#2 Paul Podolsky: Markets, Geopolitics

25:52Yeah, no, the whole topic is fascinating. We can talk for hours about that whole thing. And then how do you think about risk across kind of the different religions and kind of how that fits into the big picture of how you invest, particularly the risk of really bad things happening. If you think about, you know, as an investor, your main goal is to avoid catastrophic loss. Yeah. I think that both being locked into either silo has a huge, has huge problems with it. And I'll give examples for each of those. So with the equity investors, it's obvious. And I've, you know, I've seen people through this, which is that they tend to get crushed when there's abrupt shifts in monetary policy or financial crises.

26:37It's like They're not even building the airplane so that it can withstand those types of things. So for me, I love having – I mean, there's periods of time in my own portfolio where I'll get both short bonds and long stocks at the same time. It's very, very scary to do. But that's my style of investing. I'll do that at times. not that long ago, I was in that sort of portfolio, but I'm generally much more comfortable being long stocks and long bonds at the same time because the bonds can basically cushion the stocks. And if something really unexpectedly terrible happens, I love having that protection there.

27:14So the value investors, I think they're right about the interest of picking good companies and even sometimes the value of concentration, but they terrify me with not thinking about that bigger cause-effect relationships. Another classic example of that would be the 1998 Asian financial crisis. It was basically around exchange rates being not properly backed up, and it led to a whole daisy chain of reactions. And if you weren't a macro investor, a lot of these people don't even understand how exchange rates work. And so it was an absolute bolt from the blue. So I think the case against value investors for not thinking about the risk factor is pretty obvious.

27:51The trick with the macro investors is that they can rely too much on history and not think about the way the economy itself is shifting, which I feel like great value investors know about much more clearly. And so an example of that is what we've gone through recently, which is that inflation collapsed without any rise in unemployment. Well, what was that due to? It literally had to do with how supply chains work, how global shipping works, how the technology stack was changing the nature of pricing of labor and all this arbitrage. That you have a much more clear view of if you're actually looking at individual companies and thinking about how they work.

28:34And I think that certain macro investors could get really beaten up by that because if you looked at a macro model, it wasn't supposed to happen. If you looked at a micro model, it was much more understandable. And so you really, you know, I used to say, I still believe this, that risk is anything that can take your money. And my goal over time is never to outperform an index or outperform a manager. I'm just trying to get the fastest line, the smoothest line to like 8 % or 9 % with minimum drawdowns. So I spend a lot of time thinking about terrible things that can happen, which generally don't happen, but it's been really helpful for me with controlling risk.

29:13And that's why I'm bringing up this issue with this election next year. One big thing I keep thinking about is, okay, what are the odds of that happening? What could happen to the treasury market? How many treasuries do I have in my portfolio? What should I do? How early should I move? It's a low probability event, but it would be so disruptive that it could just cause chaos. Yeah. And I guess there's a lot of things that fit that camp. And you can't really position for all those because you'll put your head in the sand and not earn anything for a long period of time. So how do you think about, in some ways, if you're blind to all those risks, over time, you actually do probably better than you would.

29:52Depends on the country. Right. Until you get wiped out. Yes. But you could look brilliant for 10 years, 20 years, a long time. And so how do you think about the risk of being too conservative or too scared or, you know, too pessimistic, you know, too paranoid versus, you know, maybe doing something that's kind of more in the middle that protects you against those catastrophic losses without overweighting them in your portfolio. Yeah, I think it's a great point. And obviously, you can miss out on unbelievable returns. I mean, there's beautiful things to being investing and what it works like you're just sitting back here, You know, it's not, you're just sort of thoughtfully looking there, pushing buttons on a computer.

30:33Your money is compounding it, you know, 5%, 10%, 15%. It's unbelievable over time, particularly if you avoid the drawdown. So taking risk is highly beneficial. And I think how you do it again, it very much comes back to who you are and how much time you have to allocate it to it. So for people who are not full-time investors, I think the much better thing is being in a truly diversified portfolio of passive assets. I like some of the ETFs that you guys have created. I use some of them in my own portfolio. I'm not paid to make those things. I'm just telling you that I like them. And being sufficiently global with that, so a truly global portfolio of stocks and bonds held and rebalanced in a certain amount of inflation protection, that is by far the best thing for the vast majority of people to do.

31:26In terms of what I actually do, it's much more thinking about sort of a multi-step process, which is I'm first thinking about what my target asset allocation will look like across assets, and I'm really making sure that that is global. Then I'm overlaying on it a macro framework, including what these risks are. And then I'm getting down to the individual company level. And I'm looking for different combinations of things to try to immunize myself out of these various different risks. And, you know, for me using short positions can, while it's very risky, for me personally, it's been essential being able to do that.

32:12You know, that's how I got through 2022, for instance, was, you know, taking most of my wealth and actually putting it in short positions. That's, by the way, not something you should try at home, but this is an investment advice, so do your own research, I should say. Yeah, I mean, it's, the whole thing is just, to me, it's fascinating and challenging at the same time. And the part about investing that I think is maybe more challenging in this industry than just about any other industry is you could be a complete idiot and look brilliant for a long period of time. And you could be a great investor and somebody looks at you and says, all your knowledge and experience and all the moves you've made.

32:51I would have been better off just owning the S &P the last 10 or 15 years. Like, where's the value in that? Yes. And I'm sorry, just because what you're saying is so important. And that gets back to, you know, be imaginative at what could have happened. And I think for me, that confidence that that's terrible, like I would never put all of my money in the S &P, ever, because of these other scenarios. And for me, the experience of working in Russia and spending a lot of time in China and also talking with a lot of people there is one of the things that has given me confidence that you really want to think outside the box.

33:34So I know a number of people in Russia who weren't related to the government at all. They ran good businesses who either lost 70%, 80 % of their wealth or were literally wiped out. Like the stories that you've heard about the Great Depression and stuff like that, those are happening now in Russia. And the reason is, is their framework of what the range of outcomes was, was wrong. Just like the LTCM guys. they said, listen, Putin is crazy, but there's no way we're going to have a full-scale hot war of Ukraine that is lasting years. Well, they were wrong. And that thing happened. One of these people, very successful businessmen, and not only has he been wiped out, he's literally down to selling artwork and cars and stuff like that to cover his bills.

34:20These are people who I know, who I've known for many years. And so it goes back to our frame of reference around, well, could the Great Depression happen or not? Again, one of the things Ray said to me once, he goes, you know, Muffet would have been wiped out in the Great Depression. And he would have been. Stocks fell 90%. And who's to say that those types of things can't happen again? And, you know, I recently, there was a very popular book that came out called The Psychology of Money that probably maybe some people are familiar with. But a lot of it is, listen, the buy and hold portfolio, you know, it's just offered these wonderful returns.

34:54And I'm like, in one country, in one country only. Doesn't work in Germany, doesn't work in France, doesn't work in Brazil, doesn't work in China, doesn't work in Russia. And you're convinced that this is like the perfect, like, who's to say, if people are the same, that the things that have happened there can't happen here. So that, I agree with you. When you're assessing somebody's results, you really need to think about them, about what your goal is, what the full range of outcomes is, and saying, you know, I think the S &P could do great for a long period of time, but you could also imagine scenarios where it'd just be absolutely toxic to wealth.

35:29Yeah. Our data set is during the, you know, the rise of the great American empire. Yes. You know, and even then, you know, companies within that index, you know, a lot of them just go out of business eventually. All of them do. So I wrote a post called All Companies Die, and it literally went through it and looked at who the index members are, have been for the Dow, you can get it back to the 19th century, they're dead. So all the companies that you're looking at, it's like a constant creative destruction process that's going on. And that's the nature of the gift of productivity, but it's also the nature of the disruption.

36:05And it's a very difficult thing for societies to manage well. Yeah. Yeah. And you can be skewed by whatever your data set is in terms of your expectation of future outcomes. That's right. And you see this a lot with, again, I think people asking something money that doesn't want to provide. So they try to approach those data sets to give you a sense of confidence, like, look, this thing is going to work. And it's like, maybe, maybe, you know, the recent, the thing that happened with commercial real estate recently is another example of that. Nobody could imagine that a pandemic could happen, which would literally obliterate, even though work from home has been possible for 10 plus years.

36:44Everyone was like, well, the office creates unique environments, wrong, wrong. And there goes, you know, you're marked down by significant amounts. And, you know, now you can think about the disruptions that are coming from global warming or from, you know, other political shifts. Yeah. And if you think about, you know, if you knew anybody who lived through the Great Depression, they never changed. It was such a devastating experience. They probably never borrowed money again. You know, their perception of risk is very different from somebody who's, you know, two generations removed. Right. That was my father.

37:18My father was a Great Depression child. He was an older father. And that's, again, when I speak with my Russian or Chinese friends, they have a much broader imagination for the range of possible things that could happen. Could one form of government give way to another form of government? Could there be hyperinflation? Could there be a mass banking? Could there be hunger? Different ones of them have experienced that firsthand, so these no longer seem improbable. improbable. I once gave a talk where I was talking about the currency hedging and the possibility that there could be hyperinflation.

37:54I said, you know, just because it hasn't happened in your life doesn't mean it hasn't happened. And somebody raised her, she was like, listen, I'm Venezuelan, you're acting like this is some big sort of revelation. And I said, well, clearly for you, it's not. But that happened recently. Right. Yeah. I mean, and then obviously, you got to balance all that versus what's most likely to happen, which is more of the same. You know, the future typically resembles the recent past until it deviates materially. And it doesn't happen often. Yeah, and the very exciting things that are happening. So, you know, this current change of, if you think about the big shifts in technology, so canals, steam engines, railroads, combustion engines, antibiotics, widespread use of electricity, computers, and then now AI, that basically sequence of, call it like eight major waves of innovation, we're clearly in the middle of something that is very new.

38:50And I think it's most likely to create great new forms of wealth, huge increases of productivity, and it's going to destroy a lot of models of business. Like that's what we're on the verge of right now. We're already in it. And so how do you navigate that one? What are the winners and losers? So I don't think you want to be sort of in gold and Bitcoin hiding out and away from those things, but it's the balance. And that's what's incredibly hard. To do all this, again, coming back to the painting, it's like you don't want a painting to be dire. You don't want it to be too optimistic. You just want it to be accurate.

39:27And it's very difficult to get it accurate. A great work of art is great because it's true. And a good portfolio is like that true as well. And it's about trying to get just that midpoint of those balance of those risks and those opportunities all together. And it's shifting a little bit every single day. And it's also, I think, having that catastrophic risk radar on all the time. And so you're kind of thinking about these things. You're not necessarily acting on them all the time, but you have the radar ready. And when there's red flags and you're like, you know, this is something I've been thinking about and I'm starting to see some things.

40:04And maybe I, you know, take more action now than I would in normal times. Yeah. And that's, I mean, it's happened to me. So first of all, I've gone in, I've taken like significant risk reducing actions more time than bad things have happened. But there have been times in my life where it's literally saved me. So a classic example that is actually Putin's invasion of Ukraine. So going into that, I owned Russian stocks and bonds. And the bonds were trading at a significantly higher real yield than you could get here at a period of time when inflation was low. They had pretty good inflation control.

40:40The currency they were denominated in was wildly depressed relative to the dollar. And the equities, you could literally do equity to equity. There were banks here that were good, solid, near monopolistic banks that were trading at 10 PEs. And virtually the same structure over there was trading at like a 5 PE. They're literally the exact same cash flows for a fraction of the price. And so I was like, well, you could put the two of these things together, put the stock and the bond together with the depressed currency, put a certain amount of my portfolio on that, and this is going to be a great return stream.

41:10And it was a pretty good return stream. And then Putin began to put these troops on the border. And I was like, he can't really be thinking he's going to do this. And I called up contacts that I had there. Everybody told me, including the guy who ultimately got crushed, that there was no chance that this happening was a bluff. And the way I looked at it is I said, well, probably it probably is a bluff. But if it happens, my money isn't going to decline in value, it's going to go to zero. I'm never going to get it out. And I was like, well, how comfortable am I with zero? And I was like, I'm not comfortable.

41:43And so I began selling in waves and waves. I got the last of it out in January of 2022. And then in February, they invaded and poof, there's people I know. I know a fund that has, that was a pretty significant EM fund that literally has hundreds of millions of dollars stranded in Russia. Such things happen. Yeah. Yeah. I mean, when you're analyzing a portfolio, just thinking about it from an analysis perspective, when something has the risk of going to zero, you can't really analyze that. Even if the risk is low, but the risk of, you think of like an asset class, it shouldn't go to zero. But when there are circumstances that are present that give you the risk of zero, then it's like almost not worth the risk return because that, yeah, because you don't bounce back.

42:30You can't just hold on or buy low and bounce back. Yeah. And if you look at, you know, you look at the example of investors in Europe in the first half of the 20th century, you know, there was a lot of wealth transfers of people being wiped out and you see it in Asia as well. Yeah. So you talked a little bit about Russia, Ukraine. I know you have a lot of insight there. And just geopolitics in general, there's obviously a lot at stake. It seems like tensions are rising globally. How do you think about that whole landscape? There are cycles. And one of the classic cycles you deal with in asset allocation is the monetary policy cycle that we're talking in the back.

43:13Are they tightening or they're easing? I think there's obviously seasonal cycles. There's our own life cycle. There's business cycles, expansion and contraction. There are also these big political cycles. And I think that at the very high level, you know, why is money unstable? At the most fundamental level, it's because we've never figured out how much to create of it ever. Like through thousands of years, people have been trying to figure out what's a good source of money and how much of it should we create and who should decide that unanswerable debate. Outside of gold, right? that has a finite supply.

43:49Yes, but it causes huge problems when you're a gold, you know, that's what caused the Great Depression, basically. And so there's no fixed solution to it. And Bitcoin is fitting into that. So that and technological progress is what I think the two core reasons that create the political instability. I mean, the financial instability. In terms of geopolitical instability, the basic issue is, we haven't really agreed what the optimal structure is to run a society. And so on the one hand, if you look over the last couple hundred years, you have more people than ever who are living within democracies, because population has grown and democracies.

44:31On the other hand, the ratio of people living in basically authoritarian systems, like think about like in the 16th century in Europe, it's kings, so it's basically all authoritarian. So if you look now at the modern system, it's roughly the same amount of people, the proportion of people in free versus authoritarian systems has remained unchanged. And if you're in those places in China or in Russia, there's a belief among the party stalwarts that that system is actually much more effective at solving problems in the system that you and I live in. So that's sort of the stage, that these political cycles is where are we in the political cycle.

45:08I tend to believe that the force of history is solidly on the side of democracy. And my measures for that are two things. A, look at what system creates more wealth. So look at where GDP per capita is higher. It's much higher in democratic systems. And B, watch the flow of people. People are literally willing to give their lives to leave those systems and get to a system like that. And so I'm like saying, okay, that's the - way. Not the other way. Right. And if you think about, in essence, what is the Ukraine battle is about, is the Ukrainians want to be part of the European Union. I was there, as you know, this summer, meeting with various different people and seeing things firsthand.

45:52And the right way for people to think about the European Union is it's sort of like McDonald's for government. Like if you open up a McDonald's franchise, you could do what you want, but there's certain standards for what an Egg McMuffin looks like and a Big Mac. And if you diverge from those, you're screwed. That's basically the way the European Union works. It's like government in a box. And what the Ukrainians are saying is we like the government in a box much more than we like the Kremlin model, the Putin model. And for that, Putin wants to kill them. And he wants to kill them because clearly if that thing touches the Kremlin, he's done.

46:27Like in the eyes of sort of modern democratic society, Putin is a war criminal and needs to be brought to The Hague and tried the way Milosevic was after the stuff that happened in Yugoslavia. According to the command and control system, he's like a hero. So there's this battle underway. And I think that the democratic system is going to win, but it creates an enormous amount of tension. And people need to see it as not like, well, we need to find it. You know, we can agree on global warming and stuff like that. Like these systems are in intense conflict because to the degree that the democratic system achieves inroads and those other systems, it doesn't lead to their adjustment.

47:10It leads to their collapse. And so that's the nature of the stakes. And I think that this creates a lot of tension, obviously, but I think you can read too much into the tension because the momentum, the cycle, I think, is gradually going in that direction of a democratic thing. because, again, because of those things of looking at what creates wealth and look at what draws people in. So it's a tension, but I think these places are dying more than they are a threat to take over the world. But it's a very slow-moving transition. It's slow-moving, but it can be quick. In other words, if Ukraine were to lose and the West doesn't provide them, I think that that thing can snowball.

47:51And the other key thing is what happens in Taiwan, where I was recently too, there's a key presidential election actually next month. And the big debate there is between people who want a starker division from China or more cooperation, how that election goes to can also have a big impact. So this is one of those situations where there's sort of a fight between modernity, which is the democratic systems, or the more medieval systems, which are Russia and China. I think that's a fair description. But when the medieval systems are threatened, they can be very hostile and lethal. And so that's what the risks are.

48:27That's big enough to disrupt wealth. So if there was the conflict in Taiwan was spent out of control, it affects the chips that run this conversation that we're having right now, which then would spill into automobile construction, air traffic control, water. I mean, literally the ripple of it is massive. So the stakes of these things are big. Just like this, you know, with the energy we were able to get around Russia, I think the tech is going to be harder. But again, the right framework, I think, is, you know, the medieval versus the modern, the democratic that is drawing people in versus these more authoritarian systems.

49:04Yeah, and significant implications across, you know, economic, social, political. I mean, there's just so much at stake. Yes. And, you know, if you're talking about fat tail risks, I think the thing, one of the reasons it's shaped all these crises is the risk of nuclear confrontation, which again, nothing has gone off for a long period of time, but the stakes there are non-zero. So you could end the war in Ukraine literally in what I'm told by military experts is within a couple of days. And the way you do it is you'd have the US Air Force take out the entire command and control system of Russia that's allowing them to target.

49:46But to do that, you have to have US bombers wiping out air traffic control systems all over Russia. What's the obvious thing that Putin would do back? Nuclear war. So basically, you're sort of fighting this battle there. But in the background of these two nuclear powers, they could get to that situation. And that has been the main thing the West is thinking about is how to stop Putin without triggering nuclear war. And again, just like your example with the S &P 500, because it hasn't happened, we're like, oh, it won't happen. But those risks are real. That's right. So given kind of all the geopolitical instability, how do you think about constructing a portfolio given that elevator risk right now?

50:31Yeah. It's basically, it's made me less enthusiastic about emerging markets, given my experience there. So if people look at emerging markets on a typical valuation basis, they'll say, oh my God, it's unbelievably cheap. And I'm fascinated by these places. I've spent a lot of time there. But in my mind, emerging market basically means lack of rule of law. Like at one time, Korea, South Korea used to say it's an emerging market country or Singapore, it's clearly these are not emerging market countries because the investor protections are very high. Hong Kong didn't used to be an emerging market country, but it's become one again because of what China has done there.

51:10So for me, the simplest steps to build a great portfolio are A, hold assets, not cash. B, be highly diversified. But C, hold assets in places that have good rule of law, even though they're quote unquote more expensive. So if you look at the PE of developed world, they tend to be higher. If you look at the real yields, they tend to be lower. I hold a little bit of emerging market assets. In my portfolio, I've been holding Brazilian bonds for about a year and I like that. They've got extraordinarily high real yields. But basically, these geopolitical tensions make me feel, combined with the AI thing, make me feel like there's plenty of investment opportunities without having to get involved with emerging markets heavily.

51:58And also I'd say, you know, over the period of time, you know, real interest rates in the United States have shot for minus one. They were not that long where they were two and a half percent. So I think that you could build a great portfolio without getting involved in that. And that's a shift in my thinking relative to what I held before. Yeah, so be global, but reduce, you know, a little bit more than you would otherwise given that elevated risk. Yes, and I think it's because you're worried about investor protections. What is going to be your protection there? So there's a lot of people who are very enthusiastic about investing in China.

52:38I ran China research for a while at Bridgewater. I don't have any money in China. And the reason I don't is because I think that the risk of what they're doing, a Ukraine-type situation developing there is low, but it's not low enough that I don't have confidence. You know what, if you own the bonds there and something like that happens, I don't think you can get your money out in an orderly way. And so for me, it's not worth doing it, even though macroeconomic, you know, look at the places of deflationary depression, bonds can be a fantastic asset class. They certainly were in Japan. But that's where I come out of it.

53:11So I sort of go through an investment criteria, you know, and the things that I've added to it since leaving Bridgewater, there's certainly a value momentum to it. There's a, you know, momentum of conditions. I look at flows is two things are the geopolitical risk and also the sensitivity to global climate change. Yeah, two things that don't seem to be diminishing in any way. Right. But if you think about like climate change, okay, you know, are the insurers in your portfolio adequately, you literally can bring this into every single asset if you're predicting what inflation is going to be. Do you think that that's, you'd at least have to make a calculation based on that.

53:48Yeah, this is a really interesting. Why don't we end it on one unique insight that you've learned throughout your career, you know, being kind of all over the world and the experiences that you've enjoyed, and maybe something you learned on your podcast, things I didn't learn in school. But maybe one unique insight that might be interesting to, you know, people that maybe they haven't heard it elsewhere. So I'd say, particularly for investors, matters intuition really matters so um you know investing there's a lot of it that comes from the left brain the numbers the calculations the scenarios that's really important but the intuition is valuable and it takes training to be able to be attentive to that and again that's something that you're not going to learn in school and it relates to you know if you're sitting down if you're investing with an outside manager what's your feel when you talk to the manager you feel like it's somebody you can trust.

54:42Now, this stuff isn't 100 % reliable, but nothing is. So, I'm just, add that to the mix. And then in terms of the podcast, at the end of each podcast, I ask a person, you know, what's the biggest thing I didn't learn in school? And I've had, you know, 60 plus guests on. Nobody has answered the question the same. And what I take away from that is our life is, you know, our life goes through stages, and it's relatively prescribed up to you're about age 25, which is the goal in high school for these people who are probably listening to this is to get into a college, getting into college is to get into a job.

55:19Boom. Okay, that's that first. From there though, the range of outcomes widens vastly and things happen to people in there. Some of them unbelievably good, some of them unbelievably hard. I've had people that have founded companies and become extraordinarily successful. I've also had people who have lost children through car accidents, who have gotten terrible diseases, who have had regulatory run-ins. So, life throws all sorts of challenges at people. And it's from those challenges that you learn these lessons. And I find it so interesting that when you ask those people what they are, what their takeaway is, everybody has these different lessons.

56:03And I absolutely adore hearing them. I'm fundamentally curious in those. And I think those two things, the intuition of those life lessons go away. Because that intuition is sort of your internal computer synthesizing all those teeny little information pieces you've got in the past about who you can trust, what's dangerous and not dangerous. When I was writing my second book, Master Minion, I shared it. It's like a political thriller. I never worked in this spy agency or anything, but I wanted some spies to check it before I put it out to say, hey, if a spy reads this, will it be believable? And so, I had invented this complicated app that allowed the hero to see what he was being followed.

56:43And one of the spies said to me is, he said, if you're being followed, you know it. And I said, how? He said, you can feel it. And that's interesting. That's intuition. So, we have a part of us that was hunted by wild animals. And if you're being hunted again, you'll feel it. In Ukraine, when I was there the summer, knowing that you were target, you felt it right away. And so that feeling is like a survival mechanism. And I think you can use it in investing. Yeah, that makes a lot of sense. Paul, this was a lot of fun. I appreciate you taking the time to share your insights and your experiences.

57:18I thought it was very fascinating, and I hope you enjoyed the conversation as well. That was awesome. Thanks for having me on. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice.

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