#30 - Meb Faber: Industry Insights, Investment Framework

30:02Most fund managers don't. And I think that's a shame. And also, if you think about it, as an investor, you're investing in a fund. The onus is on the fund manager to decide, at this level, we can't continue to generate the returns we have in the past. So we should close our fund, not accept more capital. And I've seen some funds return capital. But then there's a disincentive to do that because the bigger your fund, the more you make for yourself and your firm. And so that conflict can be challenging for the investor, particularly since it's not easy to see it from the outside. Yeah. I mean, how many hedge funds have we seen where they have 20 % of performance fees, they get into a big drawdown, they just shut down the fund, and then six months later, like, we're launching a new fund.

30:51Like, how could you possibly, you know, unless you get some sort of discount on that next fund, Come on, man. You're just restarting. You're just turning the computer on and off. That doesn't seem fair to your old investors, but it happens time and time again. The other challenge in the investment management world that I've noticed, and you probably have as well, is there's a tendency for investors to go and invest in, particularly actively managed fund, to invest in the actively managed fund that has outperformed the last three, five, 10 years. And inevitably, they underperform the next three, five years, and then they terminate that manager and then hire the one they should have hired five years earlier.

31:28and you repeat the cycle. And one simple measure is just looking at the time way to return versus the dollar way to return. And typically, investors earn is a lot less than what the funds have earned on a time-weighted basis. Would you talk about that? We have a whole thread on this on Twitter where Vogel had this in one of his books where he was looking at the top managers of each decade and then how they did the next decade. And not surprising, you already know the punchline, they underperformed. We did the same thing with the Morningstar does like the mutual fund managers, the decade, same thing, right?

32:03They do amazing. And then the next, next regime, they do poorly. I think this applies certainly to, I mean, it's, it's most, it shows up most in active managers, because they tend to be more concentrated. So you have the outliers, it's like the distribution, you have more on the upside, but also the ones on the downside just closed down. So like it's almost, I think it's 50%, 5-0, half of all public funds close or emerged over the course of a decade, which is an astonishing number. So, you know, in 20 years, that like entire universe is totally recycled. So you have that sort of survivor bias where people don't see all the ones that just close up shop.

32:45But I think it's true with assets as well. You know, we did this recent article called the bear market and diversification. And if you're a financial advisor listening to this, it might be a little PTSD, which we wrote about, which is if you go back to the bottom in 2009, and the U.S. stock market has done 15 % compounded since March 2009. Unbelievable, right? Just creamed. One of the best periods in history. If you compounded 15 % for long periods, you become rich pretty quick. However, if you had invested in any asset allocation strategy, so it could be the endowment model, it could be 60-40, it could be risk parity, permanent portfolio, it doesn't matter.

33:24It doesn't matter what it was. First of all, they did just fine. So I don't know, 6%, 7 % on average, which relative to inflation, that 4 % probably over inflation is in line because it was a low inflationary period. You know, inflation is much higher now. And so the challenge was, this has arguably been, we look at this for the past 100 years, all these different types of asset allocation strategies. If not the number one, then maybe number two, and the only comparable period is post-World War II. In terms of absolute level of underperformance relative to the S &P. and the hardest part if anyone knows anything about investing for long periods it's not the absolute underperformance it's the consistency of underperformance so it's something like most of these strategies underperform the s &p 12 13 of the past 15 years and in like 10 in a row right so it's like every christmas every thanksgiving you have cousin eddie over here who's just put all his money in the S &P or NVIDIA.

34:32And every year he's like, you do this for a living? Like, why? Like, why are people paying you? I just put all my money in SPY. And then you have all the reasonable things to say to him. You say, you know, he's like, like you invest in foreign stocks. Are you an idiot? Like who would invest in foreign stocks? Diverse, like he's like global diversification. Like, that's crazy. Like, why would you invest in any other country than your own? And I'm like, well, you know, just to be clear here, globally diverse, diversified portfolio even just stocks has worked in like 44 or 45 countries. It just hasn't worked in one.

35:06It hasn't worked in one this cycle. I guarantee you, if you're Greek or Brazilian or Japanese or Chinese or a Brit or Australian, and you said, hey, I actually globally diversified for the past 15 years, you did vastly better. Now, largely because you had a huge chunk in the US, right? But the cycles flip. Anyway, so I think people extrapolate. The biggest disconnect probably in all of investing is that investors want short-term results and certainty. They want their returns and they want them now. And so they are so used to this instant feedback that they believe that if you buy something, doesn't matter if it's active manager or stock, you should know or you should see the returns, I don't know, this month, this year.

36:01But it could easily go three, five, even 10 years. Now, we had Ken French on the podcast recently, and he said 64 years. He's like, statistically speaking, you need 64 years to tell if they're any good. I think that's a little too long. I think you need less than 64. But it goes back to this just entire challenge of chasing the hot returns. And active managers, it's easy because they tend to have a little more of an outlier. but it happens in indexes. It happens in countries, assets, on and on. And almost always, you've read all the same academic literature I have. It works against you. You almost always end up doing it at the wrong time.

36:38My favorite example is Ken Huebner, CGM, who had amazing returns on a time-weighted basis, but on a dollar-weighted, it was like 20 % a year. On a dollar-weighted, it was not 20, it wasn't even 10, it was negative. Because then everybody piled in after he had his hot run and then lost 70 % immediately thereafter. Yeah, it's one of the hardest things in investing because we can see the historical returns and it's easy to project that into the future because most of the world works like that. Past performance is indicative of future results in most of the world. You know, if you have an outperforming employee, they're likely outperforming the future and vice versa.

37:17So it is very counterintuitive in that way and it can really catch you off guard. Yeah. And the challenge is if you look at something even as simple as the S &P, you're getting a stream of all future cash flows. And so if you're at a period where right now we think that U.S. stocks or market cap weighted pretty expensive, you're simply pulling some of the future returns into the present. So if you've been in the last 15 years, God bless you, pat yourself on the back, like you've realized that return. But on average, and again, you could go back to Bogle, wrote a paper about this in the 90s, where you could kind of draw up your broad expectations about what markets should do.

38:00um you know the flip side is is also true if if something's been stinking it up down and the market goes down 40 60 80 super cheap like that's that's probably on average uh the time that that should look really good a lot harder to do of course that's for sure that time seems to take longer in markets than it does in most of the world uh well you've been in the industry a long time and you know a lot of financial advisors. So let's talk about the financial advisory industry. Would you share some of your key insights into this part of the investment world for our listeners? Yeah. I think financial advisors are worth their weight in gold.

38:48I think, however, I think the asset allocation decision is really table stakes. And in a world where you can buy an asset allocation ETF, you and I both run one, or you can buy a basket of ETFs, that's like the default already. That's the foundation. So you better bring something to the table. If you're a financial advisor charging 20, 50, 100, 150 basis points, whatever it may be, you better be able to add something. And my belief is the vast majority of the value add is not on optimizing the excess return of that portfolio. Now, I think optimizing tax efficiency of that portfolio, optimizing it for the client's goals and desires, I think the vast majority of the value add for many in the wealth management financial advisory business is the litany of other value-added ideas.

39:57It's tax management, it's behavioral coaching, it's taxes, filing taxes, being a CPA, it's estates and trusts and wills, all the other basics, blocking and tackling that I think a lot of people don't do or certainly don't optimize. I mean, just the simple fee and tax discussion alone we spend so much time on is way sexier to me than the actual investment management side. But that's what everyone spends 99 % of the time talking about on Bloomberg and CNBC and elsewhere. Where, you know, we were saying the other day, the other day, it's now like five years ago, probably, on Twitter, the decision to move from the average mutual fund to the average ETF is probably at least a 70 basis point up to about a percent and a half benefit alone.

40:54So you got just the difference in the average mutual fund and the average ETF. So that right there is like 70 basis points. average mutual fund and this isn't dollar weighted this is the average cross numbers is 125 and then the tax benefit particularly if you're in a taxable high state like us you know and you're doing equities and you're doing equity turnover you're adding on quite a bit more and so just that basic decision like you're not like how many people were you know still we still see the mutual fund solid portfolios where somebody comes over here maybe here's my 40 mutual funds I own.

41:31And I said, my God, that's, uh, that's unfortunate, you know? Um, cause you, you, you're in this legacy anyway. You know, I, I think that the boring tax is always like my number one tax and fees. Those are things we can control and really optimize in a way that I think, uh, most people eyes glaze over. They think about taxes about once a year. And that's usually when they, you know, I have to write a check and in April or whenever it is now, that's my, that's my big thought on that. Now, again, we could go deeper in certain areas, but I think the advisory business is a future-proof business that is going to be around for a long time.

42:13But it's one that I think the majority of the value add is not as much on the investment management space as people think. Yeah. And probably a lot of it is just helping people avoid the big mistakes that we often see. You know, you're supposed to buy low and sell high and most people buy high and sell low. So just helping people reduce the tendency to do that is probably very beneficial over time. We have an old paper called the investing pyramid, which harkens back to the days of the old food pyramid. And we were kind of talking about how, you know, when I was a kid, the food pyramid, the thing you're supposed to eat the most of was carbs.

42:50It was like on the end and look at the pyramid. It's like cereal, pasta, you know, all these things that now it's like inverted, right? It was like, you probably shouldn't be loading up on Frosted Flakes to Fruit Loops all morning. And the same thing was kind of true with investing. And we kind of talked about what it meant to be an investor 50 years ago, and what does it mean today, and what's the foundation, and what are the main steps you should do in order. And number one is that do no harm. Don't do the really stupid things first. That seems to be the number one. Don't get taken out of the game.

43:23And then it's kind of doing the steps in order, I think, is a thoughtful way to think about it. So if we look at the way the investment advisory business is set up, if we were starting from scratch and it didn't exist and you had the opportunity to whiteboard it, how would you set it up? This is asset management or more of the planning side? The investment advisory. So like my side of the business. I love the concept of stating very clearly, almost like the nutrition information on the back of a soft drink or food. Here's what you're signing up for. And I think most investors, you ask them, I think they just assume that most people in the financial world, by law and regulations, have to have their best interests in mind.

44:16And that's not true, right? which is kind of crazy if you think about it. So I think that should be like a very clearly worded designation where you say, look, this person, registered investment advisor, whatever you want to call them, is like they have to, by law, at least attempt to have your best interests in mind. And that if you want to have all these others who can do all these things, like go have at it. You know, I think that to me would be like number one. And then like, very clear, no industry, no other industry has as much jargon as we do. My God. And so just like very clearly have just this statement, you know, this is what you're going to get charged.

45:02This is why blah, blah, blah. I think if you're an entrepreneur out there, I'm still shocked that there's not a well-developed Yelp or ZocDoc for our world. You know, how do most people find us? It's they ask their friend and their friend says, oh, man, man, been a client of Alex's forever playing golf. He's amazing. Same thing. Like, oh, he's a little crazy shop down in Manhattan Beach that does asset management, been investing with them. You know, that's how they arrive. But, you know, Google search is probably not the best way to go about finding, you know, someone you're entrusting your entire life savings to.

45:42Right. So I think there's opportunity there that I'm surprised that hasn't hasn't quite happened yet. So I think having that clear accreditation and distinctions would be important. After that, I think there's all litany of ideas, but that that to me is the number one. I think we have a big problem in the U.S. of we wrote an old article called How to Narrow the Wealth and Income Gap in the U.S. And one of them was to teach education, teach investing in personal finance and money in schools. So education. Another was, you know, our retirement system is a little cobbled together. You got Roth IRAs, IRAs, 401ks, on and on and on.

46:22And doing something similar to what like Australia does with their superannuation funds where, you know, you just X percentage of your earnings go straight into these retirement strategies that are invested. And you ask people in Australia and they all have these giant balances because they've been, you know, mandated and required to save a little bit, I think is a really thoughtful way to go about it. And we don't do that in the US. We kind of tie it to employment. And it's just it's too damn confusing. All this, our entire world, this could headline just be too damn confusing for most people.

46:57And so just trying to simplify it and trying to get everyone invested. I really struggle. There's a chart. The anonymous Jesse Livermore, who used to talk about this, where it's the percent of assets, household assets that are allocated to stocks in the United States over time, right? And it goes waxes and wanes. And usually it's up and down with the markets. and I struggle with it because I want everyone to be an investor. You know, Brad Gerson at Altimeter talks a lot about this, this concept of not a baby bond, but a baby investment. You're born in the U.S., you get$1 ,000,$5 ,000, whatever, invest in the stock market.

47:37You know, I love that idea. I think it's fantastic. So I want everyone to be an investor. Now, the struggle with this chart, of course, is at this point in 2024 is U.S. stocks on our average are expensive. So this recently hit the highest it's ever been, right? So the two other peaks were, you know, 2000, 2021, and today. So it's conflicting because I want everyone to be an investor. I want everyone to put all the, you know, invest this concept of be the owner. But at the same time, know that kind of on the sentiment side, when everyone's clamoring and putting all their money in, usually the future returns stink.

48:12So I don't know. I'd say the industry has gotten better over the last three or four decades. If you go back, you had people selling stocks and they really didn't know what they were talking about, but they were selling stocks and getting commissions. And then it evolved to an advisory fee. And so it's, I think, getting better, but very slowly. And I think if we were to start from scratch, a lot of what you see probably wouldn't exist. You kind of fast forward maybe a decade or so where it's very, very objective, very transparent, simple easy to understand and so on i think you're spot on i think it uh it takes longer than i think you and i would both hope but the arrow of progress is moving in the right direction i mean you can look at the every year you know we're saying etfs are eating the asset management industry but on average and there's nothing there are some magical and special things about etfs but They're not just a structure, but it really just comes down to that total after-tax fee and just cost.

49:18On average, every year, it's just every year just moving down, which is wonderful. The rest of the world is miles behind. You look at some of these countries where a lot of these investment products are linked to banks, and they cost 2.5%, 3 % points to get invested in some of these products. It's not just tiny countries like Japan and Canada, etc. You look at some countries where no one invests. A lot of Europe, most of the people out there aren't investors. They don't really invest to the same extent Americans do. I think we're leading the charge. Maybe that's why the U.S. is soon to be 70 % of world market cap.

49:57I don't know. But I think it's moving in the right direction. But that's the thing about money is that it doesn't go back to the places it was treated poorly. So we say the two big things is death and divorce. So if you got 50 mutual funds at 1.5 % and your father or grandfather dies or you get divorced and those get liquidated, no one wakes up and is like, I'm going to buy those 50 mutual funds again. No chance. They go by the broad portfolio of ETFs. And so many investors get stuck on this where they say, oh, man, I just got these legacy positions. I got big tax bases. And I say, well, you know how much this 1.5 % is costing you per year just to stick around?

50:42It's costing you a fortune. And so there's actually coming up with, stay tuned, some really innovative ideas, you know, where you can kind of move from highly taxable positions into diversified funds. We've had these exchange funds for many years, and now you're starting to see it in the ETF world, which I think in 2024, the balance of the year, you'll start to see even more innovation here. So again, it's a great time to be moving away from a lot of the garbage. But so many people make decisions based on tax alone and end up in a far worse place. But I think that is one positive trend moving in the right direction.

51:23Well, let's transition to your investment framework and talking about how to build a portfolio efficiently. What would you say are the main goals of a portfolio? Let's start there. um the first one that trumps everything else is is this mental mindset of being the owner and what do i mean by that you know i i have a lot of non-consensus views and some are much more out there than others but but the most important one in my mind at its core if you look at all the top celebrities and athletes for example make a ton of money It could be Dr. Dre. It could be Dolly Parton. It could be Ryan Reynolds, on and on.

52:09They actually didn't, none of them made their big money from their career. Now they made decent money, Jay-Z, right? Made decent money from rapping and Dolly Parton made decent money from singing and athletes. Michael Jordan is probably my favorite example. But where'd they make their real money? Like the big get rich money is from business. It was business they're investing 99 % of the time. And so this concept of being the owner, being an investor, there's a million different ways to do it, right? So, you know, we sit down and we wrote an old book about this. We're trying to update it this year called Global Asset Allocation.

52:46It's free to download. But we looked at all these different asset allocation portfolios. And the big takeaway to me was that there's plenty of ways to get rich. You know, there's people out there, I'm a dividend person or I'm a real estate person. And I think this applies to housing too. I often say, you know, the reason that so many people use it, why my mom bought this house for a hundred grand and now it's 2 million. Look how great this return was. And in most cases I say, it's actually not even the return that's that out there. It's the decision to have invested. So real estate's great because it's forced investing.

53:26You get a mortgage, like you have to pay it, right? And if you didn't have the mortgage, what would most people do with it? They would spend it. They'd buy a new F-150 or Tesla or they'd go on a vacation or go out to dinner, pop some bottles of club, I don't know. And the same thing is true with reasons why target date funds are so successful, 401ks, where it's that automated and back to the superannuation in Australia for savings. And so I think as long as you get the basics right, So the goal of just getting that money in there and automating this is always better than not. Enforcing it, right?

54:02So you don't even see it. It just skims off every month, whether it's$100,$1 ,000,$10 ,000. And starting today, right, that's the big one. The compounding, we always try to tell the young people, say, look, you get 10 % returns per year. It doesn't sound like much. 25 years, you have 10 extra money. In 50 years, it's 100x. Think about that. 100x. You put in 100 grand, that's going to be worth 10 million. And, you know, that's people are, well, it's hard to come up with 100 grand. Sure. But like that compounds anyway. So I don't think it really matters what you put your money into. So that's the first kind of weird comment.

54:37But you want to diversify it across the three main buckets in my mind, which is global stocks, global bonds and global real assets, meaning like real estate tips, commodity sort of link things. And I don't think the proportions matter that much. They'll matter in any given year. So in this book, we looked at all these asset allocation strategies. In any given year, the top performing strategy versus the worst would vary by like 30 percentage points. So that's why people end up chasing whatever the hot strategy is, right? But over time, they all end up kind of in the same place, which is astonishing takeaway.

55:13And so I think it doesn't really matter. And then after that, you know, that's the basics. If you can implement that low cost, tax efficiently, all in one ETF, basket of ETFs, boom, you're done right there. That to me is like the investing pyramid, like first like nine levels of the pyramid. Now, are there things I think you can do on top of that that are particularly important? I do. Well, what's interesting about what you just said is, at least in my experience, most people don't do that. They have a portfolio that is not that well diversified. It's heavily concentrated, perhaps today more than normal.

55:47and it's almost like violating the first rule of investing has become convention. almost everyone you know does the i'm all in on the stocks in my own country so in the u.s I mean, it's getting even more and more extreme, but everyone owns U.S. stocks. I don't know that I've ever met an investor, certainly a professional investor that's an allocator, particularly on your side of the fence, that doesn't own U.S. stocks. Now, there may be one account for like grandma. She's like, hey, I'm just going to put her in CDs, whatever. But on average, everyone owns U.S. stocks. right and u.s stocks with almost the entire portfolio they may own a sprinkling of foreign stocks but it seems you can forget about emerging markets that's that's not even consideration at this point um and then they own some u.s bonds right and then but as the percentage of the world you know people always forget u.s is a percentage of world gdp is like a quarter u.s the the people are always surprised the majority of global gdp is in emerging markets the vast majority of population is certainly in emerging markets but these other parts of the portfolio the big one that's usually missing is the real asset side now caveat most people own a house that are investors and so that house definitely contributes a real asset portion but it's extremely non-diversified right you're on one block in one city in one part of the country so on average getting the basics right with the diversification i think is important and and that means global stocks so right now the u.s is 60 ish percentage of the world maybe two-thirds foreign bonds are actually bigger than u.s bonds on average and then the real assets i think is is the most important that now once you get those basics covered and that's good you know um then you can move on to other things like tilting towards value which we do tilting towards trend uh which we do and kind of getting the periphery right but most people like you mentioned and this is also true around the world the home country bias is very real still if you're in japan if you're in uk if you're in australia you put all your money in your own country which is totally insane you know and you look at all the charts on this and it's just like the biggest head scratcher ever but people people like to invest you know going back to the very beginning of the discussion like i'm a broncos fan i will never ever be a raiders fan so i like to cheer for and it feels comfortable to me it feels like i understand and know it and And that's my people.

58:23And the same is true as investing. People, if you're in Brazil, you're going to invest in Brazilian stocks, right? Because that feels like you really know them. You know it's warm and comfy, but it's historically an absolutely horrific idea. It's one of the worst things you can do is put all your money in one country. And the list of why that's true is endless, including the US. Right. Earlier, you mentioned two things you can be sure of are beneficial. keeping your fees as low as you can for what you're getting and trying to minimize taxes. The other that I would add is diversification. They talk about the one free lunch in investing is diversification.

59:04You can basically get similar returns for less risk or greater returns for same risk by being properly diversified, yet so few people are properly diversified. It's really fascinating. It's particularly apparent this cycle, right? Because when the big, the big one in the room, the S &P is the one that's shining, it becomes, I think, particularly in the US, particularly apparent, right? Now, if like REITs or the Long Bond or something was doing this for 10, 15 years, it's not as, I feel like a, you know, a parent situation, but particularly when it's the S &P. And this year, my goodness, not only has it been going on for 15 years, then you have something like this year where I think small caps are down on the year.

59:54Mid caps are flat, if not down. And the S &P is up, what, 15 %? We're recording this kind of early July. And you got a handful of stocks that are just propping this up. So I think it's challenging for sure for a lot of people not to just put it all in on US. Yeah. So let me ask you about that. So if you're investing for the next 5, 10, 15 years, why wouldn't an investor just buy the S &P? It's low cost. You can basically get it for free, low taxes, low headache. Why don't they just buy that and just hold it for 10, 15 years? Why worry about trying to be more complicated with your portfolio? Yeah.

1:00:37First of all, I think it's fine. If you look at the long list of things that are totally fine, I put that in this bucket. But if you look at the long list of things that are absolutely horrific, I don't put that necessarily in this bucket. I don't think it's a good idea. And I think it will be potentially extremely problematic. There's people out there that not are paying three basis points for the S &P. They're paying one, one and a half. Right? So that's like, that's in the not okay bucket. But here's the problem with that. So you go back 50 years. When people really started to do market cap investing, Bogle, Wells Fargo, others, you know, this was a neutron bomb that went off in the asset management industry.

1:01:23And fantastic, in a good way. I don't know how you make that analogy. In a good way. But it just destroyed all these high fee, do nothing shops. and is continuing to reverberate today. But it's actually not the market cap indexing that was the innovation. Now, market cap indexing means you invest the most and the biggest and the least and the smallest companies by market cap weighting, but there's no tether to fundamentals. But because you don't do anything, if you're a market cap investor, you just buy it and you don't actually ever rebounce. I mean, you do corporate actions, but otherwise you just let them float.

1:01:57So you don't need anyone. You don't need any employees, really. And so you're able to offer that for a low fee. So really, it's the low fee part that really was the huge innovation. But 50 years forward, you can now do any sort of other indexing or active management strategy in ETF wrapper and have it be tax efficient. So you could do equal weight, for example, let's say you equal weighted the S &P 500. Well, historically, that beats the S &P. It's like one of the easiest ways to beat the S &P is you just break that market cap link because Because the top stocks in the S &P, so if you look at, say, the top 10, historically, they underperformed the S &P.

1:02:34Now, it's not a huge amount, but let's call it like half a percent or something. So you just either eliminate those. And we have some charts on Twitter that talk about this because most of the time it's totally normal. But when you have these euphoric bubble periods, the stocks that get the biggest and go up the most then have the biggest weight. and then if you think globally is an easier way to to i think visualize it you know u.s in 1999 that most expensive it's ever been well it was the biggest part of the world's market right it was the largest stock market in the 1980s japan which hit a long-term p ratio of two of a hundred almost a hundred was the biggest stock market in the world so you put most of the money in the u.s uh the japanese stock market and so it's the same truth within indices and there's been a lot of research out there that demonstrates if you just simply got rid of the top stock, you know, the top stock underperforms that index, usually by about three percentage points per year for the next decade, right?

1:03:31So it's you have this situation that historically, it's not a good idea to market cap weight. However, GMOs got my favorite chart on this. It looked at the top 10 stocks versus the other 490. And on average, again, a terrible idea underperforms by I don't let's make it up 2 % a year. But every once in a while, you get this face ripper period of five, 10 years where those stocks just go absolutely nuts. And usually it's in the bull market crescendo. And then they beat by 5 % a year or something. And that's kind of here we are, right? Now, this goes back to the beginning of our discussion. And what makes this so much fun and challenging is that like that doesn't have to stop here at a long-term p ratio of 35 the u.s hit 45 and 99 and again japan hit 100 so there's nothing there's no stop sign that says you have to this bull market has to end here and and the same is true on the opposite side right the p in the u.s has been as low as five a couple times but on average if you're a betting person and the probability weighted, future returns should be lower for market cap weighted.

1:04:46So if you look at things like value, we do shareholder yield. It looks incredible relative to the overall market, the spreads, all the big quants like to talk about this, whether it's top deciles, top two deciles, I think it really peaked in February 21. It's a great time to be moving away from the market cap weight and that could add returns to that traditional portfolio. So So, yes, if someone's going to put an S &P and just live with it, it's probably going to be okay. I don't think they're going to do the historical 10%. They may do five, but it's not zero. But I think if you tilt it toward things like value, tilt it towards foreign and emerging, which on average are much cheaper.

1:05:28And then the one way to protect yourself on kind of the, what should we call this, the euphoric hedge would be to have an allocation to trend as well, which I think is the one big thing that most institutions don't do that I think would be the number one thing to add to a traditional buy and hold diversified portfolio once you get to that point. But SPY is not the worst thing. It's just not the best thing. Yeah, I think one helpful way to think about it is it's all probabilities. So the probability that just buying the S &P 500 gives you a good return for the next five to 10 years is probably low, given how expensive it is, but it's not zero.

1:06:09So it could continue to run, but it's just like the more it runs and it outperforms its historical average, the lower the odds of good performance from that point forward. And likewise, if you're buying cheaper things or being more diversified, your odds of success just increase and you're spinning that wheel and you're playing the odds. My favorite way to illustrate this is if we simulate quantitatively U.S. stocks, just two simple buckets. They're expensive, they're cheap. And then are they in an uptrend or downtrend? Something like the 200-day moving average. Very, very basic. Go back 100 plus years.

1:06:45The best quadrant is a cheap uptrend, which is not surprising. The worst is a expensive downtrend. Again, not surprising. But the second best is the expensive uptrend, which is where we are now, right? So stocks are expensive, but they're continuing to go up. And so the trend following type of strategies, I think are a hedge against your neighbor, right? So listening to that cousin Eddie, just yap on about how much money he's making in NVIDIA and S &P, well, at least the trend gives you some exposure that the rebalancing, like you mentioned, I think is a thoughtful way to trim those positions.

1:07:26Because if you just have a US stocks and bonds portfolio, or even a diversified portfolio, and you never touch it, it gets offsides, right? The US stock portion, if it goes up for 15 years relative to everything else, it's getting to be the biggest weight relative to the rest of the portfolio, probably when you least want it to be. So that systematic rebalancing, I think is a thoughtful, and I don't think it matters how specific you do it, as long as you do it at some point. It could be every year, be every couple of years, but you got to do it at some point. Otherwise you just end up all in and at a time when you don't want to be.

1:08:00And then I think one of the biggest things to think about in constructing a portfolio is what's your goal? And probably more practically, what's the reference point? So you can judge success or failure. And I think there's a tendency for the reference point to be US stocks and more specifically the S &P. Because you ask somebody how the market's doing, they're going to quote the S &P. And that's what's on CNBC and the Wall Street Journal. And if you have a portfolio that is very different from that because it's more diversified, then you can go through a long stretch like we have the last 5, 10, 15 years where you feel like you're not doing well.

1:08:35And also, if you don't have a goal, we talk a lot about this, where you should write down an investing plan. If you're partnered with an advisor like yourself, obviously you do, but a lot of investors who are winging it, you know, if you don't have a goal, the answer ends up just being more, right? Like you don't have a reference point. And the problem with no reference point is you have no rudder or tiller, I guess you'd say, foundation where you have to base your decisions upon. And then it just becomes the vast majority of investors that, you know, going back to when you buy a fund, you know, buy a fund and I'm just going to wing it, you know, and that's probably the absolute worst way to go about it because your emotions creep in.

1:09:16What are you going to do when it's down 10%, 20, 50, right? And so if you don't have an investing plan, if you don't have the goals set up, I think it becomes a huge problem. And it's not just when things go wrong. It's also when things go right. Something doubles. What are you going to do? Right? Are you going to let it ride? You're going to, you know, something goes up 10X. You know, you got an investment in single stock. That thing's a 50 bagger. How are you going to think about it? It can be stressful on that side too. It's a better problem to have than down 70%, but it happens. Yeah. And I think another way to think about it is if you have a plan and you have a sense of how things will perform in the future, at least the range of expectations.

1:09:56And when they perform within that range, maybe you don't overreact. If you don't have those kind of ground rules established upfront, you're much more likely to respond to your emotional reactions to returns. And as we know, that tends to lead you in the wrong direction. So you talked about in terms of portfolio construction, having global equities, global fixed income and real assets, those inflation hedges. How do you think about other investments like private assets or hedge funds? We love to take a historical simulation approach with a lot of the assets. And I love to pick fun and post things on Twitter.

1:10:40One we posted the other day was people out there love to identify with their tribe. So my Canadian and Aussie friends, my goodness, they love gold, right? But other people, their bond, fixed income, folks, whatever, stocks, stock, bulls, dividend, aristocrats, on and on. But I was trying to make the point the other day, I said, you know, if you did the blind studies, the old Pepsi, Coke, taste tests, where you actually didn't look at the name of the asset, you just put in the metrics historically said, okay, you got to make decisions. I think people would come up with totally different outcomes, right?

1:11:22They would come up with totally different conclusions. Like if you put the statistics of a diversified portfolio versus the S &P, no one would choose the S &P. Zero people would choose the S &P, right? But then how many people do or versus 60-40? And so it's a fun simulation and test to do with investors. And one that I was doing on Twitter the other day that stirred up the pot a little bit is I said, all right, you got a 60-40 portfolio, the foundation, the global benchmark. Let's just replace the entire 40%. So that 60 % U.S. stocks, S &P 500, 40 % government bonds. I use 10-year U.S. government bond.

1:11:58I go, let's do some crazy. Let's just replace all the bonds with gold. Like that's a horrible idea, right? And it turns out it literally makes no difference. You could go back 30 years. And then of course I did it, whatever, the first one I posted, I forget, 30 years, 40 years, whatever it was. And I was like, yeah, yeah, but this is such a specific period. I go, it doesn't matter. Go back 100 years. It doesn't matter. Now it's better to have both. But my point being is that when you do some of these simulations and think, it goes back to what you're talking about is like, what is the role of this investment?

1:12:30And I think there's kind of two categories, right? So the less investments you have. So if you just have the S &P, it's easy to add things that improve upon that return stream. You know, you add bonds, you add real assets, and it's very clear to demonstrate what that adds. Now, once you get to that diversified portfolio benchmark, the bar is a lot higher, right? And so you say, okay, well, it's either got to do one of two things. It's got to add returns, right? You You want it to be something that's offense really thinking about. So it's better in some sense. And whether you have a significant amount of confidence in that, or it's got to be a diversifier.

1:13:16So is it going to zig and zag when the rest of the portfolio is doing poorly? Or a combination of both. That's kind of the holy grail, right? Right. And then, of course, being honest about it on an after tax basis or somehow does it improve taxation, et cetera. And so, you know, I think a lot of people, they'll have a portfolio and they'll spend all this time on this investing idea. And then they'll be like, all right, I'm going to swap this out. It's like one percent allocation. Also, that's not going to do anything like almost never would that have any impact. So, you know, are you going to allocate five, 10 percent, et cetera?

1:13:53You know, to me, the number one thing that we look at relative to so if you what do most people do? They don't own any foreign stocks. They don't own any foreign bonds. They don't own any real assets. So let's assume you've done all these things already. You got a diversified portfolio. I think that the number one for me, and I'm an outlier here, is trend following type of strategies. So some people would call this managed futures. Some people would call it lots of other variants. I think on average, these types of strategies are one of the best diversifiers to a traditional portfolio, particularly during the bad times, the long bad times, not necessarily the short bad times, but long bear markets, particularly in U.S.

1:14:39stock. The biggest weakness of a traditional portfolio, I think, is that it's too highly correlated to economic cycle, which also ends up being too highly correlated to people's human capital. And so things like private equity, you know, to me is like, can you get that outperformance? Maybe. And if you assume that you can, the challenge with private equity is it's still just businesses. It's equity. It just happens to be private. So there's benefits to that. And I've changed my mind over the years on private equity, the illiquidity being a feature, not a bug, as long as you know that. But I think trend following to me has been the one that I think most investors, if you had to look at where is MEB the weirdest, it's that.

1:15:26And our default allocation is 50 % in trend, which I'm guessing there's no advisor or asset manager in the country that's north of 20, 25%. I think 10 is probably a comfy space for that. And if you look at trend, you know, for 2009 to 2019 was a rough period, right? Like, again, S &P creamed everything, but particularly trend. It's done well since then. But traditionally, it shines when it's hitting the fan in traditional markets. And then how do you think about private investments like private real estate or private credit is very popular these days or even hedge funds, particularly the ones that actually hedge and might generate an uncorrelated return?

1:16:15You're kind of opening a long discussion on this private-public sort of demarcation, differentiation over the years, which used to be pretty stark, has been muddled a lot by ETFs, a lot of public vehicles. So you can do a lot of what used to be hedge fund type of strategies in ETFs and public vehicles. So I just mentioned managed futures. We have managed futures ETF. There's a lot of styles and strategies that are applicable now where you have this curve of what used to be high alpha type of strategies that have morphed into what you'd almost call like alternative beta. That having been said, there's plenty of things that should not be in an ETF.

1:17:06You want to go invest in cat bonds. That shouldn't be in an ETF. Never. And it's not appropriate. And there's other areas like fixed income where ETFs don't offer the same tax advantages as they do in active equities. Certainly, angel investing or private equity, you're not going to be doing that in an ETF and really probably shouldn't even maybe in a mutual fund or interval fund. So there's areas where it's totally reasonable. I think the challenge for most investors is, do you have the access? Do you have the consistent ability to invest and research and find these funds and strategies? Most hedge funds, in my mind, you're going to look like just kind of levered beta.

1:17:57So is that fund actually doing something that's additive? So maybe you're investing in an expert, small-cap, private, not small-cap, small, private, gold-streaming investor. You're not going to find that probably in public markets. So is it something that's unique, differentiated, interesting? Or do they have some special ability or an edge in process? I think it's certainly doable. I think it's not easy. It's certainly hard, hard to find. Yeah. Particularly in that of fees and taxes. That's the biggie. You know, the two and 20 is a large toll. It's, it is, it is a massive, massive toll. Like you got to, we, we did a post on this many moons ago on what is the gross bogey you got to hit on a hedge fund just to get to S and P like returns after tax.

1:19:00and it is a lot of alpha. Like you gotta be damn good. And most of the academic research shows that on average, these managers are good. They just keep most of the alpha for themselves. And so that it's, hey, look, God bless them. It's good to be a private equity manager. It's good to be a hedge fund manager, but do those returns flow through to the end client? Where's the customer's yachts? I think it's tough. And it gets more competitive by the day. So if we were to summarize, what would you say are the main enemies of long-term investment success for investors? Look in the mirror, right? I think the struggle of, even if you understand history and you say, look, my favorite investing book, Triumph of the Optimist.

1:19:50You go back and read all the history of markets. You understand, you've studied markets. you have the full playbook of what's happened and why things have happened, you know, the future is always going to be different. And so I think the struggle of being able to maintain your goals, your dignity, your approach is a real challenge for a lot of people. Some people it's not, you know. I think having a fiduciary in your corner is a big deal. but uh coming up with a written investing approach at its core most people listeners be honest to yourself like we're you're listening to this i'm you're not gonna get feedback from me but just be honest and ask yourself do i have a written investing approach and we know because we do this poll over and over and it's like 90 don't so just write it down it could be an index card doesn't have to be a 10 pager just say kind of here's here's here's what i'm doing here's why And the challenge is, I think, of when and why things come in and out of the portfolio, what your expectations are going to be, how you're going to measure those, I think is a worthwhile exercise that most aren't going to go through.

1:21:03The wing it approach is kind of where everyone is. Yeah. And I guess one of the key parts of what you just described is have an investment approach and strategy and don't be quick to change it significantly because if you keep doing that, you may be worse off than if you had any strategy, regardless of what it is the whole time. Yeah. We looked in kind of this old book where we were talking about if you had perfect foresight on just stocks and bonds, you got to pick the best one each year. your return is like 20%. But if you pick the exact opposite wrong one, your return's about zero. I mean, it's actually positive, I think.

1:21:47So you can't even lose if you tried, right? If like you were perfect at picking the wrong investment every year, you can't even lose. But so many people actually do end up losing, right? They end up losing a lot of money. I can't tell you how many portfolios we've seen where they've had negative and zero returns for many, many years. and it's because they're always chasing what's hot, right? What's working. And even the timeframes, I think that most people, like Vanguard did a great study that showed, if you even look at the winners, so let's pick the ones that have done well and won, the amount of years where they trailed or did poorly was way more than people would expect and could be years in a row, right?

1:22:30So, you know, let me give a good example. If you go back to what's the most universally held belief in all of investing, I would argue that it's stocks for the long run, right? Stocks outperform bonds. Stocks are the premier asset. You should put all your money in stocks. But if you were to ask the average investor, hey, you just bought this active manager. How long are you going to – what's the leash you're going to give them? The answer is usually, as you mentioned earlier, three years, right? Like that's their, and you say, okay, well, let's apply that to stocks. You know, how long do you think you need to give stocks versus bonds to know that stocks are this good asset?

1:23:13And if you said three years, well, that's crazy. Obviously, there's been many, many three-year periods where stocks underperform bonds. During the pandemic, it was like 40 years where stocks had now not outperformed the long bond, or they had about the same returns. so there's been many periods in history if you look back where stocks do poorly for 10 20 years right if you go back to the 1800s it's like 60 years so uh this this magical belief that you can somehow judge an active manager on a couple years but you know but stocks don't get that same pass right that you know uh but then they can go decades decades imagine decades you know most investors think about that.

1:23:55What are you going to look like in 20 years? Are you even going to be alive in 20 years? I don't know. What's the setup? But 20 years from now, they could underperform bonds. And I think most investors just, they don't, it's hard. We all want the certainty of the short term, but that's unfortunately just not the way markets work. So tying it all together in terms of portfolio construction. So have a sound investment strategy, that strategy should probably include focus on fees, focus on taxes. If you're a taxable investor, focus on diversification and having a good understanding of the path all these different assets can take over time, not overreacting to the path in real time, particularly if it's within that range of expectations.

1:24:42And if anything, rebalancing and buying the things that have done poorly, selling the things that have done well. And over time, that's a very good strategy. And then if you can add more diversification inside your portfolio, it seems like if you're on that path, you're going to have a much higher likelihood of long-term success than if you're on the opposite path. Well said. There's a paper we wrote on this topic called the Trinity Portfolio, And it was inspired by a Seattle-based asset investment advisor, Paul Merriman. And the older crowd may know Paul. He used to write an old piece called The Ultimate Buy and Hold Portfolio.

1:25:22But the reason I like this piece is that he started with the S &P and then kept adding the diversifying ideas. So he would say add bonds and then maybe add REITs and add foreign stocks and walk you through the process. one step all along the way to show and then show that final portfolio versus the starting portfolio. And it kind of demonstrates how this diversification really helps and works over time. And so we did our variant on that. We took it kind of a step further with adding things like value and things like trend following. But I think that's a fun way to frame it where you kind of walk through the portfolio construction process.

1:26:02It's like cooking, you know, where you're kind of going through the recipe to get to the final souffle or omelet or chocolate chip cookies. I bought an air fryer, so we're big on anything air fried now. So, but getting to the final product, which I think when you mentally walk through it, it's a lot more visual and you can kind of see why that diversified portfolio makes a lot more sense. particularly when you're zoomed out. You alluded to this a little bit earlier. We tend to zoom in and the more we pay attention, the more zoomed in we get. And you just look at recent results and then you extrapolate that into the distant future.

1:26:44But if you were to zoom out and you see that you're on this very sustainable path, you may be less likely to overreact. I want to do this book. Maybe it's a coffee table book. I started to write it with some AI help on the airplane the other day where, you know, we've all in our world seen the 120-year chart of U.S. stocks. And it overlays all the crisis events. So Pearl Harbor, Vietnam, COVID, whatever it is, every year there's something terrible going on. And, you know, you see these periods where stocks did awful. awful, but over time, this just relentless march up of the free markets and capitalism and U.S.

1:27:24stocks, you know, creating generational wealth. I want to redo this book, but also include the globally diversified portfolio and sort of, you know, talk about the event each year. But then, hey, you know, even though it's short term, you may have struggled or lost XYZ in 5, 10, 20 years, you probably ended up okay. I think it's an interesting way to visualize this where there have been plenty of pretty tough periods, but over time, it tends to work out. Just over time means a lot longer than most people think. That's right. And it kind of goes back to one thing that you said earlier that struck me as really insightful is looking backwards, the downturns are great opportunities, but looking forwards, it's all risk to the downside.

1:28:08and when you zoom out, you're more likely to see it as an opportunity. Yeah, well said. Well, Meb, this has been great. I appreciate you sharing all your insights and spending some time with us. So thank you very much. Been a blast. Thanks so much. 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.

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