#59 - Bob Prince: Portfolio Engineering, Psychology of Investing

31:45She called the wrong person. And so I was like, OK. Should I answer this question once and for all or should I just let this go? And so what I did was I said, OK, I'm going to answer this question once and for all. It's not the first time that it came through. And so literally, I took a yellow sticky pad like this, and I went on to the Vanguard side and some different mutual fund sites. And I was looking for the measure of the standard deviation of the funds, and it wasn't even there. So I was like, well, it doesn't matter. So I just said, OK, stocks, let's call that a 15. Let's call gold a 20.

32:28Let's call bonds a 5. And I just had a yellow sticky pad and I said, OK, if I was going to balance risk across these things, how much would it be? OK, and it's pretty straightforward. So that was the answer. So I ended up calling that my sister-in-law portfolio. And then I was having a meeting with a major sovereign wealth fund describing these concepts. I told the story and and and later when I got back to the office the message came in hey can you send me the mix of that sister-in-law portfolio and I and I also um I was at a conference and same thing I told the story and then when at the break of the conference like everybody wanted to know what was the mix of that sister-in-law portfolio.

33:22So anyway, it doesn't have to be complicated. But the starting point is just what we're talking about. By and large, is the risk level a 5, a 10, a 15, a 20, or a 25. Put it in a bucket. Know how many dollars you need to hold in one thing versus another to have a roughly similar risk. And then diversify across things that have different environmental biases. is something might as well in rising inflation, something in falling inflation, stronger growth, weaker growth, and just do the best you can on that. And you're going to achieve 80 % of what you need to achieve. And so I guess the way to think about those asset classes, it's like a package of returns.

34:09It's a stream of returns that has some history that you can observe and it has some future pattern. And the key to understand is each of those represents exposures to various factors. And what you want to diversify is not the line items. What you want to diversify is those exposures. And that's how you can compound well through time because you're basically diversifying the risks that are easily diversifiable. That's right. And then you know us very well in that kind of very simple way. But in recent years, it's been interesting to take those ideas forward and say, well, what if I only held an equity portfolio?

34:48We had a client a couple years ago that asked us to propose a new approach. The only problem was their portfolio was almost entirely equities and they couldn't use leverage. So you had to figure out how do you do asset allocation if you're really just holding equities? And so that really forced us to kind of broaden in our minds more to the the overarching concept of resilience and minimizing environmental bias which you can do many more ways even by what than what we're talking about where if you understand you have a whole set of companies and different companies have different environmental biases their earnings streams have different environmental biases obviously oil companies do well when oil prices go up.

35:34Some others do badly when oil prices go up. And so you can actually diversify the earnings streams of those companies, which has been a really important thing, particularly in recent market action, to kind of get through that. And then the other thing that we've done is to carry forward those ideas of the environmental biases of global TAA, extending those concepts, meaning if you can build in each economy, now I can then look at all the different economies and see which one is most conducive to assets in terms of liquidity conditions and monetary policy. And then also even within that economy, the growth or inflation environment will automatically then favor stocks versus bonds versus commodities.

36:25And so you could tilt in that direction and recognize the environmental biases of assets are also, those concepts are universal enough that they're extendable in many other ways, which is, you know, you asked the first question you asked me was, you know, are you still interested in what you're doing kind of thing, right? And that's exciting stuff because the founding strategy of risk parity and even extending into just the equity market where you have to create degrees of freedom by separating the cash flow stream and the drivers of that versus the discount rate and the drivers of that. That framework of investing is very different, at least in my experience, from the way most people do it.

37:09And the way most people do it, including a lot of large, sophisticated portfolios, is they think returns come from stocks. All the other things are diversifying to stocks, but they lower your return. So you balance between higher return, more stocks, you know, lower return, less risk, more other things. And that framework is just completely different. And at the end of the day, it's not that diversified because most of the risk is in stocks. Correct. I totally agree with you. To do what you just described is hard, right? It's hard to say which stock market is going to do better. When are stocks going to do well?

37:47When are they going to do poorly. You're just stuck with that equity market decision with a lot of risk and probably too much risk. And so your only choice is just don't take very much risk, hold a tiny amount of stocks and a lot of bonds, or just take too much risk and sell after things go down. You could just have a diversified portfolio of currencies or diversified portfolio of assets and allow for that risk premium to compound over time through that good diversification. So we just walked through the kind of the science and the engineering building a portfolio. And I put that on one end of the spectrum of a well-balanced, well-diversified portfolio.

38:26At the other end of the spectrum, you have a more conventional portfolio. And as we talked about, the conventional portfolio isn't that diversified. But the advantage the conventional portfolio has is that it's more familiar and it often becomes a reference point for investors. So if we move into the psychology of investing part of this, meaning how do you practically implement some of the science, what science proves through time. How do you think about navigating that spectrum for the average investor? Knowing what you're supposed to do, what the science says, but comparing it to what everybody else does and your reference point, basically how is the stock market doing?

39:04And how do you think about navigating that spectrum? And just conceptually, how do you think about it? I think the answer is different. If you're a professional investment manager managing somebody else's money versus, and you're being held to that as a benchmark versus if you're managing your own money and you have some other purpose for your savings. But I think if you're actually held to a benchmark, you're a professional manager, you're held to a benchmark, you need to explicitly know how much tracking area you're going to have relative to that benchmark. And you might actually, even if it makes for a less efficient portfolio, you might actually You have to hold some of that asset in order to measure the proper amount of tracking error, right?

39:48And so that's, you know, we have to do that when that's what it's called for. It's nice to have the freedom to not do that, right? It's much better to have the freedom to just say, I'm going to build the most efficient portfolio, the highest return per unit of risk, the lowest probability of hitting the adverse outcome that I referred to earlier. and, you know, have, you know, we do these things, we call a cone chart, right? Which is like, what is my cone, my range of outcomes over time. And as long as I'm inside that range, I'm achieving my own goals. And I have to be making my decisions based on my goals, what I need the money for, how much risk I can take and build this strategy for that.

40:33Not, you know, what somebody else might've done or what I could have done or something like that, because that will draw you into the mistakes that everybody else is making. And like I said today, what everybody is doing effectively, what the average person is doing is holding a highly concentrated portfolio in a limited number of stocks in the United States and taking a lot of risk in doing that. and the problem with risk is that it you only feel it after the fact and after the fact you can't do anything about it and so we were just talking about you know the fires in california and it that was a risk that pre-existed but you don't really feel it and then afterwards it's happened you can't do anything about it in the markets what happens is you have that risk and It's out there.

41:30It's latent. It may happen. It may not, but it may. And after it happens, it's too late to do something about it. And that's when you really understand it. But the time to manage your risk is before things happen that are unacceptable. So you have to know your unacceptable outcome. And you have to know whether your portfolio or your investment strategy is going to be inside that cone of what's acceptable. One of the challenges that I've experienced in the last couple of decades is that you could reach a logical conclusion about what your portfolio looks like. And so that's this kind of one end of the spectrum.

42:13And then you have what everybody else does. And the challenge there, even if you know that it's not efficient, you hear about it every day, right? It's in the newspaper, it's on TV, and the stock market's doing well. and your friends are talking about it and it's part of conversation. And so it's like you have a belief, but over time, because these periods can last a long period of time, you're swayed to go to the other way. And so the risk I see in terms of practical application of some of these concepts that we're talking about is you have to be able to hold firm to that strategy, whatever it is, through those periods, knowing that it's going to last a long time and it's hard to predict.

42:53And that can be really hard because it's constantly dripping on you. Well, yeah, exactly. And a rise in real interest rates has a negative impact across assets. Now, if it happens in a favorable growth environment, that favorable growth environment, and particularly a big tech revolution, favors equities, right? But today, the real bond yield is not negative 1.5. Today, the real bond yield is positive 2.5. So from this point forward, it's a different set of circumstances than where you were. And so you shouldn't look back and say, oh, that's going to, you know, that's what I should expect going forward.

43:31You'd have to expect the real bond yield to go from two and a half to four and a half or something like that, which would be the top end of the last decade or the last, you know, 100 years or so. So the second, so, but, and then the more general, so number one is do an attribution, understand why was that logical? Is that repeating? Does this make sense to me? The second thing I think is very important is the return of a portfolio or the return of an asset reflects a whole number of things that are coming together, right? If you look under the hood, are the underlying premises that were the basis of me making that portfolio, are those things holding true?

44:13If the underlying premises are holding true and the return is just at the bottom end of the range, then I can expect that in the future that I will achieve my expected return. So, for example, a simple example is if I'm looking at a stock, right? And I'm buying this stock and I, let's say I have the expertise to believe that their earnings is going to grow by, you know, 10 % a year, right? And with very high positive free cash flow and so forth. And now that stock goes down. Okay, you could say, well, the stock went down. Is that a problem? Well, you didn't necessarily predict that it was going to go up or down this year, but you thought that there would be a 10 % earnings growth.

45:06So the question is, was there actually a 10 % earnings growth? If there was 10 % earnings growth, and you continue to expect 10 % earnings growth, then actually your underlying premises are holding true, and that's likely to work out for you over time. one of the things that I look at is I look at what I call a diversification ratio. And so the test of that is if I add up the volatility of all the assets that I hold relative to the total volatility that my portfolio experienced, is that ratio roughly two to one? So if the assets were all 100 % correlated, I get 20 % ball. But actually, I got 10 % ball on the portfolio.

45:53So I was getting the diversification that I expected to get that's working. And if my diversification ratio is still two, I'm getting more risk premiums. This is going to work out. Everything's working fine. Whereas if I hold, let's say, a 70-30 portfolio and my diversification ratio is like 1.2. So fundamentally, the portfolio is performing better. It's just in this particular period, the return might have been worse because of the other set of circumstances. So are the underlying primacies holding true? And have you done a proper attribution of your returns to know why it did what it did, including on the upside, right?

46:39You might've got lucky on the upside, but understanding why the return was what it did in terms of those underlying drivers that we're talking about. And one of the additional challenges, if we kind of jump into the psychology side of all this, is you look back and you look at real yields, one from negative one and a half to two and a half to plus two and a half. Of course that was going to happen, right? They're not going to stay that low forever. And so, so part of the challenge and all of this, and the attribution is the narrative comes into the picture. And, you know, the one thing that's almost as powerful as compounding is hindsight bias, not quite as powerful, but you look back and say, we knew that was going to happen.

47:20I knew it was going to happen. My gut told me. And, and as a result, I can't trust that my, my strategy. So that, that folds into all of this, which makes being, I guess, thoughtful and sticking to the plan for a long period of time very hard in practice. It is. That's what markets are like, which is why. What is the statistic that the average investor in a mutual fund has had? You might know this better than me, but it's something like negative returns, even though the average mutual fund has gone up a lot. the experience return of the holder of the asset has done much worse than the asset itself has done because they get out at the wrong time, along the lines of what you've been saying.

48:09That's the emotion of the game, right? And I always think that a really important criteria is if I build a strategy,

48:22that when I, today, looking forward, I'm going to build a strategy that when I look forward, on the day that I'm losing money, will I still have confidence in that strategy? Right? So do a pro forma, you know, stress test on yourself. Do I believe in this thing enough that when it's lost money, I will say, oh no, this is going to work out, right? This is a good strategy. Or do I start to waver, right? And if I start to waver, don't do it in the first place. Right. Because your experience won't be good. Because whatever the strategy is, you can look at it as a single manager, any return stream, it's going to go through an inevitable period of underperformance, however way you measure that.

49:17So you're right. If going in, you know that it's going to go through a bad period at some points and it's hard to predict when, and you know that your reaction is going to be to sell it, your experience probably won't be good. Yeah. And I think it's very different mentality than what you're kind of drawn to as an investor. As an investor, you're really drawn to, oh, this is going to be a great investment. this is going to work out great, right? Otherwise you wouldn't do it. And so you're sort of like, oh, you're excited about it. This is going to be a great strategy. And then you just have to temper that and you have to say, hold on, it's going to lose money.

49:58When it loses money, will I still say the same thing? Or will I waver a little bit? And if you're going to waver, like just take less, maybe take less risk in it. And that applies to everything we do. One of the patterns that I've observed on the institutional side is it's very typical where you're hiring a manager, whatever they manage. You hire the ones that have outperformed in the past. It's very unusual to say, you know, they've underperformed for a long period of time, but this is their moment. So you hire the outperformer. And then when they underperform for a long enough period where you can't stand it, you're going to fire them.

50:37And because we know managers are going to be cyclical through time, nobody persistently outperforms or underperforms, then you end up with a generally bad discipline to compound wealth over time. It's really interesting how that happens, but it persists. An example of this is value managers, equity in the equity market. You probably remember this study we did a couple of years ago. We took every equity value manager since 1970. We got a database of 3 ,000 some equity value managers. All the equity value managers that ever existed, all the ones included, they all went through the ones that went out of business.

51:19And starting from 1970, if you just held the equal average of all the value managers through time and say, what was that return? It was about 100, 150 basis points higher than the S &P. But the 10-year return had half the range. If you take their different 10-year returns, it had half the range of the S &P. So they actually had a moderately higher return and a much more consistent return than the S &P, which is like, that's what you would want, right? Higher return with half the risk, half the long-term risk. But if you look at the total amount of money invested in value managers, it's about the same as it was in 2007.

52:13Even though since 2007, the stock market is up a ton, the total amount of dollars in value managers is about where it was in 2007, which is telling you there was a persistent selling of those assets to buy the hot thing in the thing that had lesser performance. Because at the time, they were having the consistent return and that was underperforming the hot return. And so they sell one and buy the other. Yeah. And I think part of that is it's almost like humans are hardwired this way. You can see past returns, you can't see future returns. So even though the warnings say, don't extrapolate the past into the future, I think our natural inclination is to do exactly that.

53:00And then you get this momentum where you start to see underperformance and you're like, you extrapolate that into the future. And then you, so this is why buy highs, sell low keeps happening. It's pretty fascinating how it repeats and literally the fact that a price went up more means that a favorable outcome is now a more favorable outcome is now discounted for the future the more the price went up actually the lower the chance going forward that'll outperform what's discounted so it's that also is working against you yeah which kind of goes back to where we started where the things you can be confident about is the benefits of diversification.

53:43Compounding is how you build wealth over time and just don't mess it up. So my guess is, is most investors shouldn't try to time because that's lower odds of success. And unless they're, you know, one of the top five in the room, which obviously most people think they are, but most of them are wrong. They can probably do more harm than good. And that kind of goes back to just be diversified and forget it. Yeah. Build a well diversified well constructed a properly diversified portfolio and today global diversification is really uh really valuable useful and and uh uh the opposite of what most people are holding because i would say today we're probably holding the most concentrated portfolio ever i did a study also at it was called life cycle of the market champions going back over the last hundred years basically taking the, you know, in 1900, what were the 10 highest market cap assets?

54:47Like seven of them were railroads, right? 1900 and 1910. Like, wow, railroads are hot, man. Railroads are going to be great. And in every decade, there was a set of companies that was the favored set. And it goes kind of railroads, and then it goes to chemicals, and then it goes to oil companies. Today, it's the tech sector and a particular segment of the tech sector, I think is an interesting thing to consider. So in every case, you had the market champions, And in every case, they faded, every single one, right? They didn't necessarily go out of business, but they became less significant. And I think an example to think about today is IBM.

55:40We have a tech revolution going on. We have the tech sector comprising, what, almost half of the total S &P. IBM is not mentioned. And yet you go back 20 years ago, 30 years ago, it was IBM. In fact, to such an extent that it was unfair, right? Monopoly power and all that kind of stuff. They're a tech firm. They're not even mentioned. So when you have a deep seek comes in and that hurt, you know, the effect of deep seek on NVIDIA, you know, what about the effect of NVIDIA and the rest of the crowd on IBM? That's the process of creative destruction in the economy. That is how the economy grows.

56:30It is through the process of creative destruction. And it's fed by the process of complacency. of the current champion, market champions, and then maybe overinvestment. So it's very hard to see the future as a different version than today. But when you go back and you take those time slices through history, you see that it's a very unstable, the market champions is a very unstable group, and that the powers of creative destruction are at work at deciding who the winners and losers are, the aggregate keeps going up. The aggregate economy keeps growing. And you want to participate in that, but to have a concentrated exposure in today's champions is not a very safe place to be.

57:26And I'm sure if you studied the narrative during all those periods, It was extremely bullish to support that concentration. Exactly. That's how they got there. You've mentioned that you're observing a lot of regime shifts today. Would you walk us through some of those? Well, it's an interesting dilemma that we're in right now because from a cyclical standpoint, we've been going through five years of imbalances. Right. We think about economies in relation to what does equilibrium look like. And equilibrium is we define equilibrium as spending is in line with output. Debts are in line with incomes and there's normal risk premiums on assets.

58:16And in the last five years, we've had severe disequilibriums across most economies. First of all, we had a deflationary near deflationary depression from the covid. Then we have the stimulation. Then we have the overheating. Then we have the inflation. Then we have the tightening, inverted yield curves, and so on and so forth. And we are, after five years of effort by policymakers to bring us back into line, we are actually converging on about as good a set of equilibrium economic conditions as we've ever had. And that's normally a decent environment for assets. It's not a super great environment, but it's a good environment for assets.

58:58A diversified portfolio would typically give you the average, your average excess return in that environment with a little less volatility. And that'd be good. Against that set of circumstances. Now you bring in. First of all, the pricing, it tends to be optimistic in the United States, not so much globally. And then you bring in the very proactive government activity, what we call modern mercantilism, which is where economies are focused internally, where governments are focused internally on doing things that are best for their own economy. and the orientation is much more around competing instead of cooperating.

59:42And the idea of globalization and global capital flow movements and free markets is out the window, and it's much more around pulling the levers to manage your own economy in relation to others. That has, first of all, in the United States, we haven't done that very long. and are they going to be any good at it? So is there going to be capital wasted? Are we going to cause inflation? And so on and so forth. So that brings in a lot of uncertainty. China has been doing that for a while. They're pretty good at it. They've got a big challenge right now, but they've been doing it for a while. Europe doesn't even have the governance structure to have a strategy.

1:00:28They don't have a central government. So Europe's in a particularly bad place because the U.S. is going to be is doing things that are maybe bad for Europe and China is out competing Europe. The U.S. is out competing in the tech sector. China is out competing in the manufacturing sector. They've had very low innovation, very low productivity and no central government, you know, to basically steer the ship and figure out how to compete in this world. So So that's register that problem for Europe, which you're seeing in the currency. Then when you go to the US and you look at the policies, this nice cyclical equilibrium that we were coming into is challenged by the policies themselves.

1:01:14Tariffs are inflationary. Reduced immigration is inflationary. And the U.S. inflation rate is just hovering at the top end of acceptable for the Fed at a time that wages is still pretty high. And the only reason we've been able to get away with high wages and high nominal spending, nominal spending is also running at too high of a level for the 2 % inflation rate unless you get high productivity. So the U.S. economy is very dependent on a productivity miracle, high productivity continuing into the future. And the more you cut back on immigration, the more dependent it is on that. Because it's been the expansion of the labor force through immigration that's allowed actually wages to not be higher than they are.

1:02:00And as you curtail that supply of labor and you keep spending the same, you have upward pressure on inflation. So the policies themselves are generally inflationary, though they could also be negative for growth. we do the calculations. The only way to really deal with this mercantilist type of a policy is to literally sit down and go through the calculations of import by import, export by export, price by price, company by company, and tally up the impact of the first order effects, the retaliatory effects, and so forth, and just calculate bottom up. What is the GDP impact of that and what is the inflation impact of that?

1:02:47And the 25-25-10 mixture of tariffs we calculated was about a 25 basis point negative for the U.S. economy. So not overwhelming, but a weakening of the economy and a positive to inflation. the effect would be much much bigger on a on a mexico or on canada where in the one to two percent type range impact on real gdp growth not a huge impact on china and china doesn't export that much into the united states particularly not directly and um and a 10 percent tariff is smaller so you start with the basic cyclical picture which is coming into a reasonable set of equilibriums around the world, which should generally be good.

1:03:33Too optimistic pricing in the United States that can be dealt with through global diversification. Tariffs, which can really only be understood by going at the very detailed level and can also impact one company a lot more than the aggregate. And therefore, diversification, right? You don't want to be concentrated in the wrong company that's nailed by that. And then I guess the third thing is the relative equilibrium that we've achieved in the United States has been achieved by about a 15-year period of the government stepping in and taking on a lot more debt and allowing a deleveraging in the private sector and a strengthening of household balance sheets in the private sector.

1:04:19And that has left the U.S. government with a big fiscal deficit, but also a big stock of outstanding debt. So U.S. debt, the GDP has gone from about 70 percent where it was for decades to about 120 percent. The fiscal debt, it's about seven. It's probably going to be that or higher going forward. And so that's what you're left with is that the U.S. economy, you have to roll over the debt, right? And so you have both the new issuance and the rollovers of the existing debt. The rollovers of the existing debt is occurring at a higher interest rate, which is then increasing the deficit. And that can have compound effects over time.

1:05:04Ray's actually done a good study of this. And he's writing a book now on the math of that process. And so it's a precarious situation. And it hasn't come home to roost because the U.S. economy has been stronger. The Fed's been tighter. U.S. rates have been higher. U.S. companies, the tech sector is doing better. And so there's been plenty of capital flow into the bonds. But you're going to be issuing the U.S. government is going to be issuing 25 to 30 percent of GDP every year as far as the eye could see of bonds. And while you normally roll over the bonds, the holder of the bonds has to choose to do that.

1:05:55And if the holder of the bonds is a foreign government or someone who doesn't necessarily want to hold the bonds anymore, you're susceptible to that. 43 % of the outstanding debt is held by either foreign entities or the U.S. Central Bank. The Fed doesn't want the rollover of the bonds anymore. So that's a situation. Debt rollovers is not something people pay a lot of attention to. But if you look across emerging economies, it's always the inability to rollover debt that is the currency crisis and the financial crisis. It's not the new issuance per se. It's the combination of the new issuance that also scares people out of the rollovers.

1:06:43The rollovers of U.S. Treasury debt is going to be a big issue going forward, both because of the rise in the interest rate that's going to get paid and the potential that the people that hold the debt don't want to roll it over. It sounds like one of those latent risks that you described earlier, which is nobody really cares about it until it becomes the most important thing as you cross that tipping point. After it happens. That's also one of those cascading risks. If it happens, it doesn't happen in a small scale. it's like the avalanche tipping point risk so i think we're in a world where you just can't say i'm going to hold the world asset or i'm going to hold the market cap asset you literally want to be thinking about each country and each asset and how vulnerable it is to these influences and then diversify across the ones that seem to be um you know uh free of harm and then kind of bringing it full circle, recognizing that the conventional portfolio and the average portfolio is not that well diversified.

1:07:49So understand that there is going to be some difference there, which means you'll have more tracking error of your more diversified portfolio versus what everybody else does for better or for worse. And just appreciate that before the fact. And achieve your goals for your savings or your investing. Bob, this has been great. I appreciate you sharing your insights, taking the time to walk us through everything. And I always enjoy our conversations. So thank you. Great. Great to talk to you, Alex. 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.

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