Cliff Asness on How Markets Got Dumber in the Last 10 Years
Timestamps are as accurate as they can be but may be slightly off. We encourage you to listen to the full context.
Podcast Summary
In this episode of Odd Lots' 10-year anniversary celebration, Cliff Asness, co-founder and CIO of AQR Capital Management, discusses how markets have become increasingly irrational over the past decade. (05:06) Asness argues that markets are experiencing more frequent "bouts of crazy" than in previous decades, with price disconnections from fundamental values reaching extreme levels twice in his career - during the dot-com bubble and again during COVID.
- Core theme: Markets have become less efficient due to social media influence, passive investing growth, and the breakdown of independent decision-making that once enabled "wisdom of crowds" to function properly.
Speakers
Cliff Asness
Cliff Asness is the co-founder and Chief Investment Officer of AQR Capital Management, a quantitative investment firm launched in 1998. He studied under legendary economist Eugene Fama at the University of Chicago, where he wrote his dissertation on price momentum - an unconventional topic for a student of the efficient market hypothesis pioneer. Before founding AQR, Asness had a successful run at Goldman Sachs that enabled him to start his own billion-dollar hedge fund.
Key Takeaways
Markets Experience More Extreme Disconnects from Reality
Asness has observed that markets now experience wider spreads between cheap and expensive stocks than in historical periods. (10:26) His research shows that for 50 years, the spread between cheap and expensive stocks behaved predictably, but during the dot-com bubble, it reached unprecedented extremes. This pattern repeated and even exceeded those levels during COVID, reaching what he jokingly calls "the 125th percentile." These extreme disconnects create bigger opportunities for disciplined investors who can endure the pain, but they also make it exponentially harder to stick with rational investment strategies during extended periods of irrationality.
Length of Drawdowns Is More Painful Than Depth
One of the most psychologically challenging aspects of rational investing is enduring long periods of underperformance. (15:15) Asness explains that a drawdown lasting three years is "ridiculously harder to live through" than a larger drawdown lasting six months. This insight is crucial for understanding why even sophisticated investors abandon sound strategies. The emotional and business toll of explaining the same rational thesis to clients month after month, while markets continue to reward irrational behavior, creates immense pressure that pure magnitude of losses cannot capture.
Social Media Transforms Wisdom of Crowds into Madness of Mobs
The fundamental mechanism that historically made markets somewhat efficient - the wisdom of independent decision-makers - has been compromised by social media and increased connectivity. (34:54) Asness references the classic "Who Wants to Be a Millionaire" example where polling independent audience members worked because their wrong answers canceled out while correct answers aligned. However, when crowds become interconnected through social media, algorithms, and confirmation bias, independent thinking breaks down. This transformation from wisdom of crowds to "craziness of mobs" helps explain why markets now experience more frequent bouts of extreme disconnection from fundamental values.
AI Requires Surrendering Some Investment Intuition
As AQR has incorporated machine learning into their investment process, particularly for analyzing corporate communications and earnings calls, they've had to accept a trade-off between performance and interpretability. (40:01) While AI can better understand the context and meaning of corporate statements than simple word-counting algorithms, the internal workings of these models are often opaque. Asness admits this made him uncomfortable initially because their firm prided itself on understanding why their strategies worked, not just that they worked. However, the superior performance of AI-driven analysis has convinced him that some loss of intuition is acceptable if the results are demonstrably better.
Passive Investing Reduces Market Price Discovery
The growth of passive, market-cap weighted investing has contributed to market inefficiencies by reducing the number of participants actively analyzing prices. (28:28) While Asness supports passive investing for most retail investors and considers Jack Bogle a hero, he acknowledges a fundamental truth: not everyone can be passive. If 100% of investors simply bought market-cap weighted indices, no one would be determining whether individual companies are correctly valued relative to each other. As passive investing grows, fewer active participants remain to exploit mispricings, potentially allowing disconnects from fundamental values to persist longer and grow larger before being corrected.
Statistics & Facts
- AQR launched in August 1998 when the S&P was down 20% during the Russian debt crisis. (09:10) This context is important because it shows how AQR's market-neutral strategy initially appeared successful during a major market crash, only to face challenges during the subsequent tech bubble.
- For 50 years, the spread between cheap and expensive stocks behaved in a predictable range until late 1999-2000, when it went "way wider than anything ever seen for fifty plus years." (10:46) This historical context demonstrates how unprecedented recent market dislocations have been.
- AQR fell by approximately half over about three years during a difficult period, forcing the firm to shrink and let people go. (17:56) This statistic illustrates the real business consequences of sticking with rational investment principles during irrational market periods.
