Podcast Transcript - Russell Napier



Vera German
Fund Manager, Equity Value

Intro: Hi, everyone. We have a fantastic guest this week. Professor Russell Napier is an author, consultant, investor and the founder of the Library of Mistakes in Edinburgh. You may be familiar with his most recent book, The Asian Financial Crisis – Birth of the Age of Debt, which came out in July. Here Vera German is joined by Schroders colleague Tom Dykes to chat with Russell about the use of journaling and diary-keeping as part of a decision-making process, how people can respond to episodes such as the Asian Financial Crisis in the late 1990s, which Russell experienced first-hand while living in Hong Kong, and how people can become a little bit better at taking a step back and making better macroeconomic predictions. Enjoy ...

VG: Hi, Russell. Welcome to The Value Perspective podcast. We are so happy that you have joined us. Would you mind introducing yourself briefly?

RN: Yes, sure. I have been involved in financial markets since 1989, when I started as a fund manager, but really, from the mid-1990s, I have been writing about financial markets for institutional investors – and talking to institutional investors since 1995, about where they should be investing all over the world. I run a course in finance called ‘The practical history of financial markets’, which I have been running since 2004.

I have written two books on financial history and financial markets – Anatomy of the Bear and The Asian Financial Crisis. And I run a library – I am also a librarian. I am the keeper of the Library of Mistakes in Edinburgh, which has branches in Puna in India and, as of last week, Lausanne near Geneva. And our motto is ‘Changing the world, one mistake at a time’ – and that is what we can do over the next hour.

VG: Let’s start with the first question. You are a strong advocate of keeping an investment diary. Why do you think this is a helpful instrument for improving one's decision making?

RN: It is to help us remember – because we are very good at forgetting. We are very good at forgetting, not just because we have a bad memory, but because we like to change the past to suit the future. And quite often you have made a decision to buy something, and the facts start changing. And then you start changing the reasons why you actually bought the stock in the first place.

So, if it is written down on a bit of paper, it is much easier, obviously, just to go back and say, well, here are the three reasons I bought it and those three reasons have evaporated. Now I have made up three new reasons as to why I own it – and now I question that: why would I make up three new reasons? This is bad. This is dangerous. But unless I actually wrote them down, there is a tendency for the human brain to fool itself and think: this is the reason why I bought the stock. So you have to write it down. You have to think about it.

Also, it is your institutional memory. Sometimes you make a mistake – it would be nice to know why you made a mistake. Sometimes you get it spectacularly right – imagine a world where you kept getting things right but you did not know why you had got things right. So that is the way you begin to work out how good you are or how bad you are – and, probably most importantly of all, how lucky you are. Because sometimes you buy a stock for three reasons and three other things happened and it goes up. It is tempting for all of us as human beings to believe we are now geniuses but, actually, you got lucky.

So if you are going to try as a human being to make a decision about anything, really, that involves the future, I think doing that is probably one of the most important first steps. I am not a fund manager – I write for institutional investors – so I have to do it and it is in the public domain. I would say that is not a good thing to do! Keep it private. Do not put it into the public domain. Keep this diary secret to yourself – it is to help you. And the problem of putting it in the public domain – as I know after 25 years of doing it – is you do find yourself maybe irrationally defending your opinions to the public audience. So do not put it out into the public because you find yourself in a corner sometimes defending it when you know you really should not be. And I am guilty of that – as everybody else is. So a diary, yes – but a private diary.

TD: And you obviously have a lot of experience – do you find yourself revisiting particular decisions you have made in the past in the diary more frequently than others?

RN: Yes. I have a very public diary of everything I have written. I would say that, when you see something happening in a market that looks like something you have seen before, you go back. And often, as I say, the brain throws you and it is not the same. But that is why I am lucky – because I have written it up. So I can then go back and look at it and see if it is the same or not.

And the important thing about markets is they do not deal with the present and they do not deal with the past – they deal with the future. And one of the reasons I have focused on the various projects I have focused on is to try and get a snapshot of contemporaneous opinion. So if I go back three years or five years ... if I go back to a period when inflation was rising, for instance, which is where we are today, what do people think about the future?

Now, we all know what happened – but what did people think about the future? And why were they wrong? Because that is what was reflected in markets. It was not present – it was people’s expectations about the future. So I go back and I look and I say, well, last time this happened, what did people think and why were they wrong? And I try to learn from their mistakes – and my own mistakes as well.

But that is not covered very well in financial history. It is not covered well in research – because we go back and we report what happened. And we do not report what people thought would happen. And, if you have been in the markets a long time, they are obviously radically different. So the argument of my first book, Anatomy of the Bear, is you can learn more from these mistakes than you can from successes. So that is a good thing about having this record – you revisit something that looks the same and then you try to say what did people think that meant, and why were they wrong?

VG: There are lots of interesting things to pick up on here but you mentioned you think people learn more from mistakes than from successes. One of your projects is the Library of Mistakes in Edinburgh. Could you tell us a little bit more about that – how that idea came about and what you hope you can achieve with it?

RN: Sure. I could probably fill an entire library with books about Warren Buffett and yet there is only one Warren Buffett. The point is, he may be a brilliant investor and I may read all the books, but that does not make me Warren Buffett. So it must be quite difficult to learn from success – otherwise, we would just be doing what Warren Buffett did or other investors. So I think it is easier to learn from mistakes.

I remember going to a presentation by a chap called Peter Burwash, who had been a very famous tennis player. And he explained that the secret of amateur tennis – and I have never played tennis – is to get the ball over the net. That is the secret. And then the other guy makes a mistake. So all you have got to do is not make the mistake – just get the ball over the net.

And I think that is true in investing: you will always make mistakes. But reducing your mistakes is much easier than becoming an investment genius. So the Library of Mistakes is more than a library of mistakes, actually – it is a little bit of a marketing name for a business and financial history library. So it is also full of successes as well as mistakes, ironically.

But the reason for it – and it is something I started back in 2004 with a course I launched – is to try and get financial history onto the agenda for anybody who wants to do investment, whether they be professionals or amateurs – you really do need to understand the past. Now, I think it is coming a little bit more into vogue – it has been completely out of vogue.

As you know, there are people who think the equation can tell us the future to two decimal places. I sometimes envy these people for the certainty they have about the future. It is not a certainty I share. The word has paid, in my opinion, a heavy price for being full of people who can forecast the future to two decimal places.

The reason it is coming back into vogue a little bit – as I think everybody who is listening to this realises – is that, if you are going to forecast the future, you had better be forecasting politics. And you had better be forecasting sociology. That is not what economists do – you know, those are not forces that they necessarily understand very well. Those are not forces they want to understand very well.

But if one looks back in financial history, one sees how politics plays a role in financial markets. One sees how sociology plays a role ... psychology too. So the way I like to put it is that modern economics is a distillation. I live in Scotland and when you distil – we all know what the end product of distillation is! – but you throw away a lot of stuff as well. And modern economics has thrown away a lot of stuff that, more and more every day, we come to realise is really very important if you are going to forecast financial markets. How on earth do you forecast the financial future of China without understanding the Chinese Communist Party and Xi Jinping? I have no idea how you would do that. But if you have the right equations, apparently you can. So the whole point of the Library of Mistakes is to get financial history back onto the agenda for anybody seeking to understand financial markets.

TD: In some of your books you have written about the behavioural aspects of standing apart from the investment crowd. You also have some very forthright views on some aspects of macroeconomy. As your career has gone on, have you found it easier to take positions that are different from consensus or widely held views?

RN: The obvious answer would be ‘yes’ because you can afford it, as you get older and you are not as frightened of losing your job. But, to be fair, I had very forthright views when I was 25 as well. So maybe it is just something in the air – the further north in Britain you go  ... a Northerner says what he likes and likes what he says and maybe that pervades a little bit more in the north of Britain.

So it is not a problem I ever had but I think it is easier as you get older to have more forthright views. I always get this quote wrong. It was Upton Sinclair, I think, who said: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” And sometimes that is a problem for all of us but it is something we all have to struggle to get past – the institutional herd. Or the ‘electronic herd’, as I think they call it these days. Why do wildebeest run in a herd? We all know why they run in a herd because if you are outside, you can get killed. So humans are, in many ways, not different from wildebeest. And there is safety if you are running with the herd. And it is also a bit boring.

VG: We discussed the habit of keeping an investment diary at the beginning and one thing it has allowed you to do is to write a book, recently published, on the Asian financial crisis. You used your diaries as a foundation for the book and then reflected upon them and reflected on what you thought and the wider financial community thought about the crisis. Could you tell us a little bit more about the book and perhaps why you decided to write it now?

RN: That will be a very long answer so we will try and split it into three pieces. The advantage of the stuff I wrote at the time is it was trying to guess the future. So that is not history, per se – it is the history of thought about the future. It is quite different and, I think, really fascinating and interesting and not enough of has been done. And you do not need my diaries to do it because we have the press. So anybody can do it.

You can sit down and say, what were people thinking in 1987? Pick up the front page of the Wall Street Journal and you will get exactly the consensus opinion from 1987. And then, with the benefit of hindsight, we will know why it is wrong. And that gap between forecast and reality is something we can all learn about but it is not really being written about. So just on this occasion – because I had written another book where I did go back and use the Wall Street Journal – I use my own diaries.

Now, those diaries also reflected the consensus because I was walking into a room to see investment managers and saying, here is why the consensus is wrong. So I was able to have the consensus from that as well. So I thought it was good source material to look at that. So the whole of war and the whole of life is knowing what is on the other side of the hill, said Wellington.

VG: You are full of good quotes today!

RN: Well, Wellington was also full of good quotes. And that game of guessing what is on the other side of the hill is not something that is really widely written about – in terms of analysing where it went right and wrong in the past – and yet, it is what we do every day. So it was good base material to do that.

Secondly, this was a huge culture clash. People will see this as a book about the financial markets. Well, it was a manifestation in financial markets – also of a massive clash of cultures between a form of capitalism, which was newly invigorated coming out of America primarily, but actually not the old laissez-faire capitalism we all thought it was.

Initially it was that but it was then armed with huge amounts of debt and leverage and financial engineering, which I do not think is exactly what Adam Smith had in mind when he first defined capitalism. So it was a new type and it ran straight into North Asia.

And even before the Asian crisis, it had been battling with Japan, which is a very different type of capitalism – social capitalism. South Korea believes in social capitalism. And then, of course, we had the rise of China. And China – at least the bit run by the state – clearly believes in social capitalism and the two came head-to-head in 1997 and fought it out. And everybody at the time – and there was great triumphalism – thought that this laissez-faire ... what I call ‘financial capitalism’ ... it is a very bad phrase for it, actually, but ‘highly geared capitalism’ – everybody thought it had won.

And I wrote at the time that it had not won and maybe we will get on to this later. But, actually, the way the rest of the world is going now – the developed world – it is quite clear that North Asia has won, and we are becoming more like them. They are not going to become more like us – we are going to become more like them.

So I thought it was time to write this book to say, the great background for everything we have seen in financial markets, actually, is a great battle between these two forms of, well, I call them capitalism, but it is really society – how you organise a society – and that rages on and will be incredibly important for the next 20 or 30 years.

I did say it would be a long answer and there is a third part to this. And I believe that what happened in that Asian crisis set the scene for the next 20 years in terms of the massive amounts of debt that have accumulated. They devalued the currencies. They would not let the currencies go back up again. They exported very cheaply. That kept interest rates down in the developed world. That allowed everybody to borrow very cheaply. It terrified the central bankers in the west of deflation – so any time inflation went north, they would cut rates and print more money. And it was the foundations for where we are today.

And where we are today is the highest level of debt-to-GDP ever recorded in the history of the world. So something pretty spectacular happened about 30 years ago. Maybe I am wrong that this was it – but something happened to get us where we are today and that level of debt-to-GDP will determine our entire future. So those are three reasons why I wrote a book about the Asian financial crisis.

TD: The point of studying financial history is to take the lessons of the past and apply them to the future. And if you go back to the COVID-19 pandemic, about a year and a half ago, there was a lot of concern about the economic position in places like Southeast Asia and East Asia. And they have come out of the crisis having really supported their position in the global economy. Does that make you feel like the lessons of the financial crisis in the late 1990s have been learnt in some way?

RN: It is really fascinating to look at the history of debt crises because people who go through one tend to learn that lesson for quite a long period of time. And if you look at the balance sheets of Asia, in particular, they are in much, much better condition than those of the developed world. And it was a long time ago but, to some extent, the shadow of that crisis has pervaded and has capped debt levels – and particularly foreign currency debt levels, which are a bigger problem when you have them.

So I think they have run better balance sheets. And certainly, if we look at that number of debt-to-GDP – and I throw out this number that we are at a record all-time high – well, we are not in Asia. We are in China –probably. We are in Japan. We are up in North Asia. But in the other bits of Asia, actually, these debt-to-GDP levels are quite low and limited. So it looks like they learned the lesson. In fact, it is interesting ... if you look at the countries that have the highest and most dangerous private sector debt service ratios – and what that means is where the highest proportion of private sector income is servicing debt – it is China and France.

It is fascinating. Everybody just thinks it is going to be the emerging markets. But it is China and France. And these are countries that did not really have huge crises before – and that seems to be the lesson. If you have a big crisis, you do learn a lesson. But if you do not, then you are setting yourself up for more debt. So we have redistributed the debt problem. It is not as bad in America as people think it is. But it is bad in France and China.

But, as you so rightly say, there was flexibility in Asia, because they did not have very high debt levels. And they have used that flexibility – and I think they will attract a lot of capital because of that. I think people will see them as more attractive than the developed world now, because they have much better balance sheets. And it is not going to force them into some of the extreme policies we are going to witness and live through in the developed world.

I am glad you have read the book and you are still smiling! A friend of mine who was with me in Asia at the time and is a well-known fund manager, he read it and I said, what did you think of it? He said, it is like reliving a plane crash. So, Tom, you were lucky not to be there the first time – it was probably was not quite as traumatic for you to read it as it is for my friends who experienced it and are now reliving it in flashback.

TD: It sounds from that that, potentially, China is the area we should be looking at as the subject for a future Russell Napier book. At the present time, do you have a view to how China might seek to resolve the growing debt crisis it has?

RN: Absolutely. So what is the lesson from that period? You have read the book so you know it begins in Southeast Asia on 2 July [1997] with a devaluation of the [Thai] baht? Now, as an analyst who had got some sort of recognition for getting that right, let me tell you the bit I got wrong. We were looking at Taiwan and saying, we do not have to worry that this spreads to Taiwan – Taiwan had a current account surplus, which I think was 2.5% of GDP and it had some of the biggest foreign exchange reserves in the world.

So you just think, well, there is a rock-solid balance sheet – there is nothing that country is going to be affected by. This is fine. So that was true for July and it was true for August and it was true for September – and then the new Taiwanese dollar devalued by 14% in October and there was just complete shock. What on earth is going on? Why did they do that?

And this is germane for China because you can see the parallel. China has a current account surplus. China has the biggest foreign exchange reserves in the world. Most people just look at that and say, well, that is a currency that is not going to move. So why did Taiwan do that? And the answer is there was enough capital leaving Taiwan – in that case, it was the inability to roll over short-term dollar debt that was impacting that – that it sent interest rates higher.

Bottom line: they were trying to defend the exchange rate as capital was leaving and that sends your interest rates higher – and people of a certain vintage will remember the UK being in that position as well in 1992. And that is the way it works. So going back to China, my opinion – and it has been an opinion long before COVID – is China is running far too tight a monetary policy.

That is now manifesting itself in its property market – and, let’s face it, we have seen this story before. And we have also seen the answer before. How does China fix it? You slash interest rates and you print money. Now the question is, is that compatible with a stable exchange rate? Remember, China – like Asia back in the 1990s – is managing its exchange rate. It is not a free float. So, in my opinion, the answer is a flexible exchange rate.

So what now is on the front page of the newspapers is a property crisis – as it was in Thailand in 1996: “This is a property crisis.” It is not a property crisis. It is an exchange rate ... I do not want to use the word ‘crisis’ because there is nothing wrong with letting your currency float. But the ultimate end goal here for Xi Jinping is lower interest rates, print money and you need a flexible exchange rate to do it.

TD: The conventional thought would be that would lead to a deflationary depreciation environment for China. How does that align to your view that the world will be looking for financial repression built on inflation and low interest rates outside of China, if you have, effectively, a deflationary force coming in from East Asia?

RN: There is no doubt the markets would initially move to price in deflation for a very good reason – because they will have read my book and they will know that is what happened the last time. That is what happened in 1994 – it not only produced very cheap products coming out of China, it kind of bankrupted lots of their competitors. So it would be obvious that the first step the market would take would be to say, this is going to be highly deflationary as China will be selling lots of products a lot more cheaply in in dollar terms.

So let me tell you why they are wrong. The first thing that has to be said about China’s devaluation is it was against the background of the mass mobilisation of resources – and I think we can honestly say the biggest in history. I mean, the only competitor is America after the Civil War, when the railroads went into the interior. And that was mobilising people because it was dragging them across the Atlantic and it was accessing new lands and new productive lands. But there has been nothing like this thing that happened in China. So one of the reasons was not just the exchange rate – it was also the mass mobilisation of what people call Chinese peasants but I prefer to call ‘farmers’. It sounds less derisory. So that is over – it is done. You are not going to do that again. That was done once.

But the most important reason it is not deflationary is because of tariffs. The world cannot live with China devaluing its exchange rate if the result is selling goods much, much, much more cheaply – they just simply could not cope with that, given where we are in the global economic recovery, given where we are with inequality of wealth, etc, etc.

So if the response to China’s float – I prefer float to devaluation – if it is beginning to become lower Chinese product prices, then it will be hit with tariffs. And then finally, remember – the reason he is doing this is to inflate away debt. So, ultimately, it means much higher levels of inflation in China itself. So finally, I think, it also triggers a massive capital expenditure boom in the West because we are going to have to build a lot of the stuff that was previously built in China.

So that is a combination of reasons. You know, the easiest thing in the world is to go back into financial history and say, China devalued last time, therefore, it means deflation next time. But I think the reason and the way we use financial history is to understand mechanisms – that is what we have to do. And there was a very different mechanism in place back then. And nobody cared about China – it was a tiny economy. It turned out they should have cared about China, because it was growing very quickly. But things are very different now.

TD: Does that mean, in your role as a financial historian, you are increasingly interested in political relationships and how they might determine the pace and future of globalisation? And what does that mean for how you think about those political realities in various countries?

RN: Absolutely. So my career has been marked by, if you like, governments stepping away and letting markets determine prices. And that was launched by Thatcher and Reagan, it spread to Europe, and even the British Labour Party, as New Labour, were endorsing it. And we have already been stepping away from that for some time now.

Now, almost nobody is educated in what that means. Because certainly, if you have been to business school or studied economics, they do not talk about it. They talk about how economics works in a free market. But how does it work in a non-free market? Maybe we could ask the head of the IMF because she was educated in Bulgaria, at the Karl Marx University, so maybe she might understand how it works.

Anyway, the point is – we do know how it works because the history books are full of how non-market systems work. And I do not mean by that a communist society – I mean, the type of financial system we had after World War Two, where politicians decided to tell us the right prices of short-term rates, long-term interest rates. But we had price controls, we had wage controls, we had credit controls, we had capital controls. You know, it is hard for people who have been brought up in the current system to imagine that we can go back to that system and what it looks like but, ultimately, that is why politicians are important.

And I associate the word ‘politician’ with the word ‘control’ – and we are going to see a lot more controls coming in. So you have to understand the nature of what drives politicians. Now, it is not ideology, it is pragmatism – debts have to be inflated away and the market system has, let’s just say, not been very good at that, because the debt-to-GDP ratio was soaring up, so there will be active means to do this.

You raise the subject of globalisation – and that is important in terms of this wealth-inequality issue – but I think it is much, much bigger than that. It is where we are in the continuum – if one extreme is a laissez-faire market economy and the other extreme is a command economy, we are moving from the market economy towards the command economy. Not ‘to’ it, but ‘towards’ it. And that is 100% about politics. And if all your economics is based on market economics, and you want to invest money based on that, then I will be choosing a different fund manager.

VG: One of the slightly depressing themes I am hearing is you have to live through the lesson in order to learn it. What is it about the human brain that makes us so bad at learning lessons we have not experienced ourselves?

RN: Well, that is a great question. Obviously, given that I am here talking about the value of financial history, I think you can learn something from it! Living through that plane crash itself is pretty visceral and, as you know, they are different bits of the brain. There is kind of ‘part one’ and ‘part two’, if you are ‘thinking fast and slow’, like [Daniel] Kahneman – and I think it is something about learning how to control that other part of the brain.

If you have actually been through it, the instinctive part of the brain kind of takes over and kicks in. And I am no expert on this but I think that is why it matters – because it helps you get a better balance between those two parts. Whereas if you just read about it in a book, you are kind of quite cerebral and that is a cerebral process.

And then, when you live through it, there is this other part of the brain, which is really kicking in – and knowing how to control that, knowing what it is telling you ... maybe you have to go through that in real life. I do not recommend going through it in real life, if you can avoid it! It is not pleasant, but I think that is why. I think if you ask that question and then we all go back and read Thinking Fast and Slow by Daniel Kahneman, we might get a pretty good idea why living it has a different impact than reading about it.

VG: One other thing I can extrapolate from that is we are very bad at forecasting major events in general, which is funny because many industries are dedicated to nothing but that. So what makes us so bad at predicting and how can we develop a toolkit that can help us do so both in our professional and our personal lives?

RN: So when I arrived in Hong Kong in 1995 to do my job as a strategist, I was 30 years old. So I was advising global institutions where to put their money at the age of 30, which is a bit bizarre. But anyway, I printed out and put on the notice board behind my head – so that anybody who walked into my office saw right above my head – a big note that said ‘No extrapolation allowed’.

And everybody who sat in my office extrapolated! I also tended to extrapolate and there is something in the human mind that likes extrapolation – because we like certainty. So we have to remember this – that the human brain craves certainty. And some of the greatest disasters – not just in finance, but in politics – have been people craving certainty. If you want to be a very successful politician – and potentially a very dangerous politician – you find a world that is incredibly uncertain and you promise people certainty. And they will do anything for you after that. And that is the greatest disaster of the last 100 years – people doing that.

So I think it is because the human brain craves certainty. And if I say to you, there is an event going to come up and it is going to create mass uncertainty, you tend not to want to believe that. And the greatest certainty is in believing what everybody else believes. So, as we all crave certainty, I think we try to avoid these things.

The other thing is, in our business in particular, we are all brought up to believe in markets and discounting. And markets may be pretty good at discounting future supply and demand but my experience is they are pretty useless at discounting politics. So a lot of the great big changes we are talking about here are political changes and people in markets have not been very good at it.

And it is a very difficult thing because, if it is only a 2% chance that something might happen, but it would have a profound global chaotic influence. you are tempted to say, well, it is only 2%.

VG: Because you do not want to be the bearer of bad news.

RN: You do not want to be the person in the room who is making that call – even though the consequences are so dire. And, also, it is incredibly difficult to be right on the call because it is a political call. All your colleagues will be saying, but supply and demand are here. And you will be saying, but the politicians are over here and your colleagues will say, well, we do supply and demand.

So that is a brief reason to do with human thinking and it is fear of uncertainty. But there is also how decision-making happens, particularly in the investment management industry – who wants to be the one person forecasting something where there is only a 2% chance it happens, but the consequences of it happening are incredibly dire? So we tend to push that to the side and say, well, it might happen. But if it happens, there is nothing I can do about it anyway so I do not want to be the person to forecast it. So I suppose, thinking about my career, I have been the person forecasting the 2% chances and chaos – and most of them have come right. But I would say that none of them have come right in a timely fashion.

If you were in the privileged position of taking a young Russell Napier aside in the mid-1990s, as he turned up in Hong Kong, what advice would you give yourself about the situation you were stepping into and what you should focus on, in order to understand the route forward?

RN: The biggest mistake I made was not ... we in our business are in silos and I do not think it has really improved very much. So there are the equity guys and the debt guys and the commodity guys and they do not really talk to each other. In my case, I was working for what was then called Credit Lyonnais – a big French bank. The big French bank was all over Asia and I was sitting in a little equity broking subsidiary of it, writing about equities, and I never really spent any time talking to the guys in the bank. Had I done that, I would have realised that they and every other European bank and every other American bank were lending dollars all over the place. But we did not know – I mean, we really did not know. I am not sure how the companies hid that on their balance sheets but they did. The analysts did not know.

So one of the biggest things I have learned in finance is ‘get out of the silo’ – you know, go and speak to people in direct investment; go and speak to bankers. This is a great big financial system. And if you are buying equity, in particular, every single bit of that connects somewhere into the equity nexus – and yet we tend to ignore that.

Now, if we sat here for 10 minutes, we could come up with 30 or 40, places where you could get really good information about equities – but we tend not to do that. So being a bit more Catholic in my tastes and looking at a broader range of factors rather than being in the equity ghetto – and, sad to say, I think the equity ghetto persists. Not everywhere, of course – I am sure Schroders is different – but that is the key lesson: you have got to think about this more widely.

And I was not thinking that much about the politics either – and, for a country like Indonesia, it turned out that the politics were essential. For a country like Malaysia, it turned out the politics were essential. So ‘Get out of the equity ghetto’ is what I would have said to myself, and maybe I would have made some of these connections a bit earlier.

TD: You currently live in Edinburgh, but you have had a career that is predominantly focused in Asia – do you think that geographical distance between the two is an advantage?

RN: I think it probably is – and the most important thing we have to do is have a long-term time horizon. Now, that is such a trite observation yet – who does it? Who could actually do it? And the closer you are to the centre of things, the more difficult it is to have a long-term time horizon. So hopefully, by being stuck in the middle of the Scottish countryside, my time horizon is at least a week longer than everybody else’s!

And I do not claim it is really, really long but, to me ... there are lots of problems with the current financial system, but one of them actually is the one that nobody talks about – which is there is far too much liquidity, which allows some fund managers to change their mind a lot. And changing your mind a lot is not a good thing. So I am not a fund manager – I am in the Scottish countryside and, for some reason, I do not change my mind very much. And not looking at Bloomberg helps. I have to admit, I find myself drawn to it as well – but not checking your portfolio every now and then would be a useful thing to do.

So, lengthening your time horizons is the most important thing anybody can do – whether they are a retail or a professional investor – but easier said than done. But it may help, the further you get away from the buzz. Here we are sitting in the middle of the City of London – the buzz of the City of London – the further you get away from it, I think it helps a bit. But let’s not get carried away and say that everybody north of the border has a long-term time horizon because that certainly is not true. But it probably helps a little bit.

VG: One way people try to become more comfortable with the risk is by quantifying it – and I guess we see that in politics and in investment. Risk is difficult to put a number on because it is always subjective but do you agree it is always something worth trying?

It is really important because what you are doing there is you are creating a range of outcomes, and you are trying to risk-weight a range of outcomes. I think it might help that you are a woman as well – you might find it easier to do that. Men like to say – this is what is going to happen ... I know what is going to happen ... this is what we are going to do ... I have this great certainty. And it is much better to do scenario analysis and risk-weight things.

And I am going to try and get this quote, right. “Not everything that can be counted counts. And not everything that counts can be counted.” And that is a quote attributed to Einstein – but he never said it. I mean, I wish I was like Einstein, because some of the smartest things ever said are attributed to Einstein even though he never said them.

But you hit the nail on the head there. Not everything that can be counted counts. But we live in a world – in our world anyway – where everybody loves to count things. And as soon as you have counted it, you say, well, now it must be important because I can count it. And, meanwhile, there is all this stuff going on that cannot be counted – in sociology, in psychology, even I would say in philosophy – but because you cannot count it, people think it does not count.

So your risk-weighting approach – to the extent you are bringing in these other factors – is important. We should all be doing it and it gives you this wide range – spray of possibilities. At least you know what the range of possibilities is whereas, if you are forecasting to two decimal points, you really do not admit to any other possibilities beyond your own [forecast].

I do a lecture on ‘21 lessons from financial history’ and the final lesson is ‘Never trust a forecast with a decimal point – particularly your own’. Because if it is your own, then you are fooling yourself and that is even more dangerous than some stockbroker trying to fool you with a decimal point. So abolishing the decimal point, I think, could be a good thing in fund management.

TD: Russell, you mentioned the course you run called ‘The practical history of financial markets’, which is something we have sent many of the members of our emerging markets team. What have you learned from that course over the period of providing it?

RN: Right – have we got another 90 minutes! So the good thing about that course is I do not teach it – I mean, I teach a little bit at the end of it. And why that is good is I get to listen. So the greatest bane of my life is talking actually because, if you think about it, one of the few times when you cannot learn anything is when you are talking – it is only when you are listening.

So I have worked with some really brilliant people since 2004, when we launched that course. And let me just do a slight plug for that course – it has only ever been available in person but, within a month, we will launch a fully online digital video version of that course. So anybody who wants to find it, puts my name and the word ‘course’ into Google and they will find the website. We are not ready to launch that yet but it will launch so anybody can take it. Over 1,000 fund managers have taken it. Not very many retail investors have taken it but some have and tell me it is very digestible. So now that the plug for the course is over ... I should say it is owned by a charity by the way so I am not plugging it to you for personal gain!

I find it difficult to answer your question because there is just so much but, in my particular bit, what particularly interests me is the subject of liquidity. So, as I said, we actually have many bits of this and, the first time we did that, it was taught by Gordon Pepper and Gordon retired and it is now taught by John Greenwood – and some people listening to this will know both those names. They are very famous in that area.

So I would say the most important thing I have learned, over the now 16 or 17 years we have been teaching it, is the importance of bank credit. If I walk into a room and talk to fund managers for seven hours about the future, almost none of them will mention bank credit. They do not think it is important.

For those listening who want to understand why it is important, there is a nice little article on the Bank of England website, which explains that around 80% of all the sterling in the world was created by commercial banks – not by the Bank of England, but by the commercial banking system. So the commercial banking system is crucial in creating money – and, in creating money, it is in crucial in creating growth and it is crucial in creating inflation. And, to me, it is the wellspring of many of the key variables we all need to look at – and yet virtually nobody looks at it. It is one of the reasons I am more on the inflation side of the argument now – because bank credit growth has sprung into life, prodded by the government, it has to be said. And I think there will be lots more carrots and sticks for the banking system from the government.

So if I had to pick just one thing, it is getting a better grip on how banks create money. What happens to that money? What happens when banks do not create money? And the reason I flag it up is I still think most professional – even successful – fund managers still do not get it and still do not realise why the world just changed. I think the governments are effectively running the commercial banks. If that is true, the governments run monetary policy and the central bankers are impotent.

Well, if I am right, Bloomberg is wrong – because the top seven stories on Bloomberg every day will be about the central bankers. And if they are truly impotent, then why would you bother? So that has been an important story, I think, throughout the course. But I think it is even more important now if the governments really are – through a series of sticks and carrots – controlling the growth of bank credit. So I would say that is the most important one but you have to come on the course to find out what all the other important ones are.

TD: And how does that influence the view you take on situations like Japan where there was a concerted effort to try and get inflation and not much of a result? How do you look at that situation from a monetary perspective?

RN: Yes, I think that is a fascinating example because most people will attribute the lack of inflation in Japan to demographics. And this is really important because, as you know, the rest of the world is kind of following in the demographic trends of Japan. Therefore it is one of those things where [people think], well, if Japan did not have inflation because of its demographics, then neither will the rest of the world.

But, in my opinion, the reason Japan did not have inflation is it did not create any yen – that is pretty easy. And the reason it did not create any yen is the banks ... from, I think, 1997 to about 2013, there was zero growth in bank credit. There was none – partially because it was coming out of a massively overleveraged bubble and people were paying back their debt. So there was virtually no growth in the supply of yen – and, if you do not increase the supply of money, you are probably not going to get any inflation.

Now, that was beginning to change on a market basis from 2013 and it has picked up dramatically during COVID – which it has across the entire planet. So I think the Japanese will also get the message that, if you want to create inflation, you need the commercial banks to create money, not just the central bank to try to create money. And, yes, it is a particularly important lesson that we learn from Japan.

And this is all very out-of-favour analysis, as you probably know – monetary analysis is not in favour because it has not been very useful for quite a long period of time, because broad money growth was so low. But with it having boomed during COVID – and I think [with it set] to boom again under government-directed finance – then Japan will have inflation. Now, I do not know if I am allowed to make forecasts about financial markets on this podcast but, if it is true inflation comes back to Japan, the Japanese equity market should do exceptionally well.

VG: One other topic you raise in your book – and we have touched upon in this podcast – is incentives and how certain human behaviour is very easily explained when you look at the incentives that have been put in place. In terms of the topics we have discussed, such as the difficulty of forecasting and people not using scenario analysis enough, what kind of incentives do you think can be put in place to encourage the ‘right’ type of behaviour?

RN: So I steal this from Charlie Munger, of course, who is the world’s smartest lawyer. “Show me the incentives and I’ll show you the outcome” – that is the Munger quote. To me, it is the most important thing, I think. We are not just talking about finance here – if you walk into a room and sit down with anybody, ask yourself what the other person’s incentive is, before you have your first sip of coffee. And it will fundamentally change I think, how you take that meeting.

So the incentives in finance are wrong – full stop. Obviously, I am partly here as an evangelist for financial history – do I believe that, if everybody was correctly educated in financial history, they would all be much better fund managers? Well, yes – but only if the incentives were right. It would really make no difference, if the incentives were still wrong. It does not matter how smart you are – if your incentives are wrong, you are going to make stupid decisions

So we have to reorient the incentives and there are lots of ways you can do it – but it fundamentally has to be by lengthening the time horizon. It has got to be about lengthening the time horizon for decisions. You raise it in the context of scenario analysis – and you can do that too. But if you do not have a time horizon that is commensurate with your ability to be right – and we will differ about what that period is, but I think it is at least three years. It is at least three years – and anybody who can do it under three years is either an outlying genius or lucky. And there are not many outlying geniuses. So I suspect they are probably lucky.

Scenario analysis or however you do it – it has got to lengthen the time horizon. The incentives has got to be at least a three-year time horizon – and, if you are rewarding people in any way under the three-year time horizon, I think you are taking a big risk. So that is what I would do. Every other change in incentive is tinkering, unless you lengthen the time horizon – which I think is what value investors do, don’t you? You take a long-term view and you stick with it?

VG: We certainly try! Why are we so resistant to lengthening time horizons?

RN: That is a great question.

VG: It does not seem like the worst thing in the world when you are describing it but we seem to have a lot of reluctance to adopt that.

RN: Particularly the financial services industry – you know, there are other businesses that have a much better record in taking longer-term time horizons. To be cynical about it, why has the inbuilt status quo not changed more quickly? Because someone is benefiting from it, is the cynical answer. And we keep going through all these crises and I keep thinking, well, now we will change – now we will lengthen the time horizons. You know, the disastrous implications of short-term time horizons are so clear that now we will lengthen the time horizon, but we never do.

So there has got to be a great and – I assume – a financial incentive not to do it. I always remember [Alan] Greenspan going to Congress, after the financial crash, to say that his faith in his model had been destroyed, because it was based on the economic self-interest of everybody who was lending. And it was in their economic self-interest only lend to people who would pay back. And this was the whole faith of his economic model.

He had never heard of the securitisation of debt, clearly – you know, they may have been lending but then they sold the exposure to somebody else. So their incentive was not to lend money to people who would pay them back – their incentive was to create something that could be sold for a higher price. So let’s lengthen the incentive. I think that will do 90% of the work. But I am losing faith in the ability of the financial system to do that proactively. And the reason is, probably, everybody makes too much money by not doing that.

TD: I was going to ask how much you thought it was an innate human characteristic to avoid short-term pain – no matter what the long-term gain you might get from the decision you make today is.

RN: I think that is true. But you can work out an incentive system to cope with. Look, a lot of what we are doing is trying to compensate for our own fallibility. Only the Pope is infallible – the rest of us just have to get on with it. So how do you compensate for human fallibility? Incentives? Can we do better incentives if we have to? Yes. Will we become infallible? No. Can we become less infallible? Yeah.

VG: One way of becoming less fallible, in my personal view, is by reading a lot. And one of our signature questions that we ask all our guests is to give us a book recommendation that you have read – or written! – that you think our audience could benefit from.

RN: This is like Desert Island Discs! The one I always recommend is Triumph of the Optimists – and I do not see how you can invest without reading Triumph of the Optimists. For those of you who do not know, it sounds like the world’s most boring book because it basically takes all the return data for equities, bonds and bills – bills are basically cash – from 1900. Sadly, the book is a bit out-of-date now – it is from 2000 – but it is 100 years of return data for ... I think, at that stage, they had 16 markets.

Sadly, the data is not owned by academics anymore. It is not easy to get hold of – but at least there is 100 years of that data. And they call it Triumph of the Optimists, which I think is a great title though I would like to call it ‘The Art of the Possible’. And it is interesting when you speak to even professional managers and ask, what is the long-term return from equities? They are quite often way out. And certainly members of the public are usually far too optimistic – depending on where we are in the cycle. Obviously, in March 2009, the public thought the return from equities was terrible and, in a bull market, they think it is 20% per annum.

But this tells you what is possible – and that is really, really important because let’s say I was a retail investor and somebody walked into the room and sold me an equity pot and said it is going to compound at 20% per annum. Well, yes, that sounds pretty good. And then I walk down the street to buy a car and ... I think we still make Skodas, don’t we? So let’s say there is a 1989 Skoda for sale and the guy says it will do nought to 100mph in four seconds and 500 miles to the gallon – I instantly know the man is a liar.

Instantly – because I am calibrated. I am calibrated to know automobiles cannot do that. But, in investment people are not calibrated. If you walk into a room and say, look, 20% per annum and no risk, [that sounds great] if you are not calibrated to the art of the possible. So Triumph of the Optimists is the essential read to calibrate. And if you are not calibrated, then you are susceptible ...

So every person who sells financial products will be destroying copies of Triumph of the Optimists to stop investors from reading it. So it just helps. It does not mean it can make you a great investor or anything but it is like an antidote to salespeople trying to sell you stuff – to say, well, wait a minute, 20% per annum? When has that ever happened in history before? For any prolonged period of time?

And you know, there are some people who have done it – there are some very good investment people who have done it but these are the outliers. So I would go for Triumph of the Optimists and, if I am allowed a second one, it is fiction: The Money Game by Adam Smith. I am sure many of the people who come on this podcast mention The Money Game by Adam Smith, but it is a thinly fictionalised account of the great equity bull market of the 1960s. And this is not Adam Smith, the rather dour bachelor economist from Fife – this is ‘Adam Smith’, whose actual real name was George Goodman. He was a very, very good financial journalist in America, who wrote under the pen name of Adam Smith – and is a much better writer than the real Adam Smith.

TD: Russell, just to wrap up, we always ask guests on this podcast to describe a bad decision they have experienced and the impact that has had.

RN: I sort of covered that one in being in the equity silo and not really knowing about all this level of debt in the system. But let me now quickly think of another one. So, in about 2012, having been pretty bullish since early 2009, I thought, well, you know what – this economic expansion is going to be weak, inflation is going to come down, we are probably going to head for deflation and that is all going to be bad for equities.

And that was a very bad mistake because it was basically all true – apart from the last bit. Growth was weak. Inflation peaked in 2011 – and actually, even in America, by 2015, it was negative. It was not negative by a lot but, by the end of 2015, it was negative. And if you had, in advance, shown me this chart of inflation, I would have said to you – sell equities. And I forecasted it and I said – sell equities. And, as you know, equities went up – they did not come down.

And the mistake was to believe the fall in inflation could only really be caused by something going wrong in an economy – that there would have to be something going wrong. And something going wrong would be bad for equities. But actually, it was not going wrong – things were going quite well. So I think that was one of the bigger mistakes I made – but it is a very good lesson for all of us in forecasting. And, once again, if you really want to get a grip on this, you have to read fiction, which is a book by John Buchan, who became Baron Tweedsmuir, called The Gap in the Curtain.

And The Gap in the Curtain is about a clairvoyant who takes people into a room and tells them exactly what is going to happen to them one year from now and, based on knowing what is going to happen to them one year from now, they all plan their future. And of course, they all make disastrous mistakes because, although it ends up in the right place, the route to that place is completely different from the route they imagined. They drew a straight line to that place and then based their life on the straight line. And, of course, the line to that was not straight.

So even if you can make the right macro forecasts, it is not absolutely crystal-clear that everything happens for the reasons you thought they were happening. So I have learned from that because I wrote a diary and, if you like, I wrote a piece of research that was wrong. So I think that is a pretty good example of being right on seven of the variables and being wrong on the conclusion.

TD: I suppose it just provides ammunition for future books, Russell.

VG: It has been a fascinating conversation. Thank you so much, Russell, for joining us.

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Vera German
Fund Manager, Equity Value


The Value Perspective
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