Appearing on a recent episode of Bloomberg’s Masters in Business podcast, Dimensional Co-CEO and Chief Investment Officer Gerard O’Reilly talked with host Barry Ritholtz about multifactor investing and volatility. In addition to providing what the host called a “master class in how to think about investing,” Gerard offered insights and advice from a career working with some of the brightest minds in finance.
Here are some of the highlights from their conversation, edited for space and clarity. To listen to the podcast, click here.
We’ve learned that when volatility increases, so does uncertainty. When there’s a market crisis, there is a lot more uncertainty about what the range of outcomes may be, and that uncertainty increases trading costs of stocks and bonds. Spikes in volatility are unpredictable, but once it spikes, volatility tends to decay slowly over the next three to six months unless there is another big shock that comes along to spike it back up.
In the previous decade, small cap stocks, non-US stocks, and emerging market stocks greatly outpaced US large cap stocks. Then, in the next decade, it flipped and US large cap stocks outpaced everyone else, in particular US large cap growth stocks. There’s an unexpected component to that, though. It is due to the success of some of those US firms that are now the largest firms in the US marketplace. That doesn’t mean they will continue to be the largest firms. What we’ve seen over time is that the largest firms tend to get there by outperforming everybody else. Then, in the one to five years after they become the largest firms, they tend to underperform everybody else. Other firms innovate and try to take that top spot.
The higher the profits, the more cash flows investors can expect to get from their investments. So it is telling you something about expected cash flows from that investment in the future. When you talk size, value, profitability, and investment, they are all telling you something about expected cash flows. Momentum is the outlier. There is no equally simple, compelling story that lets you know why you should expect firms that have outperformed the market in the past three to 12 months to continue outperforming the market in the next three to 12 months. But it is there, loud and clear, in the data. We must decide how to use that information with as low opportunity costs as possible. We don’t know why it is there, so we don’t know if it will be there in the future. And if it’s not there in the future, we don’t want to have incurred unnecessary costs on behalf of investors pursuing something that we don’t know why exists in the data.
I have always liked mathematics, and as an undergraduate in Ireland, I studied math and physics extensively. I saw that the California Institute of Technology did a lot in fluid dynamics and aeronautics. I didn’t have a specific set of career plans. I just knew that’s the subject I wanted to study.
I shifted to finance because I preferred to tackle something that had a very immediate impact on the end customer. I had never taken a finance course in my life, and I wanted to learn more about finance. A friend told me about Dimensional’s great academic connections and how the firm takes finance from a scientific perspective. I wanted to give that a shot, so I joined Dimensional straight out of college.
I started off with no background in finance and got to learn it from some of the most amazing minds in the field, including Ken French, Eugene Fama, Robert Merton, and Myron Scholes. It was a privilege.
I’d be remiss if I didn’t say my parents. They’re your ultimate mentors in terms of shaping how you approach problems, how you view the world, and what you prioritize. My parents have always emphasized education—the importance of keeping your mind active and trying to better yourself. That’s the spirit that is important for everybody to keep working toward for as long as they are on this planet. What else is there to do but try to improve your skills and how you interact with the world?
When I was first getting started, I didn’t understand markets that well. I had the view that all you had to do was come up with a better mathematical model than anybody else. I thought I’d be able to predict where prices were going to go. Of course, I was quickly disabused of that notion after having conversations with Ken French, Eugene Fama, and Robert Merton. I wish I had known that then, but now I certainly know it, and it has shaped how I view the power of markets and what good investment solutions are for clients.
When it comes to finance, remember that you are taking people’s life savings and trying to help them achieve their goals. That is a very, very meaningful responsibility. Don’t take it lightly. You are in a field that you can really help people have a better life, but you can also harm people if you do things the wrong way. Be a fiduciary, be prudent, and then you can really help people.
At Dimensional, we have a very academic view of how to interact with each other. We interact with respect, but we also challenge and argue the issues. No one defends an idea just because it was their idea. Instead, we embrace whichever idea is the best one because, ultimately, that is better for our clients. And when it comes to business, putting clients first allows the process of making decisions to be very straightforward.
Success is a combination of three things—luck, talent, and hard work—and they are probably all equally important at different stages.
Luck is about the things you have learned up until the point an opportunity arises, like when I found Dimensional and it was well suited to the way I thought about the world. Then there is talent—having the right skill set. It turned out, for me, that a quantitative and analytical type of skill set was very helpful for an organization like Dimensional and our clients. And then hard work—being willing to do whatever it takes to complete projects, to move the ball forward, to help your clients succeed.
When you have all three of those, good things can happen. I was fortunate that I had a little bit of each of those when I came to the Research department at Dimensional. When I came in 2004, we had about $50 billion in assets under management.1 That grew rapidly, so there were a lot of opportunities for those that were willing to step up. I consider myself fortunate, and I am very happy with how it has turned out.
I like books about markets, about how to organize people, and how to make the most efficient use of resources. One of my favorite books is Free to Choose by Milton and Rose Friedman. It’s a great book written many decades ago, but it is timeless. I also like The Road to Serfdom by F.A. Hayek. It is an all-time classic.
A couple of different shows have been keeping me entertained. One is a recommendation from our board member, Mac McQuown. It is a documentary series called The Prize. It’s about the history of oil—how it started, where it evolved to, and the various issues that have arisen. I’d recommend it to anybody who is interested in historical shows. I’ve also watched a lot of documentaries about war. I find those particularly interesting. The Fog of War is one of them.
I also watch If I Were an Animal on Netflix with my 6-year-old daughter. Another one that came out on Netflix that is hilarious is Old Enough. It is a Japanese show where they have little kids doing tasks by themselves and being followed by a camera crew. It’s really fun to watch.