Richard W. Roll
Linde Institute Professor of Finance
By David Zierler, Director of the Caltech Heritage Project
August 20, 2021
DAVID ZIERLER: OK, this is David Zierler, Director of the Caltech Heritage Project. Today is August 20, 2021. It's my great pleasure to be here with Professor Richard W. Roll. Dick, it's great to see you. Thank you so much for joining me today.
RICHARD ROLL: Oh, thank you for inviting me.
ZIERLER: To start, would you please tell me your title and institutional affiliation?
ROLL: I am in Humanities and the Social Sciences, which is one of the divisions. And I'm the Linde Institute Professor of Finance. That's my title in that division.
ZIERLER: Tell me about the endowed chair, Linde Institute Professor of Finance. How did that come about?
ROLL: Well, the Lindes are a couple. He's a Caltech graduate with a PhD in physics, I believe, and they have endowed a number of things at Caltech, including I think paying for the renovation of the mass sciences building recently. And they've given money to various divisions over the years, including one at HSS, which is my division, for study of financial economics, economics, and entrepreneurship. And the Linde Institute, which is not just a chair, it's a whole institute that sponsors various things in HSS, and I'm part of that. It's a shared title, but it really doesn't mean anything in terms of money. [laugh] It's just an honorific title, that's all.
ZIERLER: Now, you're a relative newcomer to Caltech. Tell me the broader story of your decision to transfer here.
ROLL: Well, it's a bit of a long story. But I may have told you before that I was a professor at UCLA for 38 years, and that wasn't my first academic job. I'm old. I'll be 82 in October, so I've had plenty of time to be places. I came to UCLA in 1976, and I can tell you later why that happened. And I was there until five years ago. And the University of California has an unusual retirement system in that they provide, basically, economic encouragement for people who are productive to resign. They have a defined benefit pension plan, which pays you, basically, your highest three years' salary in perpetuity if you've been there for 40 years. And it builds up every year as a percentage until you get to 100%. But they won't let you stay on the faculty. In other words, you can stay there, but it doesn't do any good.
So being an economist, it wasn't so much that I needed the money, but I felt like an idiot staying there and taking nothing [laugh] after I'd been there almost 40 years. So I said to my wife, "Look, we don't really want to leave LA. Why don't I go and see if I can get another position at a local institution? I'll retire, take my pension, and then earn the new salary at the new place." And so, I did, and I was surprised that I got offers from all three of the leading schools in LA, Caltech, USC, and Chapman down in Orange County. They all offered me a job.
ZIERLER: And why did you choose Caltech?
ROLL: Well, mainly because I've always admired Caltech. It's got a fantastic reputation. And I think of myself as kind of an intellectual interested in a lot of things other than my chosen field. But it did have a disadvantage in the sense that there's no business school. I was in the business school at UCLA, and I'm a finance professor. I'm in financial economics. There was a bit of a downside because Caltech really doesn't have a finance department or business school. But they told me at the time, five years ago, that they wanted to build it up and appoint more people in finance in HSS so they could provide students with some training in that. A lot of students at Caltech actually, although they started in chemistry, physics, math, and computer sciences, end up in their life profession in finance. They go to Wall Street and become "quants."
And of course, they don't know anything about finance. I think some people at Caltech at least wanted to add to that particular subject because of the fact that so many students were majoring or taking second majors in HSS with the intention to fall back into a finance career if they didn't get a job in physics or something like that. And there were, at the time, a couple trustees who were very anxious to pursue this. One was Ron Linde, the endower of the Linde Institute, but the other one was Steve Ross, who was a very close friend of mine for a long time, a professor at MIT, He was on the (Caltech) board of trustees when I was appointed. And he had a big push on for doing this. Unfortunately, he passed away three years ago.
I took the job partly because he encouraged me to do it. He and I were coauthors on a number of papers and longtime friends and colleagues. I knew him very well. And he was kind of the impetus more than anything to get me to decide to go to Caltech rather than USC, which does have a business school and a good one, or Chapman, which is a little less attractive because it's a little further away.
ZIERLER: The fact that Caltech does not have a business school and that so much of Caltech is oriented technically towards the harder sciences, what were your reactions to that intellectually, administratively? Did that change your research agenda, the kinds of courses you teach, the things you were interested in?
ROLL: Well, it definitely changed the kinds of things I'm interested in. I've met a lot of people at Caltech in the hard sciences who have become friends. And occasionally, even have lunch with them, stuff like that, or meet them socially. But it didn't change my basic agenda in terms of research. I'm still doing financial economics. And of course, in HSS, we do have economists. I have colleagues in HSS who are not financial economists, which is one division of economics, but they're economists. Like, let's say, Charles Plott. He does a lot of models of games and stuff like that. He and I have actually written a paper together.
I've started writing things which are not strictly in my discipline from being exposed to these people. And I know a lot of people from other divisions since I've come to Caltech. I've become acquainted with them. I'm interested in physics, chemistry, and biology in particular. David Baltimore, who used to be the president of Caltech, and I have become pretty good friends. We have lunch once in a while. He likes my wine. I have a vineyard, so I give him a bottle of wine once in a while.
ZIERLER: Where is your vineyard?
ROLL: In Ojai. I've met other people, too, like Frances Arnold, the Nobel Laureate in chemistry, and Mark Davis, her colleague in chemical engineering. He and I worked on a project together briefly. It didn't turn out to be anything. So I am exposed to some people in other divisions. I've done lots of research since I've come to Caltech, I've continued to publish papers, but they haven't really been in astronomy or chemistry. [laugh] I don't really know anything about that. I'm interested in it. But I have lunch with Mark Davis and Mark Wise in physics and David Baltimore. We talk about dark matter, nanoparticles, genetic engineering. And at the end of lunch, they always ask me, "Which way's the stock market going?"
ZIERLER: Well, Mark Wise, as I'm sure you know, has gotten involved in some financial issues.
ROLL: Yes, I met him because of another person who was one of his students who's in finance and has his own company. He used to be at Pimco down in Orange County. I wouldn't say I'm really close friends with any of these people, but I've talked to them.
ZIERLER: This is the intellectual environment that you find yourself in.
ROLL: Yeah, yeah. So Mark Wise told me one time, "All physicists are really depressed." And I said, "Well, why is that?" He said, "Well, dark matter makes up 93% of the universe, and we don't know what it is. And we think we should." And I said, "Well, you know, financial economists are in the same situation. They don't know which way the stock market's going, but at least they know why they shouldn't."
ZIERLER: [laugh] That's great. You have to be at that level to appreciate how little we really know, right? Well, at the outset of our conversation, I'd like to do some nomenclature 101 just to get a sense of where you approach these distinctions. You've already said the term financial economics, so let's just break that down. Academically, intellectually, even in the job market in the way people from these varying programs get jobs, what do you see as the discrete differences between finance and economics, and where do you see overlap because inevitably, there is some between these two fields?
ROLL: Well, I've always thought that my field is a really a subfield of economics. I call it financial economics. The leading journal is the Journal of Financial Economics. And my PhD at Chicago was in economics, finance, and statistics. And I took courses in the economics department and have had many friends in economics at UCLA over the years, including Jean-Laurent, who used to be at UCLA as an economic historian. People in finance are very compatible with anybody in economics. They're closely related areas. The empirical approaches are very similar, they use similar techniques, the math is similar, and that sort of thing. The only difference is that financial economists apply basic economic theory to the study of financial markets and financial decision-making by corporations.
There are two main areas in financial economics. One is the study of financial markets, the stock market, the bond market, the foreign exchange market, the commodities market, etc. The other is corporations and how they make financial decisions, which has to do with dividend policy, the leverage structure of corporations, and those sorts of things. Those are the two main areas. But the basic approach to doing research in those areas is very similar to what you do in economics. And in fact, many people in finance, including myself, publish papers in pure economics journals, which they're willing to publish if a paper's good enough. [laugh] It's not that they're going to accept every one. But Charlie Plott, for instance, was telling me, "The Journal of Finance," which is one of the leading journals in my area, "is harder to get a paper published in than the American Economic Review." That's partly because there are more people in finance than there are economists.
Every business school in the country has a finance department, and all of those faculty members are trying to get their papers published in a limited number of finance journals. So many of us branch out and publish elsewhere. I've got a paper coming out in the next issue of Management Science, which is a top journal, but it's mainly devoted to operations research and more technical things than pure finance. But they do have a finance associate editor, and they try to get finance papers into those journals. The bottom line is, those fields are closely related. Of course, economists also study things like macroeconomics, like the money supply, the role of the government, antitrust behavior, all kinds of stuff that financial economists don't usually get involved with. It's really a specialty of economics.
ZIERLER: As you know, in the hard sciences, there's a divide between applied research and basic research. In other words, basic research is just figuring out how nature works, and applied research is using that knowledge towards specific ends. In your fields of interest, and particularly in light of your extensive business experience out in the "real world", so to speak, where is the value that you've drawn from that experience in applying it academically, and where do you make those intellectual detachments because some of the things that you work on, you're only interested in within an academic context that might not necessarily be connected to the day-to-day business world?
ROLL: Well, I think more than the hard sciences, financial economics is closely connected to the business world. The intention of most people who do research is eventually to turn it into a product that can be useful for people in the financial industry or in a corporation that's deciding on, let's say, leverage or dividend policy. I think most people who do basic research in financial economics have in mind ultimately to turn it into something of practical use. Certainly, that's my case. Although I've done some things that are completely useless in terms of practicality, I try to figure out when I'm doing something, "Well, can I use this in decision-making in some capacity?"
And to give you an illustration of that, many financial economists and business schools around the world spend time actually in practice. I, myself, went to Wall Street for three years. I took a leave from UCLA, and I went to Goldman Sachs in New York City. And I started as the head of the Mortgage Securities Research Group at Goldman Sachs. I started it back in the 1980s. I had worked on interest rates and mortgages and done empirical papers purely as an academic before that. But what I did at Goldman Sachs was run a department where we actually traded mortgages, and underwrote collateralized mortgage operations, and invented various kinds of mortgage-backed securities.
In my experience, it was not unusual in the sense that a lot of professors go work at financial institutions. Sometimes, they don't come back. They make too much money, and they get wedded to that life and never come back to being an academic. But others do. For example, at UCLA, I'm just thinking of two of my colleagues, Francis Longstaff is one, and Mark Greenblatt is another, that went to work on Wall Street, returned, and are now still professors at UCLA. Another one is, Andrea Eisfeldt, who went to a hedge fund. She's a younger person. She just went about seven years ago, stayed a couple years and came back. But there are others that never come back. They go to work for a financial firm, let's say a money management firm, an investment firm, something like that, and they spend the rest of their lives there. Or until they retire. Often, it doesn't take them that long to amass a fair amount of money.
ZIERLER: A really broad historical question that would ask you to survey, really, the whole of your career, and that is the way that your field culturally has changed in terms of the way that people talk about how wealth should be deployed. What have you seen change in the course of your career in that regard? For example, now, so many corporations emphasize the importance of inclusivity and environmental values.
ROLL: That's a much more recent phenomenon. That started during the last few years. It has to do with corporations responding to the political environment that's giving them some reason to at least claim they're doing something about those matters. Whether they're actually doing anything or not, I'm not really sure. In terms of environmental values, there are firms, for example, Black Rock in New York City. Larry Fink is the chairman of the board of Black Rock. He's a UCLA graduate. I've known him very well since he was a student. When he first went to New York City, he worked for a company called First Boston. And they specialized in doing mortgage-backed securities in the 80s.
And so, when I was in New York doing it for Goldman Sachs, they were a competitor. And I've known him for many years. He started this firm, Black Rock, which has become the world's largest money manager. In the last couple years, he's started saying, "We need to make sure we invest in environmentally sound things that are renewable resources and things like that." I don't really know. I saw a portfolio that Black Rock publicized not long ago, which was something like the S&P 500 but was more environmentally friendly, and I looked at the composition of that portfolio and the S&P 500. They're not that different.
So I'm not really sure what's going on there. He's saying they're investing more in environmentally sound and renewable resources, but it's very hard when you're that large, the world's largest money manager, not to buy everything that there is. [laugh] You've got to hold just about everything, right? Because otherwise, you wouldn't have a diversified portfolio. I'm not really sure what those things amount to. But back to your original question, I got my PhD in 1968. From '68, '78, '88, '98, 2008, there was no mention of any of this inclusivity or environmental stuff. The only thing that's similar to that was that there was a period where people were anxious not to invest in South African stocks during the period of Apartheid. When I was running a money management firm with Steve Ross, we had clients that asked us to do that.
We would not buy any companies that were headquartered in South Africa. Well, South Africa's a tiny fraction of the global market index, so it really didn't matter whether you had any South African stocks or not. [laugh] Somebody's going to buy them who doesn't care about Apartheid. So it really didn't matter too much. We had another client, by the way, we had a partner in Saudi Arabia, and we started a mutual fund in Saudi Arabia that appealed to the Muslim world. It only bought stocks that would not be restricted under Sharia law, which means that there's no alcohol, a whole bunch of restrictions like that. But the biggest one is that interest is forbidden under Muslim law. You can't have interest income. You can't pay fixed interest. That excludes a lot of companies, right? As you can imagine, out of 28,000 stocks that we could buy around the world, only 500 qualified for that portfolio.
You can build a portfolio with 500 stocks that has similar risk to the S&P 500, but it's always going to have some discrepancy because you only have stocks that don't receive or pay any interest.
Until 2008 or maybe later, I was not aware of recent goals such as "inclusivity." And I don't really know how much they really matter. It's kind of like South Africa in a way. You look at Black Rock's portfolio, it looks just like any other portfolio, more or less.
ZIERLER: Another broad historical question, but one more germane to your own educational trajectory and maybe even intellectual background, and that is your understanding of what the Chicago School is. And the first question there is sort of a chicken and an egg. Can it be assumed that if you want to go to Chicago to study these things that you're already a member? Or is there a proselytization that you become a member upon successfully graduating? Or are there people at Chicago who don't ascribe to the Chicago school? How do all of these things work?
ROLL: Well, first of all, let me tell you what I understand to be the Chicago school, of which I'm a member because I got a PhD there, and some of my most favorite professors were big shots in the Chicago school. I took courses from Milton Friedman, and he became a lifelong friend. I knew him for many years. Even after he retired and lived in San Francisco, my wife and I used to go up for lunch with Milton and Rose Friedman. And I admired him incredibly. I think he was one of the most brilliant economists. And he won the Nobel Prize. And not only that, he was the best debater I've ever seen in my life. He could take on anybody, Paul Samuelson or anybody else, and just nail them to the wall.
Now, it's true that he would occasionally make up some facts as part of the debate. [laugh] But he was a very impressive intellect and wrote some really fantastic books like Capitalism and Freedom. Part of the Chicago school, he was one of the main persons. But not the only one. There were several other people like George Stigler, who was actually at Chicago, but he was in the business school, not in the economics department. But at Chicago, like we were talking about earlier with economics and finance, the business school and the economics department are very closely connected. Most people who are getting a PhD at Chicago in either one take courses in the other department. I did. I took courses from Arnold Harberger, Gary Becker, Milton Friedman, a bunch of people in the economics department at Chicago.
And then, in the business school, Merton Miller, another Nobel Laureate who was a finance professor but an economist by training: he was in the business school along with Stigler. The whole atmosphere of Chicago was that people in the economics department and in the finance group of the business school, agreed pretty much on the general way to think about economics, and to a lesser extent, politics. They're free market people. I would say they're Libertarians, basically. They don't like big government, they like freedom to pursue business and do whatever they want, and they don't want people telling them what to do. And they provided a lot of evidence for the students that the freer the market, the better everybody is off. Even the poor people are better off by being pulled up by the bootstraps by the people who get wealthier. And if you look across the world at different countries, you will definitely see that the freer the economy, the less the government intervention, the more prosperous the average person is, even the poor people.
You go to one extreme, like let's say Cuba, Venezuela, Zimbabwe, people are dirt poor. You go to the other extreme like Luxembourg and Switzerland, they're rich. Of course, there are other factors, but if you look at the main thing, it's the rule of law, property rights, things like that that the Chicago school was very much in favor of. Your second question is, do people go to Chicago because they're already inclined to believe that? Well, I didn't. I didn't know anything about it. [laugh] Before I went to Chicago, I was an engineer. I went to Auburn undergrad. I'm a southerner, by the way. I was born in Arkansas. And I went to Auburn undergraduate in aeronautical engineering, and I took a degree there, and I went to Boeing in Seattle, where I was an aeronautical engineer. I didn't have any economics at all prior to that time. But Boeing sent me to become a manager, to get an MBA at the University of Washington, and they said, "We'll pay your tuition if you go there."
Of course, tuition in those days was not much, but I said I'd do it. I went and got an MBA at the University of Washington, and that was my first exposure to economics and finance. And one of the people that I had as a professor there was Bill Sharpe, who's a Nobel Prize winner in finance. I've known Bill Sharpe longer than anybody else in the whole profession because I was a student when he was an assistant professor. We're both really old now. I've known him for 60 years or more. And so, when I graduated from Washington, I went to see him and another professor, and I said, "I like this economics and finance a lot better than engineering, designing a hinge for a 727 or something like that," which is what I was doing. "Where should I go to school? I was thinking about going to Harvard."
Bill said, "That's horrible. Don't ever think about going to Harvard. Go to Chicago. That's where they're doing the best work." To answer your question, I certainly didn't know anything about the Chicago school before I got there. But they pretty much took me in and persuaded me that they had a good idea while I was there. And three years later, I graduated with a PhD, and I really haven't changed my mind that much over these years.
ZIERLER: Finally, among my more current questions, right up to this present day, what are you currently working on now, just as a snapshot in time?
ROLL: I'm just working currently on kind of a statistics paper. But it has an application to finance. It has to do with non-stationary expected returns, which means that returns change over time for various reasons. For example, a company becomes more leveraged for many reasons. Mean returns change, the risk profile of the company changes, and so on. And this paper shows that when those mean returns are non-stationary, the serial correlation coefficient of observed returns can be spuriously positive. And the serial correlation coefficient is something that traders look to to devise a trading rule.
So for example, if stock returns are dependent from period to period, you can build a trading rule that'll make money. Changing expected returns induce positive serial dependence, but it's not something you can make money on. So it's a paper that warns practitioners not to just look at the serial correlation coefficient as a possible way to make money because there's another reason that it can happen that will not allow you to make money. I'm just finishing that paper up now. We first show why that happens.
We have both theoretical algebraic explanations for it and empirical simulations, and then we look to see whether or not there's empirical evidence that this actually happens in the real stock market. And then, we look at changes over time in mean returns and relate that to serial dependence, and we do find that it's quite prevalent. So it's something that people should be careful about when they devise trading rules.
ZIERLER: How has your research been affected by the pandemic? Have you found opportunity to be more productive just from being at home? Has it been difficult not to have that in-person interaction with your colleagues and students?
ROLL: I didn't think it would make much difference, but when I look back on it now, I think it has. Because I haven't done as much over the last two years as I had typically been doing. Of course, there's another factor: my age may be partly responsible for this as well, and I may be slowing down because I'm in my early 80s. Most people in their 80s don't publish that much. But I was publishing at a pretty good clip for a long time. During the last two years, I have not done as much. And I don't know whether it's because I'm just not going to Caltech and seeing all my colleagues and friends in the division, getting good ideas, things like that. I think partly, that is true. If you hang around the building, talk to people, go to seminars–well, we don't have any seminars now because nobody's there. There's no visiting. We used to have a finance seminar every two weeks, which we haven't had since January of 2020. About 19 months now.
ZIERLER: Yeah, feels a lot longer though.
ROLL: Yeah, feels like it's been forever. And I've taught three times since then using Zoom. I taught three classes over that period. But I don't find that very satisfactory either because half the time, the students mute their video, and you can't see them. And then, when you ask them not to mute it, they say, "We don't want to unmute it because we're still in our pajamas." [laugh] And I thought they weren't getting much out of these courses, but they still do pretty well on the exams. I don't know whether that's just a good Caltech student quality or what. [laugh] They seem to be doing all right, but it kind of surprises me in a way because they don't interact nearly as much as they do in person. Maybe others have told you that, I don't know.
ZIERLER: Well, let's take it all the way back to the beginning. Let's start, first, with your parents. Tell me a little bit about them.
ROLL: This is a long story. I don't know whether you want to listen to all this or not.
ZIERLER: Absolutely, this is what I'm here for.
ROLL: All right, so I was born on Halloween 1939, right before the second World War. My mother was a nurse. And so, when the war broke out, she was recruited to go off to the military during the war. I think she spent most of the time in the Pacific, I'm not really sure. But her parents, my maternal grandparents, basically raised me during World War II. And I didn't really know my own mother that well until the end of the war, when I was about 6 years old or so, and she came back. Her sister, my aunt Ebbie, lived with her parents, my maternal grandparents, and we all lived together. And Ebbie's husband was off in the war as well. He was in Italy in the Air Force.
My maternal grandparents' surname was Roll. But my mother had been married to a person named Whittington. So when I was born, my birth certificate said Richard Whittington. Now here's where the story gets a little bit unbelievable. My grandmother told me that Richard Whittington, the person who was married to my mother, was not my real father. She said that my mother had an affair with a Cajun shrimp boat captain. We were in Louisiana, by the way. His name was Richard Bascaux, and he was my father. [laugh]
ZIERLER: Where in Louisiana was your family?
ROLL: Well, this was in Abbeville, Louisiana. It's near Lafayette. It's a little town. We didn't live there all the time because my maternal grandfather was a railroad executive. And so, when I was about 7 or so, we moved to St. Louis, where he was the head of the western district of the Missouri Pacific. And then, we moved around to a couple of other places, including St. Joseph, Missouri, and so on. And they're all southerners, my parents and grandparents. Here's the strange thing. I believed that my real father was this Cajun named Richard Bascaux. I believed it all my life until about five years ago. Five years ago, I did 23 and Me. The reason I did that was, one of my cousins, the child of my mother's sister, is a doctor in Northern California. He did it and said, "Why don't we try it and see if they really identify we're first cousins?" I did it, and they identify us correctly. The first person who came up on 23 and me was Jeff, my cousin. But then, about six months later, another person came up that shared 25% of my genes. Somebody named Susan Charest in Arkansas.
And so, I was saying, "25% of the same genes means she's my half-sister or my own child. But I don't have any children that I don't know about." I thought maybe my own son had had a child he hadn't told me about. My son, by the way, is 58. So that could've been the case, except that this person, Susie, was already in her 50s. I got in touch with her, and I said, "Who are you? How are we related?" She said, "I'm your half-sister. My father is Richard Whittington, and he was your real father too." And then, I discovered from Susie, my newly discovered half-sister, that my maternal grandparents, and my mother, and everybody in my family, had lied to me since the time I was a child. They claimed Richard Whittington had died. In truth, he lived into the 1960s, and I never had a chance to meet my real father.
Susie has sent me many pictures of him and other family members on his side. My grandmother was either mistaken or lying outright. She may have thought Richard Bascaux was my real father, but actually my real father was my mother's husband. Now, here's the funny thing. I had four cousins from my maternal side of the family, but my real father was the youngest of eight children, and I have 17 cousins from his side of the family. And my paternal grandfather was the pastor of the biggest Baptist church in Arkansas and a very well-known political figure there. I never knew any of this until I was in my late 70s. Can you believe that?
ZIERLER: Wow. What did you feel about having been denied the opportunity to meet your real father?
ROLL: I was really mad. Because I could've had a good relationship with my father–according to my half-sister, he was a really great person. And my maternal family basically kept me away from that. He was in the Army in World War II and came back after the war. But of course, I was born right before the war. So my mother was married to him at least briefly. They got a divorce, and then the people on my maternal side never told me a thing about it, although they knew it. I'm mad but what can I do? Everybody that knew about it is gone. You can't do a thing about it.
ZIERLER: Do you have any early memories having a sense, even as a very young child, of the United States being in World War II?
ROLL: Yeah, yeah. I knew about it. I have pretty vivid memories. I guess when I was maybe 4 or so, my grandfather would take me out in the yard and show me a whole flight of bombers going over to Europe. Stuff like that. And then, I remember very well, right at the end of the war, I guess it was VJ Day, I got to ride in a fire truck. There was a big celebration. I remember doing that. That was the highlight of the war. [laugh] But I had several relatives that were in the war. My mother, of course, was somewhere. My uncle Frank, who is my aunt's husband, was in Italy in World War II. I had another cousin who was killed in Tarawa. I knew people who were in the battle. But I don't remember much except watching these bombers fly overhead and riding on the fire truck.
ZIERLER: And what was the circumstance of the family moving to St. Louis?
ROLL: My grandfather was transferred there. He started with the Texas and Pacific Railroad, which was in Louisiana. He was a railroad executive. And then, he became the chief superintendent of the western district of the Missouri Pacific Railroad, which extended from St. Louis, to Kansas City, to Denver. We moved to St. Louis, where he supervised that segment of the Missouri Pacific. He had his own private railroad car. He'd hook his car up to the end of a passenger train, the Colorado Eagle, and we'd go to Colorado. They'd put our car in a siding next to a trout stream, and we'd go fishing. He was great to me, [laugh] except he didn't tell me about my father. But I still think he was one of the greatest and smartest persons I've known. My maternal grandparents legally adopted me toward the end of the war. They actually went to court and got my birth certificate changed. Why they did that, I still am not sure. I guess maybe to keep me away from my father, whom they didn't like. But I'm not sure exactly why.
ZIERLER: And you spent your childhood in St. Louis?
ROLL: No, I spent the first few years in Louisiana, and then a couple years in St. Louis, a couple more years in Kansas City because that was kind of midway on the route of the Missouri Pacific. And then, my grandfather basically retired, but he didn't retire. He became the president of a small railroad that was headquartered in St. Joseph, Missouri. And so, when I got to high school, we had moved to St. Joseph, Missouri. That's where I went to high school. I graduated from Central High School in St. Joseph. And from there, I went to Auburn and entered the aeronautical engineering program. I also had a Naval ROTC scholarship to Auburn. But I went back south for college.
ZIERLER: And in high school, were you more technically oriented? Were you stronger in math and science, and that's what you knew you wanted to pursue an undergraduate program in?
ROLL: Well, I had good grades. I actually skipped the 4th grade. The teacher said I had already done the material. When I graduated from high school, I was only 16 years old when I went to Auburn. And four years later, I was only 20. To be a Naval officer, you'd have to be 21. They excused me. Actually, they didn't need anybody in the Navy anyway. This was 1960, so before Vietnam. Since I was only 20, I didn't go in the Navy, but I took a job at Boeing. The Navy told me that if I went to work for a defense contractor, they'd just forget the whole thing. So they did. And I was lucky because a few years later, Vietnam came along. I was actually a Marine Corps option. I went to Quantico between my junior and senior year, trained in the boot camp for officer training school. Because when you're in Naval ROTC, every summer, you go on a cruise or something like that. So between freshman and sophomore, I went to Europe on a cruiser, and between sophomore and junior, I flew from Pensacola, and then between junior and senior, I went to officer candidate school in Quantico. But I never went into active duty.
ZIERLER: Did you have a good experience at Auburn?
ROLL: Yeah, I liked Auburn. I had some really good aeronautical engineering professors who worked at Redstone Arsenal, which is where they brought Werner von Braun from World War II to develop rockets. There were some people teaching aeronautical engineering who were also working at Redstone Arsenal. And the funny thing is, when I went to work at Boeing, I worked briefly in the airplane division, but then I started working in the missile division. The third year I was at Boeing, I wrote the operating manual for the moon rocket, the Saturn. Boeing built the first stage booster for the moon rocket. There were three stages.
This gigantic first stage thing was just a big tank with giant pumps to pump the oxygen and kerosene into the combustion chambers. And you can't believe how big it is. They built it in Metairie, Louisiana, so I was back in New Orleans when I worked for Boeing on that thing. They had to build it there because it was too big to transport except by barge. And so, when they sent it to Cape Canaveral to shoot it off to the moon, it was transported from Metairie, Louisiana on a barge to Cape Canaveral. That's how they got the thing there.
ZIERLER: Was Auburn integrated at that point? What was your sense of the racial politics there?
ROLL: No, there were no Black students there. When I first went there, there were none. In fact, the first year I was there, 1957, the Auburn football team won the national championship. No Black players. And then, a few years later, when Alabama played USC, I think, there was a Black player for USC named Sam Cunningham, who just killed Alabama. And at that point, Bear Bryant and Shug Jordan at Auburn and Alabama said, "We're going to stop this nonsense about white players." [laugh] And yeah, they started letting Black players into the school. I was the editor of the school paper at Auburn. I worked part-time as a news editor and editorial writer. And then, when I was a senior, I was the editor of the Plainsman, which is the school paper.
ZIERLER: How long were you at Boeing?
ROLL: Four years.
ZIERLER: Did you specifically want to go back to graduate school? Why didn't you stay longer and develop a career at Boeing?
ROLL: As I told you, they sent me to get an MBA.
ZIERLER: With the intention of coming back to grow within the company though?
ROLL: Yeah. I was actually working full-time while I was getting the MBA. They wanted me to be an engineering manager, and they thought that I needed business training to do that. But then, when I went to the University of Washington to the business school, I liked the things that I was studying there better than I liked engineering. So I decided, "Hey, I think I'm going to switch fields."
ZIERLER: What specifically resonated with you in the MBA program?
ROLL: Oh, just economics and finance. I liked studying the stock market, I liked accounting, that kind of stuff. Even though I had an interesting job at Boeing, like working on the moon rocket, but I was basically writing a manual that was describing how a gigantic turban pump can pump liquid oxygen into a combustion chamber. And I didn't feel like that was anywhere near as interesting as the stock market. So I thought, "If I have a chance, I may as well try something different."
ZIERLER: How much opportunity did you have to take econ 101? Tell me about the curriculum for the MBA at Washington.
ROLL: Yeah, Econ 101, you had to take an economics course. That economics course was what we call in economics price theory. It was supply and demand, the basics of things. And then, I started taking more advanced electives. Bill Sharpe was teaching a course in finance, which was concentrating on risk and return, how you measure and quantify risk, whether or not that quantification leads to higher average returns for stocks. When he was an assistant professor there, he wrote a paper published in 1964 about the capital asset pricing model, which is called the CAPM by people in the field, for which he won the Nobel Prize. He was very excited about that paper. I remember in class, his enthusiasm infected everybody in the class. I didn't really know what he was talking about. But it was not until I got to Chicago that I realized, "Hey, this is really good stuff." [laugh]
ZIERLER: Did you go back to Boeing and say, "I'm so sorry that you spent all this money on me, but I'm going to pursue an academic career"? Or how did that conversation play out?
ROLL: I gave them notice and said, "I don't want to be an engineer anymore." And my supervisor said, "Well, you're making a big mistake." But they didn't try to talk me out of it. I was one of many engineers at Boeing. They're a dime a dozen. It's not a huge loss for a company like that. Boeing is a gigantic company in terms of engineers. I don't know how many thousand, but at least let's say 30,000 engineers, something like that.
ZIERLER: Where did you think about going to pursue the PhD? What options did you have?
ROLL: Since I was a southerner, nobody had advised me about which colleges were good and bad. I knew nothing about anything. But then, when I got to Washington, I started hearing about better schools. I was suddenly aware that there was a college called Harvard. Princeton, Yale. [laugh] I'd never even heard of Harvard when I was a kid. So I said, "Hey, Harvard sounds good. Let me apply to Harvard." And that's when I went to Bill Sharpe and another professor at Chicago and said, "I think I'm going to go to Harvard to get my PhD." And they looked horrified. They said, "No, don't ever go to Harvard." They said, "Go to Chicago. That's where the real research is happening." And so, I changed my mind even though I had applied and been admitted to Harvard.
But the Harvard Business School did not have the best reputation in those days. It was a case studies school. They did not do quantitative research or any kind of scientific research. They just studied cases. I didn't know that, of course. But Sharpe did. And he told me, "Don't you go to Harvard. That's the wrong place if you want to be a professor. You've got to learn how to do research, not write cases." And that was very good advice because I certainly made the right choice. I'm not saying that Chicago was the only place. I could've gone to Stanford, Wharton, or a few other places that had similar mindsets about doing research. But Harvard was the wrong place. At least in those days. It's changed now.
ZIERLER: While you're making these decisions, are you exempt from the draft? Were you thinking about enlisting? Where was Vietnam in all of this for you?
ROLL: I was not exempt from the draft. But as I mentioned to you before, I was in Naval ROTC in college. And then, since they didn't really need anybody in the Navy in 1960 when I graduated, there was no war going on, the Korean War was over, the Vietnam War had not started and didn't really get underway until '63 or '64, there was a surplus of Naval and Marine Corps officers. So they were letting people go, especially if they'd promise to go work for a defense contractor. When I worked for Boeing, that was a defense contractor. And basically, as long as you worked for a defense contractor, in those days, you didn't get drafted. There was no draft, really, until Vietnam got underway. Nobody was being drafted in those days. I was lucky because I escaped that.
And then, when I got to Chicago as a PhD student, it was still a little early. Then, when I graduated, I went to Carnegie, where I took my first academic job. At that time, I was married and had two children, so I got a deferment from Vietnam for that. They used to give people exemptions if they were married and had children. I don't know if they still do that or not. But I never went in.
ZIERLER: What were your impressions when you first got to Chicago, both of the city and the university?
ROLL: Well, I definitely was not impressed by the city. [laugh] The first month I was there, I was in married student housing, and I walked out one morning, there was a bus stop in front of my apartment building, and there was a guy laying in the bus stop with a bullet hole in his head and a guy with a gun standing over him. And there were about seven or eight people gathered around, and they didn't seem to be that bothered by it. The police came, and it turned out that the guy on the ground was a robber. He had come to the bus stop, pulled out a gun, and started holding up people. But one of the people in the crowd had a gun, who shot the robber right in the head. This guy had a permit for the gun. The police said, "OK, you've got the permit," took the witness statements, and everybody got on the bus and went to work. [laugh]
The South Side of Chicago, where the University of Chicago is located, is surrounded by poor neighborhood. It's scary. It was probably scarier in those days than it is today. And then, the weather. Here's a boy from Louisiana. I get up one morning, I had a Ford Falcon parked out in front of the building. The snow that night was so much that I could walk right over the top of the Ford Falcon. It took me a week to dig it out. [laugh] So I didn't care for the weather or the city. But I loved the university. You go to the university, and you're in this little Shangri-La of intellectual people who are just doing their best to do good research. That was an incredible thing.
ZIERLER: And when did it dawn on you that there was such a thing as the Chicago school, and that you would become an adherent to it?
ROLL: Well, I knew I was becoming an adherent to it. I didn't know it was the Chicago school or that they called it such. I only heard that after I left, when I got to Carnegie. They said, "Oh, you're from Chicago, the Chicago school." I said, "What's that?" He said, "All the guys at Chicago." [laugh] But I don't know who gave it that name originally. But it was because there were a lot of people, mainly in the economics department, also the business school, that believed in free markets, low taxes, and had a certain point of view. And it was not Keynesian. It was anti-Keynesian. The Chicago school stands for that. Because you remember in the old days, John Maynard Keynes, the Cambridge economist, had become so paramount in the way the government worked, everybody in the federal government believed they should do what Keynes said.
And Chicago said, "No, that's not the right way to behave" said Milton Friedman. But I knew people who were Keynesians like Paul Samuelson. When I graduated from Chicago, my dissertation won a prize as the best American dissertation in economics. And it was published in a book, and Paul Samuelson was on the committee, and he wrote the forward to the book. I got to know Paul Samuelson. He was a great person. I got to know some people at other schools because even when I was a student, I was writing papers with the professors, and I would go around to present them. I went to MIT, and I met Paul Samuelson, who was in the economics department at MIT. And Franco Modigliani, who was also in the econ department and was a coauthor of Merton Miller, who was on my committee.
I got to know some people at other places. And then, when I graduated, I went to Carnegie, which in those days was called Carnegie Institute of Technology. Now, it's Carnegie Mellon. That was my first academic job. And I had some no-name economists as colleagues there like Bob Lucas and Ed Prescott, both of whom were Nobel Prize winners. Tom Sargent, also a Nobel Prize winner. They were all faculty members at Carnegie. But I was the only finance professor because even though they had a business school, they were all economists. They didn't know anything about finance. I ended up teaching all the finance courses at Carnegie for six years.
ZIERLER: What was the intellectual process of developing your thesis research?
ROLL: I worked with Gene Fama, who was my principal advisor, although I had other people on my committee. Merton Miller, Rueben Kessel, and Arnold Zellner. Zellner is a econometrician, so he's not a finance guy. The other three are finance guys. And Gene Fama had written a bunch of papers about the stock market and serial dependence in stock returns, which is the thing that I told you about earlier in the paper I just wrote. But nobody had done any work on interest rates. And so, he suggested that I collect data on interest rates and try to see what the empirical behavior was of interest rates. The trouble was, there was no data based on interest rates. Chicago had developed a database on stock returns but not on interest rates.
And so, I had to go to New York City to Salomon Brothers, and dig through their archives, and collect a dataset of treasury bill rates, which were the empirical things that I used in my dissertation. And I basically wrote a book called the behavior of interest rates, which describe how the term structure evolves over time, whether or not there's any way to make money on the movements in the term structure, and that kind of thing. I had some theory in there about that, too. Because there are theories of the term structure of interest rates going back to the mid-30s. Irving Fisher, for instance, talks about it. The term structure of interest rates is the relation between the term to maturity of a bond and the yield in the bond. And that term structure fluctuates over time.
If you could predict that, you could make a lot of money on that prediction. So I did study that in my dissertation. But the reason for that, really, was, we were just looking around for all kinds of ways to apply these new techniques to different financial markets. And nobody had done treasury bills and short-term interest rates before. I dug into that and produced a book, really, that was a pretty comprehensive study of that.
ZIERLER: Who else was on your thesis committee?
ROLL: Well, I mentioned Arnold Zellner, who's an econometrician, so he's a guy that knows a lot of statistics and that sort of thing. Merton Miller, who is a finance professor, but a Nobel Prize winner. Deceased now, but his main specialty was corporate finance, leverage and dividend policy, things like that, not so much stock market behavior. Gene Fama, who was my dissertation chairman, who is still at Chicago. He's also a Nobel Prize winner. He's a lifelong friend of mine. His wife and my wife are like bosom buddies, and he spends six months a year in LA because he just wants to get out of Chicago.
We have dinner with them quite often. He's only a year older than me. He just graduated a year before I did, actually, and joined the faculty at Chicago right from graduate school. Very unusual that somebody appoints a PhD student to the faculty, but they were right about him because he's been brilliant. I think he's the most cited person in economics. He has more citations than anybody else. I believe that's the case. At least it was a couple of years ago. And he and I wrote several papers together. When I was a graduate student, we wrote three papers together and published them, one of which has become one of the most cited papers in finance and has to do with events studies, which I don't need to go into.
ZIERLER: Well, what is an event study?
ROLL: An event study examines stocks that do the same thing, but at different points in time. Suppose they announce a dividend increase. They don't all do that at the same moment. You look to see what the price reaction is to a dividend increase. But of course, if you look at a single stock, there are lots of other things going on, a lot of noise in the data. When you do in an event study is, you line up all these different stocks, find a sample of companies that have done the same thing, announced a dividend increase, and you line them up on the date of the dividend increase announcement. And by doing that, you wash out all the noise of other things that happened to each stock so that you're left with only a pure measure of the dividend increase.
The first event study was one that we did together when I was a graduate student. There have been thousands of them since then because everybody wants to do this since they're all interested in, "Well, what happens if I split this stock? What if I do a merger?" Everything that a stock can do, you can check the effect by doing an event study. So many different events have been analyzed by now, at least with older data. You need to redo them every now and then because things change.
ZIERLER: At least informally, how important is it for you to consider psychology, sociology when you consider these things?
ROLL: For a long time, I didn't think it was important at all. And that's my Chicago school training. There's a market. In any market, there are thousands of people buying and selling. So when you think about the market price, that is an indication of the consensus belief of all the buyers and sellers who are inhabiting that market. All the buyers think the price is too low, and all the sellers think the price is too high. But there's wisdom in the crowd. The price is probably just about right. In fact, empirical studies show that that's the case when you have a really well-functioning market with lots of competitors in the market. You rarely find a situation where the price is completely wrong. Ex-post it's going to be wrong because new information comes out. But nobody knew such information at the time.
So new information will, of course, change the price. But since that information isn't known to the market participants at the beginning, only later, the surprise moves the price. The essence of market efficiency, which is what Gene Fama popularized, is that the market price of the stock is always an unbiased estimate of the future value of the stock. Sometimes it's too high, and sometimes it's too low, but on average, it's right. And what that means also is, the only thing that changes a price is a surprise in terms of information. For example, tomorrow, the CEO has a heart attack. An utter surprise and boom, the stock price falls. But nobody knew he was going to have a heart attack the day before. So new information is the only thing that should affect a market price at all. If there's no new information, the price should just stay basically pretty much where it is. But people that are doing psychological things don't believe that. They think there's a bargain every day.
The only problem is, because of psychological factors, some people bid the price up too high. Or maybe the price is too low. The trouble is, how do you detect that? How do you detect which it is? For a long time, I thought, "Well, really, there's not much scope in finance for psychological things because markets are operating pretty efficiently." But I realized after a while, there are some cases in finance, some situations where there's not a market, you don't have thousands of buyers and sellers coming into a marketplace, and bidding up or down the price, and putting into the price their best estimate of the information that's available. And a good example of this is in an acquisition, where a company wants to take over another company.
Microsoft wants to acquire Yahoo!, let's say. That's a situation where there are only one or two people making the decision. There isn't a whole market making decisions. Yahoo!'s selling for a certain price in the market, but Microsoft thinks that price is too low. And if they believe that, and they're willing to pay more, they can pay the stockholders of Yahoo! more than the current market price. The question then, is it possible that people who are overenthusiastic or overestimate the value of the target in an acquisition are wrong most of the time? And the reason you suspect that might happen is, suppose you have a publicly traded company like Yahoo!, and Microsoft says, "I'd like to acquire that, so let me do a valuation of Yahoo!." And Yahoo!'s selling for $30 a share.
When Microsoft does a valuation, it comes up to only $25 a share. You never see a bid. You'll only see a bid when the valuation exceeds the current price. So basically, you've lopped off half the distribution. And only the people who have overestimated the price are the ones who make the acquisition, which means that they generally lose. When an acquirer acquires a target, the market generally reacts negatively because the acquirer has overpaid . So let's say Microsoft makes a bid for Yahoo!. What happens to the stock price of Microsoft? It goes down on the announcement because the market assumes that Microsoft has overestimated the value of Yahoo!. When you do empirical studies of many different acquisitions using an event study, an announcement of an acquisition is an event, you can see that the effect of the announcement that the company is going to acquire another public company is to reduce the value of the acquiring company.
It's rational from the market's point of view. But it's irrational from the acquiring CEO's point of view because he's either got hubris or overweening pride and arrogance that his valuation is right and the market is wrong. There's psychology for it. And there is hubris. There are people with hubris. They think they're right and the market's wrong. And that's a case where you actually see it empirically because unlike a general stock market trading every day, there's one person or just a small number of people who make that acquisition decision, and they don't make that many of similar decisions in their lifetimes.
They don't learn that much typically. You can trace psychological effects from that. I also wrote another paper where I looked at overconfidence in mergers and acquisitions, and in that case, there's evidence that if you are overconfident or narcissistic, you have an effect on the negotiations between two companies in a merger. This isn't just an acquisition, but let's say two pretty much equal-sized companies are talking about merging, and one CEO is more narcissistic than the other CEO. Narcissism includes self-centeredness and analogous psychological quirks. In this paper, we actually measured the narcissism of CEOs in merger contests. And we did that by looking at the fraction of first-person pronouns they use in transcripts when they're interviewed.
If you say a lot of "I" instead of "we", you're more narcissistic. And psychologists have shown that that's actually pretty closely correlated with their standard tests of narcissism, their big tests that include all kinds of other factors. If you look at the transcripts of interviews given by CEOs, the fraction of first-person pronouns used is a very good measure of narcissism. If you have two companies, one of which is more narcissistic than the other, the impact on the negotiations affects which one is more narcissistic, which one is going to hold out the longest for the best price, which one is going to insist on theirs. And if both are equally narcissistic, it takes a lot longer to do the deal. They can't come to an agreement. There is some scope for psychology in some of this. Although generally, I'm not much of a believer in behavioral finance. I don't deny that it exists.
ZIERLER: Speaking of psychology and sociology, being in Chicago in 1968, what was that like in terms of the riots, the convention? Where were you in all of these things?
ROLL: I was on the campus. The '68 riots were downtown at the Convention Center for the Democratic nomination. It was 60 blocks away, so we didn't feel that close to it. We followed it on TV, of course, like anybody did in those days.
ZIERLER: You were not very politically engaged at that point.
ROLL: No. In fact, the Chicago school is not really very politically engaged. It's more Libertarian. Neither the Republicans or Democrats appeal to those guys. [laugh] The Republicans are spending like crazy just like the Democrats. In Washington, you really can't tell the difference between which administration is in power. They're all spending trillions of dollars. Now, there were some people at Chicago that got involved in political situations in other countries. For example, in Chile, Arnold Harberger became a leading advisor to Pinochet, the dictator in Chile.
And so, he got castigated for doing this, even though Pinochet was basically a hands-off guy when it came to the economy. He let the Minister of Finance and the head of the central bank manage the country. And the country had an economic boom. Economic prosperity in Chile became incredible under Pinochet, even though he was repressive in terms of his political policies. It kind of reminds me of Hong Kong when the British were there. There was no voting, but Hong Kong became richer than England because the British administrator let them in Hong Kong do whatever they felt like doing, and the taxes were low. Pinochet was a bad guy who didn't allow political representation, but he let the economists run the country. And Chile became the richest country by far in Latin America in that period. Harberger was the advisor to these economists who were in charge under Pinochet.
He got castigated in the press for having helped them. And I don't know whether that was justified or not. He did help a government that was headed by a dictator, but the Chilean people did very well in terms of economic prosperity.
ZIERLER: After you defended, what opportunities were available to you? And was it only academic opportunities that you were looking for? Did you consider going into the world of finance?
ROLL: Yeah, I considered it. And I did have offers to go to Wall Street, to Salomon Brothers, and to a few banks, like a bank in Chicago, or the Chicago Mercantile Exchange, which trades options, futures, things like that. I've written papers on those things, too. But I really wanted to be a professor. That's what I was getting my PhD for. I could've gone to the financial industry and not bothered with a PhD, although having a PhD in finance is still an entree into a good job in the financial industry. But it's not necessary. Yeah, I wanted to be a professor. So I had job offers from several universities when I graduated from Chicago, and I picked Carnegie because it was, according to my advisor, Gene Fama, the best of what I had available. I could've gone to the University of British Columbia, to Wharton, to a few other places.
ZIERLER: Carnegie Mellon was considered better than Wharton?
ROLL: It was for research, yeah. Now, that may have been Fama's opinion. I'm not saying that everybody shares the same opinion. One of my co-students the same year at Chicago did go to Wharton, Marshall Blume, and he spent the rest of his career there. So it wasn't that you couldn't go to Wharton. But Gene advised me to go to Carnegie. I could've gone to Cornell. They offered me a job. I went there for a job interview, and I arrived in the middle of a blizzard. And I thought, "Pittsburgh can't be this bad."
ZIERLER: What was some of the research that you did during the Carnegie years? What was some of your key work?
ROLL: Well, I did several papers on interest rates, which followed my doctoral dissertation. I got that published the first year I was at Carnegie, and that won the prize, the best dissertation in economics. But then, I worked on a number of different things. I wrote one of the early papers on gun control, which is not finance at all. But I'm kind of a data guy in a way. If you've got a lot of data, I like to dig into it and see if I can figure out any patterns that might be interesting in data. So I wrote a paper on gun control, which I still think is a pretty good paper. In fact, some of the recent studies on gun control have really corroborated this paper. It was published in the Duke Law Journal.
And the data were the following. They were local ordinances against gun control and state ordinances against gun control back in the 1970s. And so, we tried to correlate those ordinances with rates of homicide, suicide, aggravated assaults, robberies, things like that. And we found that stricter gun control had very little effect on homicide rates, but it had a very big effect on suicide. It actually decreased the suicide rate dramatically. And it raised the rate of aggravated assaults. And here's the reason. When you have gun control, you try to kill somebody with a knife, and it's not as effective. So if you have a gun, you're more likely to succeed. But an aggravated assault is basically an attempted murder but with something less effective than a gun.
What people do is, they substitute other weapons that are not as effective. But it has a big effect on suicide. I read just recently at Berkeley, there's another professor that's still doing these kinds of studies, and they also found that gun control has a big impact on suicide, but not so much on homicide. And of course, it has very little impact on stuff like robbery and things like that. But I'm not sure whether that still holds today.
But then, I did a paper that really made my career, which was a study of previous empirical papers that had studied the capital asset pricing model, which is the model that relates the expected return of a stock to the risk parameter of a stock, commonly called the beta of a stock.
There's an equation that says that the expected return of the stock is going to be equal to the risk-free rate plus the beta, which is the response of the stock return to the market's conditions. A high beta stock means that when the market goes up, it goes up even more. The market goes down, it goes down more. The higher that beta coefficient, the higher the average return of the stock. That's the prediction of the capital asset pricing model. It's hard to test though, empirically. There were a bunch of papers that tried to do it, and I wrote a paper, which basically criticized these papers and became very well-cited, called A Critique of the Asset Pricing Theory's Tests, which is really, I guess, the most cited paper I've ever written in my whole career.
Because it really made people stop and think, "Are we really doing the right thing when we test this?" It's very technical because what they were doing was highly econometric, very hard to understand unless you're a specialist in this. And so, I became a specialist as part of my PhD program. And I discovered after that that there seemed to be some flaws in these papers, and so I published that one.
ZIERLER: What were the circumstances of moving to UCLA? Were you recruited? Were you looking for new opportunities?
ROLL: I didn't tell you that there was a period when I'd left Carnegie, and I wasn't yet at UCLA. I went to Europe. In 1972, I left Carnegie, and I went to Brussels, Belgium and was appointed to a place called the European Institute for Advanced Study.
ZIERLER: Is this to say you resigned, or you took leave?
ROLL: I first took leave from Carnegie, and I went to Belgium, and I went to this research institute in Brussels. The research institute was sponsored by nine European countries that had business schools, but very few finance faculty that knew how to do research. And so, they had the idea to put this institute in place, recruit Americans who did know how to do research to serve on the doctoral dissertation committees of students at these nine countries at various universities in Europe. So as a reward for that, they let you do your own research. You didn't have to teach, but you did have to go to a country now and then to serve on a doctoral dissertation committee. You were assigned countries.
I had three countries, France, Finland, and Ireland. So those were my three countries. Every now and then, I'd go to Ireland, to Dublin, or to Helsinki, and more often because France is much bigger, I went to Paris or someplace in France to serve on a dissertation of some student who was trying to get a PhD in finance and didn't have any faculty, really, to advise them. I was there for two years doing that and writing papers that I was publishing. At the end of two years, I had gotten to know several people in France at a place called Hautes Etudes Commerciale, which is HEC. It's one of the Grand école in France, which is one of the schools founded by Napoleon.
So École Polytechnique, École Normale Superior, all those Grand école. Napoleon had his cabinet members each sponsor a school. The Minister of Commerce sponsored this school that I went to, which is Hautes Etudes Commerciale, which stands for Advamced Studies in Business. It's in a little town near Paris called Jouy-en-Josas. They offered me a job, and they said, "We're going to turn HEC into the world's leading research institute in finance." I said, "OK, I'll come and give it a try." Then, I quit Carnegie, I resigned, and I went to HEC. And I was fully what they call in France aggrégé, which means you're appointed for life as a full professor. And in France, in your field, you're ranked from oldest to youngest. Whenever somebody older than you retires you can move to that school.
If I wanted to go to the University of Paris, and somebody retired, and I was the next ranking person, I could grab that spot. Well, that's what it means to be aggrégé in the French system, which I was. So I thought I was going to spend the rest of my life there. And I was teaching in French. I am still fluent in French. In those days, they didn't have any English courses. But I had been married previously, and I had gotten a divorce when I left Carnegie. Pretty amicable divorce, but I had two children. And my ex-wife had moved to California with the kids. And so, after two years in Paris, she called me and said she couldn't handle the kids. They were teenagers. And she asked if I could come back and take care of them. They had come to spend summers with me in France anyway. I'd spent a lot of time with them in the summers when they were out of school.
I said, "All right, I guess I'd better do this." And so, I called up a professor at UCLA named Fred Weston, who was the leading guy in finance. I knew Fred. And I said, "Fred, I need a job. Can UCLA give me a job?" He said, "Oh, yeah, we'd love to give you a job." I went to UCLA. And my kids moved to LA, went to high school here in Culver City. By that time, I'd been married to my second wife, and she had two younger children. But we were in Paris together, and she told me that if I moved to LA, she wasn't going to go. And I said, "Why?" "There are too many blonde divorcees in California." But believe it or not, I said, "I'm going to have to go, so I'd like you to go." She went. And six weeks after she got here, she said, "I'm never going to leave this place."
And her daughter, my stepdaughter, who was in grade school in a French school in our little town in France said, "I don't want to go to America. I'm French." I said, "I'll tell you what. When we get to LA, you can go to Le Lycee Francais." There's a French-speaking school here in LA. She went there for several years, then finally got used to it. All the kids went to grade school and high school right here. And by the way, that stepdaughter went to Chicago for undergrad and MBA.
ZIERLER: Another member of the Chicago school in the family.
ROLL: And her daughter, my granddaughter, is at Chicago right now.
ZIERLER: Wow, family business!
ROLL: And her little brother--you won't believe this--is at Auburn studying aeronautical engineering.
ZIERLER: Oh, my goodness. [laugh] That's great. What was your home department when you got to UCLA?
ROLL: Business school, finance department. Now, it's called the Anderson School. When I went to UCLA, it hadn't been named Anderson School. But of course, I knew a lot of people in the economics department, too. Like Armen Alchian, Harold Demsetz, and people like that were good friends of mine. And Clay La Force, the chairman of the economics department, was and still is a very good friend of mine. In fact, in November 2019, right before the pandemic, Clay and Barbara La Force along with my wife and I went on a 14-day Mediterranean cruise together. He is still a very close friend of mine. He was the head of the economics department when I went to UCLA, and then he became dean of the business school. He was dean of the business school for a long time while I was a professor there. And he and I are really good friends. He's 91 years old now. You wouldn't believe it. He looks like he's 60. Amazing guy.
ZIERLER: What was your reaction in the mid-late-1970s to the stagflation and economic malaise? Did you work in areas that you saw as responsive to these broader problems?
ROLL: No, that's macroeconomics, the stagflation. That has to do with what's called the Phillips curve. Prior to the stagflation episode in the 70s, there was a lot of research done by macroeconomics that claimed that full employment is related to higher inflation. There's a curve that says that if you've got higher inflation, you get less unemployment. That's the so-called Phillips curve. That Phillips curve was widely believed by Keynesian economists. Phillips was an English economist, I think. I don't know him personally. He published, I guess, the first paper on this, where he studied different periods and tried to show that you get more less unemployment if you have higher rates of inflation.
Now, when I was at Chicago, even before the 70s, in the late 60s, Milton Friedman talked about that in his class and the money workshop that I would attend, and he claimed that this was a lot of baloney and said there was no such thing as the Phillips curve. And he based that on international evidence, where he looked across countries and couldn't find any relation between the inflation rate in the country and the unemployment rate. I guess in England, there was a relation, but England may have been the only place. Anyway, there were a lot of people who thought that was the case. Stagflation was the result of the Phillips curve not working in the late 70s. That's what it meant. The government under Jimmy Carter produced high inflation, but the unemployment rate was also high.
The Phillips curve didn't hold. Which is what Friedman had been saying all along. And there's no theory behind it, unless the theory is psychological, that people don't understand inflation and are fooled because they think they're getting higher wages when they're not really getting higher wages, they're getting higher nominal wages but in devalued dollars. That's the only theory behind the Phillips curve. If you believe that people are not complete idiots, they're not going to fall for it. In the 70s, they didn't. You remember that in the late 70s, we had 15% interest rates. Treasury bill rates were 15%.
ZIERLER: My parents' first interest rate when they bought a house in 1977 was, I think, 15.2%.
ROLL: Yeah. One thing we know about interest rates is that inflation does affect interest rates. It may not affect unemployment, but it definitely is going to affect interest rates. Because if you lend $100 to somebody, and the inflation rate is 15%, you're going to get back $85, even if you earn nothing, in purchasing power. You've got to charge 15% interest rate to make up for that. It's very clear that interest rates and inflation are strongly correlated, and that's true in every country in the world in every single period. In 1979, interest rates were 15.5%. And Paul Volker got into the Federal Reserve, and he lowered it dramatically. And they did it without having any impact whatsoever on employment. [laugh] So if you look at 1979, that was kind of the peak of the inflation rate.
By 1983 or '84, the inflation rate was down to 2 or 3%, and interest rates had fallen from 15% to 4 or 5%. The real interest rate, which is the difference between the nominal rate and inflation rate, was always only 2%. If the nominal rate is 17%, the inflation rate is 15%, that's a 2% real rate. Later, the interest rate is 4%, and the inflation rate is 2%, the real rate is still 2%. If you look historically over the entire lifetime of when we've had data for interest rates, the real rate of interest hardly ever goes above 1 or 2%. It's almost always below 2%. In most cases, it's below 1%. So even today, now we've got inflation that's suddenly heating up to, let's say, 5%.
The real rate of interest, the rate of interest on indexed bonds the government's issued, is still 1%. It's always been 1%, and it's always going to be 1%. But the nominal rate of interest can be anything. Some countries have hyperinflation. Brazil, I think their interest rate today is something like 35%. And there have been many countries where it's even been higher. In Germany, the Weimar Republic, the rate of inflation became something like 10 billion percent. They couldn't even use the money anymore. There's a famous story about a German going to the bank with his wheelbarrow full of marks. Somebody robbed him. They didn't want the money; they wanted the wheelbarrow. [laugh]
ZIERLER: Talk about your 1980s paper, The Hubris Hypothesis of Corporate Takeovers, and more generally, your interest in mergers, acquisitions, and takeovers during this period.
ROLL: That's the paper I was talking a little bit about before, where if Microsoft believes that Yahoo! is worth more than the market price, the CEO of Microsoft, if they're infected with hubris, that means they're overconfident, and they really believe in their own valuation more than they believe in anything else. That's where the hubris came from. Hubris means overweening pride, confidence, and arrogance. If you make a valuation of a target, and you believe your valuation is absolutely right, and you don't pay any attention to what other people are saying, that's hubris, and you're going to make a mistake.
And so, that paper was first laying out the psychology of why that happens and then pointing out that whenever you make a valuation mistake that's negative, if it's below the market price, you never observe that observation because there's no takeover bid. Because nobody's going to make a takeover bid below the market price. They're only going to make it when it's above the market price. So right away, the bids are biased. The only bids observed are biased high. It doesn't mean that on average, people make erroneous valuations. But we never see all the valuations, only those that are too high.
Half the time, the valuation is below the price, and half the time, it's above the price. But if you have enough hubris believe that your assessment is correct, you will make a takeover attempt. But if it's below the price, you won't even try because nobody would accept that bid. So right away, you see that there's a bias between the target price offered by the acquirer and the market price caused by the hubris of the CEO.
ZIERLER: Tell me about your collaborations with Stephen Ross. What made that such a productive relationship?
ROLL: Well, the first thing that made it such a productive relationship is, he was an absolute genius. I was just lucky to have him as a coauthor. [laugh] And he also became one of my best friends. I think the best friend I ever had in my life. And he always called me the best friend he ever had in his life. A Caltech undergrad I physics, he went to Harvard for a Ph.D, but not in finance, in the economics department, which was a good department. At Harvard, he studied international trade, which is kind of a sterile field. His first academic job was at Wharton. When he was an assistant professor at Wharton, I was an assistant professor at Carnegie. During that time, I went to present a paper at Wharton. I think it was the paper I wrote on the asset pricing model. And Steve was interested in trying different fields because he wasn't very keen on international trade theory. He came to my presentation and he liked the paper. The next week, they had another speaker at Wharton. It was Fischer Black, who invented the Black-Scholes option pricing model. And Steve went to that seminar too. And he said, "After those two seminars, I said, 'If those are typical people in finance, I'm going to get into this field.' Because those are the smartest people I've seen in a long time."
At the time, I didn't know that. He told me later. But when I left Carnegie and went to Europe, it turned out that he also went to England at the same time, but only for a year. When he was in England, he wrote an incredible paper on the arbitrage theory of asset pricing, which he sent me. I was in France, and I read the paper, and it's a fantastic paper. But it's theory. And Steve is a complete theorist. He and I would always argue because I'd always say to him, "Look, the empirical guys like me have to discover something weird to give you theorists something to talk about. Otherwise, you won't know what to write." [laugh] His paper on the arbitrage theory of asset pricing was the first multi-factor paper on asset pricing.
And it's a brilliant paper, not only in its theory, because it's very, very elegant, but it also is practical in the sense that you could use the arbitrage pricing model to devise optimum investment portfolios. When I got the paper and read it through, I called him up in London from Brussels and said, "Steve, this paper is fantastic, but it needs to have empirical work done. So how about if you and I work on empirically fitting your model?" He said, "That's great. Sounds great." He came over to Belgium, we worked a little bit, I went to London, we worked a little bit more. It took us a long time to get it done. And by the time we had a working paper going, I had gone back to California, and he had gone back to Wharton.
And we decided we'd spend the summer of that very first year back in America in Vancouver because we'd been invited by the University of British Columbia to spend the summer there. They often did that; they'd invite people for the summer. Steve and I went to UBC for the summer, and we finished that paper. We got it published in the Journal Finance not long after that, and it was one of the most widely cited papers in finance. But that wasn't the end of the story because we realized that we could use the results in the paper and in his theory to start a money management firm, except that neither one of us knew how. [laugh] In the meantime, I had gone to Goldman Sachs.
Steve and I started a money management firm and had no clients. We were joined by a junior partner, a lawyer in Philadelphia, and I started producing paper portfolios, nothing with real dollars. We worked on this and we got it going on paper. Suddenly, we got a client. Steve went and talked to somebody, and unbelievably, they gave us money to invest in this thing. We started a company called Roll and Ross Asset Management. The people at Goldman Sachs knew I was doing that. I wasn't trying to pull the wool over their eyes or anything like that. The next year, I was still at Goldman Sachs, and we got some more clients. And I started taking a few days here and there and going to visit clients, building portfolios, and stuff like that at the same time I was doing mortgage-backed securities for Goldman. The third year, we had seven or eight clients. We had maybe a billion dollars by that time.
So Goldman Sachs said, "We have Goldman Sachs Asset Management here, and nobody knows how to run it. How about if you and Steve take over?" I said, "OK, that sounds good. Goldman Sachs Asset Management with all these sales people out in the field." Steve wouldn't do it. He said, "I don't want to work for anybody." I said, "You're crazy. These are great people. I love the people at Goldman Sachs. Steve Friedman, Bob Rubin, (the future secretary of the Treasury.) They're wonderful people to work for." And he said, "Nope. Not going to have a boss." So that was the end of that.
So then, I decided, "Well, we have Roll and Ross Asset Management, and I have Goldman Sachs mortgage-backed securities. I've got to choose between the two." I told the Goldman partners I was going to quit, and go back to UCLA, and work on Roll and Ross while I was in California. So by that time, we had offices in Philadelphia, in Blue Bell, Pennsylvania, and in New Haven. Steve had gone to Yale, so we had an office in New Haven. And then, I started one in Culver City. And for 20 years, we ran Roll and Ross Asset Management, where I did all the portfolio selection in Culver City. I had several people there on the staff. Alan Yuhas in Blue Bell, Pennsylvania, did all the trading, and Steve did all the client interactions. He was the guy who went out and solicited the money.
I solicited occasionally, but I was not as good at it as he was. He was very persuasive. So then, 20 years went by, and we made quite a bit of money from this company. But it was still a little company. We had 15 employees total, something like that. A money management firm is a very good firm if you have clients. There's hardly any expense. It's all revenue. So you're charging people 50 basis points of the money they put in, which means a half a percent. If they put in $100 million, think about it. It's a good business. It's a great business, but the trick is to get people to give you the money. [laugh] They have to believe you do something for them, like produce a portfolio that beats the market, which we did, most of the time. I'm not claiming we beat it by a huge amount, but most of the time, we did. We started mutual funds. We managed one of Vanguard's mutual funds. We managed a mutual fund in Saudi Arabia. We had a couple other things. And then, we had a whole bunch of institutional clients. We had CalPERS, we had Citibank, we had John Deere and Company, we had a bunch of the Fortune 500 pension funds that we were doing. JP Morgan in New York approached us, saying they'd like to buy our company. And I said, "Well, what will you to pay for it?"
And they mentioned a price that was beyond my wildest dreams in terms of money that I could ever imagine having in my life. The only trouble was, they wanted Steve and I to work in New York for five years with them. Steve wouldn't do it. He didn't want to have a boss. So that was it. [laugh] We didn't do it. A few years later, we sold Roll and Ross to our junior employees and got out of the business entirely. We started a couple of other businesses. One business using option prices to value stock option grants for corporations. We had a lot of clients doing that, too. But that was more of a consulting firm. It wasn't the same thing as a money management group.
ZIERLER: Going into these ventures, how much of it was an opportunity to be in a laboratory environment as an academic, if you will, and how much of it was just the rush of being in the business world and operating in it?
ROLL: It was some of both because you realize that when we did Roll and Ross Asset Management, we were the first company that actually applied an academic idea, the multi-factor asset pricing that Steve pioneered. We were the first company that ever did that. If you look today at investment management firms, there are thousands of them doing the same thing. And we didn't have the business sense to expand the company into what it could've been. We weren't really businessmen, we were academics. We applied a theory and empirical results that supported that theory that we'd developed as academics. And we saw an opportunity to at least start a small company. But actually, we missed an opportunity to make it a gigantic company.
There are many investment management firms now that do multi-factor asset pricing. And we were the first one.
I would say that Goldman Sachs and then Roll and Ross, the two main business ventures I had, both of those was the sheer joy of being in business, and making money in business, and doing things that are worth doing from a business perspective. Goldman Sachs went into the mortgage-backed securities business. When I went there, they had never done it before. And I hired 53 people in the time I was there, half of whom were PhDs in physics and math. Some Caltech students and others. We started a trading desk and we built the models for the traders on the trading desk. We had an investment banking function, which meant that we did mergers and acquisitions of mortgage-related companies like thrift institutions and savings and loan companies.
We did mergers for those. And we did our own trading for our own proprietorship. Mortgage-backed securities are complicated things, and they need academic research to understand them. You've got to model the prepayment propensity of people, which is psychological partly. And there are a lot of different varieties of mortgage-backed securities, all of which are very different. When I was at Goldman Sachs, my group invented the stripped mortgage-backed securities, where we would take a standard mortgage, separate the principal and the interest, and sell it as two separate securities. And we did that and made a lot of money doing it, until other people got wind of what we were doing and started doing it themselves.
We cornered the market on adjustable-rate mortgages. Nobody would trade with us because we had the best prepayment model. At Goldman Sachs, a lot of it was business but there was an underlying academic perspective, underlying research because we needed to do pretty fundamental academic research to understand it. These things are not at all easy to deal with. Today, how many people have lost fortunes in mortgage-backed securities because they've done things that are not smart? We always made money, but I was always in charge of being the cautious person that said, "OK, we've got to hedge this position. We shouldn't do that trade." But of course, Goldman Sachs in those days was a pure partnership, so the partners were very, very wary of any kind of risk. [laugh] It came out of their own pockets.
ZIERLER: Did you always know that you were going to go back to UCLA? Did you ever give serious thought to making this your new life?
ROLL: Oh, yeah. As I told you, when they said, "Would you like to take over Goldman Sachs Asset Management if Steve would come and run it with you?" I expected to continue doing that and to resign from UCLA. Or when JP Morgan offered to buy our company 20 years later. I did think I might do that. And when I was in New York City those years at Goldman Sachs, my wife still stayed in LA. As I told you, once she got to LA, she never wanted to leave. We would commute every other weekend. I knew the People Express 747 intimately. I'd take the red-eye back to New York on Sunday night and go straight to Wall Street on Monday morning. And she would come to NYC every other weekend or so.
Some of the Goldman partners, when they were offering us this job, invited us to their homes and would try to persuade my wife that she needed an apartment on the Upper East Side of New York with a painting by Willem de Kooning in the foyer. "That's what you could have." She spurned all that. She had her own ideas about a career. My wife started a restaurant 27 years ago in Ojai. She started Suzanne's Cuisine. And she ran it for 25 years. In the Zagat Guide, at one point, it was rated the second-best French restaurant in Southern California. It was a very successful restaurant.
ZIERLER: Is this where the vineyard started?
ROLL: We bought the ranch a couple years before she started the restaurant. I actually bought it with money I made at Goldman Sachs. When I came back from Goldman Sachs. I call it a "ranch," it's 360 acres, so it's pretty big. And I put in a vineyard help from some professors at UC Davis in the wine department. But in the little town of Ojai, she bought a house on the main street, remodeled it, turned it into a restaurant, and opened a very, very good restaurant. It became the most popular restaurant by far in that whole area. It was popular. She didn't close it after 25 years because they had no business. She made money in the restaurant.
But her daughter, the one that I told you went to Chicago and got her MBA at Chicago, left her Wall Street type job to come and help her mother run the restaurant. This annoyed me to no end since I paid all her tuition. [laugh] and she was making a lot more money than she would be making with her mother. But she did the business side of the restaurant, managed the wait staff for 25 years with her mother. My wife, Suzanne, was the kitchen. She's the chef. Of course, she had seven other people in the kitchen, but at the beginning, she did a lot of the cooking, and she concocted all the recipes. It was a very good place. But after 25 years, Sandra, our daughter, said, "I don't want to do this for the rest of my life. I'm 50 years old. I've been doing this for 25 years. I want to do something else. I want to close the restaurant. Besides, you're almost 80 years old now. You're too old to be a line chef."
And my wife had not been working that much in the kitchen the last few years anyway. She'd be in the dining room, greeting the guests. They decided to close and my wife was very, very unhappy for at least a couple years. She missed it so much. But she finally got over it. And Sandra, my daughter, went into a different business. She owns trailer parks now. [laugh] I keep telling her, "Owning a restaurant and owning a trailer park?" [laugh] A trailer park's a lot more profitable.
ZIERLER: Coming back from Goldman, how did that experience affect your research, the kinds of questions you were interested in pursuing?
ROLL: I did get a lot of ideas to do serious scientific papers from my experience at Goldman. I published maybe seven papers on mortgage-backed securities; aspects of things we were doing in practice at Goldman. After our competitors had caught onto what we did–because we kept it secret initially. I'd write a paper on, for example, the prepayment modeling that we used at Goldman Sachs for adjustable-rate mortgage. Adjustable-rate mortgages are different than fixed rate mortgages because their interest rate fluctuates with some index, such as a treasury bill rate. The prepayment behavior is different for those.
I wrote a bunch of papers on mortgage-backed securities, valuing them, modeling them, and so on. And then, I also started writing papers on options because we did a lot of option pricing at Goldman Sachs. And in fact, the essence of a prepayment model as an option, because the borrower has the right to decide to prepay the mortgage whenever they feel like it, and that's an option pricing model. It's a long term and difficult option pricing model. Because if you have a 30-year mortgage, the borrower can decide to prepay that any time in those 30 years. When will they prepay it? Exactly when you don't want them to do it because they can refinance at a lower rate, which means the lender gets the money, and then must reinvest at a lower rate.
There are a lot of reasons why the options on mortgage-backed securities are extremely valuable to the borrower and a big decrement in the value of a mortgage to the lender. We would model that. And since they're long-term options, the typical–the typical option pricing model (Black-Scholes) cannot be used. It is for short term options, like a month, three months to maturity. Mortgage related options can extend to 30 years. And not only that, there's psychology involved. Because when you look at the prepayment behavior of average homeowners in the economy, they don't do the optimal thing. They follow psychological rules of thumb. They make the decision to prepay. And it's not always the best decision. But in order to model that, you have to model the psychology of why they do it. I'll give an example.
There's one big factor that makes a prepayment option worth less, called "burnout." When there are a bunch of mortgages in a pool, some people in the pool that will refinance right away when interest rates go down. But not everybody. Some people will keep paying those high interest rates, maybe for 30 years. So you've got to figure out who these idiots are that keep prepaying at 7% interest when they could refinance at 3%. There are people who do that and it makes the mortgage pool more valuable. One of the most important valuation questions in a prepayment model is, how much "burnout" is there in this particular pool of mortgages? Is everyone going to refinance right away when rates decline? Or will there be a bunch of people in North Dakota that are stuck on their dairy farms and never think about it? [laugh]
That leads you models of geographic heterogeneity. You have mortgage-backed securities that are originated in all kinds of different cities, states, even different countries in some cases. And each one of those might behave distinctly, psychologically. The people in Alabama don't behave the same as the people in Washington DC or California.
I've got an interesting story about that. I mentioned a few minutes ago a thing called stripped mortgage-backed securities, where you take the principal payments and the interest payments, and you separate them out, and you sell them as two separate securities. So when the investment bank does this, let's say Goldman Sachs does this, buys a mortgage, strips it into these two pieces, and sell the two pieces. If it can sell the two pieces for more than it's paying for the mortgage, immediate profit. At Goldman, we generally could do that for the first year and a half or so we were doing it.
And then, one of the salesmen from Goldman Sachs who covers the southeast called me up and said, "I always thought that some financial institutions would buy the principal piece, and some financial institution would buy the interest piece, but neither one would buy both pieces because they could buy the original mortgage, which is the same thing as both pieces put back together. But Alabama Federal down here has been buying both pieces. Would you call them up and tell them to stop that?" This was Goldman Sachs trying to help the client.
I called the treasurer at Alabama Federal in Montgomery and said, "How come you're buying both pieces of these stripped mortgage-backed securities? You could buy the whole mortgage cheaper?" He said, "No, no, you don't understand. There's a tax option in this. In January, we buy both pieces, and then at the end of the year, one of them will go up, and one goes down."
I said, "Yeah, that's right." "We hang onto the one that goes up as a capital gain, and we sell the one that goes down. That's a tax loss. And we end up with more money than if we'd have bought the original one. Because we don't know whether that was going to go up or down. But what we know about the IO and PO is that they're always going to go in opposite directions. We don't know which one will go down and which will go up. But by the end of the year, it's almost sure that one will do one way and one the other." And I had initially thought this guy was dumb. He turned out to be smarter than any of us. [laugh]
ZIERLER: Tell me about your tenure when you were President of the American Financial Association.
ROLL: That's an honorary position. You are elected mainly because of publications. People know who you are from your publications. It's a one-year term. There's an election every year. There are two candidates usually. The election really happens in the previous year between two people who then will take over in the subsequent year as president of the association. The president of the association really doesn't have much to do.
First, he's in charge of organizing the annual convention, which in the case of economics and finance, occurs the first week of January every year. This convention is also the job market for new PhDs.
They go to that convention and interview various universities that are hiring new PhDs. That's the so-called new hire job market every year in economics and finance. That happens in the first week of January.
Also as president, you have to decide on the papers that are going to be presented at the convention. But you have a committee for this. You appoint colleagues from various universities to read the papers and decide which ones will be accepted for the convention program.
The final, and most time-consuming task, is that you must write a paper that will be published in the Journal of Finance in the middle of the following year.
I was still at Goldman Sachs when I was elected, and I wrote a paper that has the following distinguishing characteristic. It has the shortest title of any paper ever published in Finance. The title of the paper is R-squared, R to the exponent 2. That's it. And actually, to my surprise, it turned out to be a pretty well-cited paper. Not because of the title, but because the subject of the paper was to look at news articles about companies to see whether you could explain a large part of the returns of companies by news that came out about the companies.
We know that new information causes stock prices to move. My idea was that the R-squared, the explanatory power of this new information, should be high. That is, if you could tabulate every news item that came out about a company, you should be able to explain most of the volatility of the stock price. Not in advance, this is after the fact. You look at the stock today, some news story comes out about the stock, then the price will move maybe today or tomorrow. I built some models that looked at all the stories, and I collected all the data. And to my incredible surprise, the R-squares are not that impressive. In other words, there's a lot of volatility in returns that are not even related to news stories. That's why the title is R-squared. Because the essence is, the R-square, which is the explanatory power in a regression, is way too low compared to what you might think you'd get from trying to tabulate all the news items that come out about a stock.
And so, I did a big empirical study of this and tried every different way I could think of to increase the R-square, and the most I could ever get was about 30% for big public companies. Which means that 70% of the day-to-day variation in returns cannot be explained by publicly available news. What can it be? Perhaps individuals that collect private information and act on it secretly. It has to be something like that. Or maybe it's just pure irrationality, like the psychologists say.
People get a bug in their bonnet, they're going to buy AT&T today, and they go buy zillions of shares. That drives the price up. There's no public or private news associated with that.
Even today, years later, my R=square paper still gets lots of citations, and people try still today to add to the explanatory power, thinking there must be some way to explain this variation in returns. There was a fellow at Yale named Robert Shiller. He won a Nobel Prize a few years ago. His main contribution to finance was to show that there's too much volatility in returns relative to what there should be given the changes in the dividends that companies have.
This was done before my paper, but it's a similar idea and a similar empirical result in the sense that returns fluctuate too much to be rational. That's what he says. Now, I don't know whether it's rational or not because I don't know how you figure out who's doing irrational trading. But he's saying that these fluctuations have nothing to do with fundamentals. They're just irrational people going in, buying and selling stocks when they shouldn't be.
ZIERLER: What opportunities did you have to interact with undergraduates at UCLA?
ROLL: None. Unless they took a course in the business school. UCLA does not have an undergraduate business degree. There's only MBA and PhD. There are no undergraduates. There's a small program that teaches undergraduate accounting, but I didn't teach accounting, so I didn't get involved in that. The entire time, the 38 years I was at UCLA, I didn't teach anybody except MBAs and PhDs. That was it. I usually taught a PhD course every year, one quarter, and then an MBA course. And I taught a lot of different MBA courses. I taught international finance, fixed income securities, security analysis, mergers and acquisitions. I taught a lot of different things just because I didn't want to repeat myself over and over again every quarter. [laugh] And I've done that at Caltech, too. I taught the first course in finance a couple times, and the last two years, I've taught a course on investments. But I'm getting a little tired of that one, too. I'm going to see if I can do something different.
ZIERLER: What was your reaction to the dot-com boom and bubble burst? In what ways was this predictable based on the way the market operated previously, and in what ways did you see this as new events?
ROLL: There were new inventions coming out; e.g., Cell phones. It wasn't just electronics though; biotech companies were part of it. There was a huge boom in biotech in the late 80s, early 90s. I think there were something like 850 biotech companies that did IPOs in the late 1980s. There was a huge inflow of brand new companies. But here's the thing about a brand-new company. Who knows what they're worth? Most of them had zero profit, and you were lucky if they even had any revenue. When a company goes on an IPO, they generally hire an investment banker at Goldman Sachs, for instance, that takes the stock to the public, goes through all the regulatory paperwork and things like that, and then distributes the stock in a syndicate to their own investors, or they form a syndicate of several investment banks that sell these initial public offerings to their investor clients.
They did that for dot-com and for biotech. For those brand-new companies, nobody has a clue, including the investment bankers, about what they're worth. I know, for example, because studies have been done about biotech. I'm not so familiar with the dot-com bubble. The main thing that caused the value of a biotech company to be high when they did an initial public offering was the credentials of the chief scientist employed by the biotech company. So often, these are little companies formed by, let's say, a professor at Caltech in the chemical engineering department.
He or she goes initially to some friend or "angel" investor. Eventually, after a flirtation with venture capitalist, the inventor seeks an investment banker to sell the stock in an IPO. But the main thing that causes that stock to be high in price are the senior staff of the company. When you look at the biotech crisis, you can see they're very highly related to the quality of the PhDs that you have working on the biotech products that the company is bringing to market. And I think the same thing is true of dot-com as well, although it's not so clear on dot-com because in the case of biotech, most of these people are chemical engineers, or biologists, or something like that, where you can look at their credentials and see, "OK, this guy is a biotech scientist from Harvard, and his senior partner is one from Berkeley.
The junior guy on their staff is a Caltech PhD. That company is worth a lot of money because they're likely to invent something good." And so, the price that the investment bankers set on the initial public offering is just all over the place depending on that more than anything else. The first 50 or so biotech they did, the investment bankers had no idea that this was true. They learned that as they took more companies to market and noticed that the ones that had better-qualified staffs in the aftermarket went up much more than the ones that didn't have such qualified staff. The investment bankers learned from the first few biotechs that the way to price these properly is to charge high prices for companies that had really well-qualified staffs.
Now, after the fact, sometimes these companies fail. In fact, most of them fail, I think. Of 850 biotech companies that were started up late 80s, early 90s, how many are still here? Very few, right? Genentech and Amgen. Some of them became hugely successful, but most of them didn't. The dot-com crash was, a lot of investment managers bought every single one that came out with the idea that 5% of them will be really successful, but that would be enough to pay for the losses of the other 95%.
When you look at the dot-com crash, if you look at the number of stocks that are traded on the New York Stock Exchange, there was a peak in the early 90s of something like 5,000 companies. It's 3,000 now. Because 2,000 of these company no longer exist. Now, it's been a long time, so there have been other failures since then. But when you think about it, if you don't have any idea which company is which, but you think biotech is going to make a lot of money, why not just buy a small fraction of every single one that comes out? It's like insurance. Your house is probably not going to burn down, but if it does, you're going to eat it. It's the same thing in reverse.
ZIERLER: I'm particularly interested in your consulting work for law firms. What were some of the things that law firms wanted to retain your services for?
ROLL: Valuation, mainly. When there's a lawsuit, let's say federal court, which is where I had most of these cases, let's say a company issues a fraudulent financial statement and gets caught. When this is disclosed to the market, the market price falls dramatically because people thought the earnings had been, for example, $10 a share, and it turns out they're only $5 a share. So there's a big price drop. There's a lawsuit because the people who bought the stock, believing that the earnings were $10 a share, sue the company for not having disclosed the truth. That's called a 10b-5 case under federal law.
The reason they hire an expert like me is to try to figure out the correct price that they should've paid prior to the disclosure of the fraudulent information. For the people who bought the stock prior to that. It's complicated in the sense that there are many other things that might've happened before that aren't related to the fraud. You've got to try to figure out and testify that Mr. X paid $9 a share for this, and really, he should've only paid $7 a share. Stuff like that. It's a valuation problem. Most of the things are valuations.
I have some really funny stories about this. There was a case in LA, actually, one of the first cases I had, where the defendant was Budget Rent-A-Car. And they issued a statement that they had purchased from an inventor an engine that turned water into gasoline. And they were going to install it in all their rental cars and lower the price of their rental cars.
And channel 5 in LA had the inventor on, and he hooked up a garden hose to one end of this paraphernalia, and a stream of fire came out the other end. [laugh] So he was on TV5 one night, and the price of Budget Rent-A-Car went from, let's say, $3 a share to $20 overnight. They had all these professors on channel 5 testifying that this violated the second law of thermodynamics. And I remember that included Caltech professors the whole apparatus was impossible. And sure enough, it was. What happened? The channel 5 news anchor invited this inventor back a month later, he brought his machine in, hooked it all up, and then somebody noticed that there was an electric cable that was plugged into the wall. And when they unplugged the cable, no fire came out.
The next morning, the price of Budget Rent-A-Car fell from $20 a share to $3 a share. [laugh] So that was a very clear-cut case. I remember talking to somebody in the physics department at UCLA about this, and I said, "Everybody believes the second law of thermodynamics except the people who paid $20 a share for Budget Rent-A-Car. What is the probability that the second law of thermodynamics is wrong?" And he said, "Well, practically impossible." I said, "Well, is it 1%?" "Maybe half a percent." I said, "If it's half a percent that the second law of thermodynamics is wrong, Budget Rent-A-Car should've sold for $2,000 a share, not $20." Because a half a percent that this thing really works means that that machine is worth an incredible fortune. Of course, most physics professors thought that the probability was zero, not half a percent.
ZIERLER: Was there anything of concern to you in the run-up to 2008? Did anything seem off that you were focused on in 2006, 2007?
ROLL: I don't think there was anything wrong with the financial markets. I think the problem was within the housing sector. The housing market was overheated. And the reason for that is that the growth rate in real wages for the average person in the economy was doing very, very well in the early 80s. In other words, the unemployment was low, and the real wage rate was going up. And when you think about housing, the main thing that determines the value of a house is the lifetime earnings of people that buy housing.
If you think your earnings are going to grow over your lifetime at 3%, you can afford to pay much more for a house today than if you think your earnings are going to grow at 2%. 3% versus 2% doesn't sound like much, but over a lifetime, that's enough to make a house go up by about 50% in value if everybody believed that. And what happened in the early 80s is, a lot of people started thinking, "Hey, the growth rate is really good for real wages. I think I can afford to pay more for this house."
And the lenders, who were issuing mortgages, also believed it. They issued mortgages to people whose incomes at the current time would not have qualified them for such a large mortgage. But it did qualify them based on the presumption that those people would have growing incomes over time and would be able to pay off these mortgages over time. I remember very well at UCLA when a guy from Freddie Mac came out and gave a talk, and a guy from a local savings and loan institution came out and gave a talk and was saying, "We're issuing alt-A mortgages, which are basically mortgages that depend only on what people say their income is going to be over the next 10 or 20 years."
People were lending money to those individuals when they probably shouldn't have been doing so. But it was understandable that they would do it because their business is to lend mortgages. They were issuing mortgages to these people that were unqualified based on current levels of income but would be qualified if you looked at their lifetime income. What happened toward the end of 2007 was that there was a big revision in people's expected lifetime income. That's what I think happened. I think those people decided, "You know what? My income is not going to grow at 3%, it's only going to grow at 2%. And guess what? I can't afford this house that I just bought for $150,000 with a mortgage that's $145,000. I'm not going to pay the mortgage interest." [laugh]
The mortgage lender says, "Wait a minute, how come you're not going to pay the interest?" "I'm not going to do it. Here's the house." And a lot of people did that. And to me, it's obvious from the clear-cut evidence, prices of houses fell. They fell dramatically. They went down 25 or 30% in some areas. People had believed that houses just keep going up in value. That's not true. There's a lot of volatility in house prices. In 2007, it really showed up. The prices fell below the values of the amount of the loans that were outstanding on the mortgages in many cases, and people just walked away.
A lot of these lenders borrowed money to finance the loans for the homeowners, they couldn't repay the loans they borrowed either, so you had a big debacle in the financial sector. But I think the whole thing was caused by the housing market initially. Well, by the housing market indirectly. But the real fault was in people's expectation about what their lifetime income was going to be, what the growth rate of real wages was going to be. And one reason they revised that downward was because of the election that year, when they elected a Democrat, which is not good for real wages. That caused revisions in people's expectations. I think that's what happened.
I wrote a paper on that called A Misdiagnosis of a Crisis that won an award in the Financial Analyst Journal, in which I tried to show that you can't have a crisis because a lender and borrower default. Because for every borrower, there's a lender. So basically, if a borrower defaults, it just takes money away from a lender. So in aggregate, there's no loss when there's a default on a fixed-income security like a bond. There's a loss when a house price goes down because that's a real asset. But not between, let's say, a borrower in a mortgage and a lender in a mortgage because that's just a transfer between one party and another. There's no increase or decrease in real assets when that happens. I tried to argue in that paper that, unlike a lot of other people that blamed it on financial institutions lending improperly, it was true that they did that, but that wasn't what caused the crash.
ZIERLER: What was your reaction to the government response, the bailout?
ROLL: As a Chicago school person, I don't like it because they're taking money from the taxpayers and giving it out to people. And that's bad from a Chicago school perspective. I think that the Fed, at least in the short term, does need to intervene from time to time in markets when they're melting down. They didn't do that with Lehman Brothers, but they did that with AIG. They helped AIG weather the storm. There's something to be said for the Fed or the Treasury in a short term basis doing this. But I don't think either one should be buying up zillions of dollars worth of mortgages and holding them for long time periods. Now, they're having to sell them off. They've held onto these mortgages now for 13 years. It shouldn't be the role of government to do that.
ZIERLER: This inevitably gets us into issues of morality about who helps people in distress.
ROLL: Yeah. But you help some people, and you hurt others. Somebody's going to have to pay the bill for this. Look at the current budget in the new administration. A $4-trillion budget. The government doesn't have its own money. It's got to get the money from somewhere. And where does it get it? There are three places it can get it. It can borrow it, but that doesn't really get it any money. It's going to have to pay that back. It can raise taxes. Tax rates are already way too high. Or it can print money. But that's just an inflation on the price level. If it prints money, inflation will go up, and that's another form of tax. It's a tax on people holding cash balances. So basically, there are only two ways that the government can finance this. One is by raising taxes, and the other is by raising taxes by printing money. It's helping some people. But what about those taxpayers in the next generation? What about my grandchildren? I don't think that they should have to pay for this.
ZIERLER: The year after in 2009, you were named Financial Engineer of the Year. And I'm curious about the term financial engineer. How much of that is real engineering, and how much of it is a term of art?
ROLL: There's an International Association of Financial Engineers, and it's made up of people who do quantitative modeling for all kinds of financial institutions and some academics who do quantitative modeling. In a way, it is really engineering because when you do something like that develop a trading model for, let's say, adjustable-rate mortgages, there's really is not much difference compared to building an airplane. It's engineering. You've got to get the bells and whistles right, think of all the different contingencies, and test it, just like you would in a wind tunnel. I don't really see it's that different. And secondly, the math involved is almost the same. You're using the same mathematical techniques.
We use calculus, differential equations. That's what they use in chemical engineering. That's what we do when we're studying financial markets, too. To give you an example, the Black-Scholes option pricing model is a model that Black and Scholes derived from a differential equation. It turns out that their equation is the same thing as the heat transfer equation in physics. It's the exact same form. They didn't know that until they were all done, but honestly, it really is engineering. I don't think people need to be sheepish about calling themselves financial engineers because they're basically doing the same sorts of things that other engineers are doing.
Of course, other engineers are dealing with completely different problems. But the techniques and the approaches are pretty similar. This International Association of Financial Engineers, which is pretty big, gives an award every year called the Financial Engineer of the Year. They gave it to me. But they've given it to a lot of academics. I'm far from the first one. There are many other people. Steve Ross was one. A lot of other academics before me received it. Even some that shouldn't have. I was totally surprised because I don't really think of myself as a financial engineer, although I guess I am in a sense.
ZIERLER: As we mentioned right at the beginning of the talk, obviously UCLA's retirement policy was not a surprise to you. When you were thinking about what you might do afterwards, were you considering non-academic opportunities as well, given your deep contacts and experience in the business world?
ROLL: Yeah, I thought that, except that I didn't really have any obvious places that I could go for work. I know a bunch of people in LA. I wanted to stay in Los Angeles, number one. Our children and grandchildren are here, so I did not want to move back to New York, Texas, or anyplace else. So that was the first consideration. And secondly, I could've looked for a job at an investment management firm that's local. For example, Dimensional Fund Advisors, I know David Booth very, very well. Gene Fama's on their board of directors. I might have applied for a job there. But they pulled up and went to Texas before I knew what happened. [laugh] There are other firms, too, but I didn't really want to go to work for another investment management firm. I'd rather just be an academic, write my papers, lead a tranquil life.
ZIERLER: And just one year into your tenure at Caltech, you won the Onassis Prize. Tell me about that.
ROLL: That's another international honor that's awarded every two years. There are several similar awards. There's a Deutsche Bank Prize. Steve won that, I think, the year before I won the Onassis Prize. The Onassis Prize was set up by Aristotle Onassis, the Greek shipping magnate as part of his legacy. When he died, he set up a foundation whose board gives that prize every year to two people. I won it jointly with Stewart Myers, who's a professor at MIT and a specialist in corporate finance.
The award is conferred in London. I must say that the English really know how to do ceremonies. It's incredible. I went to London, they invited my whole family, paid our airfare and everything. They have a big ceremony in the Guildhall in the city of London, where there are people playing trumpets. And there were probably 500 people in the audience. It's a very impressive thing. I got up, and I didn't know what to say. I said, "For a country boy from Arkansas, this is pretty good." [laugh] But my grandson went with me. You have to wear a tuxedo. And he was about 9 at the time. He got his tuxedo fitted in London. He'll never forget that.
ZIERLER: Have you had a chance to collaborate with Michael Ewens since you've been at Caltech?
ROLL: I have not written a paper with him, but I've done other things with him. I collaborate with him on the finance workshop, which he's in charge of now. And we work together on special events. We had an event a few years ago where we invited Steve Ross and Bob Merton, a Nobel Laureate, and several people to campus and had a day-long finance thing for alumni, where we invited local alums. Michael and I worked on organizing that. We've done several things together. I've not written a paper with him yet though. He's a specialist in venture capital, which I don't really know anything about.
I haven't seen the opportunity to do anything with him yet. I have written a paper with Charles Plott, but he's mainly interested in doing artificial markets, where he gets people on computers, and they trade with each other. And we did a study where we looked at the spreads in bid-ask prices and looked to see what caused those things to change. We published that paper. I would think I'd more likely work with him.
He's an economist, but he's interested in financial markets and doing experimental financial markets in his lab, where he has all these students on computers that are trading with each other. He's done other things before he did it with me. He's done other financial markets, for example.
ZIERLER: Have you ever enjoyed the opportunity to interact with undergraduates since you've been at Caltech?
ROLL: Yeah, the first three courses I taught were this beginning course, and the enrollment was incredible. I had 75 people in each one of those classes, which, for Caltech, is unheard of. I think the average class size at Caltech is seven or something like that. But there are so many people in other divisions that are interested in finding out something about finance because they think they might have to get a job there someday. That's my guess. They flocked to that course. So I had a lot of undergraduate students in that course. And they are very, very talented.
Some of them are much better than me at math. I also had the basketball team in my class the second year. The famous Caltech basketball team that lost 250 games in a row and finally won one when I was teaching them. [laugh] And their picture was in Sports Illustrated. It was about three or four years ago now. It wasn't the same players every year, of course, but Caltech's record was something like 0-250. They won a game when I was teaching them, so they were elated. And Sports Illustrated had their picture in it. The longest losing streak is now broken.
ZIERLER: Well, we talked about your current work right at the beginning of your talk, so for the last part of our conversation, I'd like to ask a few broadly retrospective questions about your career, and then we'll end looking to the future. First, I'm curious what kinds of stock answers you've developed over the years to people who want to know things that are not necessarily in your research agenda but fall generally in the topic of personal finance wisdom. What are some of the things that you like to tell people when they inevitably ask you questions like, "How do I retire securely? What's a good investment strategy?" What are some of the things you find yourself saying over and over?
ROLL: Well, it depends on how good a friend they are.
ZIERLER: Well put!
ROLL: If they're a really good friend, I say, "I haven't the faintest idea." If they're not such a good friend, I say, "Buy." Which is not a bad idea. Because generally, the stock market does do pretty well on average. So if you buy and hold on, you're going to do pretty well over 20 years probably. So if somebody's asking me when they're fairly young, I say, "Just put your money in Vanguard. It's got very low fees." That's another thing, I say, "Don't pay any fees to anybody. Put your money in a place that has very low fees," which Vanguard is the obvious choice because they probably have the lowest fees in the industry. "And buy a big diversified investment in one of Vanguard's portfolios." Diversification always pays, that's clear. You don't ever want to be in a position where you have all your eggs in one basket. But I haven't the faintest idea which way the market's going to go tomorrow, next week, or next year. So don't ask me.
ZIERLER: But the larger story is, you don't know, but nobody knows.
ROLL: I don't know, and if anybody says they know, don't listen to them. [laugh] But in the long run, if you buy a diversified portfolio of common stocks, and you don't go crazy trading them, just hang on, you'll probably do pretty well. Historical experience has shown that you earn 6 or 7% per year on average. Not every year, of course. There are down years as well as up years, as you well-know. But that's a pretty good idea. Some people, I tell, depending on the age, something slightly different. And I do this for myself. When you're a certain age, and you build up a certain nest egg, the best thing for you to do is to not risk losing money because you're going to use it for your retirement.
So I'm 82 years old now. I've got eight more years maybe. I've got a good nest egg. I don't want to put it all in the stock market and see half of it evaporate, and then have half as much when I'm 84. So what do you do in that case? Particularly, when inflation is a problem. Inflation's a serious problem for retirees because if your pension is in fixed nominal terms, you're going to end up losing in real terms. Your purchasing power's not going to keep up with inflation. So what do you do? Well, there is a security designed for this situation. It's the US Treasury Inflation Index Bond, or "TIPS." If you go to Vanguard, they have a mutual fund that's entirely invested in US inflation-protected bonds.
So last month, when the inflation rate was 4.5%, that portfolio went up 4.5% (on an annual basis.) Last month, the CPI went up 4.5% on an annual basis. That portfolio went up the same amount. It's indexed for the CPI. Now, the only risk there is that the government will renege on its obligations to pay, which I don't think they're going to do in our lifetime. I can't imagine that the US government would not pay its promised payments on all of its bonds. On nominal bonds, they don't have a problem because they just have to print the money to pay those. But on inflation indexed bonds, they have to get real money because the bond price goes up every month by the inflation rate as defined by the Consumer Price Index. TIPS are not perfect, but they're better than anything else that you can come up with. So if you're 80 years old, you want to say, "I've got $5 million. That's plenty of money for me the rest of my life as long as I don't lose anything." There you go.
ZIERLER: Our discussion has been largely devoid of overly political issues, and perhaps that has something to do with the fact that you come from the Chicago school, and its Libertarian tradition. But I wonder, in all of your decades in the field, if you have any overall ideas about whether the Democrats or the Republicans are overall better for the economy.
ROLL: I don't really know, to tell you the truth. I like the Republicans' attitudes about other things like freedom of expression, liberty, and things like that better than the Democrats', because I think the Democrats are more prone to interfere with people's lives. Which I don't like, being basically a Libertarian. But in terms of which one's better for the economy, it's really hard to know because when you look back at history–I'm a data guy. I like to look at the empirical evidence.
There's not much evidence in favor of one versus the other. There have been very good empirical conditions under Republicans, and there have also been good ones under Democrats. Bill Clinton had a boom. I didn't have happen to like his personal life, and I don't really think he had anything to do with it, except he didn't bother anybody. [laugh] On the other hand, you had people like Reagan. During Reagan's administration, there was a boom. Jimmy Carter was pretty disastrous, but that was just one term. But then, how about Herbert Hoover back in the 30s? He was horrible. The economy went to hell under Hoover.
So I don't really know. When you try to do an empirical study of this, and some of my colleagues in HSS who are political scientists do this, they look at the Republicans and Democrats and try to figure out which one's going to be better for the economy, I don't think you can point to any hard empirical evidence that proves it one way or the other. It's pretty ambiguous. Maybe one reason for that is that there's really not that much difference in terms of economic policy. I guess there's some difference in terms of military and things like that. When Trump was president, he cut the federal tax rate from 39% to 36%. Big deal. I'd like to see it cut to 5%. And then, of course, Biden is going to raise it back to 39%. But it's not going to make enough difference that you can empirically say, "That ruined everything," or, "That helped everything." It's not enough.
And then, you look at spending. Democrats are supposed to be the big spenders, but Republicans are, too. They may not spend it on the same things. But we had huge deficits under Trump, under Bush. We had huge deficits under everybody. Obama practically broke the bank. And of course, Biden is going to do even more, it looks like. Although I'm not sure whether that'll happen or not. It's not done yet. So tax rates and spending, is there really much difference? I don't know.
ZIERLER: An overall question about your research as it relates to computers. Over the course of your career, computers went from essentially nonexistent to really enormous capacity today. How has that changed the field, both academically and in the financial markets?
ROLL: It's everything. I would think that the entire field has been pretty much dictated by what's happening to computer power. When I was at Chicago as a graduate student, we had an IBM 650. You don't know what that is. It's a machine that you have to put a tray in, and you program it by taking a pin and wiring it to another slot in the tray. So it takes you hours to do the simplest thing. That was the first computer that I ever saw. And, a year later, I thought I had gone to heaven because we'd bought a computer that read paper punched cards. And I could punch cards a lot quicker than I could wire trays in the machine.
Soon after that, we bought a reader for reels of magnetic tape. I'm not kidding. You see how big this; reels 14 inches in diameter. And on each one of those reels, there was maybe 400 kilobytes of information. So when we first started doing the stock market studies at the University of Chicago, I worked for Larry Fisher, another professor, who was in charge of that. And we would go to the computer center in the middle of the night and take off one reel of tape after another. We had to mount 26 tapes to read through one month of stock market returns, monthly returns, one per stock. Computers are now much smaller, of course, more powerful and more user friendly. Now, we can do things that I could never have imagined. I've done more recent papers that involved data from every single transaction from every single stock exchange around the world for 20 years.
Billions of pieces of information. Really, multi billions of pieces. I'm talking about every trade that's done on every single market from Rio de Janeiro to Sydney, I have the data for that on a computer. For a long time period. So I can look second by second at the connection between every single stock market around the world. Every second and every day. If something happens in New York at 12:10 pm on Monday, does it happen in Sydney at 12:11 pm? That's the kind of thing you can do today with these databases and computers. It's just incredible. So the truth is, every paper I have written over my entire career has had an improvement in every single case in the ability to do data analysis. Every empirical paper. I've written some theory, but for theory, it doesn't matter.
I started doing annual observations because that's all that would fit on the computer. Then, we did monthly observations. Then, we did weekly observations. That took another ten years. Then, we did daily. And now, we do trade to trade. And not only do we have every single transaction, but we have, prior to every trade, the bid-ask spread that's offered on the stock exchange. So we can see whether or not the person that made a trade did it at the bid price or ask price, which tells you whether they were buying or selling. It's really phenomenal what you can do today.
ZIERLER: Well, for my last question, let's look to the future. For however long you want to remain active, what do you want to accomplish? What are the issues that, in the next year, three years, five years, however long you define your research agenda, are most compelling to you?
ROLL: You asked me earlier about what I tell people when they ask me questions like this. I'm a believer in efficient markets. That means that if I knew what I was going to do in the next five years, I would've already done it.
ZIERLER: [laugh] Very good. It probably helps to keep things interesting, also.
ROLL: [laugh] Yeah. So I don't know. I hope I'm healthy enough to still contribute things. Let's face it, I'm an unusual person in this regard. Gene Fama's another one. There are very, very few people who are 80 and still doing research. Hardly anyone. He and I talk about it sometimes. The typical person today is in their 30s. I just hope I'm still healthy enough to keep doing something worthwhile.
ZIERLER: Well, one thing it suggests is that you love doing it.
ROLL: Yeah, I do.
ZIERLER: Well, Dick, it's been a great pleasure spending this time with you. I'm so glad we were able to do this. I'd like to thank you so much.
ROLL: My pleasure.