructed and rebalances over time. But then I hear about the adaptive markets hypothesis, and I go to you and I say, "What should I do differently as I'm approaching retirement than this target-date fund?" What, if anything, would I need to consider if I were to invest consistent with the adaptive markets framework that you've come up with?

Dr. Lo: Well, the first point to observe is that a target-date fund is not necessarily one-size-fits-all. But it's not that far away. What it says is that maybe five-sizes-fit-all. And that's a problem because for many of us our personal circumstances can be so different from one another that they really don't fit any of the buckets that are designed by a target-date fund. So, the glide path is probably not the sufficient statistic for getting us to think about how to manage our portfolio.

The beauty is that we live in an age where financial technology advanced to such a point that we ought to be able to create personalized indexes in the same way that we have personalized medicine. Medical specialists are now able to craft therapeutics that are designed specifically to your particular DNA. And so, we should be able to do that on the financial side as well. We certainly have the hardware and the software. What we don't yet have are the algorithms that allow us to create that personalized portfolio. But if we could do that, that would actually address a lot of the issues of adaptation, because all of us are going to be adapting in our own personal ways based upon our specific contributions over the years to our portfolio, as well as our specific needs in terms of medical expenses, children, and other investment opportunities. So, I think that that's where we are today. We're at the precipice of being able to really deliver on the promise of financial technology. But we're not there yet.

Benz: You lay out an interesting framework of 16 different investor archetypes that are determined based on four characteristics: risk aversion, income levels, spending level, and economic environment. Can you talk about that and how it can be used to map someone to a portfolio?

Dr. Lo: Well, the inspiration for the archetypes of investors really came from psychology, specifically, Carl Jung, the Swiss psychologist, that came up with these various different personality types—introvert, extrovert, sensing, feeling—that kind of categorization. What Steve and I wanted to do was to illustrate both the complexity, as well as the opportunity of thinking about investment preferences. We all know about risk tolerance. That’s something that the SEC has adopted as an important component of considering whether or not a particular investment is suitable for a client. But beyond risk tolerance, there are many other factors. And thinking about whether or not one has the ability to focus, and the time involved, and whether one is at the early stages of saving for retirement or at the later stages, about ready to retire, all of those considerations really gave Steve and I the impetus to create these different archetypes, so that we can show investors there isn’t just risk-tolerant, risk-seeking, or risk-averse investor. It’s really a much more complex landscape of 16. And the hope is that by investors thinking about which archetype they are, they will then be able to approach their choices of investments in a somewhat more sophisticated manner to be able to deal with these kinds of issues.

Ptak: For my last question I wanted to shift a little bit and talk about technology in investing—I should say technology and innovation, one of its applications to investing, which is direct indexing. What’s your take on direct indexing? The potential tax savings seem appealing. But do you think it also could create incentives to overcomplicate portfolio constructions in ways that are ultimately self-defeating?

Dr. Lo: That's certainly a risk that we have to be wary of. And I think this goes back to the point about picking the right tool for the right purpose. For certain individuals, I think that kind of complexity they would enjoy and be completely comfortable with. For other individuals, that would be far more complex and dangerous because they don't understand what they're getting into, and they may not be able to react in the appropriate ways when markets dislocate. So, I think that, like all financial innovation, it has to be tailored for the right circumstance, the right individual, and the right set of purposes. But having said that, I'm a big fan of using these technological tools, because it gives us enormous flexibility and power. Along with power comes great responsibility. So, we have to spend the time and effort to learn on how to use these tools, but once we do, I think that that opens up a much wider landscape of investment opportunities and ways that we can manage the risk that we enter when we start thinking about retirement planning.

Ptak: Well, Dr. Lo, this has been such an enlightening discussion. Thanks again for joining us. We really enjoyed having you.

Dr. Lo: My pleasure. Thanks very much.

Benz: Thank you so much.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

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Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)