The Market is Getting Less Efficient: Here is Why That is GREAT for Value Investors | Cliff Asness
What this covers
In this episode of Excess Returns, we sit down with AQR founder Cliff Asness for a fascinating discussion about market efficiency, behavioral finance, and the future of quantitative investing. In this wide-ranging conversation, we explore Cliff's recent paper "The Less Efficient Market Hypothesis" and discuss why markets might actually be becoming less efficient over time, despite advances in technology – a counterintuitive but compelling argument.
We dig into how social media and constant connectivity might be making markets more prone to extremes, the real impact of passive investing, and why periods of market irrationality might last longer than ever before. Cliff shares his perspective on the current market concentration in the Magnificent Seven stocks and offers insights on high-volatility alternatives from his latest paper.
The conversation also covers the role of intuition in factor investing, inflation's impact on markets, and ends with Cliff's essential advice for the average investor. Throughout the discussion, Cliff brings his characteristic mix of academic rigor and practical wisdom, peppered with his unique brand of humor.
Whether you're a quant enthusiast, professional investor, or just interested in understanding today's markets better, this conversation offers valuable insights from one of the industry's most influential voices.
#Investing #QuantitativeInvesting #MarketEfficiency #FactorInvesting #AQR #CliffAsness
0:00 Intro 3:17 Less Efficient Markets Paper: Two Giant Observations 8:25 Technology's Impact on Price Discovery 10:03 The Challenge of Testing Market Efficiency 19:28 Understanding Value Spreads and Market Recovery 25:44 Duration vs Magnitude in Market Drawdowns 28:13 The Impact of Passive Investing 38:51 The Social Media Effect on Markets 43:08 Case Study: Message Boards and the Dot Com Bubble 46:59 Factor Investing Strategies in 2024 51:11 Do Investment Factors Need Intuitive Explanations? 56:52 Modern Inflation Environment Analysis 1:01:33 Market Concentration and the Magnificent Seven 1:06:28 High Volatility Alternatives Strategy 1:13:16 Key Lesson: Look at Your Portfolio Less
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Source description (no synthesized summary yet).
Markets have become somewhat less efficient over time, not more, driven by technological overload, passive investing growth, and social media dynamics; this creates larger and longer-lasting extremes for rational investors but also greater eventual payoffs for those who can endure them.
- Two unprecedented valuation extremes (dot-com and 2019-2021) exceeded historical records, contradicting the efficient markets hypothesis
- Technology accelerates information speed but not accurate processing; social media and algorithmic reinforcement create larger bouts of irrational behavior
- Rational strategies will face bigger drawdowns lasting longer, but the payoff for sticking with them should increase
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If markets were 100% passive Jack Bogle-style index investing, everything would break down because no one would be doing price discovery—everyone would be free-riding on everyone else's research to determine whether NVIDIA is worth more than the corner drugstore.
“there's literally nobody doing the work of saying is NVIDIA worth more or less than the corner drugstore we're all just assuming the other person did it and coping them and so let's just say that would be nuts I don't know what it would look like it's hard to think about”
Investing decisions that are checked more frequently feel more painful due to perceived risk increasing with observation frequency; this is an empirical phenomenon where even sophisticated investors like Asness show loss aversion and prospect theory effects intraday, feeling down days more acutely than up days.
“whoever looks at it more loses um I don't know what the right frequency I I can't imagine someone not checking once a year how's it going um but perceive v um perceive risk when you look frequently I by the way”
A rational investor offered an opportunity to allocate portfolio capital to a bet that doubles 2/3 of the time and loses 100% one-third of the time should put some fixed percentage into the bet and then rebalance to that percentage annually, not try to size based on individual outcomes, because rebalancing forces buying losers and selling winners which is mathematically correct even though emotionally difficult.
“imagine you're offered a trade and you never really offered this so you know this is god coming down with a burning bush and telling you here's the deal once a year you can put as much as of your portfolio as you want in a bet that two-thirds of the time doubles your money and one third of the time you lose all your money well I contend that a rational investor um it it would not put 100% of their money in this portfolio um to to put it a little faci iously negative 100% returns tend to affect your lifetime compound returns for a long time um you can actually argue a lot of you get to start over declare bankrupcy I don't want to get into that negative 100 it's something most people probably wouldn't risk I think a rational investor would always put something this is a wonderful risk adjusted return what they should do is figure out what the right number is and I'm not going to tell them what that is but put x% of the portfolio in this and then every year reload some onethird of the years you're going to be disappointed two-thirds of the years you're going to make money it's going to make your portfolio better reloading is rebalancing in this case it's just going back to that same percentage”
Any actively managed strategy that beats the market is by definition taking money from passive investors and making the market more efficient; therefore, all active management contains an arrogance in claiming to be on the right side of Sharpe's arithmetic that dictates the average active manager underperforms after fees and transaction costs.
“any kind of active management has an arrogance because it says I can be the right side of Bill Sharp's arithmetic they are taking you're taking someone's money and now you're serving a purpose you're making the market more efficient if you're taking the right side That's What markets work everyone try you know everyone deviating from cap waiting is trying to take someone else's money um and that that leads to pretty good results if the market stay stay stay close to efficient uh but the fact that the average doesn't win”
Testing market efficiency is historically extremely difficult because of the joint hypothesis problem: you cannot test whether markets are efficient without simultaneously testing a model of how prices should reflect information, and rejections of efficiency could mean either markets are inefficient or your model is wrong.
“testing market efficiency is historically extremely hard uh first it runs up uh against uh something famous in academic circles which is a bit of an oxymoron it means famous among 11 of us uh but that uh called The Joint hypothesis problem the efficient market hypothesis boiled down to one line says prices reflect all available information not included in the hypothesis is a model of how prices should reflect what information is relevant”
The Capital Asset Pricing Model, despite being one of the greatest theories in finance, is a spectacular failure in practice; across 75 years of data and every country tested, the security market line is relatively flat and does not reward beta as the CAPM predicts.
“the capital asset pricing model is a great example of a famous part of the joint hypothesis you can test The Joint hypothesis that markets are efficient and the capital asset pricing model is what's being used to set returns and prices that test is wildly rejected it's one of the great failures you you know uh you know 50 to 100 Years of data across every country no the security markets line is relatively flat it is it is not uh rewarding uh beta as the capm says”
Bill Sharp's arithmetic is tyrannical: the average active manager by definition cannot beat the market net of fees and transaction costs, so observations that average active managers underperform do not directly prove market efficiency—instead you must look at subsets of managers to test efficiency claims.
“Bill Sharp's arithmetic is tyrannical the average deviation from the market doesn't beat the market and the average deviation from the capway to Jack Bogle style Market loses to the market after fees and transactions costs so the observation that the average person owning a active portfolio doesn't win um if it does win your your measures are are broken”
The core issue with testing market efficiency is the joint hypothesis problem: you cannot test whether markets are efficient without simultaneously assuming a model of how prices should reflect information (like the Capital Asset Pricing Model), so a rejection of the hypothesis could mean either markets are inefficient OR the model is wrong.
“testing market efficiency is historically extremely hard uh first it runs up uh against uh something famous in academic circles which is a bit of an oxymoron it means famous among 11 of us uh but that uh called The Joint hypothesis problem”
Expensive stocks in recent periods have not actually outgrown cheap stocks at rates anywhere near justifying their valuation multiples; expensive stocks do grow faster but not by enough to offset their premium prices, validating value investing on pure fundamentals.
“the expensive outgrow the cheap yet you still win by being underweight the expensive on average because they don't outgrow by as much as is in the price therefore uh base solely on this if you held my feet to the fire and said I have to bet my life on the mag 7 I'd say on average when people assume as they've done many times that this time is different these firms will outgrow Forever at magnitudes enough to justify their already fairly massive uh valuations I would take the other side of that”
Betting Against Beta (the strategy of overweighting low-beta stocks and underweighting high-beta stocks) works empirically and can be explained by either leverage constraints on institutional investors or lottery-like preferences of retail investors—providing a behavioral bridge between pure market inefficiency and rational risk management.
“I'm willing to short that theory um I think we have good reasons that's the famous betting against beta factor I think uh think leverage limitations or Lottery preferences are actually a pretty good behavioral story uh so that's not quite the example from this paper where there's no story uh but it's always been a mix of the two”
Higher volatility alternatives (long-short strategies with low correlation to stocks and bonds) should be sized as a small portfolio allocation (1-2%) and rebalanced into on drawdowns; they won't move the dial much on absolute returns but can meaningfully improve risk-adjusted returns if uncorrelated.
“a higher volatility alternative it's still trivial risk in terms of your whole portfolio if you take normal numbers I'm going to put 1 2% of my portfolio in this alternative asset that's uncorrelated to my major my main portfolio double the V it's still going to move the V of your whole portfolio a trivial amount”
Looking at your portfolio frequently (daily/weekly) increases perception of risk more than actual risk, leading to biased decision-making; investors should look less frequently, ideally annually, to let returns compound rather than obsess over short-term volatility.
“look at your portfolio as little as possible uh probably probably 20 of your other people have said the same thing U but that just means it's true um particularly for for what you call the average in investor um I think they've actually been studies on this uh but just intuitively you know whoever looks at it more loses um I don't know what the right frequency I I can't imagine someone not checking once a year how's it going”
Betting against the Magnificent Seven specifically requires betting your life on seven stocks, which is foolish from a portfolio construction perspective; one should allocate only trivially to the view that valuations will revert, relying instead on diversification across hundreds of value factors.
“if you held my feet to the fire and said I have to bet my life on the mag 7 I'd say on average when people assume as they've done many times that this time is different these firms will outgrow Forever at magnitudes enough to justify their already fairly massive uh valuations I would take the other side of that but I would bet a trivial amount of my portfolio on seven stocks um you know I'm sorry if this is useless as a trading strategy”
Bond performance in the 1970s was catastrophic due to rising inflation eroding real returns; nominal prices may not have fallen dramatically but real (inflation-adjusted) returns were devastated, illustrating how inflation affects different asset classes.
“negative real rates for a while um help drive people crazy that was actually reason too in my paper um and and just to parenthetical that one for a second I have no theory for that other than paying people negative re on their cash for an extended period drives them mad um they they end up doing some silly things”
Most intuition about technology making markets more efficient conflates speed of information dissemination with accuracy of information processing; the real change is 10 minutes to 10 milliseconds, not a fundamental improvement in how well markets process information.
“I think it's almost it's almost a certainty that information gets into prices faster than 35 years ago which is roughly the beginning of my uh paying attention to this stuff um but I think the difference is 10 minutes versus 10 milliseconds uh I you know I'm old but I'm not car your pigeon old we had Bloomberg's and we had phones and you know when news would come out uh prices prices would react um so it you know it it in information itself has to be processed well”
The Capital Asset Pricing Model, despite being a theoretically elegant framework suggesting that systematic market risk (beta) should drive expected returns, has been empirically rejected across 50-100 years of data in every country tested, showing the security market line is flat rather than positively sloped as predicted.
“the capital asset pricing model is a great example of a famous part of the joint hypothesis you can test The Joint hypothesis that markets are efficient and the capital asset pricing model is what's being used to set returns and prices that test is wildly rejected it's one of the great failures you you know uh you know 50 to 100 Years of data across every country no the security markets line is relatively flat it is it is not uh rewarding uh beta as the capm says”
Price momentum (the tendency of past winners to continue outperforming past losers over 3-12 month periods) is the chief flaw in efficient market theory and extremely difficult to reconcile with market efficiency, yet it persists across long periods and multiple markets.
“the factor that I wrote my dissertation on him price momentum um he's always been very generous in calling that the chief uh jeed and titman should get pride of place for finding and I was right behind them um but he always says that that's that's the chief flow to their three and now five Factor model and very hard to reconcile with market efficiency”
The difference in valuations between growth and value stocks hit an all-time record level during the dot-com bubble in the late 90s, and then surpassed that record during 2019-2021, with the extreme spread persisting far longer than the prior bubble.
“the difference in valuation between uh so-called growth and so-called value stocks I prefer to call them expensive and cheap uh stocks every once in a while the cheap guys are actually growing pretty well um but this the the difference in valuations hit uh easily Far and Away a record level compared to history in the dot bubble um and then actually surpassed that during Co”
Markets have gotten somewhat less efficient over the past 75 years, not more efficient as technology and participant sophistication might suggest, evidenced by two record-breaking valuation extremes between expensive and cheap stocks in the dot-com bubble (late 1990s) and again in 2019-2021 that exceeded anything in prior history.
“the difference in valuation between uh so-called growth and so-called value stocks...the difference in valuations hit uh easily Far and Away a record level compared to history in the dot bubble um and then actually surpassed that during Co”
Markets are like democracy: the worst system ever devised except for every other one that's been tried; they're not perfectly efficient but there's no better alternative for allocating capital at scale.
“um I I don't think they're grossly inefficient um I I don't have a better way for society to allocate Capital uh I'm fond of the Winston Churchill quote um it's my second Winston Churchill reference in six minutes I I didn't mean to do that uh but he has this great quote about democracy it's a good dat for this quote good date for this quote actually um democracy is the worst system for governing ever devised except for every other one that's ever been tried um and you know you might say the same about markets”
Jean Fama (originator of EMH) is intellectually honest and explicitly admits perfect market efficiency is ridiculous and impossible, so the legitimate object of research is how imperfect markets are and how much that imperfection matters, not whether they're perfectly efficient.
“Jean fmer I I sat through his class three times um first as a student in two two more years full-time sat and every lectures the TA and he always tells the class about a few weeks in markets are after introducing the concept that markets are assuredly not perfectly efficient um and Jean you know if anything though super intellectually honest um he admits perfect efficiency is ridiculous nothing's perfect uh but once you admit things aren't perfect how imperfect they are and how much that very Sue time become a legitimate object to test”
Prospect theory (losses hurt more than equivalent gains please) applies intraday—a day with ups and downs that nets flat feels like a bad day because the downs are psychologically weighted more heavily than the ups.
“if we have a day where we've been up we've been down we've been up we've been down and we ended up flat I feel like it's been a bad day uh the Downs hurt me more than the UPS made me feel good uh the formal term for that is prospect theory and it applies intraday”
Price momentum (stocks that have gone up continuing to go up in the medium term) is one of the hardest-to-reconcile anomalies with market efficiency and is the chief flaw in Fama-French's factor models, though Asness credits Fama and French with finding it and developing early momentum theory.
“you know the factor that I wrote my dissertation on him price momentum um he's always been very generous in calling that the chief uh jeed and titman should get pride of place for finding and I was right behind them um but he always says that that's that's the chief flow to their three and now five Factor model and very hard to reconcile with market efficiency”
Inflation at 3% is normal and historically typical; the unusual period was 0% post-GFC and the 2021-2022 spike above 4%; current 3% inflation should not materially affect long-term asset allocation or market efficiency.
“you know that was certainly abnormal and and markets reacted quite poorly to it that was 2022 the inflation we have now is still above the fed's target it's you know roughly three instead of two um but it was the inflation we had post GFC that was abnormal um if abnormal is bad in some sense that maybe historical relationships won't won't hold I think that's exaggerated too”
The rise of passive investing from negligible levels to very high levels (current estimates suggest 30-40% of market holdings) has weakened the tether between valuations and reality, but the magnitude of this effect is difficult to quantify and likely overstated by those who have made passive-bashing their life's work.
“I do think the general notion that that that money going to passive radically distorts things in favor of the bid caps is overdone um you ask the exact right question um what's the impact compared to liquidity”
Academics and practitioners need to distinguish between 'passive' as true market-cap weighted Jack Bogle-style index investing (which can theoretically threaten market efficiency at 100%) versus rules-based or anti-market ETFs, which should not be conflated with passive in efficiency discussions.
“by passive I mean true Jack Bogle market cap style passive every once in a while someone will Define passive as like rules based so every ETF no matter how anti-market it is would would fall into passive that makes no sense to me passive is owning what everyone else owns”
Jean Fama admits that perfect market efficiency is ridiculous and that once you admit things aren't perfect, how imperfect they are becomes a legitimate object of study and speculation, which is intellectually honest despite being unprovable.
“Jean fmer I I sat through his class three times um first as a student in two two more years full-time sat and every lectures the TA and he always tells the class about a few weeks in markets are after introducing the concept that markets are assuredly not perfectly efficient um and Jean you know if anything though super intellectually honest um he admits perfect efficiency is ridiculous nothing's perfect uh but once you admit things aren't perfect how imperfect they are and how much that very Sue time become a legitimate object to test and if it's hard to formally test to even speculate on um I I think the intuition”
Rob Arnott's research on index additions and deletions shows sometimes-large effects that are plausibly new or larger because of the increased role of passive investing in responding to these mechanical events.
“Rob AR not um who I I've had my run-ins with Rob but I have great respect uh for him uh has recent work on uh on additions and deletions uh to to to passive indices um that shows some uh some at least in my quick reading uh rather large effects and that again I I don't know the ins and outs but it's very plausible that that the larger role for Passive would make that effect a unique and new thing that probably is driven by the specific role larger role of passive”
Bettin against beta (the phenomenon that low-beta stocks outperform what CAPM would predict) is a robust factor phenomenon that Asness attributes to leverage constraints and lottery preference biases, making it a hybrid risk/behavioral explanation.
“I think we have good reasons that's the famous betting against beta factor I think uh think leverage limitations or Lottery preferences are actually a pretty good behavioral story uh so that's not quite the example from this paper where there's no story uh but it's always been a mix of the two”
The rise of passive investing (defined as true Jack Bogle-style market cap weighted passive) has likely loosened the tether to reality that would otherwise pull mispriced securities back to fair value, but the magnitude of this effect is difficult to quantify and probably overstated by those who have made anti-passive positions their life's work.
“I do think uh the rise of of of passive and by passive I mean true Jack Bogle market cap style passive...could help loosen that tether to to reality”
Duration and intensity are both independent sources of pain for underperforming strategies; a 2/3-size drawdown that lasts 3 years is harder for clients and managers to stick with than a full-size drawdown lasting 1.5 years, even though the latter is mathematically worse.
“there are two ways to hurt when you're underperforming uh intensity and duration you know how bad are your losses be they absolute losses in say a long short portfolio or relative losses to the market in a traditional portfolio um how big are they and how long do they last and one thing uh in my career if you ask me at the very beginning of my uh career um you know back in the stone ages um which of these two are more important I'd say oh you you know the magnitude um that's you know magnitude is what counts if you write down formal utility functions uh maybe there is one maybe some genius professors done it I don't know any uh that have uh you know duration of of annoyance uh in in them or duration of uh pain uh in them in the real world sticking with the strategy even if the absolute size of the draw down is 2/3 of the size smaller if it lasts 3 years instead of a year and a half that's much harder to stick with”
Social media and online forums have made markets less rational by creating echo chambers of confirmation bias, algorithmic amplification of extreme views, and 24-hour gamified trading platforms, paralleling how social media has degraded political discourse.
“We have access to all the information in the world but but 85% of it is false um I and please don't hold me to that specific number I'm speaking for fun and hperb uh but some large number amount of it is false um we're overloaded with us we're subject to algorithms that that by Design reinforce our biases confirmation bias um and push us to more extreme views and if you're a believer that this has made our politics worse well markets are just voting mechanisms they're votes where you count the votes by your dollars”
Inflation is no longer the primary issue for asset allocation that it was in 2022; current inflation levels around 3% are historically normal, and the market has largely moved past inflation as a dominant concern.
“the inflation we have now is still above the fed's target it's you know roughly three instead of two um but it was the inflation we had post GFC that was abnormal um if abnormal is bad in some sense that maybe historical relationships won't won't hold I think that's exaggerated too I don't think inflation was um was the key driver behind crazy uh craziness”
AQR has meaningfully improved trend-following and alternative data/machine learning strategies over the past 5 years to provide return streams that are less dependent on the value/growth cycle, creating portfolio diversification that makes the core rational investing strategy easier to stick with during drawdowns.
“we're also savagely pursuing things that would make us less dependent on this cycle um we we think and I'm going to do a little commercial for our stuff here I apologize but we think we've radically improve what we do in Trend following moving into very esoteric markets uh fundamental and price trends we think those hold hold up a lot better than pure rational investing at times when there's irrationality going on um we've moved more like many quants have into the realm of alternative data and machine learning”
The rise of passive investing hasn't driven the extreme valuation spreads in value stocks; when you exclude the 5, 10, or 20% largest caps or isolate the Magnificent Seven effect, the value spread persists broadly across 700-800 global stocks, suggesting passive is part of the story but not the dominant factor.
“when we've done things like recalculate that value spread throwing out the 5 10 and 20% biggest caps throwing out just the most expensive stocks uh throwing out some version of The Magnificent 7 in a more Dynamic way like always looking for what was the closest thing at it at its day um obviously the Magnificent 7 20 years ago wasn't the Magnificent Seven and this the value spread and I know I'm I'm singing the same song but the value spread historically comes out looking very similar and value performance comes out looking very similar no matter how you're doing this”
The dot-com bubble coincided with the rise of Yahoo Finance message boards and text-based proto-social media; when Asness posted a hypothetical question about Cisco (trading at 100x P/E), investors responded with momentum-based answers rather than valuation-based answers, showing confirmation bias in real time.
“I posted on AIS go Message Board again compliance approved hypothetical question you all seem perfectly comfortable with this at 100p at how much would the price have to change tomorrow for you to sell and I'm looking implicitly for well 100p I have a model I think it's reasonable it would not be a reasonable model but that I could imagine someone making one up but at 200p I'd be out... only answers I got with the other direction if oh if it's down 30% I'd be out and I was like oh God I asked a value answer and I got a momentum answer”
If markets have gotten less efficient with larger and longer-lasting valuation extremes due to weaker gravitational pull toward fundamentals, rational value-based strategies will be harder to stick with but ultimately more lucrative, creating a tradeoff between bigger extremes and bigger payoffs.
“harder to do but a bigger payoff if you can do it is even within an inefficiency argument is some type of efficiency that strikes me as a fair tradeoff I steal a line from my ex- professor Ken French who labels the market has what does he say um and he attributes this to someone else but I'm giving it to him that markets have an efficient amount of inefficiency um and we could get into that that gets a little geeky uh but this strikes me as something that is fair going forward um I think the payoff to being a the rational investor willing to take the other side of extremes will be bigger in the next 20 years than it's been in the last 20 years but it will occasionally test you more”
Factors with no intuitive explanation can work going forward if they worked historically and have high Sharpe ratios, but intuitive factors should be preferred when quality is equal because they're more likely to persist and easier to defend through drawdowns.
“I'm unwilling at this point to say we should throw out intuition um Intuition or guard rails around things um but I will say separate from their findings the rise of machine learning uh even us building something we've done the Last 5 Years A far more uh systematic basian approach to allocating among factors where we let the data speak more um has pushed us... aqr has always pried itself on being relying on both economic intuition um and that that's that's any good story it could be behavioral it it could be risk it could even be more common sense uh kind kind kind of thing uh and data roughly equally”
Negative real interest rates (when inflation exceeds rates) motivate people to engage in silly financial behavior more than the level of inflation itself; extended periods of negative real rates are more corrosive to rational investing than modest inflation at normal rates.
“I have no theory for that other than paying people negative re on their cash for an extended period drives them mad um they they end up doing some silly things um but I think the inflation environment now looks a lot more like the last 100 years of History than the prior 10 years be before the bout of inflation”
Gamified trading platforms with smiley faces on wins and frowny faces on losses, combined with 24-hour 2am Saturday trading availability, introduce affective biases that make investors emotional about short-term gains/losses rather than long-term compounding.
“throw in other things 24-hour gamified trading on your phone where when you buy you get a smiley face when you sell you get a a a frowny face or confetti confetti coming down on the screen if you are are up and you can trade it at 2 a.m. on a Saturday um I I don't know how old your kids are or even if you have kids actually but when your kids hit teenage years almost all of us eventually say something along the lines of nothing good happens after midnight um and we mean in a very different sense but if if you need five more shares of Nvidia at 2 am on a Saturday you might reconsider your whole investment plan”
Markets are voting mechanisms where votes are counted by dollar amounts, making them subject to the same forces that have made political discourse worse due to social media; if social media has worsened political rationality, it logically should worsen market rationality.
“markets are just voting mechanisms they're votes where you count the votes by your dollars and the final price is some weighted average of the votes so why wouldn't it make our markets worse”
Private investing should not be pursued primarily for its supposed lack of correlation with public markets; private equity and private credit are essentially beta one or larger assets that are just less liquid, not genuinely uncorrelated alternatives.
“I get my backup over Alternatives I think um I I think they should be some degree of of really hedged um uh you might love private investing for a lot of reasons but you shouldn't love it because it's uncorrelated uh they're just beta of one or or larger assets so I'm talking about true Alternatives”
Expensive stocks on average outgrow cheap stocks in terms of actual earnings growth, but the market overestimates this outgrowth; value investing wins not because cheap stocks outgrow expensive ones, but because expensive stocks don't outgrow by as much as their high prices imply.
“one of the massive footnotes to my last paper uh looks at the predictive power of of the cross-section of different valuation ratios for next 3 or 5e growth and it shows that on average the expensive outgrow the cheap yet you still win by being underweight the expensive on average because they don't outgrow by as much as is in the price”
Markets can be thought of as operating with an 'efficient amount of inefficiency' where some deviation from perfect efficiency is necessary and even optimal; the goal is not perfect efficiency but finding the right balance of inefficiency that allows rational investors to profit while preventing gross mispricings.
“I steal a line from my ex- professor Ken French who labels the market has what does he say um and he attributes this to someone else but I'm giving it to him that markets have an efficient amount of inefficiency um and we could get into that that gets a little geeky uh but this strikes me as something that is fair going forward”
The dot-com bubble was significantly amplified by proto-social media in the form of Yahoo Finance message boards and similar platforms where confirmation bias was rampant; this represented early evidence of how information technology can worsen rather than improve market rationality.
“it it it's been around for a while so it didn't start immediately but a huge amount of the 19 and 20 particular blowoff top for for expensive versus cheap um took place on the internet and in discussion forums and in Reddit...the firstcom bubble coincided with the Rye and and the fellow graybeards listening to this will be the only ones who remember this uh but coincided uh with uh message boards becoming extremely popular that call that Proto social media”
Higher volatility alternatives (long-short diversified portfolios of attractive and unattractive securities) should be sized appropriately rather than abandoned; a 1-2% allocation to a high volatility alternative that doubles volatility in that portion still only trivially increases portfolio volatility, making the risk manageable despite concentrated discomfort in that line item.
“a higher volatility alternative it's still trivial risk in terms of your whole portfolio if you take normal numbers I'm going to put 1 2% of my portfolio in this alternative asset that's uncorrelated to my major my main portfolio double the V it's still going to move the V of your whole portfolio a trivial amount if you're myopically focused on this on line item of this alternative yeah it'll freak you out occasionally but in if you're if you're if you're a coldhearted Vulcan and you're just being rational it's not changing your portfolio very much”
Negative real interest rates (interest rates below inflation rates) for extended periods drive investors mad and cause them to take excessive risks and do silly things with their capital, more so than inflation itself.
“I have no theory for that other than paying people negative re on their cash for an extended period drives them mad um they they end up doing some silly things”
The intuition that technology makes markets more efficient is largely based on speed of information transmission, but the relevant distinction is speed versus accurate processing of information; information gets into prices much faster now (10 milliseconds versus 10 minutes 35 years ago), but the speed improvement is separate from whether information is processed correctly.
“I I think the intuition you me mentioned that markets would get more efficient over time is largely based on technology um the speed of trading the cost of trading has gone down um the ubiquity of information uh but I I think most of that is about speed not about correctly processing information”
The Cisco Systems example during the dot-com bubble: when Asness posted a hypothetical question on message boards asking at what price investors would sell Cisco (then trading at 100 P/E), he received momentum-based answers (sell if down 30%) rather than value-based answers (sell if price double), illustrating the prevalence of momentum thinking.
“I posted on AIS go Message Board again compliance approved hypothetical question you all seem perfectly comfortable with this at 100p at how much would the price have to change tomorrow for you to sell and I'm looking implicitly for well 100p I have a model I think it's reasonable it would not be a reasonable model but that I could imagine someone making one up but at 200p I'd be out that can't be a good investment or whatever call it a th000 PE I was looking at a number only answers I got with the other direction if oh if it's down 30% I'd be out and I was like oh God I asked a value answer and I got a momentum answer”
Having lived through two unprecedented episodes of value underperformance and seen how they resolved (dot-com 1999-2000, and 2019-2020), it becomes easier emotionally and intellectually to stick with the strategy through subsequent episodes because you have actual historical evidence of recovery.
“from our own ability to stick with it and keep confidence in what we do we were open-minded we did listen to every possible story for why this time is different and it's never coming back um and ultimately we rejected those stories but not after taking them seriously but having lived through the movie once before and seeing how it ended um it did make it considerably easier at least for me uh maybe may maybe not emotionally every day but in terms of keeping intellectual confidence yeah the second time is easier than the first and the third time should be easier than than the second”
Markets are less concentrated in the Magnificent Seven than commonly assumed; even when calculated on a value spread basis focusing only on expensive versus cheap stocks, the effect of the top 10 mega-caps is not driving the entire value spread dislocation, as evidenced by similar spreads appearing when removing the largest companies and calculating across thousands of stocks globally with balanced industry weighting.
“when we've done things like recalculate that value spread throwing out the 5 10 and 20% biggest caps throwing out just the most expensive stocks uh throwing out some version of The Magnificent 7 in a more Dynamic way like always looking for what was the closest thing at it at its day um obviously the Magnificent 7 20 years ago wasn't the Magnificent Seven and this the value spread and I know I'm I'm singing the same song but the value spread historically comes out looking very similar”
Passive investing creates a specific new opportunity through index additions and deletions, as demonstrated by Rob Arnott's recent work showing large effects from these events; this may be a genuinely new type of inefficiency created by the larger role of passive investing.
“Rob AR not um who I I've had my run-ins with Rob but I have great respect uh for him uh has recent work on uh on additions and deletions uh to to to passive indices um that shows some uh some at least in my quick reading uh rather large effects and that again I I I don't know the ins and outs but it's very plausible that that the larger role for Passive would make that effect a unique and new thing”
The three-year redemption wall: after year one of underperformance, clients are usually patient; after year two, they're skeptical; after year three, they've redeemed and only the manager's mother remains in the fund.
“After year one you go back to client who likes you who chose you you're saying this is what happened this is why we like it going forward you're usually okay with that you go back after year two they're like you know that's what you said last year uh and you go yeah it just happened again and this is why we like it even more some don't buy it many do you go back at the end of year three it's pretty much you and your mom in the fund at that point”
Professionals like portfolio managers must monitor portfolios daily because clients expect it, but they should minimize their own personal monitoring of their own wealth to reduce behavioral biases, creating a tension between professional duty and personal discipline.
“I have to look at how we're doing each day it's just a little weird if one of my clients calls and goes oh big event happened today how you guys doing and I go I don't know um that's that's just a little odd uh but but I'm a hypocrite I I look at it all day when when I'm in the office I look at it all day when I'm out of the office I'm actually much better I I can check it on my phone but I just I I just do it a lot less”
Macroeconomics is genuinely difficult to understand; after attempting to master it four times by reading canonical textbooks from across the political spectrum, Asness remains convinced that macro experts don't understand it either despite their confidence.
“I don't think I'll do it again but probably four times in my career i' thought I need to know more about macroeconomics... and at the end of a fair amount of work I I go well I've put in a lot of work for about a month and a half I still don't understand macro but I'm reconvince that they don't either”
A hypothetical 2 AM Saturday trading impulse for five more shares of Nvidia suggests considering whether one's whole investment plan is sound; normal investors shouldn't need to access markets at odd hours, and the ability to do so enabled by technology encourages poor decision-making.
“if if you need five more shares of Nvidia at 2 am on a Saturday you might reconsider your whole investment plan”
Valuation-driven approaches should work broadly across fundamental strategies including not just pure quant value but also concentrated stock picking and fundamental analysis by skilled managers who focus on price as a key metric.
“my basic valuation driven approach it doesn't have to be just Quant value it could be broader than that it could be multi-dimensional value that considers profitability uh you know changes get moving in the right direction short term in terms of fundamentals risk levels beta all um but my basic intention is those who follow that rigorously will do better going forward in a world of less efficiency”
Corporate concentration in the S&P 500 has occurred before in history and doesn't automatically lead to disaster; mechanical effects are correlated with wide value spreads, but structural advantages of mega-cap tech firms are often overstated and survivorship bias makes them appear more dominant than warranted.
“concentration is high today but we've seen it before uh and the effects of it are not disastrous and they're not uh clearly One Direction or another um I think mechanically they're correlated with with wide value spreads um you know some things are being valued very high it would be pretty odd if that we're only showing up in seven stocks”
The payoff to rational investing strategies lived through two major tests (dot-com and 2019-2021) and ultimately recovered, making it easier to stick with such strategies in future downturns because history demonstrates the pattern actually works out.
“we've now seen two episodes of this and as I've as I've said in other forums I'm keeping the receipts you know I business-wise it was still quite difficult um but from for our own ability to stick with it and keep confidence in what we do we were open-minded we did listen to every possible story for why this time is different and it's never coming back um and ultimately we rejected those stories but not after taking them seriously but having lived through the movie once before and seeing how it ended um it did make it considerably easier at least for me uh maybe may maybe not emotionally every day but in terms of keeping intellectual confidence yeah the second time is easier than the first and the third time should be easier than than the second”
Having lived through the dot-com bubble and the 2019-2021 valuation extremes gives Asness intellectual and emotional confidence that the market will again revert toward fair value, even though that knowledge cannot guarantee against future extremes becoming even larger.
“we were open-minded we did listen to every possible story for why this time is different and it's never coming back um and ultimately we rejected those stories but not after taking them seriously but having lived through the movie once be before and seeing how it ended um it did make it considerably easier at least for me uh maybe may maybe not emotionally every day but in terms of keeping intellectual confidence yeah the second time is easier than the first and the third time should be easier than than the second”
Professional investors must look at portfolio performance frequently (daily, to handle client calls), while average investors should check as infrequently as possible (maybe once yearly), because professionals cannot avoid the frequency bias but amateurs can discipline themselves to avoid it.
“I think the answer is a little different for profession uh I have to look at how we're doing each day it's just a little weird if one of my clients calls and goes oh big event happened today how you guys doing and I go I don't know um that's that's just a little odd uh but but I'm a hypocrite I I look at it all day when when I'm in the office I look at it all day when I'm out of the office I'm actually much better I I can check it on my phone but I just I I just do it a lot less um but I will tell you myself and if anyone should be aware of these biases I'm I'm I'm up there with people who should be”
The price level being high is a legitimate concern for voters even if inflation (the rate of change) has come down, because people's lived experience is shaped by absolute prices they pay, not the rate of inflation.
“prices are still high we saw that in the election obviously people are you know a lot of uh individual ual focus on the price level not the change in inflation and that's not entirely Crazy by the way um if if you if you put me in 130° room and you stop raising the temperature and you tell me you should feel great because I've stopped raising the temperature you're like you know you haven't lowered the temperature uh so I I get why people were upset about that”
Ken French has labeled markets as having 'an efficient amount of inefficiency'—implying markets have optimal-level inefficiencies that balance the costs of seeking efficiency against the actual gains available, similar to how you wouldn't want perfectly efficient roads (would cost infinite resources).
“I steal a line from my ex- professor Ken French who labels the market has what does he say um and he attributes this to someone else but I'm giving it to him that markets have an efficient amount of inefficiency um and we could get into that that gets a little geeky uh but this strikes me as something that is fair going forward”
Morning routines like ice baths and special drinks are likely correlated with success among high achievers, but causality is overstated—the mindset that makes someone wake up and do uncomfortable things is correlated with productivity, not the specific activity.
“there's a little bit of humor in there but it's uncomfortably close to uh accurate um you know some of these it's a great example of correlation versus causation those morning routines may be correlated with very highly productive people the same mindset that can make you wake up and do some wacko uncomfortable painful uh routine um but I don't I don't think it's as causitive as people as people think”
Jack Bogle admitted on a podcast that 100% passive investing would break the market, and when asked how much of the market could be passive before things get 'weird,' he said 75% and then openly admitted he 'completely made that up'—revealing that the right threshold is unknown.
“had Jack on the podcast we got into this discussion and Jack like Jee F I'm going to say this about another famous person incredibly intellectually honest guy he's like of course 100% of the market can't be passive I think my marginal recommendation to most investors to be passive is the right one but 100% everything breaks down he he freely admitted that and I said Jack so how much of the market can be passive before it starts to get weird um and he said 75% and I'm like oh that's really cool that's you know where'd you come to that Jack uh and he just looks and goes he gets a little twinkle in his eye and goes oh I completely made it up”
The Chen-Lopez paper on whether factors need intuitive explanations is interesting, and AQR has been moving incrementally toward letting data speak more and away from requiring strong intuitive/theoretical foundations for factors, shifting from roughly 50-50 intuition-to-data weighting toward something like 66% data and 33% intuition.
“the rise of machine learning uh even us building something we've done the Last 5 Years A far more uh systematic basian approach to allocating among factors where we let the data speak more um has pushed us don't these are madeup numbers are just as for a concept but aqr has always pried itself on being relying on both economic intuition um and that that's that's any good story it could be behavioral it it could be risk it could even be more common sense uh kind kind kind of thing uh and data roughly equally the the rise of better statistical techniques let push just I don't know 2/3 one3 data”
Rational/value-based investing strategies may see larger extremes and longer durations of underperformance in the future compared to the past 20 years, but the eventual payoff should be commensurately larger; this represents a fair tradeoff of bigger temporary losses for bigger long-term gains.
“I think the payoff to being a the rational investor willing to take the other side of extremes will be bigger in the next 20 years than it's been in the last 20 years but it will occasionally test you more”
On the Magnificent Seven: if forced to bet, Asness would take the short side against them as a portfolio, but would bet a trivial amount because betting all capital on seven stocks is risky regardless of the thesis.
“if you held my feet to the fire and said I have to bet my life on the mag 7 I'd say on average when people assume as they've done many times that this time is different these firms will outgrow Forever at magnitudes enough to justify their already fairly massive uh valuations I would take the other side of that but I would bet a trivial amount of my portfolio on seven stocks”
AQR has significantly improved its trend following strategies by moving into esoteric markets and using alternative data with machine learning, creating return streams that are less correlated with rational value investing and thus more resistant to the periods when value investing is out of favor.
“we're also savagely pursuing things that would make us less dependent on this cycle um we we think and I'm going to do a little commercial for our stuff here I apologize but we think we've radically improve what we do in Trend following moving into very esoteric markets uh fundamental and price trends we think those hold hold up a lot better than pure rational investing at times when there's irrationality going on um we've moved more like many quants have into the realm of alternative data and machine learning and sometimes those two combined”
During the dot-com bubble, the Cisco example at 100x P/E was not unique in being overvalued—Amazon could have ended up being worth it, but almost everything else didn't, so even extremely overvalued stocks like Cisco could theoretically have justified their prices if growth had materialized.
“I cautioned that any single stock can end up being worth it you look at the dot bubble Amazon ended up being worth it almost everything else didn't so even Cisco could have ended up being worth it”
Academic and practitioner research prior to AQR's work (around 1999) had examined value spreads by sorting stocks and looking at return differences, but no one had asked the metric of how big those spreads are (expensive divided by cheap), which is the foundation of tracking valuation extremes.
“where the prior tests almost all the academic and practitioner research had sorted stocks on something like Price to Book formed a portfolio of the cheaper versus expensive and just looked at the return differences they to our knowledge none had asked the question how big are those differences well if you take the price to book of the expensive and divide it by The Price to Book of the cheap that number better always be more than one um I'm fond of saying if it's not more than one your code or your spreadsheet is broken um you've you've sorted the stocks and you took the high divider by the low and it's not allowed to be negative so you're going to get a number bigger than one but from 1950 to 1998 it had looked like a very well- behaved series”
Winston Churchill famously said that democracy is the worst system for governing ever devised except for every other one that has ever been tried; the same logic applies to markets—they are the best system for allocating capital that has been devised, despite their imperfections.
“democracy is the worst system for governing ever devised except [0:31] for every other one that's ever been tried um and you know you might say the same about markets”
Changing one's investment philosophy as evidence improves is a sign of intellectual honesty worth aspiring to, even if it's uncomfortable; Asness is willing to shift away from equal-emphasis on intuition and data toward more data-driven approaches as statistical techniques improve.
“if the if the if the data if the data science gets better at doing its job our intuition and our and our theoretical models ain't getting better uh so I you know I think the old keing if the fact change I changed my mind what do you do sir um I'm unwilling on one paper to throw out intuition but their paper is really interesting and for maybe some different reasons we have been moving at least a decent step in that direction anyway”
Correlation versus causation is often confused; successful people who have extreme morning routines (ice baths, etc.) may be correlated with success due to the mindset that makes them willing to do uncomfortable things, but this does not mean the morning routine itself causes success.
“there's a little bit of humor in there but it's uncomfortably close to uh accurate um you know some of these it's a great example of correlation versus causation those morning routines may be correlated with very highly productive people the same mindset that can make you wake up and do some wacko uncomfortable painful uh routine um but I don't I don't think it's as causitive as people as people think”
Meme stocks like AMC represent an extreme example of social media-driven, momentum-based investing divorced from fundamental value, though this is an outlier and not representative of the general market.
“the US mem stocks would be an example of you know purely social media driven um kind of insane in their both how they act and at times their valuations um and I I don't think many aside from some True Believers which are dwindling over time”
During periods of high inflation (post-COVID 2021-2022), markets reacted poorly, but the actual correlation between inflation levels and rational investing returns is more complex than markets are simply 'inflation-proof' or broken.
“that was certainly abnormal and and markets reacted quite poorly to it that was 2022 the inflation we have now is still above the fed's target”
The author does not have strong conviction on macro questions and has attempted to study macroeconomics multiple times across the political spectrum (from Robert Barro to Paul Krugman) but consistently concludes that economists themselves may not fully understand macroeconomics.
“I I don't think I'm admitting that or bragging about it but uh inflation um you know predicting inflation and effects are not my number one goal when we build portfolios”
Favorite redemptions in asset management are from clients who've made so much money that the position became too large and they're taking profits, which is still often a suboptimal decision for their wealth growth.
“my favorite Redemption on Earth is of course you've made me so much money you're too big a part of the portfolio I'm taking it back um and and I usually think that's still a bad idea you never you didn't have enough to begin with because I'm a little biased to to us uh but it it's it's that's a person who's thinking about it right”
The most favorable redemption scenario for an active manager is when investors redeem after substantial gains, not after losses, because it signals the strategy has worked and the fund has become too large relative to the investor's needs.
“my favorite Redemption on Earth is of course you've made me so much money you're too big a part of the portfolio I'm taking it back um and and I usually think that's still a bad idea you never you didn't have enough to begin with because I'm a little biased to to us uh but it it's it's that's a person who's thinking about it right”
The author acknowledges that his paper on less efficient markets is largely opinion rather than formal statistical proof, as specified in the paper, and he is intentionally not claiming p-values or t-statistics despite his usual academic approach.
“unlike many of my papers that are filled with t statistics and other formal approaches I'm not going to be claiming I have uh A P value of 003 uh that I'm that I'm right I'm going to be claiming I think I'm right because of what I'm observing but it is more anecdotal and logical and iated than than my normal kind of work”
Asness's morning routine consists of alarm at 5:30 a.m., texting his trainer not today, sleeping another hour, drinking coffee, going to the office, then getting mad about something, which he ironically recommends as a path to success.
“you tweeted something that gave all the rest of us hope that maybe we can have a normal routine and be successful so what you tweeted for people who are not watching us on video is you said your morning routine is alarm goes off at 5:30 a.m. I text my trainer not today I sleep another hour I awaken drink coffee and go into the office then I get mad mad about something I'd recommend it”
Compliance and regulatory departments at investment firms were generally skeptical of messaging on social media/message boards during the dot-com era, but eventually allowed very carefully worded neutral content like hypothetical questions.
“I asked compliance at aqr back then a few times can I post on these and they were like that's not a good idea really bad idea finally they let me post one purely hypothetical question”
Asness made a joke about fearing he would be played by Albert Brooks if a movie were made about him and Jack Bogle's relationship, because it would bring out the 'pure Jewish angst version of Click' (the Adam Sandler film).
“I've always been terrified that if I ever show up in anything like that uh I'll be played by Albert Brooks um and not nothing against Albert Brooks he's hilarious uh but that would bring out you know that would be the pure Jewish angst version of click”
Asness was short AMC on CNBC, which resulted in backlash from the Reddit/meme stock community and made him realize there is a darker corner of the investing universe than he previously understood.
“I had my run-ins with with with this world when I I won't say accidentally because it was quite non-accidentally but I mentioned we were short one on CNBC um these are not people you want to to do that to uh I I discovered it's a much darker corner of the investing Universe than I actually knew about”