10 Rules for Building a Portfolio That Actually Works for Your Life, with Cullen Roche

26:32And that becomes really acute too. And I mean, anybody who invested in 2008 knows that there was nowhere to hide in the stock market. Utility stocks were down 65%. So like the things that people think of as like even the safest components of the stock market, they can get really, really scary when things get really, really bad. And COVID was kind of like this too, where a lot of asset values just all went down at the same time. that's the thing that makes a strategy like risk parity potentially more interesting or one of the strategies i talked about that we didn't mention yet was trend following which is the strategy that the trend following traders what they're basically doing is they're buying commodities or true alternatives and they're just riding trends and the interesting thing about that is that those sorts of strategies they oftentimes work best when everything else is terrible and so So typically inside of like stock market, it crashes and things like that.

27:28The trend followers are, they're short the market because what trend followers are trying to do is they're trying to capture what looks like a small trend with the hope that it eventually becomes a really big trend. And that's kind of like the best trend followers are really good at capturing those types of events. And they're not biased against being long or short. So a lot of the times they're buying weird instruments or they're shorting weird instruments and they're getting exposures that are truly, totally uncorrelated. And that's one of the things that, you know, you're getting into markets there where you're finding versions of greater diversification in a strategy like that, that aren't necessarily going to be viable inside of like a 60-40 or just segmenting yourself to stocks and bonds.

28:13We're at the beginning of 2026. The stock market is high, but gold is also high. You typically don't see those two high at the same time together. We're seeing things now that we don't normally see. How do you make sense of that? Yeah, it's a really weird time to be an investor because the arguments and benefit of diversification are stronger than they've ever been because the disparity across so many different asset classes is just wider than it's ever been. This is most apparent with the US versus foreign CAPE ratios. If you look at like the this is the cyclically adjusted P.E. ratios, the United States is at 40, which is basically equivalent to like what it was during the Nasdaq bubble.

28:58Foreign stocks are at like 22 or something. And, you know, the weird thing going back to the Nasdaq bubble was that these two components, they tracked each other almost perfectly through the Nasdaq bubble. But today they've like gone in completely different directions. It's a very, very different environment. But you also see it in the disparity in like, you know, commodities last year. Right. Silver was up 150 % or something. I think gold was up 70 % or 60 % or 70%, whereas the average commodity was only up like 16%. So you had this huge disparity in the commodity market. I'm not typically like a huge advocate of buying commodities in general, but I would say that in this sort of an environment where you've got these huge disparities in returns, diversification, again, makes a huge amount of sense.

29:47We're going out and buying. If you want to own commodities, I think it makes a lot more sense these days to own a diversified commodity basket versus owning something individually like, you know, the Harry Brown permanent portfolio talks about how gold is the only component that they own there as like the inflation hedge, which is potentially like much higher risk these days. because the way I like to think about really high return markets is that when you generate 60 % inside of a single year, you create what I call a price compression, where if gold on average, let's say it generates 8 % per year.

30:24When you take 60%, what you've done is you've basically taken 8 % and you've compressed all these long-term returns way down into the short term. And what does that do? It creates potential for sequence risk again, where let's say you average 8 % over the course of the next 50 years. But if that includes 60 % in year one, well, that means that along the way, you're going to get a lot of negative volatility along the way. So I think, again, going into this sort of an environment, you have to look at something like gold and say, my potential for sequence risk is through the roof right now. And that may not necessarily be a bad thing in the very long run, but it might expose you to a huge amount of behavioral risk in the short term.

31:06People often say that behavioral risk can be offset by having a very clear investment thesis. Does that actually work though? Does having a very, very clear investor policy statement help you hold onto it when things did not go the way that you expected? Yeah. I mean, I think you should understand what you're doing and having a process and going back to the Warren Buffett methodology. I think one of his superpowers is that Buffett built this really brilliant process through which he does everything. And he, he stays steadfastly disciplined to that process. And so not only does he have this like incredible understanding of the things that he's buying and holding in the longterm, but he has this process that he understands so well that, you know, I do think that if you don't understand the things that you're buying, you will second guess them at times.

31:57And it's, it's an interesting one for me from like a behavioral perspective, because I've seen this front and center in my own business where sometimes I understand something really well, but if the people I work with don't understand it almost equally well, they'll come to me at times and they'll say, Hey, this thing isn't performing well. I don't understand it. I'm now second guessing you that creates behavioral risk where people then look at something when you get involved in something that maybe you didn't fully understand, you then look at it and you start to question it. And that creates the risk that especially when things are, you know, no bueno, that creates the risk that then you're going to sell into the downturn, which is like the worst possible thing you can typically be doing.

32:41And so you got to go into this whole process, I think, with a really solid understanding of what is the process? What are the things I'm owning? And do I feel fully comfortable with my understanding of all of it, knowing that weird things are going to happen and I'm going to expose myself to environments where I might second guess this, but I understand this stuff well enough to know that, hey, yeah, it feels risky in the short term, but I know in the long run, the probability of the outcomes to stay comfortable with it. At what point does diversification become diversification and how does that happen?

33:16How does it typically happen? It usually happens with a bad financial advisor in my experience. You wouldn't believe the number of portfolios I've seen where somebody will come to me with 50 different holdings and they probably look roughly like the S &P 500 and I run the math on it and I'm like, oh my God, like you could have owned one index fund and this would have looked exactly the same. But the financial services industry has mastered the art of making things look very, very complex to I think make it look like, Like, oh my God, this is so difficult to do that you have to pay somebody 1 % a year or else you'll never be able to figure it out yourself.

33:55All the big brokerage firms, I always laugh at looking at their financial statements because you get a monthly statement and the thing is like 15 pages and half of it is illegible or written in language that nobody can decipher. and it's all part of the confusing nature of finance and the way the industry has kind of been constructed. But it's important to look at a portfolio and understand what you've constructed to know that, hey, did I do something that made all of this overly complex in a way that relative to something really simple like an S &P 500 index fund, you know, would have been way lower cost and just way, way easier to manage.

34:38And so it's one of the dangers with stock picking that you can very quickly get into a portfolio where you, if you have 25 or 30 stocks, you probably own something that looks a lot like whether it's the Dow or the S &P 500, it probably looks a lot or has a very high correlation to the S &P 500. And so you can very quickly get into an element there where you have to question, you know, hey, was there a simpler way to do this. And I think the biggest danger of diversification is when people start trying to make things overly elaborate, where they're building a portfolio that kind of going back to that risk parity portfolio, where finding 15 uncorrelated return streams is really, really difficult in a fast track to diversification, because before you know it, you've got 15 different really opaque sort of unusual components in a portfolio where maybe this thing is really no better than like a 60-40 portfolio.

35:35The other thing about financial services is it's an industry that is made up of very, very brilliant people, but also people that love to overthink things and build things that are overly complex and oftentimes with the intent just to sell the product to somebody. And so it's very easy to build in layers and layers of added complexity that, you know, maybe they're not that beneficial compared to something like, you know, a 60-40 portfolio or understanding like it's one of the reasons why I'm such a big advocate of understanding the global financial asset portfolio, because look at that portfolio and then you can benchmark everything to that.

36:11And you can say, OK, I've got five different mutual funds and 10 different ETFs and then I own 25 individual stocks and looking at that and comparing it to something like the global financial asset portfolio, is it really any better? And the GFAP, as I call it, the global financial asset portfolio, it can be owned with as simple as like four ETFs. And so you've got to benchmark things correctly and understanding from a correct starting point so that you're not just building in layers and layers of complexity, not too dissimilar to the way that like we were talking about different accounts earlier, where you can get all these different accounts in different places over time.

36:52And before you know it, you've diversified everything because you've just made everything unnecessarily complex. Keeping things simple, it just will make everything much more manageable in the long run. But it's a balancing act too. You can, you don't want things to be too simple to the point where it's counterproductive, but you want to find that right level where you're also not just making so much complexity in the portfolio that it becomes impossible to manage or the different elements are just so costly that they start actually being counterproductive relative to your returns. So unnecessary complexity is essentially the factor that makes it worse.

37:29And that same unnecessary complexity can also, especially if you're not working with a financial advisor, can make you freeze because you get frozen by indecision. Yeah, I mean, and I think that's part of the complexity aspect that is so, it's so important to be really well organized with all of this and make it, you know, you want it to be complex enough, but not so complex that it becomes counterproductive. I try to distill all of this down as simple as it should be. But it's again, it's subjective. So you've got to do what's right for you. And that's such a personalized and subjective sort of thing.

38:10But it's something that is a balancing act because there's a fine line between building something that is way too complex and then building something that is way too simple to a point where, you know, like I'm a little bit critical of the three fund portfolio. because you can argue that the three fund actually requires more funds. Maybe it requires a cash fund or, you know, you could argue maybe it's not aggressive enough. You know, like it's the three fund portfolio isn't appropriate for Paula, but it might be more appropriate for like a retiree or something. It's a balancing act and it's personalized.

38:45Right. And if it's something like a three fund portfolio, you don't really have much opportunity to practice asset location. Yeah. And that gets into, you know, real financial planning and the aspects of all of this, where especially the older you get and the closer you get to retirement. I mean, when you have kids and things like that, life gets really complex. I think this is something that a lot of people struggle with as they get older is that your life gets really complex as you get older. And it gets more unpredictable also as you get older. Being young and having a decent job and having a lot of time, it's like the easiest time to be an investor.

39:22And I think it's one of the reasons why a lot of young investors take a lot of risks is because they kind of know they have the flexibility to be able to do that. But when you get older and life gets more complex, it actually becomes even more important to simplify your portfolio because everything else in your life is so complex that you don't want to deal with a lot of excessive complexity in managing your finances. Distilling that down into like a really simple portfolio, it can be accretive to the rest of your life in really beneficial ways because you're offsetting some of the complexity that you've got in the rest of your life that's inevitable.

39:58Right. Let's talk about the fifth principle, the cost matters hypothesis. Yeah, so this is probably John Bogle's most famous conclusion. And we talked earlier about the 60-40 portfolio and the origin story of it. And one of the most interesting components of the 60-40 portfolio was that Walter Morgan eventually hires John Bogle to run the Wellington Fund. It's kind of the thing that made the Wellington Fund most famous and ultimately led to like Vanguard and Bogle's fame. The most famous thing that Bogle was an advocate for and the reason why Walter Morgan hired him was because he wrote, Bogle wrote a really critical thesis paper at Princeton about how important costs are and how changing the cost structure of the industry could be really beneficial in the long run.

40:49This kind of became Bogle's most important contribution to the whole industry was that he became the advocate of the low-cost index fund. He talked a lot about how these seemingly small numbers add up to humongous numbers in the long run and how that 1 % figure, it doesn't seem very big when you just think about it. You're like, oh, 1 % doesn't seem like a lot. But when you think of 1 % as being 1 % of that real, real return in the long run, let's say it's 5%. Well, wait a minute. Now, all of a sudden, 1 % of 5 % is actually 20%. And all of a sudden, 20 % actually is a lot. And when you add in the fact that this is a compounding return over the course of the long run, that fee can add up to, for a lot of people, it'll be hundreds of thousands of dollars.

41:38And so the old book was called Where Are the Customers Yachts? And the reality is the customers yachts are sitting in the harbor across the street here because they're owned by the financial advisor who is charging 1 % a year. Right. And sometimes, for example, inside of an HSA, there are such limited choices and there's a necessary fee that you have to pay. And there are probably a bunch of people who are listening who are saying, I have an HSA or an employer-sponsored 401k or maybe a 529 plan where there are just these fees inside of it that I can't escape. Yeah. And you feel trapped. The traditional financial services industry, it moves at the speed of molasses in a lot of ways where, you know, these – especially these old legacy structures like 401ks, they still have not fully evolved.

42:29And it's one of the crummy things about the industry is that we haven't updated these things fully to reflect even like, you know, like I'm a huge advocate of owning ETFs over mutual funds for the basic fact that a mutual fund is just it's a far worse product wrapper from a tax efficiency perspective that the beauty of the ETF wrapper is that ETFs are able to basically reallocate and diversify their assets inside of themselves in a way that doesn't necessarily spit off capital gains distributions. At the end of every year, we see these capital gains distributions reports from mutual funds. And you could buy a mutual fund in July and have a zero gain in it by the end of the year, and you could still get a tax bill from that fund at the end of the year because they distribute some of the shareholder capital gains distributions in it.

43:16Whereas ETFs are much more easily able to eliminate or mitigate that risk because of the way that they fundamentally operate, The way that the, you know, not to get too deep in the weeds about like the structure of the product itself, but ETFs do what are called in-kind redemptions rather than cash redemptions like the way mutual funds operate. ETFs operate in a fundamentally different tax structure, basically. You know, it's actually one of the weird things with the cost matters hypothesis that Bogle didn't love ETFs. And I never it's one of the few things that I think Bogle got wrong in his career was that he was really critical of ETFs because he thought that they necessarily induced like more of a trading mentality because they trade on the exchange all day.

43:59Whereas a mutual fund, it basically, you know, it doesn't necessarily trade on an exchange. It settles every day at the end of the day and you can only buy and sell it basically once a day. So there's not this like gambling mentality. And Bogle was very specifically critical of the gambling mentality. But he also was just critical of ETFs in general because I think he thought they induced that need, which I don't know. I think that can be mitigated just with good disciplined behavior. But it was an interesting thing to think about in the scope of like the cost matters hypothesis because ETFs are from a total return perspective.

44:32They can be far, far lower cost than mutual funds and other types of instruments. They're hugely beneficial. And the industry just, you know, even to this day, the amount of assets in mutual funds is still enormous relative to ETFs. It's a slow-moving change, but we're moving in the right direction. Right. First, just to clarify for the audience, when you say mutual funds, you're including index funds in that, index mutual funds. Yeah. I think colloquially, people often distinguish actively managed mutual funds versus index funds. But when you say mutual funds, you're also referring to index funds.

45:08In the defense of some mutual funds, like the Vanguard mutual funds, for instance, they were able to eliminate this capital gains distribution event because of the way that they had a patent actually on the ability to use their ETFs the same way they basically use all their mutual funds. Vanguard is kind of a unique beast in that sense. But yeah, I mean, index mutual funds, and I'm generally being probably more critical of the actively managed mutual funds that are doing things like maybe they're buying or implementing a risk parity strategy inside of the mutual fund wrapper. And when those funds are rebalancing and being active in the underlying, they're incurring capital gains potentially that they have to, by law, distribute to their shareholders.

45:52For a person who's holding these assets in tax-advantaged accounts, does this matter inside of a tax-advantaged account or is this something that you should really only be concerned about inside of your taxable brokerage? Yeah, no, it's not as big of a deal. I mean, I generally, I don't know, just from a practitioner's perspective, I always default to ETFs. I mean, like one of my favorite stories is when I was a young analyst at Merrill Lynch beginning my career, I remember like looking at the iShares ETFs had sort of just come out at that point and they were basically brand spanking new. But I was looking at these and studying them and I'm thinking, we own all of these actively managed mutual funds for our clients.

46:32And I go to my boss one day and I was like, you know, hey, there's these ETFs and they seem to do the exact same thing that the mutual funds do. They generate roughly the same returns, but the fees are like a fraction of what the mutual funds are. Like, what are we doing here? Like, why are we buying the mutual funds? And my boss basically said, he was like, well, you get paid to sell this one and you don't get paid to sell this one. So you can sell this one if you want, but you're just not going to make any money working at this firm. And I was like, OK. And I up and left like six months later.

47:04I'm just a huge advocate of ETFs because I just think that the ability to buy and sell, the liquidity, the innovation in a lot of the different ETFs, like we're talking about the 351 exchanges. This is still a component of the market that is, I think, relatively young compared to mutual funds. And I just the wrapper itself, I just think, is superior in numerous different ways. As long as you can restrain yourself from that temptation to kind of buy into the gambler's mentality. And to Bogle's credit, he weirdly has been right in some ways in that there are a lot of really crazy ETFs coming on the market all the time now.

47:41Like, you know, I see these things like the super triple leveraged ETFs or whatever they might be. Like these things are these are instruments that especially on an after tax basis, they are just crazy, crazy expensive. And they're feeding into that like gamblers mentality of like, oh, you're only getting 1x the S &P 500 return. Well, wouldn't you be better off with 3x? And it's like, well, no, in a lot of ways, you'll actually be way worse off because of the excess volatility, the excess fees and all these other things that they kind of feed on that gamblers mentality. But when it comes to just plain vanilla sort of indexing style ETFs, they're really, really hard to beat.

48:34Outside of fees, where or how else should individual investors be appropriately tuned into costs? And where I'm going with that is financial advisors in general. There are a lot of people who say, well, the voices on the internet, the keyboard warriors on the internet who will say like, you don't need a financial advisor. You can figure all of this out on your own, or you don't need to pay for coaching or training or classes. You know, you can get any answer that you want through Google or now prompts. But I would argue, or I think some would argue, that people will shortchange themselves by not getting education or not hiring advisors, you know, not building out that team, that structure, that support.

49:17So to what extent is it appropriate to be tuned into costs? And to what extent do you actually harm yourself by being too concerned about the pennies? Yeah, it's hard. I mean, one thing I see a lot working with individuals is that you don't know what you don't know. So if a financial advisor has some sort of unique understanding about something that you just don't know about, then what's the benefit of having worked with that person relative to the alternative? You know, so it's a super personalized thing. And I think it's, I think it's one thing that's really important actually when picking a financial advisor is that, or considering whether to work with one in the first place is that, what are you really paying for?

49:57Are you, are you paying for a 60, 40 portfolio that this person is going to basically tell you, you know, during the course of a bear market to, Hey, you know, stay the course? Like, is that what you're paying for? Because I would argue for the vast majority of people that is not worth paying for a financial advisor for. Whereas, you know, if you're paying a financial advisor to do detailed financial planning and structuring a portfolio in a way where, you know, it's based on a financial plan and you're, you're getting the benefit of like help with Roth conversions and doing things like required minimum distributions and things that are a little more difficult for your average investor to handle on a, you know, a daily or monthly basis, that's a totally different structure.

50:41And, you know, it's also important, I think, to understand the different types of fee structures where, like, I'm generally a big advocate of flat fee financial advisors, where you're paying someone a flat fee more akin to like the way you might pay your doctor or your, you know, your accountant, rather than like that compounding effect of paying an AUM fee and assets under management percentage fee, where that number can add up to a lot of money really fast. The funny story that I steal from Meb Faber is the story that he tells about when if you have a million bucks and you pay 1 % fees a year, think of this as you go to your financial advisor once a year.

51:16And before you go into that meeting, you take a briefcase to the bank and you take out$10 ,000 and you walk into the meeting and you walk out without the briefcase. That's how big of a fee that is. So on an AUM basis, and again, this is a compounding fee, It's something to be really mindful of, not just the amount of fees you're paying, but the type of fee you're paying. But then there's also other fees. The biggest fee, arguably, is the inflationary fee that we all pay every year along the way. And so you have to build in an inflation hedging component to the portfolio where if you're in a T-bill and chill portfolio, you're not really getting much of an inflation hedge.

51:56Maybe you're not getting an inflation hedge at all. Ten years ago, you weren't getting an inflation hedge there at all in that portfolio. You have to layer in things that will compound in a way where you're offsetting that cost. And then, you know, there's the other big fee, which is taxes. Taxes are ultimately one of the biggest fees, maybe the biggest fee you're ever going to pay in the long run. And so you have to do things, you know, you mentioned tax location earlier that you have to structure a portfolio in a really thoughtful way where you're optimizing for taxes. But again, this is something that is, it's a balancing act because taxes are something that I think people can start to over optimize for.

52:34Like I, to some degree have gotten away from owning like municipal bonds for people because behaviorally, I think they, they confuse a lot of my clients, but also you can start getting into structures where you start using certain instruments in different accounts where maybe they're not the most beneficial. Like a lot of people will actually argue from a tax location perspective that like you should put your bonds in your retirement accounts because bonds are typically pretty taxing efficient instruments. And I would look at something like that and say, well, wait a minute, I think that's actually completely wrong because if this investor is, say, 30 years old and they've got a 40-year time horizon here, they might not be required to start withdrawing from that IRA until they're like 75, in which case this person has a 45-year time horizon.

53:24There's an argument there that bonds are a completely inappropriate allocation because based on the time horizon, you're subjecting yourself to inevitable low returns in that allocation. It's a super personalized thing, but you have to be conscientious of all of these different types of fees that you're going to be paying, whether it's the actual fees in the funds and the cost of management, or if it's inflation, or if it's taxes. Let's talk about principle number six. Real, real returns are all that matter. Yeah, so one of the things that I really emphasized was that when I portrayed all the data, I did it on an inflation-adjusted basis because the main reason that I did this was because we sometimes hear the gross figures in the financial media, and you hear things like, oh, the U.S.

54:15stock market does 10 % to 12 % per year. and kind of going back to the emphasis on all of the fees we pay along the way, you know, inflation is a biggie, taxes are a biggie. And then the, you know, the actual fees in the underlying are really important. And so when I talk about real, real returns, I'm trying to back out all of these other costs. And I think that's the right way because this is ultimately, this is the return that you actually eat. This is the return that you can actually go out and spend because once you liquidate something, you'll have to pay to offset inflation for whatever the goods and services you're buying are, but you're also paying the taxes ultimately from having distributed that or liquidating the instrument.

54:58And so this is the actual money that matters. It's the money in your pocket. And so that 10 to 12 % figure is exaggerated because it's unrealistic. It's not the actual money that you're gonna end up with at the end of the day. I portrayed everything on this real return basis to try to emphasize that, hey, especially with the stock market, the stock market actually doesn't do – it's not going to generate as much of a return as you really think it will because when you liquidate the stock holdings and actually go out and pay for things, the actual dollars in your pocket are going to be far lower than the gross figure that we talk about in the financial media sometimes.

55:35Right. There's taxes. There's the distinction between nominal dollars and inflation-adjusted dollars. There's all of these forces that eat away at those returns. There are those who say that a big purpose behind investing is simply trying to beat inflation. That if you can beat inflation plus have some additional margin of a few percentage points on top of that, that that's really the game that we're playing here. Would you agree with that? Yeah, to a big degree it is. But it's a balancing act because it's – you're trying to do two things with a savings portfolio. You're trying to build a certain amount of principle that is predictable.

56:14You know, you want to have predictable pools of money at certain points in your life, you know, especially working from like a financial planning basis. Like I like to emphasize the strategy that I call defined duration, which is it's basically like an asset liability matching strategy where you're actually trying to construct expenses in the future. And you're creating like a almost like a bucketing strategy where you're creating pools of money that are funding very specific needs into the future. Using like a really simple example, let's say you just want like two years worth of emergency funds, and then you've got a house down payment that you're maybe looking at for at some point in the next two years, and then you've got maybe a kid going to college in 10 years.

56:54You can, from a planning perspective, you can actually quantify what these numbers are gonna be, and then you can match them to very specific instruments that are gonna be matched to specific time horizons to fund that need. And you know, then from a planning basis, you kind of know like, okay, I've got, you know, going back to Bill Bernstein's tips ladder, like you build a 10 year tips ladder, you can go out all the way to your kids college, you know, needs, and you can build this tips ladder in a way where, you know, from an inflation adjusted basis, I'm going to have exactly this amount of dollars to fund this need over a certain time horizon.

57:29And so in the long run, inflation is in a lot of ways the whole ballgame because you need to adjust for inflation to be able to consume the future goods and services that are going to be inflation adjusted. And you've got to build a portfolio, though, that also has the nominal principal stability to be able to predictably consume. And especially if you're drawing down a portfolio, this becomes even more important where you need pools of sort of short-term money. The great thing about the T-bill and chill component is that you're generating a real return. You're getting actual inflation protection inside of that instrument.

58:05But you've also got to build in the fact that the stock market is typically the best inflation protector, because in the long run, what do corporations do? Corporations, they buy things at cost and they try to sell them at a markup, basically. And the return that stocks generate is a function of that markup, basically, the profits that they distribute in the long run. But again, that's what I call the next principles is the temporal conundrum idea that the allocation of savings is a temporal conundrum that you're trying to consume in the short term, but you're allocating assets that are on average in the long term.

58:41This creates temporal confusion for everybody because you don't know how much money you're going to need in the future, but you want to allocate it to assets that are going to grow enough that you know you can fund your needs in the future. Let's talk about that. You want to be able to fund your needs in the future, but you don't know what those needs will be. And you don't know how long that future will be. So with retirement planning in particular, let's even just take the quote unquote standard age of 65. You still don't know if you're going to live to be 75, 85, 95, 105, right? You've no idea what you're, and I think it's hilarious that it's called quote unquote longevity risk because only in financial planning is living a long and healthy life considered a risk, but there's the risk that we might have a long life.

59:30So we don't know how much time we're planning for. And the great unknown is, are we going to need assistance with activities of daily living? Are we going to get to a point where we are no longer able to cook our own meals and button our own shirts? And we're going to need to hire help for that. The standard thing that people say when they're young, which is, I'll just adjust my lifestyle, might not be an option in old age because there's that necessity of spending. So how do we deal with that? Yeah, you know, it's interesting to talk about asset management in the concept of allocating or savings.

1:00:11But what people probably don't talk about enough is liability management. One of the things that Bogle liked to talk about is, you know, how you should control what you can control, like fees are something that you can very acutely control in your portfolio. You can very acutely control the way you're diversified. But the other thing that people can control, especially when they're younger, is their liabilities. And this kind of gets into the conversation of like needs versus wants. I think one of the great superpowers of investing and having a good financial plan in the long run is understanding your needs versus wants.

1:00:46And Bogle actually wrote a whole book called Enough and understanding, you know, what is enough for you? And, you know, do you need to constantly be chasing the where the grass is greener and finding that point in life where you just feel like you have enough will, you know, in a lot of ways, it'll enhance your overall financial plan because you get to a point in life where, you know, if you discover what is enough for you, you be able to control your liabilities in a very controlled manner where you say, you know, oh, I don't need, I don't need a Ferrari. I could afford a Ferrari, but I just, you know, I'm totally happy with a Honda Accord.

1:01:22It may not be as flashy or, you know, as fast getting me from point A to B, but it's still going to get me from point A to B in a really reliable way. So that liability management is really important in the context of all of this, because in a lot of ways, it's maybe more important than the asset management part of the whole equation. But again, it gets really hard, especially when you get older, because the liabilities become fixed to inflation and they're fixed to the worst components of inflation. Like the real risk of longevity risk is healthcare costs, basically. And healthcare is something that is probably only going to get more and more expensive as we all get older, especially as the demographics of the current economy continue to deteriorate where everyone's living longer and people are seemingly less healthy.

1:02:13And so the healthcare inflations are going to be probably one of the biggest risks going forward. I make a ton of bad leg day jokes in the book. And, you know, part of the thinking, yeah, I keep reminding people don't skip leg day. And it's a corollary to all of this in large part because maintaining a healthy lifestyle is probably the best liability management that any of us can do. You know, not that I'm like a fitness guru or fitness expert by any means, but it is from a financial planning perspective, like one of the things that's probably the most important element of managing your longevity risk and your liability management in the long run because it's one of the best ways to mitigate your healthcare risks in the long run.

1:02:56Right. Well, and to the extent that fitness can facilitate that, that's great. But the challenge in financial planning is that I have no idea if I might suffer dementia. Yeah. And if I do, that presents me with a major expense. There's all of the expense associated with knowing that I will need to pay for whatever care is required at a time in my life when I'm increasingly incapable of being able to pay my bills. Yeah. It's especially hard with, like I do a lot of what I call asset liability matching with people I work with. And it's one thing that's really hard with especially older people because you're trying to build certainty into the portfolio in a way where you're trying to match assets very specifically.

1:03:47And like Bill Bernstein is a big advocate of long duration tips ladders. And the reason he likes that is because he says that you can match the long duration assets to long duration expenses. I'm a little bit critical of that idea because of what you're saying, that those long duration expenses are totally unpredictable. And I actually think that long duration bonds, long-term bonds, I think they're actually really terrible matching assets for long-term expenses because those long-term expenses are so unpredictable that you probably, you're almost, I would argue, certainly better off. If you've got a 20-year time horizon, you probably can and should take stock market risk with that component of your portfolio because, you know, it's not 100 % guarantee.

1:04:33Like, you know, that's the beauty of the 20-year tips instrument is that that thing has 100 % certainty of having the amount of money, basically, that you quantify out. But the problem is, is that the opportunity cost of not having owned the stock market that whole time is probably gigantic. And even though it's not 100 percent guarantee, you know, over rolling 20 year periods, the stock market will outperform things like tips. Ninety nine percent of the time in historical terms, you know, it's not a guarantee, but it is a super high probability outcome. But it's it's one of those things that from a planning perspective, it's really hard because you're you're necessarily trying to make these predictions about things.

1:05:12And it's one of the reasons why it's so beneficial to take diversified stock market risk over the long term, knowing that it's a long term instrument, because the probability of that thing funding those unpredictable needs is much higher than trying to peg it to something like a 10 year treasury note yielding three and a half percent or something like that, where you're you're locking in a low real return that probably is not going to come close to paying for things like health care costs in the long run. Right, right, exactly. And you have, as you alluded to earlier, a lot of the expenses that we pay, particularly as in older age, rise at a rate that exceeds inflation.

1:05:51You know, health care being one of them. I think car insurance recently has all insurance. Yeah, exactly. Property taxes often exceed insurance. It's one of the screwy things with inflation because inflation is a hyper personalized thing. You know, we talk about things like the consumer price index and the government issues these like nationalized levels. But your personal inflation rate is probably completely different than what the CPI is. And, you know, living in New York or, you know, I live in San Diego, like the inflation rates in places like that are wildly different than they are in places like Idaho or, you know, other parts of the country.

1:06:31It's a super personalized thing and you've got to actually understand it and quantify it at a personal level. Right.

1:06:49We have already talked about principle number seven, which is that risk is uncertainty of lifetime consumption. Is there anything else that you want to add? Yeah, no, this is a famous Ken French quote. The reason I like it is because it's kind of all-encompassing. And in sort of academic terms, like we define risk as basically standard deviation or volatility. It's kind of a neat little academic function because it's quantifiable. But for your average person, volatility isn't necessarily a risk. In fact, volatility could be like we were talking about with the stock market risk. In the long run, stock market volatility is a really good thing because it's the thing that correlates to higher returns in the long run.

1:07:32You've got a lot of different definitions of risk. And the reason I like the Ken French quote is because when you think about your ability to consume in the future, it involves things like inflation risks and fee risks and volatility. And when you think about your ability to consume out over different time horizons, you can then start to think about risk in a little bit of a different nature where you're customizing it more to a financial plan and the actual risks that are exposed inside your financial plan rather than the sort of like jargony academic concepts like volatility or standard deviation.

1:08:09I think where a lot of people that I talk to, where they feel frustration is the challenge in modeling that out. People often, especially if you're in your 30s or 40s, you kind of have to use these extremely heuristics and shortcuts and rules of thumb because what else can you do that there's no way that you can in any way accurately predict your needs or costs in your 80s or 90s, 50 years into the future? I try to think about this stuff in very specific time horizons where, like you said, I mean, 10, 20, 30 years out. I mean, who even knows what the world's going to look like then? I mean, I've got a four and a five year old daughter and I have no idea.

1:08:53Like, are they just going to be sitting around the house all day, like being served by robots all the time when they're 50 years old? Like, I have no idea. The world's going to change so much between now and when they're 50 years old that it's it's like crazy and unpredictable to think about all this stuff. you do have to just sort of block that out in a way where you sort of say like, I don't know what that's going to do. You can also like create a lot more predictability across different time horizons. I try to emphasize with people, especially like the people I work with, that the most important time horizon is the zero to five year time horizon.

1:09:26because the zero to five-year time horizon is the one where you can actually, to some like sort of rigorous way, actually quantify all the needs out over the course of five years. You can inflation adjust an emergency bucket or, you know, expenses out over five years and you can kind of know, okay, inflation is unlikely to deviate too much from, you know, my estimate over this time horizon. You've even bed like a three to 4 % inflation adjustment or something like that. But you can also predict things like, hey, I've got a 15-year-old car and I know this thing's going to kick it in the next five years.

1:10:02So I've got to block out, you know, 50 grand to go buy a new car. I don't know when in the next five years, but at some point in the next five years. Or, you know, my kids are going to college in 10 years. Like there are certain things that are somewhat predictable. But I do think in the – especially that zero to five-year time horizon, that's the one that is the most predictable. And it's where good financial planning can really function well because you can then start to build out these, you know, whether it's bond ladders or, you know, like I like to talk about it in terms of like asset laddering in the defined duration chapter where you're building a financial plan and then you're matching assets very quantitatively to the zero to five year buckets in very structured ways where you kind of know like, you know, I've got X number of dollars to cover, you know, Y expenses over these time horizons.

1:10:49And the biggest benefit actually of having seen this implementation in real life is clients actually will see the front loaded certainty of the expectation or the liabilities being structured in this sort of a methodology. And it frees up a ton of behavioral bandwidth where before when I would do risk profiling, like the traditional sort of financial planning way to do all this is to say like, OK, like you get scared when the stock market goes down a lot or you're 60 years old. So maybe we need 40 % in bonds or something like that. And, you know, using these sort of heuristics and, and then you run a Monte Carlo simulation through your software and it says, okay, well, based on your 60, 40 allocation, we know that your financial plan with your starting balance, it has a 99 % success rate, but you're not giving anybody like the understanding of, am I going to have money at certain times in life to pay for certain things that I need to?

1:11:48And by blocking these things out in more of a time segmented fashion, you're then matching very specifically to the most predictable time horizons. And when you block out that zero to five year time horizon, it's interesting. I noticed with a lot of people that I work with that they actually end up being able to take a lot more risk. You might not have 60-40. You might end up actually being like 70-30 where the investor's taking more risk because they've quantitatively taken that 30 % component and they've blocked it out over, say, 0 to 5 years or 0 to 10 years or something like that in a rigorous way where that person knows, well, I've got 30 % of my assets here and I'm covering 5 to 10 years of all of my expenses and my car purchase and my house down payment or something like that.

1:12:37And that frees up the 70 % for me to take risk with, to take long-term risk. For me, you know, kids did this weird thing to me where they forced me to think across different time horizons very specifically. Because before I had kids, it was basically just me and my wife's money. And I was kind of like, you know, I was 100 % stocks. And I was just like, oh, this is all long-term money. We both have good high-paying jobs. And we don't need this cash or this allocation. So we can be super high risk with it. whereas once you have kids all that goes out the door because then you have to start thinking about like oh i need to pay for diapers and i need to pay for daycare and i need to pay for school down the line and i need to pay for college tuition potentially in 20 years and then i want to like also think in multi-generational needs where it's like i want to leave my kids some money you know like i like the i am a big fan of the die with zero component but i also like warren buffett's quote about giving your kids enough to do something, but not enough to do nothing.

1:13:36And I think that's a great way to think about multi-generational inheritance needs and whatnot, because you want to give your kids some certainty in the future, especially because I don't know what the world's going to look like. What if inflation is crazy high and my kids are unable to get jobs because the robots are doing all the work in the future? And it's to my benefit to work hard now and try to provide a little bit for them down the line, knowing that I can give them something. But also that's a super long time horizon. So it adds in that layer of multi-temporal thinking that is required in good financial planning.

1:14:14And that actually ties perfectly with your next principle, principle number eight, which is that asset allocation is also a temporal conundrum. Yeah. I mean, this is the thing that is the most important thing for all of us is time. You know, it's the most valuable thing that any of us have. And it's the thing that makes portfolio construction really difficult is navigating all of those different time horizons. And so when I say it's a temporal conundrum, I say that, you know, it's unpredictable. It's navigating future consumption across all these different time horizons. So time is the thing that it's like the one thing we all understand universally.

1:14:53It's interesting from like a portfolio construction process too, because the industry has specialized jargon around like factor investing and style investing and, you know, mid cap and small cap and large cap and growth and value. And to your average person, they're like, I don't know what any of these things are. Like I personally, like I couldn't even define exactly what a mid cap is. Like I don't off the top of my head, I don't know what is the actual market capitalization of what comprises the mid cap definition right now. Your average person definitely has no idea of what these things probably even are.

1:15:31Like they have some vague concept of it. Like, you know, what is a value stock? Well, I assume it's a stock that's selling at a good value. And it's like, well, duh, but even the pros can't actually identify what that thing is. If everybody knew what the best value stocks were, everybody would generate the best returns. We talk in the industry in these very sort of like alternative languages sometimes that your average person just doesn't understand or doesn't even care about, frankly. They want to know, can I pay for the vacation that I'm taking next summer? Can I pay to send my kids to Harvard?

1:16:08Can I pay for a new car next year? Like people think in time horizons and they don't think in factors and styles. And yet the whole industry and the asset management business is structured around style investing, basically. And when you try to communicate that inside of a financial plan, I think people just they have a vague understanding of it, but they don't really understand it. And when you can talk to people about things in terms of time horizons, it's really valuable because people get it. Like you wouldn't believe I was working with somebody. They had an incredibly complex financial plan.

1:16:45And all the wife cared about was the ability to remodel the bathroom next year. It was the only thing she cared about. She desperately wanted this new bathroom. When I modeled out the financial plan and I showed her that, hey, we've got a six-month treasury bill that is perfectly matched to your bathroom remodel next year, it was like the only thing she cared about. And she was like the biggest smile you've ever seen anyone have was her ability to understand that, hey, I've got an asset that is specifically matched to my ability to remodel the bathroom that I want. That's how people think. People think in time horizons.

1:17:21And so I think the ability to think about these things in time horizons and resolving this temporal conundrum, as I call it, is hugely valuable. And the answer might be treasury bills, but I should ask. One of the big challenges that I hear from a lot of the people who are in this audience is what to do with money that's earmarked at like a three-year time horizon, right? Because it's three, it's that awkward length of time where if it's six months or a year, you'd probably just keep it in a savings account. If it's five to 10 years, you'd have some equity or bond exposure. If it's three years.

1:18:02Yeah, it's really hard. It's not just the three-year time horizon, but also like the 10-year time horizon. To me, that whole like sort of intermediate space, it's a really hard one to navigate because it's not – You know, like if you've got a 20 year time horizon, you know, you come to me, I say, put it in stocks. You got 50 years. Maybe you put it all in tech. You know, maybe you're just crazy aggressive with that stuff. That's easy. That's like the no brainer to me. The other one that's a no brainer is the emergency fund bucket. The zero to two year time horizon. To me, it's kind of like, oh, you're just buying.

1:18:33You actually shouldn't take any risk with that. You, by necessity, probably need treasury bills or at most like, you know, Vanguard short-term bond fund or something like that. Those intermediate ones are tricky. It's that allocation, that intermediate time horizon is the one that roughly corresponds to like the global financial asset portfolio. And it's the or something like 60-40 because it's a blended time horizon. You've taken all of the instruments and you've diversified the allocation in such a way that, you know, in what I would call my defined duration methodology, it creates a blended time horizon where it's not long duration like the stock market, but it's also not super short like a T-bill is.

1:19:13And it makes it really hard, actually, because that sort of like three to 10 year time horizon, not only is it hard to predict from a liability and expense perspective, but it's hard to build a portfolio that actually aligns with that where you're not taking so little risk that you're going to not beat inflation. but you're also hopefully taking enough risk that you're generating an inflation-adjusted return, but one that isn't also whipsawing you in the intermediate term where you're trying to, you know, if you're matching it to like a house down payment, it's sort of a, you know, like, wow, gosh, maybe 60-40 isn't right.

1:19:53What if 60-40 exposes me to the risk of like a 2008 where it falls 30 % and all of a sudden when 2008 comes around and house prices are down 10 % and I want to buy the house, my asset allocation is also down 30%. And here I am like double whammy, feeling like I made a huge mistake. It's a hard one. It requires a little more finesse probably in like the way you're constructing the asset allocation. And I'm kind of a fan of building like multi-asset types of instruments where you're getting maybe a little bit of stock market exposure inside of something like that, but you're still building something that's really safe.

1:20:30But it's hard. It's the hardest time horizon, I think, to navigate. Yeah. Principle number nine, past performance is not indicative of future returns. We hear that all the time. This is in basically every investment document in human existence now. Part of the things that we need to go into all of this understanding is that the future is not going to look like the past, and it could look very, very different. You know, like we've gotten used to the United States doing incredibly well relative to foreign stocks. Who knows if that's gonna, it's one of the reasons why I'm a big advocate of global diversification, because I think that the world of the future is just gonna look so different.

1:21:10And I don't know if, you know, it's interesting, like from a historical perspective to think about like an investor in the year 1700, who was looking at like something like what I would say the global financial asset portfolio is, you're like, what were they investing in? They didn't even, the United States wasn't even a thing back then. And so it's weird to think about this through a historical lens, because that investor is probably somebody who, let's say they were living in the UK. They're a British investor who probably owns almost exclusively British companies. And two, 300 years later, you know, what are all the best performing instruments?

1:21:47They're all just totally different. And so the world is going to look very, very different in, you know, even 10 years, 50. I think the world is changing faster than it ever has. And, you know, especially with AI and the robotics and the, you know, the shifting technological landscape of everything. Yeah. I think it's useful to go into all this with realistic expectations that the future is going to look really different. And I don't know what inflation is going to be. I don't know what the U S stock market is going to do relative to emerging markets or, you know, and it was actually one of the one of my favorite portfolios that we didn't talk about was the forward cap portfolio, which is a portfolio that I actually try to extrapolate a lot of the big macroeconomic trends out into the future to sort of skate to where the puck is going.

1:22:31So like the thinking is like, well, if technology is 35 percent of the S &P 500 today, well, what is the forward capitalization of the technology sector going to be in, say, 50 years? And if it's, if I think it's going to be 50%, well, shouldn't I own 50 % in my allocation today? It's kind of skating to where the puck is, knowing that I'll generate higher returns along the way by kind of skating to where the puck is rather than what a, you know, a market cap weighted index fund basically does is it, it skates with the puck. So it's constantly, you know, which is very effective, obviously, but it's not skating to where the puck potentially is going.

1:23:07I tried to extrapolate some of this out, but also with the full admission that, and I emphasize this a lot in that portfolio, that this thing is high risk and I'm making a ton of guesses. I'm making a ton of really active guesses about what the forward portfolio is going to look like. Going into this with realistic expectations, I think, is useful because it adds to the benefit of why you're diversifying your portfolio in the first place. You diversify in large part because we don't know what the future is going to look like. Right. And the risk of that guesswork is the risk that you're wrong.

1:23:39Yeah. And the risk of missing the thing that takes off. And accepting the inevitability that you're going to be wrong about certain things at certain times. You know, like you're going to allocate money to cash or bonds potentially that looks really stupid in years like 2022. And that's just part of how all of this works is that it's never going to be perfect. There is no perfect portfolio. All right, let's talk about the 10th and final principle, which is to set realistic expectations and stay the course. Yeah. So this is, again, kind of tying into number nine that go into this with realistic expectations where you're not diluting yourself into thinking that the stock market is where you're going to become like fantastically wealthy.

1:24:24It's not going to necessarily be the driver of how you get rich. And, you know, I think you have to go into this understanding the way that certain instruments generate certain returns and build in realistic expectations by understanding things like the real, real returns. and adjusting for all of these things where you can go in and you can say, okay, well, I could realistically generate four or 5 % in aggregate. And over the course of the long run, this will generate, you know, X outcome and that'll serve me fine. You know, that'll meet my financial needs and I'll be able to retire and, you know, pay for all of the things that I wanted to consume along the way and whatnot.

1:25:02But you got to go into that with really realistic expectations. Cause if you go in with like, I think these sort of like expectations that you're going to generate 10 % per year, that you're going to like be the next Warren Buffett. Like I was convinced when I was 20 years old that I was going to be the next Warren Buffett. And unfortunately, I invested into the teeth of the NASDAQ bubble implosion for my first, you know, four years of investing there. So I got, I got kicked in the, in the, you know, what's right off the bat and then got kicked again just a few years later. But, you know, so I had a kind of a hard introduction into portfolio management right off the bat.

1:25:38But I had these diluted expectations also, where I went into all of this thinking that I was going to generate 20 % per year for the rest of my life because I was convinced that I'm a smart guy. I have a finance background and I'm going to beat the market and have these incredible returns. And then you actually start paying the bills by realizing the returns and you realize, oh crap, inflation was higher than I expected and The tax bill was higher than I expected. The fees I paid, the other, you know, sort of intangible costs were higher than I expected. So you got to go into all this with really realistic expectations.

1:26:14And I think those realistic expectations make your portfolio much more viable in the long run because they won't you won't get derailed when things go haywire and you get frustrated or you get disappointed at times. And because you didn't meet those like sort of unrealistically lofty expectations that you had going into it all. How do you know if your expectations are too wild? That's a great question. I would say, you know, just go into it with a realistic set of assumptions that, you know, you're embedding into the planning process where, you know, if you're assuming that inflation is going to be 1%, you're probably going to be wrong.

1:26:58If you think you're going to do 10 % net returns on average throughout your portfolio, you're probably going to be wrong. And so you can set these sort of like probabilistic outcomes based on the assumptions you're embedding. And that's the other hard thing about investing is that we're all necessarily making forecasts about the future in sort of explicit or implicit ways. And it requires us to sort of project all of this out in some way. But you want to approach all of that in just a, I think, a super realistic way where you're using past data to understand the future, but also being realistic about what are the likely outcomes in the future so that you're not, you know, tripping yourself up before you even take off.

1:27:41Thank you for spending this time with us. Where can people find you if they would like to learn more? My firm is Discipline Funds. Our website's disciplinefunds.com. And I write kind of a bloggy commentary there called Discipline Alerts that people can subscribe to if they want to listen to me ramble on more.

1:28:00Thank you, Cullen. What are three key takeaways that we got from this conversation? Key takeaway number one, you are your portfolio's worst enemy because the biggest threat to your investment returns isn't a recession or a crash. The biggest threat is you. Behavioral risk cuts both ways. There's a risk, of course, that during a downturn, you might get scared and sell. And people don't think that they're going to do that in advance. But then the downturn comes and you're like, oh, but this time it's different. And there's always a reason why. 2008, the Great Recession, we had never experienced anything like that before in our lifetimes.

1:28:39So this time it's different. March of 2020, the pandemic, we had never experienced anything like that before. This time it's different. So yes, there's the risk that you might sell during a downturn, but there's also the risk that cuts the other way, the risk of FOMO during bull markets. And that's just as dangerous because if you see AI stocks going to the moon, you're tempted to chase performance, but usually you're chasing risk rather than chasing returns. You think you're chasing returns, but you're actually chasing risk. We talk a lot about fear in bear markets, but the FOMO, the fear of missing out is equally as potentially disastrous for a lot of investors because it's the thing that leads to performance chasing.

1:29:24And when you look at things like the huge outperformance of the US market or the huge outperformance of AI, you might look at that and you feel this FOMO where you say, God, I maybe don't own enough of this high return yielding stuff that maybe now I should chase it. That is the first key takeaway. Key takeaway number two, the 351 exchange. This is new. I learned about this during the interview with Colin Roche. So if you have a stock position that has absolutely exploded in value, just gone bonkers, bananas, often you have this golden handcuffs scenario, right? If you sell, you pay really big taxes on all of the capital gains.

1:30:07But if you hold, then you have a risk concentration. In the last 18 months, there is a new solution that has emerged. So this is brand new. It's called the 351 Exchange. And it lets you swap a concentrated single stock into a diversified ETF at the fund's launch. What a 351 exchange basically does is it allows an investor that's got an outsized allocation in, say, like a single stock. Like, let's say, like I see it a lot these days with, like, Google or NVIDIA or, you know, a lot of the Mag7, where someone's got this huge taxable event inside of a component like that. And what a 351 exchange does is it allows you to take that single stock and actually allocate it to a new ETF issuance.

1:30:51These funds have become really popular in the last, really the last year. That is the second key takeaway. Finally, key takeaway number three, think in terms of time horizons rather than investment styles. Many investors like to talk about small cap versus large cap or growth versus value. What the average human thinks about, what the average individual investor thinks about is your life and as a subset of that, your time. So you think about paying for next summer's vacation. You think about sending your kid to college in 10 years. You think about your retirement at the age of 55 or 60 or 65. So you build your portfolio around these time horizons.

1:31:38And if you do so, you can actually take on more risk overall because you have certainty around your near-term expenses. People think in time horizons. I was working with somebody, they had an incredibly complex financial plan. And all the wife cared about was the ability to remodel the bathroom next year. It was the only thing she cared about. She desperately wanted this new bathroom. And when I modeled out the financial plan and I showed her that, hey, we've got a six month treasury bill that is perfectly matched to your bathroom remodel next year. It was like the only thing she cared about. That's how people think.

1:32:15Those are three key takeaways from this interview with Colin Roche. This was part two. If you did not catch part one, please check out part one, which aired the previous episode. And I hope you enjoyed part two. Thank you so much for being part of the Afford Anything community. If you enjoyed today's episode, please do three things. First, download our free 52-week guide to hitting your financial goals. And you can download this. You'll never guess the URL. That's right. It's affordanything.com slash financial goals. It's completely free and worth every penny. No, it's great. Somebody actually messaged me the other day and said that they used it last year.

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