Ben Felix answers questions from European investors

Rise of the individual investor

Curvo: We've seen during the last year what we call the "rise of the individual investor". The trend was driven by low interest rates, people saving more during the pandemic, and easy access to investing through apps. How do you see this trend evolve in the future?

Ben: I think we have to remember that although there's been a bit of an uptick last year, the "rise" has been a pretty significant downward trend for the last eighty years. But using US stock market data (because that's where all the data tends to come from), most stocks were held by households in the 1940s. Today it's only about 33%. The uptick maybe brought it up to about 36% with all the influx of new investors last year. So I don't really know if we're really seeing the rise of the individual investor. Maybe a small uptick.

I think we also have to remember that last year was not the first time that we've seen a big influx of people getting into stock investing through self-directed accounts. During the tech bubble leading up to the late 90s and into the year 2000, something similar happened. All of a sudden, people could access trading on their own. Maybe it wasn't as slick and maybe it wasn't as low cost as it is today, but we saw something similar happen. The end, that time, was a pretty significant decline in the types of stocks that people were trading. I think that shook  a lot of people out from being self-directed, or at least trading stocks in that way.

So where do I see this going? I think it's going to depend on how it plays out in terms of stock prices for the types of stocks that all of these individuals are trading. Not all, but a lot of these new individual investors seem to be trading in a relatively small handful of stocks. If those stocks do well, maybe we'll see more people getting into trading. If they don't do well, then I think we can have a similar situation to 2000 where a lot of people get scared off of that type of investing.

Arguments for passive investing

Obviously you're a strong proponent of a passive approach. If you had a single argument to convince someone about why passive investing is a better approach for most and active investing, what would that argument be?

I'll give you my argument. It's not one single argument there. There are a couple in there that I think are really important.

First and foremost, index investing is low-cost. It's the lowest-cost way to access the stock market. And costs, as I'll talk about in a second, are one of the most important determinants of investor outcomes. You can see this in the mutual fund landscape. Morningstar did a study where they try and figure out what the best determinant is of fund performance. Consistently, the funds with the lowest fees have the best after fee performance. This maybe shouldn't be surprising, but it is surprising because active funds all say that they're going to beat the market. I think people are getting more familiar with the idea that they don't. So maybe it's not so surprising for people to hear that low-cost is a big one.

The other piece is that you've got to remember that the market is a zero-sum game. With an index fund, you effectively own the entire stock market, which is a cross-section of all the stocks that exist, or that are tradable anyway. With active investing, in broad terms you're really doing one of two things:

1. You're choosing a subset of the stocks in the market to hold.
2. Maybe you're timing when you want to hold them.

So the alternative to an index fund is some combination of security selection and market timing. We have to remember, though, that in the in the market is a zero-sum game. What that means is every time that there's a trade, somebody wins on the trade and makes a profit. For that person to make a profit, somebody else has to lose. So that zero-sum game makes active investing also a zero sum game. All of the active funds that win are at the expense of other active funds that lose. Now, if we take all of the active funds together and compare their average performance to all of the index funds, their performance before fees is going to be the same because on average, active funds own all the stocks in the market just as index funds do.

Actively managed funds have higher fees though. And due to transaction costs and taxes, active investing also costs more, whether it's through a fund or through stock selection. So their performance is going to be worse than index funds.

This concept is called the arithmetic of active management. Bill Sharpe, who's a Nobel laureate, wrote about this in a 1991 paper that's become quite famous (The Arithmetic of Active Management). Just because of that zero-sum game, you're more likely to lose as an active manager after fees. Now, that's not even my favourite argument, though.

My favourite argument in favour of index investing is the skewness in individual stock returns. What that means is a relatively small number of stocks perform really well and most stocks actually don't perform that well. This is kind of interesting, and there's a paper with a provocative title "Do Stocks Outperform Treasury Bills?". And you hear that of course they do. The interesting thing is that a lot of them don't. And if you don't own the ones that do really well, you're much more likely to underperform the market. So that skewness makes active investing really hard, even when not considering fees.

In the paper that I mentioned, they built a model where they took they took 20,000 bootstrap samples where they constructed portfolios of 50 stocks. So they're using real stock data where they're randomly selecting portfolios of 50 stocks and they're running 20,000 simulations following that process. And over 10 year periods, the 50-stock portfolios had a 53% chance of underperforming the market. That's pretty bad, and that's before before fees. Over longer horizons, that chance of underperforming gets even higher. It's like 60% at the 90-year horizon.

So when you take those two things together, the skewness of stock returns and fees, index investing starts to look pretty compelling.

I do think it's worth pointing out, though, that there are types of stocks in the market that appear to be riskier based on financial theory and empirical observation. Maybe this sounds like I'm contradicting myself, but owning the subsets of stocks that are riskier in the market and acknowledging that you're taking more risk by doing that, I think that there can be an opportunity to expect higher returns than the market. I just think that the traditional approach of trying to pick stocks in time, the market is almost certainly detrimental. Index funds are a very elegant solution to that. I guess within the concept of index funds, you can own things like a value index, for example, where you're not owning the whole entire stock market. But you might still have a shot at a little bit of outperformance by owning riskier stocks.

Factor investing in Europe

Let's dive a bit deeper into factor investing. You have a white paper that you published that explains the different factors and their theoretical background. If anyone who is listening here hasn't read it, I really recommend it (Factor Investing with ETFs). But there's a big difference between the theory and what can be achieved in practice with the funds that are available to us in Europe. Specifically, actually only a handful of index funds invest in these factors and they don't even seem to capture the factors really well. Given these limitations, what advice do you have for a European wanting to build a factor portfolio?

So it's tricky. I'll say up front that I'm definitely not an expert in investing in Europe and what the specific investment products over there look like. I can tell you, though, that the situation is somewhat similar in Canada. The big difference though is that in Canada, it can be fairly tax efficient for us to own US-listed ETFs, and that makes their market accessible to us. Obviously, they have a lot of products available. My understanding is that it's not the same for Europeans and this is a real problem.

When I I wrote my the first version of the white paper that you mentioned earlier on, I basically looked at a bunch of factor products that were available in Canada at that time and asked the question whether these products deliver on the risk premiums that they're trying to capture based on the structure of the product. I also looked at the fees, which tend to be higher for those more specialised products. My conclusion was that there were no Canadian products at that time that offered higher expected returns after costs. And I don't think it's changed much at this point. So I kind of said that, if you want to do factor investing, here are some US-listed ETFs that you can use.

Now in Europe, I'm not the expert here. But I do know within the Rational Reminder community, which is an online community that's free for anybody to join and that stemmed from my podcast, that there's a massive thread with a lot of people talking on how to implement a factor portfolio using the UCITS structured funds. I never go in there because I'm not that interested in investing in Europe. But it's possible and I know that one of our moderators on that forum who's very into factor investing. He lives in the Netherlands and he is implementing a portfolio that's targeting factor exposure. And he's a pretty smart guy. So I I think he's probably figured out a way to do it somewhat. Anybody can join the Rational Reminder wider community and check out that thread. Or you can ask Aleks, the moderator that I just mentioned, I'm sure he can help.

It is a challenge being not in the US where they have just so much more scale. It is a challenge to turn these theoretical ideas into real products that people can use. It's getting better though in the US. Their product landscape has gotten better in the last couple of years.

Do you think it's just a matter of time before fund providers catch up with the demand for more factor funds?

We'll see. I mean, in Europe, Vanguard just closed some factor products or announced they're closing. I don't know if they actually closed yet. So the demand wasn't there for those products and they ended up shutting down. So if there's demand, then maybe products will show up. Those Vanguard factor funds closing down seems to be evidence that maybe there wasn't demand.

I think that in the grand scheme of investing ideas, this concept of factor investing has become more mainstream, but it's still relatively niche. I mean, in Canada, close to 90% of fund assets are still in traditional actively managed products. The rest are in index funds and then factor funds are going to be a tiny fraction of of that. So I don't know.

I mentioned that you expect higher returns for taking more risk, which is true. One of the tricky things about factor investing is that individual investors have challenges with sticking with risky investment strategies. Value investing for example, which is a form of factor investing, has had a very difficult 10 years. And if fund companies see assets leaving, that fund business may not be viable. That's probably what happened with those Vanguard factor products. So I'd love to think that the landscape's going to get better, but I can't make that promise.

The role of bonds in your portfolio

The next question is actually going to be closer to retirement. This was a Reddit user (/u/MadeFireBE) who said most investing advice focuses on young people who want to grow that capital. He's interested in hearing your viewpoint on where you should put your money if you're over 50 years old. So at that age, you still want to get some growth, but you'd like more protection for potential trouble. So now that bonds and bonds ETFs are no longer the safe haven they used to be, he would love to know what his options are.

I think to answer the question, I would love to know why bonds are no longer a safe haven, because I don't know if I agree with that. I think interest rates are low, bond yields are low, and real bond yields for shorter maturity bonds might even be negative. That's not ideal. I agree with that. I also think stock expected returns are lower now than they have been historically. So it's not just bonds that are suffering.

We also have to remember what the role of bonds is in a portfolio. They're never designed to be a return-seeking asset. Historically, long government bonds have delivered about a 2% real return (inflation-adjusted return). We probably don't expect that right now. Bond expected returns have been really low for the last five or six years. Meanwhile, bond realised returns have actually been very high over that period. So it's one of the tricky things with expected returns. I guess you might get something better or worse in this case.

The role of bonds within portfolios has not changed. You don't own them to seek return. You own them to decrease volatility in your portfolio. Why would you want to decrease volatility in your portfolio? Maybe because you're worried about sequence of returns risk. This is the risk that as a retiree, getting several bad years of returns in a row while making withdrawals can be detrimental. Bonds can help to reduce volatility from that perspective. Even in that case, though, in backtests, all stock portfolios tend to look pretty good, even for retirees. Although I'm not suggesting that that's what people should do.

The real reason you own bonds is to reduce volatility in your portfolio from a psychological perspective. I don't think that has changed. I just think we need to revise down our return expectations for both stocks and bonds. That's more of a financial planning implication than a portfolio management implication. I'm not going to say, you know, because yields are effectively zero or close to zero or maybe negative in real terms... that doesn't mean that you should own something else. I don't know, gold or crypto or real estate. Those are all very different from bonds. They don't provide the same type of stability.

One of the other concerns that I hear about bonds is maybe somewhat related to yields being low, but also quite a bit different. It's inflation. If inflation picks up and gets really high, then bonds decrease in value. Bonds get hurt really badly. Nominal bonds. You can get bonds that are inflation-protected, but nominal bonds get hurt really badly in an inflationary environment. The opposite is true in a deflationary environment. Where I am in Canada, I know everyone's worried about inflation right now. Policymakers are more worried about deflation, which is why we're seeing all of the monetary and fiscal decisions that are being being made now. Are we going to get inflation or deflation? I don't know. If we get deflation, bond returns historically had been phenomenally good, like better than the stock returns.

I think for someone who's worried about volatility, because they feel like they're not young enough to absorb the profile of stock returns, then bonds still play a role. It's just figuring out how to size your bond allocation and then determining what your expected returns are. Maybe they're lower now than in the past.

Annuities are another thing that I think that gets missed in this conversation a lot. I don't know the specifics of where the listeners and readers are. In Canada though, annuities are a pretty nice financial product that often get overlooked. Annuities are an insurance contract instead of an asset. It's not like a bond that you're buying, but an annuity guarantees to pay you a fixed distribution for the period that you're still alive. Now, that last bit for the period that you're still alive becomes very important because there's something called mortality credits that you gain from annuities where you can gain if you live longer than expected. You win relative to people who lived shorter than expected because you gain credits from the people who died earlier than expected. That sounds a bit morbid, but it's it's the way the products are structured and it provides longevity insurance. So if you die young, you lose out on the annuity and your estate loses out. But if you live longer than expected, you do very well. And in an environment where rates are low, if you live past your life expectancy, those mortality credits can give you maybe even a comparable expected return to the yield that you're expecting on the bond. So I think in a low rate environment like we're in now, the argument for annuities because of the mortality credits is even stronger than in normal times. And there's always a good argument for annuities, for retirees. So at 50, maybe not. But at age 65, 70, 75, you start considering annuities as part of your fixed income allocation.

I honestly don't know much about annuities in Europe either, so I think they'll be good to get to explore. You still say bonds are probably the best, stabilising part of your portfolio. What is it fundamentally about bonds that they're very good at that role?

Bonds are safe assets because of their cash flow streams. They're called fixed income because you know what you're going to get. They've got predictable cash flows, which makes their prices relatively predictable, unless we have crazy interest rate changes. That predictability is what makes them valuable in a portfolio from a consumption perspective, like when someone asks the question of "I'm over the age of 50, how should I be thinking about my asset allocation?" What they're really worried about is: "I'm going to have to fund my consumption sooner from my portfolio". And the cash flow from the payoff profile from bonds is stable enough, that I think it alleviates a lot of those concerns at the expense of expected returns. That's the trade-off. This trade-off is going to be present in any financial asset that we talk about. If you take more risk, you have higher expected returns. That often gets expressed as volatility in the market. If you take less risk, you have lower expected returns. That's what you get with bonds. If the objective is to reduce risk, then because of their underlying structure, bonds are really hard to beat from that perspective.

Finance education for children

Let's change topic a bit to education, to this question was asked by a Reddit user (/u/Temnovit). You have 4 children. How do you approach financial education with them?

Most of my kids are too young to be financially educated. I've got a six year old. He's my oldest and so he's maybe old enough to talk about money. What we do is that we talk very openly about money and about the household financial decisions that we're making. I mean, if they'll listen, because they don't always pay attention. My two oldest boys, they both have bank accounts in their own names that I make regular deposits into. No huge amounts or anything. They have money in their accounts and we then make spending and saving decisions together because they know that they have money. They understand that they can trade money for stuff. That creates a lot of good opportunities for conversations, like you could get this now or you could save up and you could get something else later.

One of the other things that we do is the following. We have, in my Rational Reminder podcast, one segment that we do called "Talking Cents". We have these "Talking Cents" cards from the University of Chicago, from their financial education initiative. They're really cool. I can pull one out so you can kind of get the idea as they have just interesting questions. So this one that I just pulled out says, "what is your favourite way to help others?". So not necessarily directly about money, but they often back into financial concepts. So we'll pull those out every now and then and try and have a conversation about it. Again, with a six year old being the oldest, the conversations, they're not always that good. That's what we do. So I guess the to summarise that, we just try to have very open conversations about it, about money.

The impact of climate change on your portfolio

So the next topic is climate change, and this was from a Reddit user, /u/tengotengotengo. Their comment was that they worry a lot about climate change in general and the effect it's going to have on the global economy in particular. So they think that we're in the final stages of excessive consumption and all of this will come to an end in the coming years as many governments are going to start to make big changes. These changes are good for our planet, but is actually bad for our investment portfolio.

It's a great question and I have to thank the Reddit user, because I think I'm going to do a Common Sense Investing video on this topic. Once I started thinking about the answer, I think there's a lot of interesting stuff in there. Climate change is top of mind for sure right now for a lot of people and I think that's the right thing. I think it should be on top of everybody's mind.

From an investing perspective, I think that the the question that we have to think about is the same question that we always have to think about whenever you see something new and think, is this different? Is this going to change investing? And the question we have to ask is whether or not climate-related risk is incorporated into asset prices. If climate risk is incorporated into asset prices, then that risk materialising should not have any kind of devastating effect on the payoffs for investors. If it's not reflected in asset prices, if it's a risk that's sort of a black swan, that asset prices aren't reflected and then the risk materialises, then it could have a dramatic negative effect on asset prices. Financial markets are the best information processing machine that's ever been created. And this is not hyperbole, I believe this to be true, they're the best. It's so great at processing information because it aligns incentives like everybody that's trading in the stock market is profit motivated. Because they're profit motivated, they're willing to dedicate significant resources to uncover new information that they may be able to bring to the market to gain an edge, to make a profit. Now, this has been studied, this question of whether or not climate risks are reflected in asset prices.

There are two two main types of climate risk. One is physical risk. It's like you think about flooding, that kind of thing, like direct physical damage to property. And there's a 2020 paper published in top journals, this paper called "An Inconvenient Cost: The Effects of Climate Change on Municipal Bonds". This was an interesting one because municipalities can't move like a company can pick up and move their headquarters. If there's physical climate risk, a municipality, they can't get up and move because that's why they are there, that geographic location. So in this study, they found that higher exposure to sea level rise for four municipalities were associated with higher municipal bond yields. So that's evidence of climate risk being incorporated into prices. They also looked at a different study looking at the real estate market. This was a paper "Disaster on the Horizon: The Price Effect of Sea Level Rise". And they found that houses exposed to sea level rise sell at a 7% discount relative to comparable properties that are not exposed to that risk. And the interesting thing about that finding was that most of that climate risk was expected to be about 50 years away. So properties that expect to be subject to flooding due to climate change within 50 years were selling at a 7% discount. So that's, again, evidence of physical climate risk being reflected in asset prices.

The other big one, and I think this is more the question that the Reddit user was getting at, is transitional risk. So transitional risk is uncertainty around how we're going to transition to a low carbon economy and the scope and timing of regulations, which I think is what this question was getting at. They produce a tremendous amount of uncertainty, especially for businesses that are relying on fossil fuels. So again, there's some pretty cool studies on this.

In the 2015 paper "Science and the Stock Market: Investors’ Recognition of Unburnable Carbon", they found that for 63 largest US oil and gas companies, their prices fell by 1.5 to 2% after the publication of a paper in the journal Nature arguing that most fossil fuel reserves would need to remain untouched if warming is going to be kept under two degrees by 2050. So that was interesting because if what that paper said is true, the value of reserves would be zero. Now, it wasn't true at the time, it's a possibility. But when that possibility became known as the price is very quickly reflected it, which is kind of what you would expect. That's what markets do. They reflect new information.

I also dug up studies that found that firms with negative environmental externalities have a higher cost of capital. And that one's not that surprising. Having a higher cost of capital makes it literally more expensive for those companies to invest and to grow. So from a business perspective, that's detrimental. It also has really interesting implications for ESG investing. I don't know if we want to go down that route but I'll just mention for a second, because it's interesting. If you're an ESG investor, you're choosing not to invest in the bad companies and the companies that have these negative environmental externalities. By not investing in them, you're theoretically increasing their cost of capital, you're making it harder for them to get money. You probably wouldn't actually starve them, but it can make it harder for those businesses to keep going. As an investor, by nature of the mechanism that you're using to make the world a better place, you must expect lower returns. Because if a company's cost of capital is lower so that good companies, the green companies, you're making it easier for them to get capital. If their cost of capital is lower, you expect a lower return. Anyway that was a total digression. I just think it's interesting. If you want to change the world by investing, you must expect theoretically lower returns from doing so. In the options market, there is another really interesting study. You can see a higher cost of insuring the downside risk of more carbon-intensive firms. I thought that was fascinating, too.

The idea here is that the market is and has been reflecting climate risk in asset prices. And if it is, which there's pretty strong evidence that it is. And not that we don't need to worry about climate risk, but we don't need to worry about it being a black swan event because it's already incorporated into asset prices.

I think there's some very interesting stuff there, so if things take long enough, then the market will already have incorporated that information. Fundamentally, when we invest in a globally diversified portfolio of index funds, we place a bet on the global economy to continue growing. Yet we live in a finite world with finite resources and those are going to deplete one day. And so does that mean that fundamentally over the very long term, investing doesn't make sense?

I don't know if that does make sense to say. I think thatif we made the assumption that capitalism must consume the finite set of resources, then the logical progression there would be that investing eventually won't work (not that it's going to happen now). I think there are a lot of cases like that that we can make against capitalism as as an ideology. The human experience though, since capitalism has been the driving force, has shown us all that from economic measures, humans are better off now than they've ever been, largely due to the the outcomes of capitalism. Depending on how you measure outcomes. I guess some people might say capitalism just destroyed humanity. I don't know if I agree with that. There's a funny saying that capitalism is the worst economic system except for all the other ones. I think that's kind of true.

I don't think betting on capitalism means a bet on continued consumption and destruction of our resources. We're seeing a lot of this now actually. It's kind of interesting to think about. There are non-market forces that can compel corporations to change the way they're doing business and what they're consuming and what they're creating. And again, we're seeing this with the shift towards hedging against climate risk and ESG investing as a principle, even if you don't expect a higher return from doing it. There is a chance that it does change the world. But what it also does, which is an interesting offshoot of ESG investing, or not even an offshoot, it's the intention, is that it compels companies to act in a way that's more conducive to reducing their environmental impact because their cost of capital should be lower if they do that. And that's no secret. Everybody knows that. So those are market forces. But there are also social forces, government forces like we're seeing starting to see potentially some regulation that's going to deal with the current level of destruction that's happening. And then the social discourse, I guess, that plays into the market forces. But it also seems to be pushing in the right direction. So I don't worry too much about a total social and economic disaster from capitalism reaching the end of consumption, because ultimately the market and capitalism in general is this expression of human innovation. There's maybe an interesting way to think about it. The question is less, is capitalism going to consume everything because resources are finite? Maybe the question we should be asking is, are humans going to stop innovating? And I think that the answer to that question is probably no.

Why are there meme stocks if the markets are so efficient?

This question is from /u/muravej on Reddit. "I respect you (Ben) very much, so I hope you will forgive me for this provocative question: As far as I understood you are a supporter of the efficient market hypothesis. If indeed markets are efficient, then why are there meme stocks? And if there are stocks that are crazy overpriced, does that mean that there also crazy undervalued ones?"

So I don't think this question is provocative at all. I think the premise of the question just needs a little bit of clarification or the ideas in the question. I'm going to try and clear up what what market efficiency means as it was intended. In 1970, Eugene Fama, he's the guy that formalised it, defined the efficient market hypothesis (EMH) with a simple statement: prices reflect all available information. That's all that the efficient market hypothesis says. Now, he does not make any claim about what information should be in prices or how that information should be used. We cannot say with certainty and EMH was never designed to answer this question. We can't say with certainty whether asset prices are set by rational investors who are rationally assessing risk and expected returns, or if prices are set by irrational investors with unrealistic expectations. Or other motivations altogether, like going to the moon with a meme stock. That's a reason somebody is investing. So that doesn't violate EMH in any way. We always have to remember that the market consists of all kinds of different participants. There are individuals investing in their own accounts, which we mentioned earlier, about a third of US investors. We have mutual funds, pension funds, governments and corporations. They're all participating in the market. Now, if you took a cross-section of those market participants and asked them:

• why they're investing the way that they are?
• why do you own the stocks that you're on?
• why is your portfolio set up the way that it is?

They're all going to give you very different answers to why they're investing the way that they are. They've got different goals, views and preferences. Their expectations for the assets that they own are different. So as I mentioned earlier, the stock market is this complex system that aggregates and processes information about the supply and demand for stocks. So we can say that the market isn't rational, for example, is GME (GameStop) rational? I don't know. Maybe somebody could argue that it is. I don't know if I would say that, though. But even if the market isn't rational, it is always in equilibrium. What equilibrium means is that every trade has to clear the price at the last trade by definition, because the trade happened, there was a seller for the buyer. Like I mentioned earlier, it's also a zero sum game. So there's a loser for every winner. So the information in prices doesn't tell us whether the market's efficient or not. They may tell us that it's irrational.

We also have to remember that this isn't the first time this has happened. This isn't the first time that a stock price has gone a little crazy for reasons that don't seem like they're possibly based on risk and expected return. There was a short squeeze situation with Volkswagen in 2008. You could describe it maybe as a mechanical lack of liquidity in shares. Volkswagen was briefly, because of this, the largest market-cap company in the world as the price shot up so much. Obviously, the price went back down when liquidity was restored and on the other side, demand died down.

There's another one in March 2000 where 3Com spun off Palm and the price of Palm shot up to the point where it was more valuable than 3Com, which it just spun it off. That doesn't make a whole lot of sense. It was also more valuable than GM, Chevron and McDonald's. This was kind of crazy as it was a relatively small technology company. The price came back down again so we can't say with certainty whether that price jump was based on rational expectations or not, but it was absolutely based on supply and demand. We just don't exactly know what was driving the supply and demand forces.

So I think if we asked the original question of whether markets are always rational, then I don't think that they are. There's no way to definitively prove whether markets are rational or irrational. But one of the really interesting things about that comment is that a lot of the pricing anomalies that exist, like I briefly mentioned value investing and factor investing earlier, those pricing anomalies are universally agreed on by academic researchers. The only difference is how they explain the anomalies. Is it explained by irrational behaviour or rational expectations about risk and and returns? We don't know. To say that the GameStop situation violates efficient markets, it doesn't, but it might mean that there's some different perspectives feeding information into the supply and demand of that stock, but that doesn't violate EMH.

Interestingly, if we say, what do we expect from GameStop as the example? If you look at it from an academic perspective, how do you classify that stock? It's a small-cap growth stock with weak profitability. That's what it is. It's a small company. It's got a very high price, which makes it a growth stock, and it's got weak profitability. They actually behave like lottery tickets. I mentioned skewness and stock returns earlier. The most skewed subset of stocks is small-cap growth stocks. We get back into this idea of what's setting prices. It could literally be that people are playing the lottery. They see it as a lottery ticket, and that's why they're holding it. Skewness means, on average, you're much more likely to get a bad outcome, but if you get a good outcome in small-cap growth, they tend to be very good. They're referred to in academic literature as "lottery stocks".

To finish up on efficient markets, I think there's one really important point that often gets missed. As you can tell I'm a proponent of efficient markets and I believe that's a good way to think about markets. But if anyone ever tells you the markets are perfectly efficient, you shouldn't listen to them because they're not. Market efficiency was always meant to be a model, not reality. If it was reality, it would be a fact, not a hypothesis. There's a great quote from from Eugene Fama when he was having a conversation with Richard Thaler, who's one of the driving forces behind the irrational point of view on asset pricing. Fama says "the point is not that markets are efficient. They're not. It's just a model."

I think that's always important. It's a really good model that we should use to gain insight, but it's just a model. So whenever someone says, "well, this proves markets are efficient", OK, sure but that doesn't mean we shouldn't use it as a model anymore.

PWL Capital in Europe

I'm going to pick one question from the audience, which should be relatively short to answer, which is PWL Capital in the EU. Yes or no?

No. PWL capital is a Canadian-based company and we only take Canadian clients.

Ben's favourite book on investing

I think a lot of people here also learn about investing through books. So we were curious, what is your favourite book on investing yet? If you had to pick one.

Oh, jeez. Probably my favourite book on investing is by Larry Swedroe: "Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today". It's a comprehensive look at the academic literature on asset pricing and how investors can use that in their portfolios. So I think that as a starting point (you mentioned my white paper that I did on on factor investing), Larry's book is effectively a much more comprehensive look at the same topic. As a foundation for people thinking about investing in the stock market and trying to make decisions and figure out how to allocate their portfolio, I think having that fundamental academic understanding of how we believe markets work is one of the most important things that anybody can have. That book does an excellent job of describing it.