How to Build the Perfect Portfolio | Cullen Roche

23:26Tell me I'm going to have a guaranteed a hundred grand to achieve that goal or something. And so for me, time is the essential element in all of this.

23:38Demetri Kofinas:How much do you feel that normal people, your average person, underappreciates the scope of risk that they are taking or could potentially be taking in their portfolio when they think that they're not doing anything particularly risky? Yeah. God, that's a great question. I mean, just because the concept of risk is so vague in the financial industry. I mean, vague is lots of different things. It's weird to think about it in the sort of academic sense because risk is basically just volatility. But then you can get into this wonky academic debate about, well, okay, but positive volatility is a good thing, actually.

24:16When a price goes up a lot and its standard deviation is high in a positive way, well, that's a good thing. Nobody dislikes when the price goes up a whole lot. Whereas negative volatility, obviously, is the thing that everyone's really worried about. You're worried about your prices going down. But so you can get into these very wonky debates. I mean, Morgan Housel defines risk as what we don't know, that risk is just these things, they're anomalies, events that come out of nowhere. And things like COVID, how many people thought that a global pandemic was going to hit and that we were going to shut down everything for two years and implement all sorts of crazy policies and all that.

24:54So in that sense, risk is what you don't know. But then you can get in debates about like, well, risk might be that you're not taking enough risk. It could be that you're being overly conservative with a portfolio. But at the same time, risk could also be that you take too much risk. So I really like in the book, I talk about a Ken French quote where he says that risk is uncertainty of future consumption. And I think that's the thing that I like about that quote is that it's sort of all encompassing, that risk is really the inability to predict how much money you're going to have across future time horizons to be able to do the things you want to do, whether that's a vacation next summer or paying for a new car in two years or paying for kids college in 10 years or having the ability to retire.

25:41Risk is not having money when you need And so when you create a lot of uncertainty in your financial life, because you don't have an ability to understand how much you're going to be able to consume in the future, it exposes a lot of risk. And that is sort of all encompassing because it includes things that are unknowns. It includes things that are, you know, might be the more academic nature of the idea of standard deviation and whatnot. So to me, risk is when you have a financial plan where you don't understand exactly what you're doing and how it interplays with your future financial goals.

26:18Demetri Kofinas:How important is having realistic expectations? And do you find that people have a difficult time with that? Oh my God, yeah. I mean, because I think a lot of us do a disservice, especially in the financial media of communicating this to people, because I think that the expectations a lot of the times are unrealistic in the way they're presented. And so one of the things I did in the book that's unusual for a finance book is I presented everything in an after inflation-based return. And so I tried to focus on real returns in the book because the numbers are literally inflated across the board with your gross returns.

26:58We often hear that the stock market does 10 % per year. And And well, that's probably true, maybe. The reality is that the amount of money you're actually going to get into your pocket after you pay for taxes, fees, and inflation, it's probably closer to like 3 % or 4%.

27:15Demetri Kofinas:And depending on your time horizon, you don't know what those taxes are going to be. Oh, yeah. And so there's a huge amount of uncertainty inside of all of that. And so, but it's crazy, you know, when you think about setting realistic expectations that, you know, if you start getting into the stock market world and you start running the math, you start thinking, you know, like, this is my mentality when I'm 20 years old and I get out of college and I'm reading about, you know, Warren Buffett's incredible returns. And I start saying to myself, well, the stock market does baseline 10 % per year.

27:43Well, if I could do, you know, say 12 or 13 or 15 % per year, you know, and I'm investing X number of dollars, well, you start running the math on that, you know, you can start getting pretty unrealistic expectations about what you're going to do. And, you know, this becomes especially true after you start realizing that, holy cow, inflation is a real thing. And the tax man is actually the biggest fee you're going to pay in all of this probably. And those numbers are, they're gigantic. They're a huge, huge piece of your net return. And so you have to back all that stuff out. So I was very intentional in the way I presented the data because I wanted to present the data in such a way where people would look at it and say, hey, I can make a lot of money in the stock market.

28:25And I absolutely should be allocating my assets to different sets of financial assets and building a smart portfolio. But at the same time, I shouldn't have unrealistic expectations about how fantastically rich the stock market is going to make me in the long run.

28:40Demetri Kofinas:So you have 10 principles that you lay out early in the book, and we covered some of them indirectly, like time horizon and defining risk and realistic expectations. One of them, The very first one is that you are a saver, not an investor. What does that mean? Because so many people think of their investments as their savings today. Yeah. So this is something that I actually grappled with when I was writing my first book, because it's really strange, actually, that the fields of economics and finance, they don't define the word investment the same way. Because in the field of economics, investment means to spend for future production.

29:18That's basically what firms do. When firms spend, for instance, if they're building a factory, let's say, when a firm spends money on the factory, they're spending for future production. They are investment spending. And this is very different than consumption because consumption is basically a sunk cost in the future. You consume a candy bar. But if a firm builds a factory, well, that actually contributes to future income, or at least it should if it's done well. And what's interesting about buying things like stocks and bonds is that when you're buying stocks and bonds, you're not literally investing.

29:54You're not spending for future production in any meaningful sense the same way that a firm is when they're spending for future production. You're buying actually an instrument whose value is going to be reflected by the way that the firm spends for investment. So buying the analogy to understand this is to think of -

30:13Demetri Kofinas:Not even, right? Because what you're really doing is you're buying an instrument tied to what other people's future expectations are about what that instrument is worth and your ability to sell it. Exactly. So there's whole other behavioral element around what the valuation of this thing is going to be. And so, but it's analogous to buying a ticket at a horse race versus being the trainer of the horse. The trainer of the horse spends for investment. They actually can get in there. They can determine who the jockey is, how well that horse is trained, what kind of drugs it's taking or whatever the diet is for the animal.

30:44And so they actually have a very direct influence on the way that that outcome is going to result. Whereas the people who are just going to a horse race and buying the gambling tickets, they have zero influence on the actual outcomes. They can try to guess and predict, but buying stocks and bonds is not really that different in that sense. It's very different from gambling in the sense that the stock market is typically a positive sum game, whereas buying a horse ticket at a race is a negative sum game actually for everybody involved. But the analogy holds true in the sense that what you're doing when you're allocating your savings is very, very different than what the actual firm is doing when they spend for investment.

31:23And I try to emphasize this because to me, the process of allocating your savings is very different than the process of doing something that is analogous to investing. Because I think investing is oftentimes portrayed as this sexy sort of get rich quick endeavor. And when you think of it as you're literally allocating a piece of your savings, I mean, you're literally taking some of your income, you're saving some of it, and then you're allocating that savings to stocks and bonds. That process to me is totally different. It involves planning and methodology and a sequence of processes and discipline over specific time horizons that you need to adhere to.

31:58And to me, having that right mentality, that right set of expectations is really important because, again, it'll avoid a lot of the traps of having unrealistic expectations where you go into this thinking that this is some sort of get rich quick scheme or something analogous to betting on horse races specifically where you're going to make a lot of money really quickly. And that's not the way it works.

32:20Demetri Kofinas:It's also true that the way that people view their investment portfolios today is very different from how they viewed them in say the 1950s when of course fewer people own stocks to begin with in part because the memory of the Great Depression and the crash of 1929 was still vividly in people's minds. But over the years, it seems that people's relationship to the stock market has also changed in line with changes to the social contract that began to emerge in the late 19th and early 20th centuries between the workers and the owners, between labor and capital. And that contract was negotiated on the factory floor and it led to things like pension systems, predictable wage increases in work hours mediated by labor unions, employer-sponsored healthcare, et cetera.

33:06Demetri Kofinas:And as the coordination costs of doing business outside of large corporate structures have dropped in the last few decades and accelerated really since COVID, what we have seen is a disintermediation of the cost savings and productivity gains that normally would have come within the firm structure as the economy has become increasingly decentralized. And people have come to depend on the stock market in place of corporate pension systems in a sort of parasitic way that allows them to benefit from aggregate economic growth. And because of how many Americans that have their life savings tied to equity performance, the government has itself become the primary investor and insurer in the stability of the stock market, which has gone from being a marketplace for allocating capital to a political utility.

33:56Yeah. I mean, gosh, that's a whole big can of worms that it's almost like there's like a fundamental disconnect between the way we view what the stock market should be and the value of the stock market should be versus the way that the stock market is actually contributing in an underlying way to the well-being of all of our lives. And I think that in a lot of ways, public policy has definitely created this, I think, a bad incentive structure where we're increasingly incentivized to just make number go up. And number go up doesn't mean that necessarily living standards are increasing. And so I think there's a really messy interplay in all of this with the debates that are going on in a lot of social circles where you look at things like consumer sentiment.

34:50I think consumer sentiment is low these days in part because the policy has been so driven around number go up, where as long as the stock market is doing well and we protect housing prices and things like that, and as long as the numbers stay up, I think a lot of politicians think that that means that that reflects a good situation. And I think a lot of consumer sentiment right now is exactly the opposite, that people are actually frustrated by the way that the numbers have gone up and they haven't necessarily participated. And a lot of public policy has been built around that, whether it's, God, I mean, things like the whole COVID experience or a lot of people will argue that policies like quantitative easing are purely driven around things like asset price inflation and things like that.

35:34And so I think there's a lot of truth to that, that in a way, we've put the cart before the horse in the sense that we're not incentivizing long-term investment, the kind of getting away from what I was talking about earlier. We're not incentivizing long-term investment the right way. And instead, we are in a lot of ways sort of incentivizing more of a gambling mentality. And I think it's part of what especially young people feel like they almost need to be doing these days is that they almost feel like they need to be gambling on the stock market or crypto or whatever it might be because they feel like it might be their only way out, that they don't see a long-run path to achieving wealth and financial independence through just a prudent long-term savings set of goals.

36:22Demetri Kofinas:Man, so much to talk about there. I'm just trying to think about how much of this do we want to broach now or wait for the second hour. Let's just dig into that really quick with one more question. What is your view of that mentality and that perspective? Do you think it's empirically based or do you think it's a subjective feeling generated by a consensus view obtained from social media and living in a digital world where you're seeing other people that seem to be doing better than you, but they all represent some small tippy, tippy top of the pyramid? It's hard. I mean, I think there's definitely a lot of truth to it.

36:54I mean, look at the real estate market, for instance, I think that anyone who didn't buy before COVID, I think they're super frustrated.

37:02Demetri Kofinas:I heard you locked it in at two and a half. So yeah, I can't remember. I think mine was 265 or something like that. But yeah, I mean, it's crazy because I think that if you were, especially if you were someone who was saving, who was being really prudent, you know, in the years running up to 2020 and then COVID happens, real estate prices jump 50%. And then all of a sudden, the worst thing that happens is interest rates go up and mortgage rates go up from, you know, two, three percent to six, seven percent, eight percent. It's a double whammy. Everything feels unaffordable. And if you didn't buy before 2020, I think you almost feel like you're permanently locked out.

37:41You know, so there's a lot of credence to that view that someone who's looking at that situation is now they feel like they're on the outside looking in and they they feel like maybe their only way to be able to get in is to take sort of extreme risks and try to accelerate things that make up for the acceleration that happened during COVID. And again, so much of that was public policy driven. Like I think that the real estate market is especially interesting in the context of COVID because so many people came out of COVID and said, ah, the inflation is transitory. And we know that there were these huge supply shocks and certain components.

38:16And real estate's really interesting because real estate kind of debunks a lot of that, that there was no shock. There was no supply shock in housing because there was already a supply shock in housing well before COVID ever happened. And so the impact of inventory on prices was relatively minimal during COVID, mainly because we know that what drove housing prices then was we kept interest rates too low for too long and we blasted, we flooded the economy with trillions of dollars of fiscal spend And so we know very acutely that in the real estate market, that 50 % jump in housing was largely due to the way that public policy impacted things and it influenced and incentivized people to do certain things.

38:59And so, you know, I do think that there are a lot of the sentiment around this is totally rational, you know, and it's really hard to sit down and look at a young person in the eyes and say, hey, you know, just do what I did and build a company and work really hard and be patient and just keep trudging along every single day for the next 20, 30 years and be disciplined about it. Because they look at the last five years, especially, and they're like, dude, you blasted$5 trillion into the economy. You made prices go up 50%. And how do I know you're not going to do that again? I feel like I've got to do something to accelerate my financial life and get ahead.

39:39So I totally get it. At the same time, I probably still would sit down with most young people and say, you know, put your head down, be patient, keep working hard. You know, you can't control what public policy is going to do. So don't gamble your life savings away and potentially put yourself in a worse position than you otherwise would be. So it's hard. I totally sympathize with, with young people who feel like they're on the outside looking in and actually feel like kind of crummy sitting here and saying to someone who's in that situation, like, Hey, you got to just put your head down and grind because that's kind of a crappy answer for them.

40:12Yeah.

40:13Demetri Kofinas:No, I'm with you. I think I totally agree. I mean, it's something I've explored on the show for years. In fact, to tie this into the observation earlier about the social contract that has led to your average American viewing the stock market as their primary savings vehicle, and therefore a political utility of the government, which basically has to do something if it drops by a certain amount. It's actually interesting because if you ask the average person, I bet they would look at you like you had 50 heads if you said to them, there's a government put on the price of gold. But if you ask them, do you think the government will let the stock market fall below X?

40:46Demetri Kofinas:A larger percentage of those people will tell you, no, they won't. Because there's an embedded expectation on the part of the public that the government is there to save the financial system and with it, the value of their portfolios. And where did they get that idea? I wonder. They got it from the last 20 years of financial policy. And this new social contract that we're talking about here overwhelmingly favors not just the owners of capital, but who happened to be the owners of capital? Older people. So there's also a generational gap between policies that serve older demographics versus younger people.

41:22Demetri Kofinas:And I want to reference a conversation I had with Nicolas Collat recently, who made this brilliant observation on the podcast, that the new social contract, the one that will emerge from this crucible, will be negotiated within the construct of housing. Because the cost of owning a home has become so expensive that people can't afford to live where the jobs are. And while the economy has become more decentralized, as we've discussed, and more people are working from home, that cost is still a giant drag on people's standard of living. And the same is true for the costs of education, the costs associated with healthcare, which are also multifaceted.

42:01Demetri Kofinas:And there are so many things that we could be doing better as a society to incentivize the emergence of a healthier food system and healthier lifestyles for people who have become themselves a burden to the healthcare system that is totally broken. But anyway, that opens us up to an entirely different conversation. I have one more question for you, Colin, before we get to the second hour, and that has to do with where one's primary income stream fits in this discussion in terms of being able to generate a predictable cashflow that can be used to make investments in the stock market or anywhere else beyond just what is needed for basic consumption.

42:38Yeah. So one thing I write about a common theme across the book is that your income is really, it's a function, it's the value of your human capital basically. So the skills that like going back to the conversation about savings versus investment, I would emphasize that the actual investment spending that most of us make is in ourselves. It's in the way that we develop skills and knowledge over time that we then utilize to leverage into generating an income. And so you generate skills and whether that is, you know, paying for school or actually paying to learn how to do certain things, whatever that investment spending at your personal level might be, you're doing this in a very intentional way where you're trying to make yourself more valuable to other people.

43:24And that allows you to earn hopefully a higher income over time where as you become more valuable to other people, they, you know, they predictably save some of that income and allocate it into things that are going to protect your human capital in the long run from things like inflation and taxes and whatnot. And so the analogy that I use is that your income is a lot like a bond allocation in your overall total portfolio, that the income you're earning is actually very similar to having this bond allocation, that you may not properly have a bond allocation in your portfolio, but functionally speaking, it is something that if you make, for instance, say$100 ,000 a year, you have something that's very similar to say a$2 million bond that is roughly earning about 5 % per year.

44:14And so you have this implicit bond allocation. And this is really valuable to you because it gives you a lot of certainty of future consumption, first of all. So going back to the Ken French quote, it gives you a lot of certainty of future consumption, but it also fuels your ability to save. And so, and then you can take that savings and reallocate it into other instruments that hopefully will compound your, you know, your balance sheet in the long run. And so again, this is an income statement versus balance sheet relationship. And that's a conversation that I talk about that's really important because especially when you're young and you have this fixed income, this implicit fixed income allocation in your portfolio, that totally transforms the way the rest of your portfolio might have to look.

44:55And it's part of why when you're young and you've got a really long time horizon, this implicit fixed income allocation, it allows you to be really aggressive because if you've got a$2 million bond implicitly that's earning 5 % per year, well, that means that maybe the way you're actually allocating your savings should be all equities. Maybe it should be in aggressive instruments, whether that is crypto or gold or an all stock portfolio. You have this capability to be really aggressive because you've got this implicit, really safe fixed income allocation that it frees up a lot of behavioral bandwidth and a lot of balance sheet bandwidth to take risk with.

45:39Demetri Kofinas:So one more question, or maybe a couple more questions. In the gig economy, so we talked about how the economy itself is transforming. People used to have steady jobs. They worked at one corporation. They worked there for 20, 30 years. They got a pension. They retired, etc. Today, people are much more on their own. They're untethered. They don't have the same type of safety net. And also, they're entrepreneurs. More and more people are entrepreneurs, whether it's their primary business or side businesses. And so, investing in yourself takes on a much more literal significance for a broader swath of the population today, it would seem to me.

46:11Demetri Kofinas:And I'm curious, in your conversations with younger people that come to you. Does this show up? In other words, this trade-off between putting my money in the market versus investing in myself or building up this business, this side hustle that I'm working on, is that trade-off more acute in your experience? It is. I think it's a lot more important these days because I think that the ability to create your own brand and create your own value that isn't so dependent on a corporation is a lot easier these days. And so I do think that, you know, you touched on this, that decentralization is a theme that I think is going to get far more exacerbated as the next, you know, 10, 20, 30 years play out.

46:56And that's in large part a function of technology, the way that, you know, everything that's going on these days, it gives us the capability to do things that you see this, especially with things like AI, where, I mean, God, I spent half of last year just, you know, writing software, what people are, I guess, you know, I was doing what people now call vibe coding. But I spent like, I mean, almost five nights a week, I was up till 2, 3am, just building tools and software components for my own business that, I mean, God, even just two years ago, doing something like that, it would have taken a team of software engineers in here doing things with me.

47:34And I'm, I would have had to relay things. I mean, even, God, even a couple of years ago, doing really simple things. Like when I would outsource like, you know, logo design, I would go to, you know, TaskRabbit or something and you outsource something like that and you send it to some guy in India and he sends back a fancy design 18 hours later. And, you know, it's this very clunky process 18 months ago. Whereas today you can do this in literally 18 seconds. And so it's a totally different environment. the ability to, I think, build brand, just personal brand value and build something that is creative and differentiated.

48:14You have the tools at your fingertips now to be able to do these sorts of things. And I think that's going to become just vastly more important. This ability to navigate the changing technological landscape in a very creative and personalized way, weirdly becomes a lot more valuable than say, being able to get a job at Microsoft or NVIDIA And a lot of these big firms where, you know, the old school way, the old traditional way of work, the way we thought of it as being, you know, just another employee at a big firm is very, very different. And so, you know, I don't know if it's necessarily easier.

48:51You know, there's a lot of logic in still doing the traditional thing where you say you go to school and you get a law degree and you get a very safe, high income earning job that is probably going to pay you very well for a very long time. There's still a lot of logic in doing that. So I don't think it's, you know, there isn't a one size fits all answer. But I do think that people, especially people who are creative outside the box thinkers, who have the ability to build and invest in themselves, the tools are, they're more valuable, more accessible than they've ever been now.

49:23Demetri Kofinas:Absolutely. I mean, it's both exciting and scary. I can see how as an entrepreneur, first of all, I'm not constituted as an individual to be an employee within a large corporation. That felt like death for me when I had tried that. But putting that aside, I would actually be very uncomfortable in such a situation because I'm so specialized in my vocation and I'm also very vulnerable to industry-wide layoffs. And then what happens if I lose those skills? The economy moves at a much faster rate. So having an entrepreneurial mindset and having an entrepreneurial skill set and toolbox is invaluable regardless of what your official training is in or how smart you are.

50:03Demetri Kofinas:You can put that to use in any context. But I also think that even as an entrepreneur, the landscape is so different today than it was five years ago. And I'm not just saying technologically though, certainly it is the technology that I think is the primary driver of this, which is that I don't feel safe anymore in the way that I do business. I recognize that I need to be on top of these changes because I already see that if I implement large language models for the post production of the show, that I can dramatically reduce my costs today. I've already seen it. Actually, there's so much more that we can do and we're trying to do it.

50:40Demetri Kofinas:And that means that other people are losing money and other people are losing jobs when I'm cutting my costs, which means that I need to be prepared for that to happen to me. And so what are the things that I can do to push back against that and offer more value than... And it's interesting in the content business, Cullen, and I don't know how much you're in this business anymore because I don't know how much you blog anymore at Pragmatic Capitalist. But what's essentially happened is large language models don't just allow the internet and bots and all this stuff out there to inshittify the internet, to create more and more garbage.

51:12Demetri Kofinas:They also allow really smart people to create more and more interesting stuff that no one reads. Because no one has time to read the additional content you've created because they didn't even have time to list the two-hour episode that you were on last week. And so I think there's something really interesting going on here, Cullen, in terms of how we navigate this deluge of information and arrive at a new plane, a new equilibrium where people can actually make sense of the world and not just feel overwhelmed by not knowing what to focus on and what not to focus on. So I just think for me, it's a really exciting time, but it's a nerve wracking time.

51:47Demetri Kofinas:So the book, as I said, it was split. I mean, most of the book is actually going through these portfolios. That's what I'd like to spend the second hour talking about, as well as larger macroeconomic theory. I'd love to go back and forth with you a bit on that and some of those big topics. There are so many portfolios that you have highlighted in the book. You've got the Buffett portfolio, the 100 % stock portfolio, the T-bill and chill, the 60-40, factor investing, forward capitalization. There are a few that I found especially interesting, like the permanent portfolio or counter-cyclical rebalancing and dividend investing, as you know, or defined duration, which is your favorite portfolio, and I think has so many elements that are sort of consistent with my own objectives.

52:29Demetri Kofinas:Even the endowment portfolio is something that I found like, okay, I feel like a lot of what I do actually looks and feels like an endowment. And so I'd love to explore those things as well as, as I said, a larger conversation about macro in the second hour with you, Cullen. For anyone new to the program, Hidden Forces is listener supportive. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Cullen, head over to hiddenforces.io slash subscribe and sign up to one of our three content tiers.

53:03Demetri Kofinas:All subscribers gain access to our premium feed, which you can use to listen to the rest of today's conversation on your mobile device using your favorite podcast app, just like you're listening to this episode right now. Cullen, stick around. We're going to move the second hour of our conversation onto the premium feed. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io slash subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page.

53:38Demetri Kofinas:Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter at Kofinas and you can email me at info at hiddenforces.io. As always, thanks for listening. We'll see you next time.