Myron Scholes
Subject: Investing with Uncertainty
Bio: Frank E. Buck Professor of Finance, Emeritus at Stanford Graduate School of Business. Winner of the Nobel Prize in Economics for groundbreaking work in Options Theory
Transcript:
Larry Bernstein:
Welcome to What Happens Next. My name is Larry Bernstein. What Happens Next is a podcast which covers economics, politics, and culture.
Today’s topic is Investing with Uncertainty.
Our speaker is Myron Scholes who is the Frank E. Buck Professor of Finance, Emeritus at Stanford Graduate School of Business. Myron won the Nobel Prize in Economics for his groundbreaking work in Options Theory. I want to find out why uncertainty is core to both investing and finance theory.
Myron, can you please begin with some opening remarks.
Myron Scholes:
I have been thinking about uncertainty over my lifetime. At the time I got started in economics, others would define economics within a certainty world and then throw an error on the certainty model. I think if we start off with uncertainty as a primary force and see how economics goes from that.
Larry Bernstein:
What is uncertainty? Let's imagine you had a game where you could flip a coin and the game could be that heads pays a dollar, tails you lose a dollar and we think the coin's weighted 50/50 and we think there's only two choices, it's heads or tails. One way of thinking about uncertainty is what happens if we're not sure the coin is weighted 50/50? We think it is, but we don't know. So, first aspect is what are the true odds?
The second is the payoffs. The coin payoff will be winning a dollar versus losing a dollar. But what if we're not sure of the payout. Tell us about uncertainty in flipping a coin and how that uncertainty can be incorporated into other financial problems.
Myron Scholes:
The uncertainty you're referring to is that when you have coins that we know the odds and you have repeated games. And you can know by looking at historical data of how the coin flips or maybe the coin is biased and if you flip enough times, you'll be able to determine the bias in the coin.
The uncertainty that I am talking about relates to using historical data to understand uncertainty or risks in the same way in which you would potentially look at a coin by looking at historical data. But in life the information set that we're dealing with other than coins are so large that it's very hard to ascertain what the risks are.
I could use historical data like the number of coin flips to be able to determine what the distribution of possible payoffs are for the future. Nature is always giving you another distribution from the one that you were thinking. The future is changing because new information comes into play that creates different outcomes from historical data. Uncertainty is changing all the time.
Larry Bernstein:
Give me an example of that?
Myron Scholes:
When you're driving your car on the highway you can look in the rear-view mirror and garner a lot of information about the road you passed. But when you have crowdsourced information such as GPS to give you information about what the risks of the road ahead are. So, it's different from coin flipping in that you can flip the coin by looking at how many times it did things in the past, but we have a very large windshield because we're trying to look at the risks of the road ahead. And in economics and finance, the most important thing is thinking about what the risks of the road ahead are and not what the risk of the road behind happened to be.
Larry Bernstein:
Donald Rumsfeld said that there are known unknowns and there are unknown unknowns and that we had to consider all those possibilities in making military or political decisions. How do you think about Rumsfeld's contribution to that thought process?
Myron Scholes:
It's not original with Rumsfeld. Simon had that in the thirties and other people had talked about definitions of known and unknown risks. It gets back to the same arguments that we had with quantum physics between Einstein and Bohr. Einstein said that nature doesn't play with dice, that everything's deterministic. But the problem is you'd have to have tons of data and huge computers to figure out all the interactions that occur. The interesting thing in finance and economics is we must garner crowdsourced information about what the risk of the road ahead are.
A lot of economics just assumes that the distributions are known because our computers are not large enough or our models rich enough to figure out everything. I call that Heisenberg’s uncertainty principle of finance. Rumsfeld is looking around about all the risks, but if uncertainty increases or volatility increases, things get more volatile, then time compresses, you need to make more decisions quickly.
For example, if you have a friend that calls you up. He says, I'm having a heart attack, and you say, don't worry I'll call six ambulance companies, I'll find four doctors that are going to handle your cardiological problem. I'm having a heart attack now. So even though the information set is known, you can't address all those things.
As volatility increases the time to make decisions compresses. Then you can't change what you do. As we get shocks in the system, as more volatility increases, then we need to figure out how to handle these conditions which are the tails of the distribution that we have in economics and finance.
Larry Bernstein:
You mentioned that we have historical data to make an estimate about the future, but we also have the most recent financial markets to help us estimate what’s going to happen in the future. And Myron, you're famous for the Black-Scholes model and the implication of the model is you can ascertain the implied volatility. Given security prices, option prices, historical prices what information do you value in helping you make an estimate of what's going to happen in the future?
Myron Scholes:
Since so many people don't trust investment managers and other people to deviate too far from a benchmark position, people ignore the cross-sectional signals about the risk of the road ahead.
Data that you have from the past is an incomplete description of reality. A lot of people in finance assume that risks are constant but the interesting part about option prices is they are the crowd-sourced information. People buy or sell insurance, and if you buy protection against loss that's buying a put option which protects you against the downside or buying a call option which you participate in the upside. It is much easier to estimate risk than to estimate the mean which is changing all the time. It's not like you're flipping a coin where you understand what the probabilities are and get the mean. If risks are changing, the price of protection goes up the same way as if you're buying insurance. The price of insurance changes as a function of risk and therefore if the price of protection for the downside goes up, you know that people are willing to pay more for that protection just the same way they're giving you that information about what the risk ahead is.
Everything we do in investment is really compounding. It's not the average return. In other words, if you start at a hundred and you make 20%, you go to 120. If you lose 20%, you drop down to 96. If you start at a hundred and you lose 20%, you go to 80. If you get 20% back, you go to 96. So, volatility or uncertainty affects your compound return. Your average is still zero, under the example I just gave you volatility reduces compound return. One of the beauties of the option market, it gives you estimates about what the market is saying about future volatility, and it allows you to use upside and downside volatility. The market implied by the option market are the same signals as if you are driving a car and using crowdsource information and know there's a traffic jam ahead, then you can decide to get off the road.
And similarly for the upside, you can know what good volatility is and bad volatility, it separates the two out and that adds tremendously to manage risk in their investment. In finance every period matters. If every period matters, you want to protect yourself every period. The beauty of the option market cross-sectional signals about the risk of the road ahead, how uncertainty is conceived of by the market and an efficient market where people are putting money on the table and willing to buy or sell protection.
Crowd-sourced information gives us a lot of information about how uncertainty is evolving over time. There's so much data that informs us that risk is changing in the investment world. If risk is changing and we ignore it, as Rumsfeld said, we're making bad military decisions by not taking account of the information set or the cross-sectional signals that exist. If we only use historical data, it doesn't tell us anything about what the risk of the road ahead is.
Larry Bernstein:
Many people in the audience have allocated a substantial portion of their net worth to the S&P 500 benchmark index and many of us never buy or sell. There are options markets on the S&P 500 and from those options, one could ascertain the forward expectation for what volatility will be tomorrow and next week and next month and next year. Let's say you're going to have an event like Liberation Day or maybe a declaration of war or whatever it is. There's an upcoming event and the market expects that the future will be volatile. How should you alter the portfolio given that expectation?
Myron Scholes:
What is downside volatility? The risk of loss, which I don't like, and what about the risk of gain? In other words, what is the so-called skewness? What is the upside versus downside? So, we know that compound returns of your investments are a function not only of loss, but they're also a function of how skewed the returns are. The option market gives us both the upside and downside risk. It tells us about correlations among assets and it tells us how risks are changing over time. These are valuable inputs that can suggest that you should alter your holdings of S&P 500.
Under Trump's Liberation Day, he increased the uncertainty dramatically in the markets and we know that with greater uncertainty growth slows down. Why does it slow down? Because excess volatility hurts growth. People don't know. Increased uncertainty reduces investment.
Larry Bernstein:
How should investors behave in front of a Liberation Day? There's always going to be trouble. It could be a war, it could be a pandemic, it could be an asteroid.
Myron Scholes:
The option market is not a hundred percent correct. A hundred percent correct, then all the prices would adjust in the market and there'd be no advantage to using it.
I'm saying that you can use that information to adjust the risk of your portfolio if you do it systematically and believe that the crowdsourced information has value.
Larry Bernstein:
In layman's terms, you gave this example of an accident on the road and Waze is suggesting getting off the highway because it's going to a single lane. If enough people get off the road, then it won't matter if you get off or stay on the road.
Myron Scholes:
Correct.
Larry Bernstein:
That applies also to the stock market. If the stock market is perfectly priced for every potentiality for risk and the distribution is correct, obviously there's nothing to do. But so many people and investment dollars are passive investments, and they've decided that they're going to hold onto their S&P 500 index over Liberation Day, then they may be making a mistake, and we can take advantage of their inflexibility in their investment management process. What you can do is if you get some data from the options market that the market is volatile and there's more potentiality for bad events than good events, and you can tell that by different implied volatilities for different strikes in the options market in the out-of-the-money puts being very valuable and out-of-the-money calls being not that valuable.
Myron Scholes:
Correct.
Larry Bernstein:
Then what you may want to do is sell your S&P 500 and then jump back in after Liberation Day after the there's less uncertainty as to what's happening. We know what type of regime changes exist. Prices have adjusted, and then you can go ahead and say, prices incorporate the information. It's cheaper or it's more expensive, it doesn't matter. We got to jump back in because I want to hold equities for the long run. Take us through that process of taking advantage of others who are inflexible as to their portfolio allocation, how to adjust before and when to jump back in.
Myron Scholes:
Because people are constrained to stay in the benchmark, then they won't act to adjust their risks. The idea of going from risky assets to safe assets is one of the primary risk management tools we have. When I first got into finance, the only risk management was going from the stock market into cash.
The dimensions that you have in risk management are how much risk to take, and how much cash to hold is one dimension. Another dimension is diversification is your friend, as Malkiel said, it's the only free lunch in finance. But because Liberation Day every risky asset around the world goes down. So, diversification is unavailable, the correlation is one, and the risk increases dramatically. If you have S&P 500 your choices are to buy put protection or you can sell your stock index funds and move into cash.
Larry Bernstein:
You mentioned diversification is your friend, but another friend is time. Time is your best friend because if the stock market provides extra returns, I want as much time as possible to do this.
As a hypothetical, imagine that that you are the casino. You want your betting customers to make small bets. I have the odds in my favor and over time the customers will lose all their money. The last thing I want is for the customer to make one large bet because the casino could lose in that case.
What you are saying Myron is if we get to a situation where it's a very risky period and there's a possibility of either a substantial or total loss, don't bet too much. Let's survive to fight another day because if we're wiped out, it's over.
Myron Scholes
In terms of your investment, there's a risk level you want to take. The risks that are most important are the tail risks.
We concentrate on investment worrying not about the ordinary risks but the tail risks. We should concentrate on this because if you're investing and you lose 80% of your money, it takes a very long time to recover from that. By not going hog wild, the compound return grows dramatically.
As Einstein said, one of the most powerful forces is compound return, the eighth wonder of the world. If you take a bad loss, it'll take forever to recover from that potentially. Trying to avoid the tail losses is crucial not by taking egregious bets but taking a little less downside and more to the upside.
Larry Bernstein:
Tell us about a longstanding investment strategy where you invest 60% in equities and 40% in fixed income and reallocate back to 60/40 at the end of every month. This strategy is marketed as risk reducing.
This investment approach does not incorporate new information like changes in volatility markets, but it does prevent against the total loss scenario. 60/40 what do you like about it?
Myron Scholes:
60/40 is a linear strategy, and you can use the option market to create a non-linear payoff pattern, which is better and more efficient.
Larry Bernstein:
You buy stocks when they go down. You sell some stocks when they go up.
Myron Scholes:
Correct, and you always have the same proportion.
Larry Bernstein:
Why do people like this?
Myron Scholes:
If you're an individual who doesn't have an advisor who understands how to dynamically adjust your portfolio, I don't think individuals have the technical skills to do that in a systematic way by using the option market. But if you are sophisticated, then what it's saying is that independent of what the risk of downside is at the time, it is not a superior strategy. But if you buy dynamic protection like buying a series of put options that cost 2% a year. But if you think about a 60/40 strategy, if you're protecting your downside, then if you have a 5% risk premium in equities over bonds, historically that's what it's been. Then if you get 40% of 5%, that means it costs you 2% to protect your downside by only putting 40% into bonds.
A 60/40 strategy is a static insurance strategy unlike one that buys more stocks and put options.
Larry Bernstein:
Warren Buffett announced that he is retiring as chief executive officer of Berkshire Hathaway. He had a great run, the most successful investor of all time. I want to know what you think about some of his strategies and whether you think he was successful in taking advantage of uncertainty.
He got into the reinsurance business. He decided to sell California earthquake insurance, Tokyo earthquake insurance, hurricane insurance, and he tends to jump in immediately after there's been an event and there's an absence of capital to insure extraordinary risks.
How did you feel about Buffett's decision to offer reinsurance?
Myron Scholes:
I thought that was brilliant because he was able to find a supply/demand imbalance in the marketplace where at the time of shock, people wanted to be insured against catastrophic loss. They wanted to pay a higher price for that insurance that Buffett thought was the actuarial risk. Given the constraints of others, he saw a profit opportunity in reinsurance.
Over time, others saw what he was doing and decided to buy tail loss insurance products in the marketplace. And he bemoaned that there was entry by competitors, and the price of insurance came down. I give him huge credit for seeing a supply/demand imbalance. He could evaluate the risk. And people, because of their constraints, were willing to pay more than the actuarial value of the insurance.
Larry Bernstein:
Warren Buffett has an insurance company, and he used the premiums to buy stocks. He didn't buy the S&P 500. He bought Coca-Cola, American Express, See’s Candies, and Burlington Northern Railroad. He said that he was going to hold these stocks for a very long time. He said he loved these companies because they generated cashflow. They had the ability to reinvest in very good projects. He loved the management teams because they were good stewards of capital, but it violates another one of the Myron rules, which is that I would want to liquidate the stock when it's overvalued.
Myron Scholes:
It's a statement of saying he trusts the management. He's working with the management to say you have constraints to produce results for what investors wanted. And he felt that because of those constraints, they were giving up investment opportunities, to grow the business, to make it very profitable.
Buffett claimed to have a long horizon and can figure out what businesses he thought were growth businesses and needed new investment. He saw that opportunity and he gave them the runway to grab the very profitable investments that were on the table but couldn't because there were implicit constraints by institutional investors to produce current cash flows and not to invest.
One of the reasons we had the development of the private equity market was to compete against Buffett because private equity guys say, you don't have to worry about cash flows or dividends. You can enhance the value of this company. And then once you've built a business, then we can take the company public again. So, there's always competition. Why is the company private? Why is the company public? The public company has access to markets and money, but they have constraints, and the private person can do what they want when they run their own businesses. One of the advantages that Buffett saw was he had the insurance company, he had very long-dated financing, he had a long-dated horizon.
He could pick managers who he trusted, he saw where the growth opportunities were and if they invested quickly and capitalized on that. Then KKR and others started going into this business and competing with him to take companies private to restructure the business that he saw.
Larry Bernstein:
I remember when he acquired the Burlington Northern Railroad, I was surprised. What does Buffett like about railroads? What's his angle? He announced in one of his annual reports that when he met with the management team, they said that they had tons of projects that could earn double digit returns. We can build side-by-side tracks, new bridges, and many projects, but we're constrained by our capital projects by our investors. And he said, I've got hundreds of billions of dollars of cash to put to work. If you can earn double digits, I'm in. Tell us about your thoughts on Buffett's decision to buy the Burlington Northern Railroad.
Myron Scholes:
In economics and finance, constraints have costs. You can make money by eliminating constraints. Buffett illustrated that proposition early on. Competition came in subsequently. But he was very smart in saying, I have an insurance company, I have long-term investors, they gave me money for 30 years. I don't have to worry about what's going to happen next week or next year. I am not a cashflow person, I'm an investment person. I want a growth way of thinking. I give him a lot of credit. And when there's a supply/demand imbalance like shocks that occurred, he was willing to supply capital.
Larry Bernstein:
I started at Salomon Brothers before you did Myron and in that pre-Myron period, Perelman bought a bunch of shares in Salomon Brothers and threatened to take us over.
John Gutfreund, the CEO called Warren Buffett and said, “Can you save us? We want to buy this fella out. Will you invest $700 million in convertible preferred stock of Salomon Brothers?”
There were very few people that Salomon could call who could provide the firm with $700 million immediately. And Buffett said, “I am here to help in this crisis, but the terms are not going to be great. I'm going to need a 9% dividend yield and I'm going to want a conversion premium that would normally be 30% to be only 15%.” Buffett did this many times over his career. During the financial crisis, he purchased convertible, preferred stock of Goldman Sachs and Bank America. What do you make of his investment strategy?
Myron Scholes
The terms he got were worth the risk that he was taking to provide that financing. As you said, he might've been at the time the only guy in town that could receive a call to do that.
That was a big business that he had early on. And he gravitated over time to a different model because people competed against him to provide the services that were bread and butter services of the past.
Larry Bernstein:
We're going to wrap up. How should investors consider uncertainty and why is that important?
Myron Scholes:
I've spent my life thinking about uncertainty. For the small investor it's very tough to handle uncertainty. So much investment is focused on the mean or the average. I focus my attention on how uncertainty affects us going forward.
If you think about what the demands of individuals for gifts to children, philanthropy or healthcare, they are uncertain. And how do I manage my assets to handle these unforeseen events? It's challenging to handle every contingency.
You can give up and hide in your bedroom and never leave it. But the house could still collapse from a natural disaster. So, all these contingencies must be taken care of. But if we don't focus on these risks, then we're not doing a proper investment process. There's risk information available from the market that we must worry about.
An investor could use that information with the help of his advisors to provide a better solution than just a 60/40 buy and hold strategy and do it an efficient way that can make a better risk adjusted return.
We must focus more on uncertainty, not on outperformance relative to a benchmark. Absolute performance is what you want. Uncertainty affects absolute performance. Downside exposure undermines absolute performance.
My focus has been to educate people away from evaluating performance relative to a benchmark towards absolute performance and to move away from static portfolios.
The future for finance professionals is to provide investors with tailor-made idiosyncratic solutions that meet their risk and return preferences.
Larry Bernstein:
Thanks to Myron for joining us.
If you missed the last podcast, the topic was Taking Down Harvard. Our speakers were Jay Greene from the Heritage Foundation who is best known for being my New Trier High School debate partner. We also had Jon Zimmerman who is a Professor of History of Education at the University of Pennsylvania.
Our focus was the Trump Administration’s letter to Harvard demanding that the institution stop violating Title VI and protect the civil rights of its Jewish students. We also discussed whether the Trump Administration’s position with Harvard was appropriate and reasonable.
Harvard recently released a 311-page internal report describing the ongoing and escalating antisemitism on campus. Jay examined how the internal report undermines Harvard’s fight with the Feds.
You can find our previous episodes and transcripts on our website whathappensnextin6minutes.com. Please follow us on Apple Podcasts or Spotify. Thank you for joining us today, goodbye.
Check out our previous episode, Taking Down Harvard, here.
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