Cullen Roche on the Art of Building a Perfect Portfolio

24:55government going bankrupt or, you know, what is going on with China? And I'm trying to sort of write about this stuff, not because it's important in the context of portfolio construction, but because it's more so about understanding how these things operate at more of a sort of a first principles level where you can look at a bond allocation. If you own a huge slug of U.S. Treasury bonds, for instance, or T-bills, you can look at these things. When you understand them more mechanically, you can look at these things and say, OK, well, the odds of the U.S. government actually going bankrupt are extraordinarily low because I understand how these things function.

25:31I understand that the U.S. government is not going to run out of money. I understand that, you know, maybe bond vigilantes aren't quite as powerful as we've all been told. And you can understand these things in the context of owning something so that you're more comfortable with what you're doing. And that's actually the hardest part about all of this is that it's all very complex. and it's all very emotional. And if you don't understand what you own, then you won't be comfortable with it and you won't stick with it.

26:13Let's talk about real estate. I bought a house in 2016. I think it's done all right. But then sometimes I'm like, man, I really wish I just put that all into QQQ or something like that. And then the other thing with houses that I think is interesting, which is like, you could look at, maybe let's say you own a house outright and it's like, oh, this is worth a million dollars or something like that. You can't really sell it because then you have to buy a house. And so it's like, I'm not even sure, like I got to live somewhere. And so you can't monetize that to the same degree you could sell your stock and buy stuff.

26:44But talk to us about how one should think. Let's start this. How one should think about the role of their home in their overall portfolio. It's the hardest asset to buy, I think, because it is, it's an instrument that you want to generate a return on. So you want to do like some financial analysis on it and, you know, try to, nobody wants to buy a house in 2007 or something and then see it go down 30%, but also your house is where you live. It's where you're going to raise your kids and you're going to eat most of your meals and where you're going to do all the little boring things in life that are actually really important to you.

27:22And so there's this really personal part of it that it makes the, to some degree, it throws all the financial math out the window. But from a basic, you know, first of all, going back to your 2016 purchase, I would say, you know, that was unbelievable timing because... Oh, thank you. Thank you. You could argue that going through COVID, I mean, any house that was leveraged, did you have a mortgage? Yeah. Yeah. So any house that was leveraged was the best inflation hedge. Right. Maybe the best inflation hedge trade of the last 50 years, you could argue, just in terms of just providing this stable level of certainty.

28:00The low mortgage is an inflation hedge. You got 50 % price appreciation or probably something like that. So that's interesting too, to think about that when you're kind of going back to the question on gold that I didn't fully answer, what happens when an asset goes up so much in the short term, the way I like to think of it, at least is that let's say that housing typically generates a low real return, or even historically, it hasn't generated a real return. The way that I like to think about things like that are environments where you get these, what I call a price compression, you get a huge boom in an asset class.

28:33And it's almost easier to think of this in like a fixed income market where like when the bond market goes down a lot, interest rates go up, the math completely changes on all that. So a lot of people these days are saying like bonds are dead. And I would say like, no, bonds are actually probably more attractive because mathematically from a yield perspective relative to the falling price decline, the future returns are much more stable now, much more probable. And so what happens in an environment where you get a 50 % increase in real estate or, you know, what was gold up last year, 65%. Let's just be generous and say gold is going to continue to do 8 % per year for the next however many years.

29:11When you get 65 % of that return all crunched down into one year, I think what happens is you create a higher probability of what a financial advisor would call sequence of returns risk, which means that the probability that the future returns are going to be much more volatile becomes much higher. And so that's one thing with real estate is that Like I'm not super optimistic about future real estate prices for now because we went through this big boom. It creates this price compression and you get lots of returns into one year all crammed up. And that means that the likelihood of either sideways or, you know, not great returns is pretty probable.

29:49So, you know, going forward, you know, I think that it's good to think of your house as basically a it's a block of commodities on an appreciating piece of land. And, you know, the thing that's important with real estate is I talk about this a lot in the book that you have to think of everything in terms of real, real returns. And that means you have to back out inflation and you have to back out all the other costs. And that's the thing that, you know, I have probably the worst housing story in the world because in 2017, I bought a house in California that had a small waterway on it. And without knowing that, which I should have probably known in the state of California, anything with water on it in the state of California is basically the biggest permitting nightmare that you could possibly imagine.

30:33It gets the EPA involved. It gets the Coastal Commission involved. It gets the State Department of Fish and Wildlife involved. And all of a sudden you get an introspective look at, you know, how all these government agencies work together. Now I'm really curious. What were you trying to do? We were literally just trying to remodel the house. Yeah. So we bought this old home. So you weren't touching the water at all. No, we weren't touching the water at all. And in fact, the water is not even, I mean, San Diego gets 10 inches of rain a year. So, you know, that's very, very little rain. And so this waterway, we call it, is really, it only has water in it, I mean, 10 days a year or something.

31:09It's crazy. It's dry. It's not like it's a lagoon or something. This is how you're a libertarian arc. Well, it's really funny because my wife is very, very liberal. And we were going through the permitting process. And she was like, these people are trying to turn me into a libertarian. I get it. Oh, actually, since you brought up your wife, I got to ask. There's a bit in the book where you talk about marrying a portfolio. And then you have a tiny footnote that says, apologies to my wife. And then it says, I'm just testing if my wife actually reads this. Did she read it? She caught it. She actually was the first editor of the book.

31:41So she and she did go through it and she caught it. She didn't just jam it all through GPT, which she kept trying to convince me to do. But no, it's funny. There's another footnote about my mother-in-law in there that she has not caught yet. Oh, what's that one? I didn't see that one. So she got trapped with us during COVID. And I make the joke that I had just had my first daughter right after COVID. And, you know, the shutdown happens, the international travel shutdown happens. She lives in France. So she just happened to be visiting us for the baby's arrival. And she gets trapped with us for six months.

32:14And I make this joke about how I was crying in the shower every morning, not because of the baby. Screaming into a sock, I think you said. Just going back to bonds for a second. It is true that you see investors behave in exactly the opposite way that they should be behaving when it comes to bonds. If you like bonds at a 2 % yield, you should love them at like a 7 % yield. talk a little bit more about, you know, what you're talking about just now with gold and real estate is a momentum factor, right? And momentum seems to have done very, very well over the past few years. I mean, this is why we say flows before pros, right?

32:53Can we just follow what everyone else is doing? That seems to be the way now. Yeah. Gosh, I mean, there's momentum. There's the momentum factor and the momentum factor, and this is the more academic version of portfolio construction, where in the factor investing chapter, I talk very specifically about, you know, it's called cross-sectional momentum, basically. And this is basically picking the stocks that have performed well in the past with the expectation that they continue to perform well in the future. And they weirdly, the data actually shows that that is a thing. And so it frustrates people like Gene Fama of the efficient market hypothesis.

33:32But it's interesting because in the context of today's world, that momentum factor is basically just everything tech, everything that's performed the best. And so you're which has, you know, weirdly continued to work and work and work throughout the years. And so you get this like self-reinforcing cycle, right? Yeah. And there's also, you know, the one chapter that I actually thought was almost even more interesting than the momentum one is one that's related, which is called the trend following chapter. And that is very different in the sense that these guys, these traders are, they're not necessarily just looking at the past and trying to, you know, they're not picking stocks necessarily and then extrapolating it in the future.

34:11These guys are just trying to find trends and they're looking, maybe they're looking at, you know, chart data or whatever. But and they're it's a go anywhere strategy. So one of the most interesting things about this strategy is that it is one of the truly fully uncorrelated strategies to everything else. And it's had this sort of big resurgence in the last. It became very popular after the GFC because it beat the pants off of everything and was uncorrelated, had these huge asymmetric returns. and then went through this period of like a 10-year lag. And it had kind of like what I was referring to earlier, where you had this like, you had that price compression.

34:47The trend following things all went up. All these CTA funds go up, you know, 50, 100%. And then they all lag for, and they lag for a long time. And that's the thing about finding uncorrelated assets is that sometimes these uncorrelated instruments, they're not like cashflow generating instruments like stocks and bonds necessarily. So the trend followers though, they go through this 10-year period of lagging, which exposes people to all these behavioral biases. I remember CTAs also became a really convenient scapegoat for anything weird that was happening in the market. They were like the multi-strats of today, right?

35:24I forgot how much we used to talk about CTAs in the early 2010s as an important driver. Actually, can we talk a little bit about tech stocks for a second? Because this strikes me as very important, and I think about this all the time. You see these surveys that Bank of America does of fund managers are like, what's the most crowded trade in the world? Tech. They've been saying that since like 2013, and it still just performs. And all these other, there are all kinds of other knock-on things. It's like people talk about US versus international exposure. But at the end of the day, this is just a bet on tech when we're talking about the US.

35:57And the other thing I think about tech a lot is that setting aside sort of theories of portfolio construction, these companies make gobs of money and they make more and more and more and more each year. We recently did an episode and Ben Snyder, the top equity strategist of Goldman was on. He's like, well, the big tech companies, it's like 33 % of S &P 500 earnings. And I listened to that as like, well, that's another 67 % of total earnings for them to gobble up. But it strikes me that, can you just talk, it must drive portfolio managers crazy that there's this one sector. And this is a novelty, right?

36:32Because these are big companies that are growing faster than almost anyone else, which is not the case in many environments when we associate big companies with maturity and slow growth. So like there is this thing going on for years and years and years that just sort of feels to bust every other strategy. And if you're not overweight tech, you're probably underperforming. Yeah. And it's really frustrated the hell out of people, especially the factor investors who haven't been in the momentum trade, who have been more value oriented or, you know, the people who know that small has outperformed large in the long run, like it's all been flipped on its head.

37:06And so I, again, going back to the time horizon thing, the way that at least I try to think about this is tech and growth is really interesting in the current environment because in going back to the NASDAQ bubble, you can actually, you know, a lot of people make that corollary. And the interesting thing about the NASDAQ bubble is that if you bought the very tippy top of the NASDAQ bubble and held on to today, you've made like 8 % per year. It's great. You've done really, really well, which is crazy. But you had this crazy sequence of returns risk, because especially in real terms, you went through this traumatic, like 15 year downturn over that period.

37:39So the interesting thing, you know, compared to then is that, like you said, these entities are completely different. Like everybody was expecting the Internet to be a big thing. And it was. And everybody expects AI to be a big thing. And I think it will be. But the interesting difference between that environment and this environment is that these companies are they make more money than any other. entities have ever in human existence. So this is completely different than the - And every year they beat analyst experts. It's crazy. And they're growing crazy, crazy fast. So it's almost unbelievable.

38:08But the thing is, kind of going back to that whole idea of price compression and thinking about time horizons, the way I think about it is that, and I write about this specifically in probably my favorite chapter to write in this book was an original strategy that I call the forward cap portfolio. And what I did was I took five huge macroeconomic trends and I distilled them all down and I tried to extrapolate data out into the future. And one of the big ones is tech, where I look at something like e-commerce retail sales and I say, you know, this is currently whatever it is, 25 percent of all e-commerce retail sales as a percentage of total retail sales.

38:47is 25%. And that number, you know, is probably going to go to 50 or 60 or 70 % at some point in the future. All retail sales will just turn into e-commerce sales at some point. Like you said, like, you know, this is, there's 75 % more for e-commerce to gobble up. I believe that. And so if you believe that and you want to buy technology, well, what should you own? Should you own the market cap weighting of 35 % like it is now in the S &P 500? Or should you go to like 50 or 60%. And the way I kind of frame it in the book is it's skating to where the puck maybe is going rather than when you buy a market cap weighted index fund, what you're doing is you're basically skating with the puck, which is, it's a good strategy.

39:28It works really well, but you're not necessarily trying to skate to where the puck is going. And so I'm doing a lot of guesswork. It's obviously very active. And, you know, there's a lot of, there's a lot of estimates that are involved in all of this. But if you think forward, like, I don't think it's unreasonable to say that in 40 or 50 years, the market cap of technology in the S &P 500 might be 50, 60, 70 percent. Who knows? Like everything's probably turning into a tech company. Might be two years. But the tricky part about that is that when, especially when valuations are really high, I talk about how valuations are the equivalent of high expectations.

40:06And when expectations are really high, it doesn't take much to disappoint. So your margin for error when expectations are really high is just really low. So what that does is it causes this potential where you have higher sequence of returns risk in the short term, where, you know, I would say if I'm talking to, you know, a 20 year old who's coming out of college, he just got a great job on Wall Street or something, I might tell him, well, hey, your time horizon is so long, and you could be so aggressive, you should maybe just go buy a growth fund and just, you know, lose the password to your brokerage account for like 40 years.

40:38And open it up and you'll probably have done really well. But if you look at that thing in five years, it might be down 50 percent. You don't know. And so that's the way I kind of frame it. And so if you're very time sensitive, I would say, you know, the retiree who is retiring next year and they're loaded to the gills with NVIDIA and Google and Microsoft, that person has a totally different risk exposure than that 20 year old does. How do you think about the index providers in this equation? Because there's this perception that you put your money in an index fund, it's a passive investment. But actually, it's kind of active because the index provider is making decisions about what to do.

41:18And I know the index providers always say they're just holding up a mirror to the market. But some of that seems very subjective to me, like whether or not you're going to add Chinese bonds into a debt index and things like that. Are we just outsourcing our investment decisions to the indexes? To a large degree, yeah. I mean, I talk about how there is no such thing as passive investing a lot, more than I should, because it annoys a lot of people. But there's a lot of people who demonize passive investing, I think, for kind of phony reasons. And a big part of that is this fact that, you know, the reason I talk about and try to quantify the global financial asset portfolios because I was trying to create a benchmark for if we were going to define something as passive, as truly passive to me is you're buying the full market portfolio.

42:05You're not deviating at all. You're not making any active decisions at all. And so when you quantify the GFAP, you can actually create a benchmark there where you understand, OK, well, this is the only if you were truly fully 100 percent passive, this is the only thing you would own. And the funny thing is nobody can buy this thing and nobody does buy this thing. Because even at a stock bond weighting, the stock versus bond weighting right now is something like 45, 55. So you're inherently underweight stock. So it's not even that close to even like the 60, 40 portfolio. And so everybody deviates from this.

42:38And I write about how that's totally fine. There's nothing wrong with deviating. There's nothing wrong with being a little bit active. And so even from the indexing perspective, though. I laugh at the way the S &P 500 is constructed. It's a committee of people that are constantly picking and choosing which firms to introduce. And it's very methodical. It's very data dependent. So it's a very systematic sort of process. But at the end of the day, they're choosing the 500 companies that go into that index in the first place. And so in the context of the global equity market, it's even more interesting because they're excluding you know, thousands of other entities just, you know, by their own volition.

43:15So everyone's active and, you know, there's very smart ways to be active and there's very stupid ways to be active. And I would say that, you know, a lot of the things, the most sort of disconcerting thing that I see going on these days is that I see the issuance of a lot of strategies and especially with the rise of crypto, there's a lot of things going on that I would describe as stupid active, where people are more having like a gambling mentality approaching all of this than anything else. If we had like another hour, actually, I would love to just pick your brain about the investment advisory business, like less the portfolio construction per se, and just how this world works.

43:50Cause I have so many questions about that, but I've won. And you know, we've seen you, we run into every once in a while down at the future proof conference in Southern California, you know, or there's a lot of advisors and then there's a lot of vendors and they're selling various products. And one of the hot things that we know that they're trying to get people excited about owning private assets or various alternatives, et cetera, non-vanilla things. In your perspective, for most clients that you see, is there a compelling reason for some of these novel products or for some to include like, yeah, private credit, private assets, private, whatever it is, do these solve problems for the portfolio manager or for the investment advisor that the existing publicly liquid assets don't provide?

44:40Yeah. 2022 messed a lot of people up because when stocks and bonds become highly correlated and you own that 60-40 portfolio that the bonds go down 15 % or whatever, and the stocks also go down 25%. Well, then you look at your portfolio at the end of the year and you say, I'm not actually diversified. If you were that retiree that you mentioned, Tracy, that is retiring that year, you feel like you made a bad decision, even though the 60-40 portfolio for the most part is a pretty good portfolio. There is an increasingly compelling argument in that context for things like alternatives. Me personally, I tend to just default towards simple is better because I think that this whole process can get so complex so quickly that the little things you can do to create organization and structure to simplify it as best as possible is going to result in a better process, a better outcome in the long run.

45:34So, you know, little things like, I mean, God, I woke up 10 years ago and I looked at me and my wife's financial accounts and I was like, oh, my God, we've got I've got a mayor, an old Merrill Lynch 401k and I've got you've got old Fidelity 401ks and you've got, you know, a bank account over there. I have a bank account over here. We've got three brokerage accounts at Charles Schwab and, you know, different custodians, TD Ameritrade or whatever it might be. And I was like, this is I can't manage all this. I've actually forgotten the password to some of these accounts or something. And so collapsing all this down and consolidating it and simplifying it and trying to own something that is very, very simple.

46:12One of the portfolios I talk about is the Boglehead Three Fund portfolio in the book. And I think one of the reasons that so many people love that and the followers of that portfolio, they're very almost militant about it. And I think in part because it is so simple that it's just beautifully elegant in its simplicity. But then you could get into debates about, is it too simple? What is it? The Bogo had three. It's basically a bond aggregate. And then, and you can mix this up, you know, in different slices based on your risk profile, but it's three funds. It's a domestic equity fund, a foreign equity fund and a bond aggregate.

46:49And these investors will buy this and they'll buy it for, you know, costs like three basis points or something in total. And so it follows like all the sort of like Taylor Larimore was the founder of it. And Taylor was, he's someone I interviewed in the book and he's not, he wasn't really in the financial advisory business, but he became great friends with Bogle over the years because he was just emailing with him. He had actually a funny backstory where he comes back from World War II and he fought in the Battle of the Bulge and jumped out of airplanes and had all these cool stories about it.

47:18He comes back and I guess he married like the hottest woman in Miami or something. And she was a model and she's making crazy, crazy amounts of money modeling. And so he comes into all this money and he doesn't know what to do with it. And he hires a financial advisor who hoses him and he starts emailing John Bogle and Bogle then starts telling him like, nah, you should be doing this, this and this. They become great, great friends. Bogle ultimately crowns him the king of the Bogle heads later in life. And so he's kind of like the most famous of all the Bogle heads now. And, but he distilled all of Bogle's thought processes down into like the simplest of all possible portfolios, which is this famous three fund portfolio.

47:59But it's arguably, I am minorly critical of it because I would say that to some degree, there is such a thing as too simple also, where, for instance, like if you own the three fund portfolio in 2022, you probably wish you owned some of the T-bill and chill portfolio, or maybe you wish you owned, you know, something completely uncorrelated, like the trend following portfolio or something, you know, that added a little bit of diversification that kept you, you know, helped you stay the course, as Bogle would say. I really enjoyed the Warren Buffett portfolio chapter, in part because it demonstrates how people get decision paralysis around all of this.

48:36So even if you're trying to replicate Warren Buffett's investment style, you come up with three different ways to do it, right? So it just seems like an infinite way to invest. But the thing I want to ask you is, you also say that you wrote to Warren Buffett and you actually got a response. What did he say? This was like before you wrote the book, early in your career. So this was in my early 20s when I was too poor to own a share of Berkshire. So in order to go to the shareholder meeting, you had to be a shareholder. And I was too poor to own a share of Berkshire back then. So I wrote him a letter and I said, hey, could I come to the conference, even though I'm this poor schmuck who can't even afford to buy your shares?

49:18And I get a typewritten letter on it comes in like a, you know, probably a five by six little piece of paper and it's typewritten. And it was from his assistant on behalf of him, but he wrote and invited me. Oh, that's really cool. That's so nice. It was awesome. I had a family event. I ended up not going, which was in retrospect. Have you ever been? I've never been. So terrible decision, but. I went once and it was a fantastic experience. Yeah. It was extremely cool. Yeah. We should do an All Thoughts. Well, he's done. He retired. Oh, yeah. He's not going to be. I mean, I guess there'll probably still be one, but it's not going to be the same.

49:55Yeah, you guys should definitely do a nod lot. Yeah. That would be great. Can you introduce us since you're corresponding? Hey, do you remember I came? Do you have a typewriter? No, but I can find one. Colin Roche, really fun. Thanks for coming in studio. Congrats on the new book. Let's stay in touch and really enjoyed chatting. Thanks for talking. Appreciate it. Absolutely.

50:27That was a lot of fun. Tracy, have you ever, have you heard of the fintech startup Acorn? Yeah, that's the one where you like invest tiny bits of like your loose change. Yeah, yeah. So years ago, like I think actually probably about 10 years ago or nine years ago or something like that. I read about it. I was like, I was like curious how it worked. So I like signed up for an account and it takes this like small amount. And also the app, at least I'm not trying to slag them. It doesn't work very well. My password is always getting reset. But every year and a half I remember that exists, that has outperformed every other investment because it's the one thing that I've lost my password to and I can't access it.

51:08Oh, seriously? Yeah, it's done great. What did you actually invest in? It's just like whatever their growth fund is. It's not very much, but God, that one thing where it's just like the one I think about and look at absolutely the least because I could never open the app. And then every once in a while I go through the effort to reset the password. It's done very well. But this is like, this is the entire irony, right? We talk about how there's no such thing as passive investing. But actually, if you just forget the password to your account and never look at it, you tend to outperform. You come close.

51:37Yeah. I really, I just find this to be such a fascinating topic. It does feel like, again, it feels a little unsexy because people are so interested in the incredible amounts of money that people have made in crypto and AI, etc. But like the puzzle of like putting it all together and how you find assets that make money across cycles but are sufficiently uncorrelated, etc. It's like an interesting intellectual exercise. Right. And you also have this entire industry that's built on the promise of outperformance mostly. And it feels really difficult to resist, I guess, the mostly masculine urge to outperform.

52:14I liked your question in the beginning because it's something I've always thought of like about actually assessing risk profile because as Cullen put it, everyone knows the right answer. Oh, I'd buy and hold. But I just I've always been skeptical that anyone is a good judge of their own risk profile. So to hear him talk about, no, let's not talk about it like that. Let's math it out. Let's talk about asset liabilities. Let's talk about the predictability of your income stream, how that is a de facto fixed income asset strikes me as a much more sort of sound way to think about it than just sort of try to imagine how you're going to behave the next time a pandemic.

52:50Well, it also gets back to what we were talking about in the intro, right, which is you can say I'm going to buy the dip if there's a 40 % drawdown, but chances are a 40 % drawdown is happening in a very bad economy where you might lose your job and not have that much to actually buy stuff with. No, like March 2020, it felt like the world was ending. Who wants to buy? Colin used the word rational, which is I think exactly right. It feels rational all the time. Everyone should be selling it this time. It's very hard, very hard to actually adhere to simple rules. Yeah. Shall we leave it there? Let's leave it there.

53:23All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guest, Cullen Roche. He's at Cullen Roche. And of course, check out his new book, Your Perfect Portfolio. Follow our producers, Kerman Rodriguez at Kerman, Armand Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks. For more Odd Thoughts content, go to Bloomberg.com slash Odd Thoughts. We're the daily newsletter and all of our episodes. And you can chat about all of these topics 24-7 in our Discord, discord.gg slash oddlots.

53:57And if you enjoyed this conversation, if you like it when we talk about building your perfect portfolio, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

54:49Faceely