DANIELLE DIMARTINO BOOTH: Well, hello. This is Danielle DiMartino Booth with Real Vision, and today we've got a real treat. We are bringing your Christopher Cole with Artemis Capital. We've been waiting for over two years for a follow-up to his seminal paper. It's out there. You have to read it. Share it with people-- maybe not people under 18. They wouldn't understand it. But everybody needs to get a copy of this and read it. We're going to discuss what it's all about today. Welcome.
CHRISTOPHER COLE: Thank you. It's a pleasure to be here and back on Real Vision again.
DANIELLE DIMARTINO BOOTH: So I'm going to start with an anecdote. Years ago, I was in Omaha, and I visited with Charlie Munger. And he made the comment to me that the entire pension fund advisory business one day would go out of business. It would go the way of the dodo bird because of the group think that surrounded the industry because of the way that the portfolios were being designed in a world where central banks were effectively running the show.
And he made the comment to me that he saw in the future, he said, I might not live to see, but you will, the death of the efficient frontier. So I'm curious about your thoughts on portfolio construction, how it's done, and how it that evolution has changed basically the way this entire generation approaches investing.
CHRISTOPHER COLE: Well, beginning with that and looking at what Munger has said, as a follow-up to my last letter, the Ouroboros letter that talked about the cycle of risk and how volatility has been used as both a proxy for risk and also as a source of return. I thought, how can I-- what will disrupt that-- what will disrupt that cycle? I posed a question to myself saying, well, if we're going to see what happens in the future, we have to look to the past, and the distant past, not just the recent past, not the last 10 years, not the last 40 years. We need to look back 100, 200 years to understand the cycle of capital creation and destruction.
And I posed this question to myself. I said, imagine that someone gives you generational wealth, enough money that you can live and your children's children can live at a high level. But it's subject to one question, one dynamic. You have to choose an asset allocation and stick with that allocation over 100 years. What allocation do you choose so that your children's children will have prosperity?
And taking that cue, I went back and looked at 90 years of historical data, backtested a wide range of popular financial engineering strategies, everything from risk parity, the traditional pension portfolio, short volatility, long volatility strategies, commodity trending strategies, and looked and how do these perform? And what asset allocation is the allocation that's going to provide wealth, not only consistently over 90 years, but through every generational cycle, through both periods of secular growth and secular decline?
And what I found surprised me, that echoing Munger's statement, the allocation that the majority of US pension systems and retirees are following, which approximately today is about 70% equity-linked products-- that could be everything from stocks to private equity, things that are the profit from secular growth-- and about 20% bonds. That portfolio has done incredibly well over the last 40 years. But when you look at that portfolio over 90 years, you see a very, very different reality. And that has a wide range of social, economic, and social ramifications that become quite startling.
But looking at that, I say, what asset allocation can I find that will actually provide protection over that 90 years consistently? And that answer came not from a macro view. It doesn't come from me having an opinion about whether or not we're going to go into a recession or whether or not there's going to be some continued economic prosperity. It comes simply by looking at data, using mathematics, looking at data, and looking at empirical data over a lifetime to come to that determination. And I think the results are quite shocking. And I think they run somewhat counter to the consensus knowledge as to what optimal portfolio allocation should be.
DANIELLE DIMARTINO BOOTH: So Charlie Munger was right.
CHRISTOPHER COLE: I think he's right.
DANIELLE DIMARTINO BOOTH: Take a step back to the October 2017 paper, if you will. Back then, you drew the scope of the financialization of the markets of the economy. You talked about risk parity, and share buybacks, and the massive effect that they had had on the crowding in to certain asset classes. So talk about what effect this herding instinct has had on the way this generation views investing.
CHRISTOPHER COLE: You and I have a very similar writing style. I love metaphors. I think visually. I think I think you do too.
DANIELLE DIMARTINO BOOTH: Yours are better.
CHRISTOPHER COLE: Yours are-- they're very good. But in that 2017 paper, I think I wanted to use the idea of an Ouroboros, this concept of a snake devouring its own tail. And what this was a metaphor for-- what is now about $3 trillion in equity markets alone. This is just equity markets, US equity markets. The number is much larger if you expand that across asset classes. But of strategies that use volatility as an input for taking risk, but also seek to generate excess yield, either through selling volatility or through the assumption of stability.
So in this number, you have implicit and explicit short volatility strategies. And I think there's a lot of confusion as to what this means. Explicit