MI Rewind: Building a Balanced Portfolio w/ Daniel Rasmussen

0:00You're listening to TIP. On today's show, we've started to reshare some older episodes that are my favorites for a few reasons. One, we get a bunch of new listeners each week, so the new listeners may not have heard this episode before. Two, even if you've been listening for a while, you may have missed this episode when it originally came out. Or three, even if you've heard it before, it can be a great episode to learn from again. If you've already heard this episode or you're not interested in hearing it, feel free to just skip it. There's no harm in that. and you can pick up with our new episodes next week.

0:34All right, guys, that's all I had for you for this new intro. Everything going forward is going to be from the original show. Hope you guys enjoy it.

0:46On today's episode, I'm joined by Dan Rasmussen. Dan is the founder and portfolio manager at Verdad Capital. Before starting Verdad, Dan worked at Bain Capital and Bridgewater Associates, the world's largest hedge fund operated by Ray Dalio. He is also a New York Times bestselling author and was named to the Forbes 30 under 30 list in 2017. During our conversation, we chat about how interning at Bridgewater Associates impacted Dan as an investor, the four types of economic environments that ultimately drive asset class returns, which asset class performs very well during an inflationary time period, why small cap value stocks are potentially a great way to diversify your portfolio, why Dan prefers to avoid investing in China, and much more.

1:33I hope you enjoy this very insightful conversation with Dan Rasmussen. You're listening to Millennial Investing by the Investors Podcast Network, where your hosts, Robert Leonard and Clay Fink, interview successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

1:58Welcome to the Millennial Investing Podcast. I'm your host, Clay Fink. And today, I'm joined by Dan Rasmussen. Dan, thank you so much for joining me. My pleasure. Thanks for having me on the show. Now, Dan, we bring a lot of different types of investors on the show, and many of them follow something similar to the Warren Buffett school of thought. That approach includes pretty much avoiding anything macro as the belief is that there are just too many moving pieces and it's very difficult to predict what could happen in various scenarios. However, you're not really in that school of thought. You started your investment career interning at Bridgewater Associates, which is the largest hedge fund in the world founded by Ray Dalio.

2:42Could you talk a little bit about Dalio's impact on you in your development as an investor? Absolutely. I studied history and literature in college. I actually wrote a book about a slave revolt in New Orleans. So my first introduction to business and investing and having any job at all was actually interning at Bridgewater my summer of my junior year. And it had a huge influence on me. I'd say first, it showed me that investing, they used to say investing is the intellectual Olympics, right? You've got all of these really smart people trying to compete to generate alpha. And it's really hard and it's really scarce.

3:17But ultimately, it's this competition, right? Who has the best ideas? That had a big influence on me. And I think that the next thing that had a big influence on me was the general framework through which Bridgewater seemed to approach investing, which was to say, investment strategies should be logical. They should follow a logic and they should backtest well, right? You should be able to prove that they work empirically. So there's a burden of proof. If someone says, hey, gee, stocks do well when interest rates go down. You don't just say, okay, great, interest rates are going down, so stocks should go up, right?

3:48You say, well, gee, let's pull all the data, take a look at that. Is that true over all of time or just recently? What about in other markets? And that really turned me on to this idea, which led me down the path eventually to quantitative or quantimental investing of taking a look at the data and seeing what the data says, as opposed to relying on stories or memes or theories. And I think if you compare and contrast that approach with Buffett's approach, right, Buffett is not necessarily backtesting his strategies or using a lot of quantitative tools. He has a simple formula, however, that has worked for him for a long time.

4:26And I think there are a lot of quants that have tried to diagnose what that formula is and replicate it. But I think at its heart, it's started out doing deep value and then transitioned into doing large, high-quality value. And I think that's sort of the story of Buffett. And I think the final question that you asked was about the relationship of macro to the buy and hold equity approach. And I'd say that they're not contradictory, right? A large empirical understanding of the world would lead you to say that most investors should have the majority of their money in low-cost passive equity index funds, or the equivalent, right?

5:02If you said, I want to choose 10 stocks or whatever, but broadly, that's the conclusion, right? Active management doesn't seem to work by and large. Diversification out of equities tends to reduce your long-term returns. And so for most people, the right answer is to have the vast majority of your money in long only, in essentially low cost passive index funds that charge next to nothing and provide you with broad equity exposure. But I think then there's the temptation or desire to do something around that, right? To change your return patterns. And I think there are a few things that people often are interested in achieving.

5:37I think the first thing they're often interested in achieving is saying, hey, can I achieve higher returns, right? What's going to beat an all equity portfolio? That's hard, but possible maybe. The next thing is reducing risk. And I think about risk as drawdown reduction, right? So the peak to trough drawdown in an all equity portfolio could be 50 or 60%, right? So if you say, gee, I spent my entire life and I'm 65 and I've got 10 million. And then in the year that you turn 66, there's a 50 % drawdown. Now you got 5 million, you ain't going to be too happy. So drawdown mitigation is another worthwhile goal.

6:14And I think some people pursue that through diversification or through asset allocation. And I think that's another reasonable goal. So I think I'm very interested in these questions, these problems of, gee, with inequities, what has over the long term beaten a broad market index? And are there times that it's easier or harder to beat an equity index? And then the second question is thinking about asset allocation and diversification. What else do I need to complement my equity portfolio, to diversify it, to reduce risk and enhance the returns of my total portfolio, assuming that I still have a large portion of my wealth in low-cost passive index funds?

6:57Then those are the intellectual questions I've been grappling with one way or the other since I started my career, whether that's at Bridgewater or being capital or now for dad. A big reason I wanted to have you on the show was to just give our audience members a fresh perspective as we seem to be entering this changing and very uncertain economic times with the higher inflation we've seen and rising interest rates. And we're going to talk about all of that. To transition our conversation, in your work, you outline that Dalio has four macroeconomic conditions that investors might find themselves in.

7:33That includes the four iterations of whether GDP is rising or falling and whether inflation is rising or falling. Could you talk about what the overall economic conditions have looked like over the past decade and where it looks like we seem to be heading? So I think if you think about sort of traditional answers to asset allocation or diversification, they basically take mean variance models and they take long-term correlations between asset classes, assign weights to them, mix them up, et cetera. I think another approach is to say, well, asset class correlations are unstable because they're based on macroeconomic drivers.

8:12Take, for example, growth and inflation, which I think are the two primary drivers of asset class returns. When inflation is low, when you have low inflation or minimal inflation, Stocks and bonds will be perfectly inversely correlated or almost perfectly inversely correlated based on growth. When growth is going up, you'll have rising rates and low bond returns, but high stock returns. Conversely, when rates come down, when growth goes down, rates go down, bonds go up, and stocks go down. You introduce inflation to that mix, however, as we have recently, and you can find that stocks and bonds can go down at the same time because the inflationary pressures that are hitting both and the negative growth pressures are driving bond yields up and stocks down at the same time.

9:00Conversely, you can think of other asset classes like gold or oil and how they perform, right? Oil and gold both theoretically do well when inflation is rising because they're commodities, but it turns out that oil is very sensitive to growth as well. Typically, now this last few months have been somewhat of an exception. But typically, when you have high inflation and low growth, the stagflation, oil can crash as demand destruction occurs. And on the other hand, gold can hold up very, very well. Or if you're coming out of a recession and you've got low inflation, but high economic growth, you can see big rises in oil prices.

9:35So oil ends up being quite growth dependent, even though most people think of it as an inflation hedge. So I think trying to then think through those macroeconomic relationships leads you to different conclusions about asset class returns. Traditional mean variance models, for example, don't find huge use for gold. I think there's a lot of skepticism about why you'd want to own gold, for example, in a portfolio. But people that approach the world from a growth and inflation perspective get really excited about gold, right? You can go read all Ray Dalio's old notes where he's super excited about gold.

10:07Why? Why are people excited who look at the world from macro lens? Why are they excited about gold? Well, if you start from a stagflationary period, high inflation and falling growth, gold is going to do well in those periods because it's an inflation hedge. But what naturally or typically happens during stagflationary periods is that stagflation increases the risk of recessions and sharp drawdowns in equity markets. And what happens with sharp drawdowns in equity markets or market panics is that people push into gold as a flight to safety asset. The world's falling apart. I wish I owned gold.

10:43So you have this whole back half of the cycle from stagflation into recession, where gold is doing really well. Now, the minute the economy starts recovering gold tanks, but if you think about what other asset class is going to perform well in both of those quadrants, right? Equities, no. Bonds, no. So it's playing this really unique role in your asset allocation mix. And so you come to these interesting, I think, novel conclusions looking at the world through the lens of growth and inflation, about how to adapt a portfolio to make it robust to economic scenarios we might have or might not have in the future.

11:17We haven't had meaningful high inflation since the 70s, right? A lot of mean variance models that are based on the last 20 or 30 years, I think aren't going to work very well if they're not adapting or incorporating the data from the 70s and other periods like that when you had meaningfully real high inflation. Let's take a quick break and hear from today's sponsors.

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14:27And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. We were talking a little bit pre-show and you mentioned that we're currently in an environment with falling growth and rising inflation. And you expect inflation to eventually roll over. So I'm really curious to hear why you believe that to be the case. Is it just the recessionary pressures, the stagflation that you were just mentioning? The way I think about the world and the research framework that we've developed is to view markets as primarily driven by credit and liquidity, the availability of credit and liquidity.

15:06And we measure that through the high yield spread, which is the cost of borrowing for the marginal company that's a double B or single B issuer. These are mostly small cap companies relative to treasuries. And so when that borrowing cost is going up, right, so it's getting harder for small companies to borrow money, we view that as contractionary, right? That growth is going to be slowing, right? If it's, you know, you think of there are sort of two things going on, right? Banks are repricing risks. Let's say banks are saying, hey, gee, this seems like a riskier time than it was three months ago.

15:36We should probably lend at higher rates to account for that risk. And that's a bad sign. And then the second thing is those companies themselves that, oh my gosh, I was going to borrow at 4 % and I have to borrow at 5%. Well, maybe I should invest a little bit less, or maybe I shouldn't hire that marginal worker or build that marginal part of the plant that I was going to build, right? Because the debt's not as cheap. And conversely, when borrowing costs come down, just like when you're thinking about the housing market, right? If mortgage rates come down, the housing market goes a lot better.

16:05And the same is true as the business world. Companies can borrow more, they're going to invest more, they're going to buy more things, hire more workers, et cetera. So it's stimulative. And then the second dimension is, well, are borrowing costs on an absolute basis, high or low. When they're low and money is cheap, it tends to be inflationary. And conversely, when they're high and debt is expensive, it's deflationary. So you can overlay that credit-driven view of the world onto your four-quadrant growth inflation matrix and say, where are we? Where are the credit markets telling us we are? Because it's hard to know, like, is growth rising or falling?

16:37Is inflation rising or falling? Like, we'll know in a few months what the retrospective data says. We don't really know right now. We're sort of fishing in the dark a bit. And using credit markets is the way we think to sort of provide direction or radar as to what economic environment we're in. If you look at where we are today, if you think about since COVID, right? COVID was the peak in high yield spreads. It was the highest spreads that go on since 2008. So you're in a major recession, a very brief one, but a very major one. And then spreads came down rapidly, right? So you went through the normal stages of credit spreads being wide and falling, which is basically low inflation high growth, and then tight end falling, which we'd say is a reflationary moment where growth is rising and inflation's coming back.

17:21Nobody probably expected how much inflation would come back. And then spread started rising again in November of last year. And they've been volatile but rising since. And that typically is a stagflationary environment, right, where you've got rising inflation, which you certainly have seen, and growth starting to fall. I think the growth starting to fall point is probably a little bit more controversial than the rising inflation. But I think that if you look at both rising rates and rising spreads, meaning higher borrowing costs for everybody, higher mortgage costs, you know, a separate issue, but all these things should play out in hitting the real economy as consumer demand and business demand reacts to tighter monetary conditions.

18:02And in that environment, what you're often see, and what you typically see in environments where inflation is elevated, is a higher risk of a crash and more severe crashes. And when you have recessions, you don't have inflation, right? Recessions destroy inflation and are deflationary, actually. We don't know when that will happen, right? And I think the nature of, especially this time in markets where spreads are tight, is a lot of uncertainty. And it's a period where more things could happen than will. And so I think there's an element of saying, gee, do I think there's an elevated risk that we go into a falling growth, falling inflation environment?

18:40I certainly do. And I think investors should be prepared for downside protection in their portfolios. But at the same time, who knows, right? I mean, I think who would have thought that Russia was going to invade Ukraine? And then who sitting there in the middle of this month would have thought we're going to see a massive rally in the equity markets in the middle of this war, right? We just have no idea, which is why, again, buy and hold should be the largest percentage of your portfolio because this stuff is so hard to predict. But I think looking out on a sort of a nine-month to a year horizon and trying to say, hey, gee, roughly what economic environment are we in and how can I best prepare my portfolio, I think is a pretty logical approach as well.

19:17You mentioned that you look at the high yield spread to try and figure out what's happening with GDP going forward or whether it's rising or falling. For those not familiar, could you define what the high yield spread is? High yield market is sub-investment grade companies. So an investment grade company is Apple, Google, Microsoft. A sub-investment grade company might be, I'm thinking like Crocs, the company that makes those little sandal things, right? Like it's not a huge company, but these are, a lot of them are still brand name companies or the companies that make cardboard boxes or some of the auto companies are high yield issuers.

19:57So you're just thinking not the safest companies, but still companies you probably would know. Those are high yield companies. And so you look at the cost of those companies face to borrow. What are their bonds yield essentially? And then what is the treasuries of equivalent duration yield? And you take that difference. So you're basically looking at the premium that risky companies have to borrow. That's the high yield spread. And you can find it on FRED, the economic database site. And it's a wonderful metric and, in my view, the most important macroeconomic indicator to understanding the US economy.

20:27When I was looking into your research, you had proposed portfolios for each economic environment. In thinking about how Ray Dalio has influenced you, he has his all-weather portfolio, which has an equal weighting between commodities and gold. And I'm curious why you didn't include commodities in your proposed portfolio, but you did include gold. Yes, we did actually include oil and copper. And I think broadly you can think of, and a lot of people say is gold a commodity or not, whatever. I think gold is a currency, but you can also think of it as a commodity, whatever. Let's not get into that.

21:04Gold and silver, the precious metals behave very differently from what I call the growth-sensitive commodities, namely oil and copper. And so when you really want to own oil, the first half of the cycle, so from when you're in a recession, right, think of buying oil futures in March, April of 2020, right, and then owning those for the next year. That was a really good time to own oil and keep holding it probably through the back half of last year. Now, what's been unusual is typically what you'd see and what you started to see in November is as growth starts to roll over, oil starts to sell off.

21:39But instead, we got the supply shock from Russia. And so oil has gone up a lot. But gold has started to do well as well. So really, gold behaved quite normally, right? Gold did badly until about November. And then it started to do well since, which makes total sense in a stagflationary context. Oil has been an outlier in this cycle. But I think broadly, if you think about a more tactical approach, what do you want to own, what are the big muscle movements, the big things that you should be aware of is that in the middle of a recession, right? So when everybody is panicked, when we spent a year or two working on a research paper called crisis investing, you always know when you're in a crisis, which makes crises unique.

22:19The optimal thing to buy is small cap value stocks. So the cheapest, most illiquid, scary things that everyone's panicked about are the things that you should be going to buy in the middle of a recession because they are on sale. There's always a buyer for Microsoft. There's always a buyer for Amazon. But there's not always a buyer for some small cap industrial company in the Midwest who they might wake up on March 24th and it's all sell orders and no buys. And the bottom just falls out. So if you can take the other end of that trade, you tend to do really well. That's the single biggest return driver available in markets in terms of absolute return opportunities.

22:58And then I think the other tools and lessons are really about diversification and risk reduction. As spreads are wide and rising, right, and you're entering that recessionary period, traumatic, as much exposure to fixed income as you have, can possibly have the better. That's really what bails you out in recessions is fixed income. And then when you're thinking about inflationary periods, owning oil and gold, depending on your view of growth, is really meaningful as a diversifier, as we've seen over the last few months, having that commodity exposure, really valuable. Now, all weather and risk parity approaches to markets just say, hey, it's impossible to sort of predict where we are in markets.

23:38Why not just own a risk weighted basket of commodities, gold, stocks, bonds, and risk weight them? And that's a great strategy, right? There's a real elegance to that. But I think where I would differ from that is that I think certain market conditions demand really different approaches. I think if you start from just the basis of the middle of a recession, should you be behaving differently in the middle of a recession than when you're not in a recession? I think, of course, you should be rebalancing into equities. You should be taking up your equity risk. If you're in fixed income, you should be adding high yield.