A Life in Finance: A Conversation with Prof. Roger Ibbotson

William Goetzmann: I’d like to ask you a little bit about your education at the University of Chicago. Can you tell us a bit about some of the people there that were influential? What did you think of the efficient market theory and all of that going on in Chicago at that time?

Roger Ibbotson: I ended up working with my PhD committee—the chairman was Eugene Fama, and Fischer Black, and Myron Scholes, and Merton Miller. All of them had Nobel prizes in the end, except for Fischer Black, but of course he would have got one too if he hadn’t died early.

So it was really a wonderful group to work with, and of course the overriding theme was efficient capital markets. It was really where efficient capital markets started, because Gene Fama had written that paper on efficient capital markets, I think in 1969. We had talked about random walks before that, but actually kind of crystallizing the idea of efficient capital markets. It was just such an exciting place to be.

Goetzmann: What was the first paper that you published in your career?

Ibbotson: I have to think about that, because I published papers both on IPOs, which was my dissertation, but I was also working on putting data together, of course, the Stocks, Bonds, Bills, and Inflation. I published two papers on stocks, bonds, bills, and inflation. One on the past, and one on the future, making a forecast for the year 2000. Those all took place approximately the same time.

Goetzmann: Those two papers, I wanted to ask you a little bit more about. The first one was about looking at the historical performance, of the long-term performance of the stock markets, and is the basis for what people now call the equity risk premium. How did you get the idea to delve into the history of it and how did you get the data?

Ibbotson: Well, you know, everybody was talking about risk premiums at the time, and we didn’t really have a measure of it, so I could see that we needed some numbers to put behind all this data and these premiums. And being at the University of Chicago, that was a great place because this is where the Center for Research in Security Prices, called CRSP, was, and Larry Fisher and James Lorie had put together data on the stock markets. Also, Larry Fisher put together data on the bond markets.

I got a job managing the university bond portfolios while I was getting my PhD. And while I was managing that bond portfolio, everybody asked me all the time, “When are Fischer and Lorie going to update their stock market studies?” because they first had a study that went from 1926 to 1960, and then they brought it up to 1965, and then to 1968, but this was in the early ’70s now.

I put that data together, but at the same time I did that, I wanted to answer all these questions about these risk premiums, because that’s the other thing everybody’s wondering about: what was the magnitude of all these risk premiums that we have on the market? So, when you put the bond data in there, and the bill data in there, and the inflation data in there, suddenly you get a real interest rate, you can get a horizon or interest rate risk premium. You put in corporate, you get a default risk premium, and of course, when you compare stocks to bonds or bills, you get the equity risk premium.

All this data was there—it just had to be collected. It was just amazingly exciting when it came out.

Goetzmann: How do people use that data—financial institutions and planners, and so forth?

Ibbotson: Well, they use it so many different ways. Of course, you want to know what the long term return of the stock market is. What I’m really most known for, I suppose, is a chart, putting together that data. Starting in 1926, investing a dollar, and letting it rise in the stock market.

Goetzmann: I wanted to ask you about the second paper, the forecasting paper, because you estimated an equity premium in 1975 or ’76. How did that pan out over time? Was it a rosy estimate or not?

Ibbotson: Rex Sinquefield was my co-author on this; we projected out for the year 2000, and we made different kinds of forecasts, but one of them was on the Dow, and we said the Dow would hit 10,000 in approximately 2000, and that got picked up by the press. This was in 1975, so we had just been through the ’73-’74 recession and the collapse of the stock markets, and suddenly some economist is saying what’s going to happen over the next 25 years. And the Dow, which was, say, 800 or something like that, was going to grow to 10,000 by 2000. And it made the newspapers all over the place, because they needed somebody to say something optimistic. It seemed to be a grandly optimistic forecast.

It actually turned out, though, to be almost exactly right. I went on, I think, CNBC in 1999, when it did hit 10,000, so it was approximately right. Basically, it was just extrapolations of risk premiums that have happened in the past.

Goetzmann: I thought I’d pull us back out a little bit and ask you some of your thoughts about investing going forward. Is there still going to be an equity premium? What are the sources of return and value that you think about when you’re not just doing your research, but also in your world of money management that you’ve entered into?

Ibbotson: I still certainly believe that there’s going be an equity risk premium. It’s not going to go away. Of course, it isn’t constant. It can get smaller or larger. And really, it gets back to my broader belief, which I’ve been working on for decades as well, about the supply and demand of capital markets. Some of it’s empirical, and some of it’s theoretical.

On the demand side, if people are risk averse, then they’re going to find equities less desirable than bonds, and the only way you’re going get people to buy equities instead of bonds is to have them expect to have higher returns. That’s what the equity risk premium is about. It’s really a payoff for something that people don’t like. But I’ve generalized this, so it isn’t just equity risk premiums. Of course, we don’t like risk, but there’s lots of things we don’t like—and lots of things we like. We like liquidity; we don’t like less liquidity. We like brands; we like things that we well recognize. We don’t like the kind of things that we don’t know much about. So all of these things end up being in the pricing of assets, and some of them, if they’re more permanent and systematic, actually turn out to be the premiums that we talk about.

One of the key things I’m really saying here is that a lot of academics think of all of these premiums as risk premiums. They’re not necessarily risks. They’re just things we don’t like. You can force liquidity into a risk premium if you like, but liquidity isn’t necessarily about risk; it’s about transaction costs and hard to trade and things like that. Make a risk factor out of it if you like, but that doesn’t catch the essence of what liquidity is all about.

Essentially, it gets back to my latest monograph that’s just out now, with three other co-authors, Tom Idzorek, Paul Kaplan, and James Xiong. It’s called, Popularity: A Bridge between Classical and Behavioral Finance. And it puts a lot of this together, because it encompasses the premiums of the market, behavioral aspects of the market, things that we like or don’t like, and all of these things enter in the pricing and the mispricing of markets.

Goetzmann: What do you think your dissertation committee members would say about this movement from classical finance more towards preferences and behavior? Do you think they buy this idea, or is it pushing the envelope of classical finance too far?

Ibbotson: Well, Gene Fama is the father of efficient markets, and has a tough time moving off that square. And I think he certainly deserves his Nobel Prize, and the idea of efficient markets is sort of the grounding, starting point for everything I look at. I’ve been trying to understand efficient markets my whole life and to what extent markets are efficient, and how prices are formed.

Goetzmann: Maybe I could turn to the business side of your life. You created a new firm, Ibbotson Associates, launched in Chicago.

Ibbotson: I hadn’t actually planned to be a professor. Now I’m so happy I have been a professor—it’s been a wonderful, stimulating experience. But I had planned on being a businessman, pretty much from the start. My father was a businessman; he was in heating and air conditioning. It was a small, successful business, and I imagine I probably would have gone into my father’s business if I had been more mechanically inclined. I really felt pretty inept at all of those things, so I had to find another route, a little more abstract.

You know, the finance field is more abstract, but I found that if you want to understand really what’s going on, it really helps to actually do it.

I did “Stocks, Bonds, Bills, and Inflation” back in the mid-’70s, and it became famous immediately. I was an assistant professor. I barely had secretarial help, and I was getting all this mail from CEOs asking me all these questions and making requests. I had no idea what to do with it. And that’s why I set up the business originally, just to help me process all the requests. And I started doing consulting.

I found I had plenty of business to do, as a consultant, and then building software. That allowed us to sell things more off the shelf, so it wasn’t just my own personal consulting all the time because I was limited in how much I could do.

So Ibbotson Associates really started with “Stocks, Bonds, Bills, and Inflation.” The big demand was there. It basically became software data publishing, and we got a lot into asset allocation—how you mix portfolios, especially for individuals, between stocks and bonds and other kinds of assets.

Goetzmann: You eventually sold the firm. What happened?

Ibbotson: You know, we talk about having diversified portfolios. It was one business, not a lot of businesses, and it could have some ups and downs. It grew fast, but it had some tough times when we had recessions and so forth, so it was difficult to know that all your wealth is in one spot here.

It was pretty difficult to run the business because the business was in Chicago. And I had come to Yale in ’84. Although in some ways it was favorable because I learned to bring in management that actually had more skills than I did at running things. It turns out, I’m better at setting up the overall themes and approaches and concepts. I don’t necessarily have any competitive edge at the day-to-day operating advantages of a business.

My newer business, Zebra Capital, is the same sort of thing, where somebody actually runs the company, but I’m just trying to set the direction. It works for me, not only because I’ve got another job here at the university, but also because it’s sort of my skill set, the fact that I can see the big picture. I’m the person that can set the themes and see where we should be going and what we should be doing, but not necessarily the person who can go through all the details of how that should work, day to day.

Goetzmann: What are some of the big themes at Zebra Capital?

Ibbotson: Our theme at Zebra Capital is the same theme as this monograph, Popularity: A Bridge between Classical and Behavioral Finance. We’re essentially trying to buy the less popular stocks. We’re all equity oriented. We’re buying the less popular stocks on the long side, and we’re shorting, the popular side, the hot stocks. And the research always shows that those hot stocks have their period of fame, but then eventually get too hot and fall off, so on average, they do much worse.

There’s always going to be a measure of popularity, but the measures of popularity won’t always be the same. If some measure of unpopularity, say, gets popular, then it no longer works in that sense. That’s why it’s always changing. It’s always dynamic.

Goetzmann: For disclosure, I have to say, I’m a member of your scientific advisory committee. So, I’m familiar with the themes of it. What are your ambitions and hopes for the firm?

Ibbotson: Well, I don’t imagine it’s going to be a huge firm. But it’s getting into other kinds of businesses. It’s getting into the insurance type businesses, different annuity products and so forth. It’s already moved beyond hedge funds into equity products. We manage a lot of different kinds of small capital portfolios, or micro cap portfolios. It is growing, and it will continue to grow.

All these things are just extensions of how I think about things. It doesn’t have to be the largest firm in the world. I don’t necessarily know that it will happen, but it is a way for me to express my ideas and to implement them.

Goetzmann: Both of us are interested in financial education, but you’ve been a bit more creative in terms of figuring out ways to engage students in the actual practice of trading. Could you talk a little bit about your stock market game and how you came up with it? And how do you use it in teaching?

Ibbotson: I originally developed the stock market game as a physical game using cards for shares and people would physically trade. Over the last ten years, it’s become an electronic game.

Going back, though, to why I think this is important: the way to get students to really engage is to have them actually interact. They’re not just talking about something here, they’re actually doing it.

One of the nice things about the stock market is that the stock market game allows you, effectively, in a half hour, to play a year of the stock market. A lot of other stock market games that are put together by commercial firms, they let you invest in actual stocks. That’s fine, and it’s great to actually look at the ten thousand stocks that you could invest in, bonds and all that. But the limitation is that you’re studying it over a few weeks or a couple of months in the course. And I really want people to have a sense of long-term thinking and what happens over a year or more.

Also, they get to see clearly this idea of efficient capital markets and zero sum games. They are trading with each other, so that when one person gets a really good deal, the other person is getting a bad deal, effectively. It’s basically a zero sum game, relative to the market. Everybody can win if the market goes up, but only half the people can beat the market.

And the game enables you to easily test how efficient that market is, too, because unlike real life, it actually has a liquidation value at the end. You can check what the actual values of these things are, and they actually do have values. You can see how the trader prices match those underlying values.

They learn about trading. They barely know what short selling is, but then they end up doing it.

Goetzmann: Do you also see some of these behavioral features emerge as the students play? Do they consider other factors like popularity in their playing?

Ibbotson: I don’t have a measure of popularity in the game, but it turns out they’re not necessarily efficient in the game. I’m always surprised to see, because in the game, all the information is available. And it’s all been seen many times across the whole market, where even if no one person has the perfect sense of all the information, collectively, the whole market has seen it numerous times. But still, I’ve seen, many times, the prices are distorted.

One of the things I find pretty strong is anchoring. Before you even play the game, before the information is out, the prices are 40 dollars a share. And they’re pretty heavily anchored to 40, I must say. I don’t tell them this in advance, but it turns out that stocks worth over a hundred dollars or stocks that are bankrupt might still end up trading close to 40 sometimes because of the starting value. That’s what you would price it at if you knew nothing, but they know everything, and they still price it often too close to 40.

Goetzmann: You’re in the office just about every day working on research, and I’m always interested to find out what your current research topics are.

Ibbotson: Well, it really extends off of Popularity: A Bridge between Classical and Behavioral Finance.

We have in that monograph a model called a Popularity Pricing Model, a PAPM, something like a CAPM. We’re using essentially the CAPM methodology, but we change one thing. We allow extra preferences on risk, and one of the key things is that those preferences don’t go away. They don’t get arbitraged away, even if some of the investors don’t have those preferences. They may find the overly popular stocks will be overpriced, and they might even short them and so forth. But they don’t remove the pricing. Because the price itself is the aggregation of all the demand of the preferences, and one of the preferences, of course, is risk aversion. But there are other preferences, and the price is the aggregation of this demand.

Now, the new research I’m doing is an offshoot of this, is saying that what we do have in the PAPM model so far, is homogenous expectations. This means that everybody has the same expectation of what the final results will be, what the cashflow might be for our firm. They have the same expectations, but some people value more than others because they’re say, more liquid, or some people have longer horizons or are more risk averse. So people will value these things differently and they will aggregate them into the price. So the price is the aggregation of diverse opinions and preferences.

And it turns out we’re not talking about anything complicated here, because it works off of the Capital Asset Pricing Model. It’s an equilibrium framework, but the demand is that aggregation of preferences and opinions. Of course, everybody holds different portfolios in this context and we have different preferences and opinions.

What’s exciting to me is, these are things that I’ve thought about my whole life. It touches on how efficient markets are. They’re not going to be literally efficient because it’s an aggregation of demand. There are going to be degrees of inefficiency depending on the systematic biases of people in the market, either in their opinions about things or in their preferences.

I won’t say I’m impacting the profession yet to any great extent, but it helps me. I feel like I’m really understanding how prices are formed and how demand is aggregated, and how supply and demand work together. Not that I can always implement this to make a lot of money or anything like that, but just intellectually, it really makes me feel like I just have this personal understanding of everything and I’m hoping that I can impact other people.

Goetzmann: I think I may have been at least one of your early TAs, maybe first or second class that you taught. Can you talk a little bit about your experience as a teacher through the years?

Ibbotson: When I was back in the University of Chicago, I didn’t know how much research I’d be doing because I really loved the teaching, and I imagined that I was going to be much more of a teacher than a researcher. Over time I actually became more of a researcher than a teacher. But that doesn’t diminish the fact that I have always really loved the teaching. I found my students always to be really inspiring.

I still teach in the executive MBA program. And I just find that there are sparks in the room. I like teaching people with a little more of an open slate in their minds. Everything you talk about is a big surprise to them. It’s like you’re waving a magic wand and they’re suddenly pulling rabbits out of the hat all the time. It’s just a really fun experience, so I don’t know that I ever really want to give it up.

Goetzmann: I’d like to ask about your interest in the very long term data collection and history. I know that’s something I got from talking together when we were doing some presentations, and it got me going on historical data. Do you think that the past is a good basis for considering what the future will be, in the world of investing?

Ibbotson: What else do we have other than the past, to predict the future? I think of finance as the part of economics that centers on time and uncertainty, and the problem with all the uncertainty aspect of this is, you can’t take a short period of time to try to estimate a mean if there’s so much uncertainty. If you’re looking at something really noisy in this area, you need a lot of data to try to get a sense of where it would go. And you and I have worked together putting long term data together. You more than me, of course. Since my data only goes back a hundred years or so, and you have studied markets over many centuries.