Could you also say that indexation and ETFs have taken over because the markets have been in an uptrend?
My answer is that indexation has taken over not because it's so good, but because active management was so bad.
Because a lot of the distressed bonds that you are in, is the chance of a downside zero?
So I'll give you a little bit of a background. Most of these are like conversations. Most of the interviews that we do are conversations. They're fairly free flowing and the audience we cater to are entrepreneurs of Indian origin who are around the age of 25 to 30. Everyone's looking to invest in the market, trade the market, start a business, building something from the bottom up. So we are speaking to them. So most of today is around that. Can we start with a little bit about you and how your own journey began from Queens to Wall Street? Maybe like how do you describe your story in your words, your origin story?
Well, you know, I was born in Queens, New York, as you know, one of the outer boroughs. Middle class upbringing. Neither parent went to college. But my father was a very intelligent man and an accountant, and I think he did his job well. And so we lived a comfortable middle class existence. I went to the public schools of New York at a time when you could get a good education in the public schools of New York. And I think I got one. And oddly enough, ended up taking courses in business law and then accounting in high school. And really connected with accounting, with the orderliness and the symmetry. It just clicked for me. So I decided to go to business school. I applied to Wharton as the best business school for undergraduates in America. I was told I wouldn't get in, but I did. Went to Wharton as an accounting student, switched my major to finance. Then went on to get an MBA in accounting from the University of Chicago Business School. And between years of business school, I had a job in the investment research department of Citibank, liked it, went back. That's my background.
Is Wharton, would you say, still one of the better schools?
No, I think it's... I have no reason to believe it's not still the best undergraduate business school. There are other good graduate schools that are very competitive with Wharton. I'm not an expert. I'm going to say that a hundred times on this tape. But I believe that Wharton is still the best undergraduate business school.
And you studied Japanese literature at Wharton?
Yes. When I went to Wharton, there were two very enlightened requirements. You had to have a semester of the literature of a foreign country and you had to have a non-business concentration, what we call a minor. And you know, the wonks would take stat or economics or poli sci.
Wonks. Yeah. Oh, you know, people who just think about making money. Or just think about numbers and business. But for my literature requirement, for some reason I don't remember, I took Japanese studies. Japanese literature. I think perhaps it was the exoticism. And I just fell in love with it. And so I ended up taking a second semester of Japanese literature and then two semesters of Japanese civilization, then one semester of Japanese art.
And what did that teach you?
Well, it taught me a lot. But the main thing I've carried away have been some aspects of the Japanese philosophy. The most important one, the most relevant one is something called mujo. Which literally means the turning of the wheel of the law. And what it means in everyday life is it means the inevitability of change. That change is inevitable, unpredictable, and uncontrollable. And that we have to accommodate to it and make the most of it rather than think we can control it.
One should. It's inevitable. Yes, of course. One should expect change. One should not expect a specific change because it's unpredictable.
I once read somewhere that a Western man, if it rains for five days, will expect it to rain on the sixth. Whereas an East Asian person, say Japanese for example, if it rains for five days, will expect no rain on the sixth because the pendulum, like you say, swings back to the mean. Is that culturally true?
I have no reason to know. I don't know. But what I would say is, if the probability of rain is let's say 50/50, if some people think five days of rain means the sixth will rain because of continuation of trend, and some people think five days of rain means that it won't rain the next day because the rain has all been used up, what I think is on the sixth day it's 50/50. The previous days do not matter for the sixth day. Well, I mean, in weather that may not be precisely true, but I'm a big believer in the independence of events. And I think that's what mujo is about, independence of events. So you know, if you flip a coin 10 times and you get 10 heads, the probability of heads on the 11th flip is still 50/50 because the trials are independent.
Do you believe in game theory?
Well, I believe that you can strategize and you can figure out which action has the highest expected payoff. Or the highest maximum potential payoff or the least probability of a really bad payoff. And you can perhaps even strategize about what your opponent is going to do. I believe in strategy. I don't know if that's exactly the same as game theory, but I think that, as I've suggested in my comments so far, what I really don't believe in is predictions. And I believe that given human nature and the dislike for ambiguity, people pursue predictions so that they can understand what world they're going to be operating in and deal with it accordingly. And if they do this to excess, then they theorize about a world they'll be operating in which is not as likely to obtain as they think, which means that their predictions can be misleading. And about 20 odd years ago I wrote a memo called 'You Can't Predict, You Can Prepare,' and that's really the essence. And you can tell that comes directly from the understanding of mujo. We can't predict the future, we can't control the future, but we can prepare for the future. Now that raises an interesting contradiction in terms: if you can't predict what the future will be, how can you prepare for it? And the answer is you can prepare for a future which is unpredictable. So in investing, you can put together a portfolio rather than one that will produce maximum success if a certain future unfolds. You can put together a portfolio which will do fine if several, any of several futures unfold, and not too terribly if a bunch of other futures unfold. Now you can't prepare simultaneously for the positive tail and the negative tail. If you prepare for a total disaster, then you're unprepared for a great future. If you prepare for enormous success and you're going to maximize your outcome should this success unfold, then you're probably totally unprepared for a very negative. But you can prepare if you suboptimize for a number of possible outcomes in the middle of the probability distribution.
Isn't that a bit contrarian to the coin example? You said if you toss a coin and it comes heads 10 times, and I toss it the 11th time, you still expect the odds to be 50/50. So I can't look at past data to predict the future or prepare for the future. Then how do I prepare?
I think the difference is that the coin tosses are independent. The result of the preceding coin tosses has no impact on the next one. That's not true in the areas I work in. Most importantly, history, the things that have happened so far and people's reaction to history, have semi-predictable implications for the future.
Not history, but people's reactions to it?
Well, not history itself as much. I mean, if you knew history, but I mean, history is the history of what people did, and what people did in the past by itself has implications for the things that will unfold tomorrow and next month and next year.
So in a way are you saying the psychology of people, mass mentality in a manner remains the same and that can be modeled for more so than events can be?
Well, of course, events are largely the things that people do, which is largely the result of their psychology. But I do think that events in the future are somewhat predictable because the implications of past behavior are somewhat predictable and future behavior is somewhat predictable. The things that have happened, for example, in the economy and the markets, are likely to induce certain behavior in the future. And you can know a little bit about that. And when the history and the past behavior has been extreme, the ability to infer from that rises. In other words, I wrote a book about cycles, and that's the one where I refer to my experience traveling in India. And cycles are induced primarily by behavior. The upcycle is exaggerating, overgeneralizing the upcycle that there's a trend line. Let's say it's GDP growth. There's a trend line. But sometimes the economy grows more than that. Why? Largely, I think because of optimism. Because people are optimistic. So they spend a lot of money. Producers are optimistic about demand for their product. So they build new factories and hire labor and buy machinery. And the sum of these things produces a period of above trend growth. But then when producers have more than prepared for the coming growth and consumers have been sated by consumption, then things will ease off and maybe it results in a period of below average growth. So, you know, I wrote the book, I was about two-thirds through writing the book and I've been studying cycles for almost 60 years now, living through cycles. And I said to myself, just why do we have cycles? Why doesn't GDP, if the average growth in GDP is two, why isn't it always two? Why is it three or four or one or zero or minus one? And the answer is excesses and corrections. And then you go to a negative which is an excess and then it corrects back to the trend line. So rather than thinking of cycles as ups and downs, which I think most people do think of them as, think of them as excesses and corrections, excesses and corrections, fluctuations around the trend line. I mean, this is most easily seen in the stock market. For example, you look at the S&P 500. The S&P 500 has returned about 10% a year on average for the last 100 years.
But the constituents of the S&P have changed many times in that period.
But the average rate of return doesn't change.
Average rate of return. I don't know about the S&P. I know in India the indexes, I'm a stock investor, that's my full-time job. We have returned about 11% over the last couple of decades, but we have depreciation of currency which is about 4-5% a year. So I'm assuming the S&P would have returned 6% if you were to ask me to wager a guess. But I don't think it's a fair benchmark because the companies in the S&P, like the indexes back home, change by virtue of market cap.
They do. But my point is that the S&P, however constituted, has returned an average of 10% a year for the last 100 years, but not steadily. In the '90s, it returned 20% a year and in the 2000s it returned zero per year. So certainly not steady. And not only is that an interesting phenomenon to think about, but even more so, the fact that the return on the S&P, which averages 10, is almost never between 8 and 12.
This is a very interesting data point.
Why is it that the norm is not the average? Greed and fear. Excess and correction. Excess of optimism, correction, excess of pessimism.
Can I ask you a small digression in a question? If humans were no longer in the picture and AI models are trading in the market, would 10% be 10% every year because there would be no optimism and pessimism?
This is another of those times when I'm going to say I'm not smart enough to know. It stands to reason that it would. If we programmed AI to find the elements and expect the patterns that produced success in the past and left it alone. And since we're told AI does not have greed or fear or optimism or pessimism, you would think that the returns would be steadier. I think it makes sense to think that.
I heard your interview a year ago with Nicolai from the Norwegian Sovereign Fund. He's a friend of mine. And when he asked you where are we in the cycle, you said somewhere near the middle.
Well, I think that was two years ago. Yes. Where are we now? Well, guess what? It's two years later. That's the only thing I know for sure. But I believe that, so I believe that interview was April of 2024, and the market continued upward from April '24 through, I think it's fair to say, January of '26. So another 21 months took it considerably higher. And of course, the economy, people think of the age of the recovery. So the economic recovery is two years older. The bull market in stocks went on another almost two years. So I would say that, first of all, as to the economy, it's very, very hard to date or talk about the age of this cycle because we had the pandemic where we did something unique. We closed the world economy to reduce the spread of the disease, and so that interfered with the normal workings. And according to the people who make these decisions, it produced a recession. It was a very unusual recession because it was only one quarter. I always thought a recession was two quarters of negative GDP growth. And of course it didn't occur for the normal reason of excess optimism leading to a correction. It was man-made. And was readily corrected. So the second quarter of 2020 was the worst quarter in the history of the world for GDP, and then the third quarter was the best. So was it really a recession in the functional terms of determining cyclicality or just some noise?
And can I ask another question here? I would say GDP, if I were to consider it the total produce going into the economy, and consumers consume as much as we can. I could argue that a recession is truly when there is more production in an economy and the consumption is organically lesser. So do you think GDP is a good benchmark to figure out when there is a recession or not? Because the consumers went away then artificially.
Well, I think your definition of recession isn't right because what you said was there's more production but that's not less consumption. Less consumption, that's the main element of a recession in my opinion. Manufacturers are always happy to produce goods to meet demand. The recession means primarily a reduction of demand. So that discourages manufacturers from producing, and the reduced production is really what causes the recession. Fewer people are at work, etc. Fewer goods are produced and consumed. So in the pandemic, production went down but the demand for consumption did not actually go down, but just that the markets were shut for a period of time because when they opened, people really consumed. Well, I mean, yes, the underlying demand didn't go down but people, I mean, in the sense that people would have liked to have parties. They just weren't allowed to have parties. So the demand, the psychological demand for a party was there, but the economic demand for rental halls and bands and food and party dresses and things like that didn't exist. So that's that. So, but this is why I say that the GDP was kind of artificially depressed by a decision of government, really. So when we say that how old is this recovery? Was that a real recession? If that was a recession, then this recovery is now six years old. If that wasn't a recession, then this recovery is 17 years old, which is the longest in history is 10 years.
Because the last recession was in '09. So it's 17 years since then.
But can you just tie recessions and cycles down to tenure time?
You can't. And that's one of the reasons why I don't believe in predictions. But there seems to be a norm. We always said that the average was eight years for a recovery. And in the 2010s, it went on for 10 plus years. So we called that the longest in history. So, and normally if we have a recession in year one X, we don't expect another recession two years later because recovery goes on for some period of years which seems to average eight. I can't explain why. I don't think anybody can tell you why. Maybe the answer is on average eight years is long enough from the last one to permit the next one. But so I don't believe you can, you know, somebody, I wrote the book about cycles and somebody in England said, 'Oh no, these aren't cycles because they're not predictable.' You know, cycles like radio waves or sine waves or something like that, these are predictable. And I think that patterns in the real world, the non-scientific, non-mechanical world, certainly aren't regular, but they do occur, ups and downs. They do occur predictably, but not necessarily predictable in time or predictable in amplitude, but they certainly occur predictably.
So, if I can bring you back Howard to the question, where are we in the cycle now?
Well, I think the recovery is, I think it's gone on a good while and it's not an infant, it's not adolescent. It's but it's also not geriatric. I think it's in middle age. And I think the US economy, if that's what you're talking about, is healthy and doing quite well. If the thing that presages a downturn is excesses to the upside, you don't find too many of those. You know, when I go to a city, I look for construction cranes in the sky to tell me if there's a building boom. Most booms are followed at some point by busts. I don't see it in most of our cities. I don't see inventories growing. Inventories grow for two reasons. In times of weak consumption because people don't buy the things that manufacturers produce. In times of strong consumption, inventories grow because manufacturers amp up production to get ahead of some anticipated surge in demand and those often presage downturns when they turn out not to be warranted. I don't see that in some sectors. Do you?
Well, I mean, maybe I don't look at the data finely enough to tell you that. In AI, maybe.
Well, of course, we don't talk about inventory in AI, but there's certainly a boom in capital investment for AI.
One could say hardware, energy, compute is inventory.
Yeah. Well, I mean, look, there's massive construction of infrastructure for AI, much like buildings. Yes, that's right. That is the area that's booming in our economy. And I need people who know more about AI than me to tell me whether it's going to bust. You know, the question is, is all of this or is some of this construction unwarranted? I don't think anybody can tell us that. We do know, we certainly know that it is an area of boom.
How do you stay so sharp Howard at your age? Like I have watched a whole bunch of your interviews and read a lot of what you have written over the years as a stock market investor all my life. I think there's so much I can learn from you. But how do you stay this sharp today?
Well, I don't think I don't, I mean, I'm lucky I have, genetically, well, I think I'm very lucky genetically. Because my dad lived to 101 and he was quite sharp at the end. And you know, we all face a decline at some point in time and the only question is when does it start and at what rate does it progress. And you know, you look at Warren Buffett, Charlie Munger, some of my role models and friends, and you know, they were or are sharp in their mid-90s and late 90s. So, it's just a, I mean, when you say how do you stay sharp? I don't go to the gym and work out. Well, I do do a lot of puzzles and I read and I read in fields that are not my fields. You know, I'm still trying to gain knowledge and broaden myself and I guess I make some effort to plow new ground and the question is when do you stop doing that? At what age? But you know, my last two memos, I hope your audience knows about the memos. Yeah. But I wrote one December 9th and one I think February 25th about AI and I had to do a lot of learning.
You changed your mind on AI as I changed my mind.
But first I challenged my mind. And you know, I had, for the second one in particular, I had an extensive conversation with Claude and learned a great deal. And you know, it was very exciting to be plowing new ground at almost 80.
And do you think it could be ambition and hunger?
Well, it is definitely a hunger. It's a hunger to learn and to stay relevant and to stay stimulated. When you say ambition, that usually starts with dollar signs.
Yes. Well, it's an ambition to stay relevant and to, to use your terminology, to stay sharp rather than start to atrophy.
I think staying relevant is the core ambition of everyone. The dollar is a means that people pick in the beginning, not at the end maybe.
Well, I think that most ambition starts with the dollar sign. In enlightened cases, it transitions to non-dollar. Not every case. Now, you know, there are people are different. You can't, Mark Twain, I think it was, said all generalizations are flawed, including this one. But you can't generalize.
Like you say very well, I heard you speak about the role luck plays in our life. Would you say enlightened or lucky? The ones who transition.
Well, now you're really getting deep because now you're talking about determinism versus intention. And I think there are some of both. I mean, some people kind of, these things are hard to parse, but some people I think transition naturally and as they grow maybe they become wiser and they start to understand that there are things that are more important than money or let's say things that are important in addition to money. And so they do it. Let's say that naturally, not intentionally. I imagine there are people who do it intentionally. People who go to the mountain and meditate and think about it and conclude, you know what, I really should change my focus at this point in my life.
Have you been able to ever pull that off? Like I've been fascinated with the idea of going to a mountain and arriving at some kind of evolutionary thought in my mind which makes me actively transition into something. Have you been able to touch that?
Well, I haven't physically gone to the mountain, but I think the key, I've written the first pages of a book. I think the key to all of this, to all of life, is to behave thoughtfully with your mind engaged. Not just let the river take you, but give thought to what's going on, why is it going on, what does it mean, why did it happen, what does it imply for me, what should I do about it? And that is, I think, going through life with your eyes open. And that's how you can intentionally get to a higher stage in life by doing that. And the image that comes back to me is the image of whether you let the river take you or whether you try to figure out a better place to get to and then try to get there. Maybe once or twice in my life I have felt like I could see the river.
I think at this stage I am able to think about this progression constructively. When I think about my early decades, not years, decades, and I think about what I did from, let's say, the beginning of high school, 1960, until starting Oaktree in '95. So that 35 year period which took me up to age let's say 49, I was adrift. I did not make proactive decisions. I let the river take me. I'm very lucky that it took me to some good places in several different aspects of life, but I don't consider, when I look at my behavior, I don't consider it thoughtful or intentional. And so I'm just lucky that I got to a good place despite my own inattention. I think that starting Oaktree was the biggest and maybe first thing I really did with intention and I've tried to be more intentional since then. But when I look back and I describe how I selected my career, how I selected my first job, how I decided to go to graduate school, and how I transitioned from the equities department to the bond world in 1978 in time to have the benefit of the birth of high yield bonds, it was all happenstance, serendipity, coincidence, passivity. You know, I was not making intentional decisions in that period.
What changed? How did you become intentional from being unintentional when you began Oaktree? Because other people can maybe learn from it. Maybe I can learn how to catch it.
Well, the easy answer is that my wife pushed me to think about it more and to independently start Oaktree. My partner Bruce Karsh and I did it together. His participation encouraged mine but that required a proactive decision. You know, the biggest change I made before that professionally was moving from Citibank to TCW in '85. They approached me. That was not proactive on my part. Not the act of starting Oaktree, but from being adrift, the river, to seeing the river. Well, I think once I made the decision to participate in the starting of Oaktree, I couldn't drift anymore because now I was the person leading Oaktree. I had to make proactive decisions. I mean, it became my job. And maybe I warmed to it. Maybe having made the proactive decision to start Oaktree and having done it, maybe I said, 'Hey, this is good. I think I like leadership.' And leadership is by definition proactive. It seems like an oxymoron to say he led passively. Those two words are in opposition. So I think that, thank God I rose to the occasion and left TCW with Bruce and my other partners to start. And then I think that it was, I don't think I ever said, 'Well, now I'm going to start taking control of my life. Now I'm going to start acting intentionally. Now I'm going to become a leader.' I just think it was inescapable.
That's very interesting because it sounds like you're saying entrepreneurship and taking risk can trigger the riding the river to seeing the river.
Some people are driven entrepreneurially. I think that entrepreneurship is the epitome of intentionality. It's taking the bull by the horns as we say proactively. So I think the entrepreneur naturally, innately, does the opposite of drifting down the river. And my inclination was not entrepreneurial, you know. I liked most of what I was doing at TCW. But with encouragement from Bruce Karsh and my wife and with a little encouragement from TCW to leave in terms of how I thought I was treated, my inertia was overcome. That's what I would describe. You know, it wasn't a proactive decision, 'Hey, let's get going.' It was the unlikely overcoming of my innate inertia. It's a very different story.
It could be like a chicken and egg thing.
Oh, it's very chicken and egg. Yes. But I think the important thing is for the purposes of your audience that my departure from TCW did not start with an entrepreneurial spirit. And some people, I know people who, you know, who were entrepreneurial, I mean, always dreamed of making a lot of money, always dreamed of running their own business, chafed at being an employee, had to get out and start their own. That was never descriptive of me. So I kind of did something that you might call entrepreneurial despite myself is the way I would describe it rather than because of my innate drive.
So Howard, my job for 20 years has been that of a stock investor. You've been a debt person almost all your life. Why would you be in an asset class which has finite upside and the downside I guess is finite because in most cases it's zero versus equity where you could have exponential upside?
Well, that's a great question and I haven't really been asked that question much in the past. My answer may take a while. Settle in. The question as you pose it is an interesting question if you assume rationality and objectivity, but that ignores personal, let's say, kinks. So, I'll return to that. But first of all, my decision to move from, I spent nine years in the equity department. So, it wasn't really at the very beginning. It felt like a long time. But my decision to move from the equity department in '69 to the bond department in '78 was not my decision. And it wasn't because I figured out it would be better for me. The Citibank I joined in September of '69 was an investor in what was called the Nifty 50. The 50 supposedly best and fastest growing companies in America. Companies where nothing bad could ever happen. There was no price too high for the stock. And if you bought those stocks the day I got to work in September '69, if you held them tenaciously for five years, you lost about 95% of your money. 95%. Because for many of them, something did go wrong. And for all of them, the price was too high. The PE ratios, as I recall, were mostly between 60 and 90. So it was a, and so that was a real disaster for the people who invested in the Nifty 50, which was most of the money center banks. And I was director of research by the mid-70s. So I was part of the process and we hired a new CIO who wanted to have a new head of research and I helped him hire my successor. And then he said, 'What do you want to do next?' I said, 'I don't know, I could do this, I could do that.' Typically I didn't think it over very much or assess my strengths and weaknesses very well. And he said, 'I'd like you to move to the bond department and start a convertible bond fund.' Because he had come from a place that had one and it was very successful and we didn't have one. And I said, 'Yes.' So that was the extent of my intentionality, which is almost non-existent. It was, you know, and I say now, and it may be an exaggeration, but I was lucky I didn't get fired. But American companies gave pretty much lifetime employment at that time. Anyway, so number one, my move to the bond department was not voluntary other than I could have said no. But number two, you talk about the fact that bonds have capped upside and some downside from default. Certainly true. But it fit me because I was brought up to be very conservative. My parents were adults during the depression. Now, your parents probably weren't alive during the depression or most people I know who are old, their parents were children during the depression. My parents were adults during the depression, which meant when I grew up, what did I hear? Don't put all your eggs in one basket. Save for a rainy day, avoid risk, etc. So I think Indian parents lived through pseudo socialism in the country. Similar. Not as bad. Yeah. But see, you as a stock guy look at bonds and say no upside, some downside. I say predictable outcome which is achieved almost every time.
Is that true though? Because a lot of the distressed bonds that you are in, which have fairly high coupons, is the chance of a downside zero?
I said almost every time. And you know, first of all, so as I said I moved to the bond department in '78, May of '78. In August of '78 I got the phone call that changed my life from the head of the bond department who said there's some guy in California named Milken or something who deals in something called high yield bonds. Do you think you can figure out what that is? Because a client had asked for a portfolio.
