RWH071: Risk, Ruin, Reinvention & Resilience w/ Victor Haghani

26:52But looking back on it, and with the sort of the context and the paradigms of behavioral economics, there was a lot of really great, great lessons in the game, actually, that we benefited from without really fully appreciating them at the time. There's that famous story that I guess Michael Lewis writes about, where John Goffrand, the CEO, says to John Merriweather, your future boss, you know, they should play a game for a million dollars. And he quotes Merriweather saying, no, John, if we're going to play for those kind of numbers, I'd rather play for real money, $10 million, no tears. I have no idea if that's purely apocryphal or not.

27:31What do you think? Did it actually happen? I think it's apocryphal. Yeah. I mean, it's a great story. It's also a great teaching moment too in our Missing Billionaires book. We talk about why it is that that kind of would have made sense to do in a normal way that sort of throwing that degree of the cost of risk onto things was like a good way of making it not happen. You know, that John Merriweather, you know, wouldn't have wanted to play for a million. And like, this was a good, instead of saying, I don't want to play for a million by saying that, which I don't think happened, but you know, it would have been really smart.

28:07And it's something that John easily could have done. And it would have all been in good fun with them. So in some ways, the game was a great example of how to think about probabilities, how to make decisions sensibly under uncertainty, how to avoid things like taking huge losses, not to worry about how people viewed you and not let that kind of skew your judgment. But in some ways, I think it also, probably when I read about it, and I see that you guys were often playing till midnight and the like, it also gives me a sense that you guys were just like rampant gamblers. You just loved speculating.

28:45And I have this kind of image, whether unfair or not, and it's not meant as a criticism, just that the culture of that group at Salomon was sort of infused with this kind of love of betting, of gambling, of speculation, of calculating odds. Is that fair to say? I think the attraction was to the edge because people didn't make large bets on speculative non-edge gambles. So, I mean, sure, people would go to Vegas and play craps and make or lose money, and they knew there was a negative edge. And it was just for amusement, but relatively small relative to their wealth. But when it came to investing for the firm or investing for themselves, that people really were willing to take risk when there was a very observable, measurable edge that was involved.

29:38And so it was interesting that on our desk, we didn't speculate on whether bonds were going to go up or down or that we didn't have this kind of speculative feel like, what's going to be the employment report tomorrow? Let's bet on the employment report. No, it was like, we don't know what it's going to be. It could be anything and the market could do anything depending on what it is. We were really just looking for these places where we felt that we really had edge. And then we sort of put on these hats and it was like, okay, well, here's this edge. Salomon Brothers has all this capital. What's the right amount to bet?

30:15And that's kind of how we were. I think that the game was just so much fun and there was so much camaraderie. It kind of went like that. Yeah, we would play it till midnight from time to time. And it was also interesting that we really kind of stuck mostly to Liars Poker and didn't go that much into poker. And part of that was this kind of edge thing again, that we knew that there were really good poker players around that would just take our money. And it was like much more, it was like the whole Liars Poker thing was like a much more level playing field, or even where because it was like our game, we sort of had an advantage.

30:56you know? And so I think that there was like part of playing the game was that, yeah, you know, this is our game and people would come from around the trading floor, you know, and they would be at a little bit of a disadvantage and that was good. But like when Bob Merton would turn up, who was a, who like almost came close to solving the game of poker, it was like, gosh, I don't want to play with him. And we'd play with him a little bit, but we'd all kind of keep folding. And, you know, it's like, no, no, we don't want to. So, you know, we all knew how to play poker, but we didn't play a lot of poker because we knew that we weren't there in terms of level against some of the other poker players.

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34:08NetSuite Next is the next huge leap because now AI is built into everything you do. It surfaces custom insights throughout your day. AI agents work alongside you on the routine stuff. And anytime you've got a question about anything, you just ask, like you're talking to a colleague. And I use it. And really, I think you should too. For the first time ever, you can try NetSuite Next for free. If your revenue is at least in the seven figures, go to netsuite.ai slash TIP. Built for every industry, ready for every boardroom, netsuite.ai slash TIP. All right, back to the show. So my sense, if I have the chronology right, is you come out of this kind of swashbuckling, very close unit at Salmon.

34:54And on the, I guess the day you left in 1993, the story goes, you won the biggest hand and this five-figure victory. So much so that - I actually thought it was a setup. I thought they were just going to say, ha ha, you didn't win that. We just all said that we had this number of sixes or whatever. It would be thrown out of a plot because it was just too unlikely. Yeah, it's really nice. So yeah, it's like a cinematic story. And I also read somewhere, maybe in Bloomberg, that there was a standing ovation when they heard the news that you were going to long-term capital management. So you sort of leave on this high as this very talented, young star, and you go join this group at Long-Term Capital Management as one of the co-founding partners.

35:43And so I think you were the youngest partner, you're about 32 years old. I mean, to set the scene, because we'll talk a bit about long-term capital management, because it's so rich in lessons, and also because you're very unusual in having talked about it from the inside, which most of the co-founders haven't done. So set the scene and tell us who some of the players were. I mean, you mentioned people like Merton. I mean, there were two Nobel Prize winning economists subsequently. Give us a sense of what an extraordinary group of people this was going to play this game in a way, in some ways, that they'd already done very successfully at Salomon for many years.

36:23So I guess when I joined, you know, John had been working on this project for a while, along with Bob Merton. And Eric Rosenfeld was the first person to leave our group, I believe. And then John also had a friend, Jim McEntee, who's passed away now, that was working with him on it. And lots of investors were out there trying to cajole John into starting a hedge fund rather than coming back to Salomon Brothers. And I had just gotten married in January of 93 and took a longish honeymoon and came back and was working. And I just kind of felt like, you know, it wasn't as much fun as it had been with, you know, the top people having left, good friend Strauss, John Merriweather, they were all not at Solomon anymore.

37:12Warren Buffett was kind of calling the shots and there was a new CEO and so on. And I don't know, it kind of was, you know, I was newly married, I kind of felt like I had, achieved financial freedom at a young age. And so I really was like, I think that I'd like to take a break in any case. So I wasn't even leaving to join John and Eric and so on. I was really leaving to maybe start a new chapter. And going back for a second, going all the way back to my dad, I think that there's this tradition out there in societies like where my dad came from and my mom's family too, where a life well spent is kind of achieving financial freedom, financial independence, financial success, and then spending the rest of your life learning and studying and being with your family.

38:08And that kind of rubric or that game plan was somewhere in my head that the idea isn't to whoever dies with the most money wins. That was never in my head, even from a young age. And I kind of had this idea like, wow, I don't know how this happened that I got all this. Well, I mean, it doesn't make any sense to me that I got paid all of this money. It makes no sense at all. But here I am, I've got to, let me try to take a step back and make sense of all of this. And so really, I made this decision to stop. And then once I was outside, to really think about, I mean, I guess I kind of knew that I was going to rejoin with John and Eric and so on.

38:50But I wasn't, you know, when I walked off that trading floor, it was more like I've got a newly married, I've got a young wife, I want to figure things out, you know, what I want to do from here. You know, maybe I kind of knew what I was going to do, but I was still felt a little bit undecided on that. And then, you know, John, I mean, John is just, you know, everybody that's worked with and for John, you know, loves him. He's like, just such a warm and positive person, you know, that, you know, once I fell in again with John and Eric and Bob, and some of the others, you know, it was like, this is going to be great.

39:26This is going to be so much fun. And then, you know, more of the people, you know, Larry Hillebrand left, Solomon after I did, and a few others. And, you know, we started to get this team of partners together and it was fantastic. It was just all so exciting. Myron Scholls, I don't remember exactly when he was involved. Maybe he was even involved before I was, I don't remember so much. But yeah, it was just kind of magical. And then... And for people who don't remember, I mean, Myron Scholls is from the Black-Scholls formula, right? I mean, these were some of the most brilliant minds in the investment world.

39:59Yeah. Well, some people call it Black-Scholls-Merton, because Bob also kind of solved it around the same time. I think it's more commonly known as the Black-Scholes option formula, but yeah, Bob and Myron and then Fisher Black who passed away, all were the creators and Fisher would have had his Nobel Prize too, along with Bob and Myron at that time. So the fund gets off to an unbelievable start, right? My sense is that you guys never lost money for two months in a row through the end of 1997 and it averaged something like 31.2 % a year for those first four years, and it grows big, right? So it's like this kind of, I mean, I remember The Economist writing about you being a sort of a superstar trader, you know, the hottest hedge fund in the world, right?

40:44So there was sort of golden period. Before we get to when things go wrong, can you give us a sense again, as we did with Salon Brothers, a sense of a sort of quintessential emblematic trade? I mean, I went back last night I was rereading some of the Roger Lernstein book on long-term capital management, which I'm sure you have some differences with, but he was talking about things like your enormous Italy trade or the trade you did with Royal Dutch and its English cousin Shell. Can you talk about things like that that give a sense of how you guys were racking up extraordinary returns, but also in some ways, how subsequently you would look back and think actually the position sizing was all wrong, or the diversification didn't really work.

41:31Like, start to give us a sense of both the glory and the peril of what you were doing. Sure. So, first of all, you know, the returns were just much higher than we expected or anticipated. And the reason for that was that there was like anything that we started to do just started to converge so quickly. And I think it was partly due to our own success, you know, and that everybody could see what we were doing. when we were at Solomon Brothers, we were trading with clients, we were trading through the government bond desks, that we had, Solomon Brothers had seats on the exchanges. We could do so much of our activity globally at Solomon Brothers without people really knowing what we were doing or knowing how much money we were making even, et cetera.

42:17Whereas here, it was like, it was all out in the open. And as we were doing different trades, they were converging so fast that we were getting these really high returns and higher than we expected. And the opportunity set really did feel like it was declining over those years. In terms of an interesting trade to talk about, I guess, we could talk about the Italy trade, you brought that up. So again, there were these different layers to the trade. So first of all, Italian government bonds, you could buy Italian government bonds and swap them and have a carry of like 100 basis points. In other words, they were trading on a swap basis at well over LIBOR plus 120 basis points or something like that.

43:00And these are like eight-year bonds. So that's a really good amount of carry to be getting. And if the spreads widened out, you would still break even if they didn't widen out too fast. What was that coming from? Well, we weren't sure what it was coming from. It was partly coming from the fact that there had been a 12.5 % withholding tax on Italian government fixed rate bonds, but also it might've been coming from people being worried that Italy might default on its debt. So we started off doing some of that trade and we thought, gosh, we don't really want to be taking a lot of credit risk. What do we know about Italian credit?

43:40We don't want to sink the whole fund if Italy defaults on their bonds. And of course, Italy had a debt to GDP of over 100 and was growing. It was before there was some greater discipline that came later. So then we saw that, well, one thing we could do is we could buy credit insurance on these, but we looked at who we would be buying the credit insurance from, and they didn't feel like they'd be able to pay off if things went bad. So we said, okay, well, we're going to limit the size of this position pretty dramatically. But then we saw that there was another kind of Italian bond called CCTs. And CCTs was a floating rate Italian bond, and they paid a coupon that was equal to the Italian treasury bill rate, like plus 100 basis points on top of that.

44:30And now we were thinking, well, these are cheaper than doing these swaps on fixed rate bonds. Maybe what we should do is actually go long these CCTs and then go short support Italian government bonds, fixed rate bonds, and do the swap in the other direction so that we actually would have some spread and we would be fully hedged to Italian credit as long as if there were a default that the Italian government treated the CCT bond the same as these fixed rate bonds. And then we did that for a while and we were like, gosh, this kind of feels okay, but still, maybe we can come up with something better.

45:07And then finally, we said, you know what, maybe we can just take these CCTs to other people and see if other investors want to buy the CCTs swapped into LIBOR plus 100. But then we keep the swap. And now we have a swap that we're going to receive treasury bills plus 100 and pay LIBOR plus 50 or whatever. I forget exactly what it was, but that this was like, we wound up with a positive carry trade with no credit risk at the end of the whole thing. And that was going really well until it wasn't. But I think that was a great trade. It kind of showed, I think it's an exemplar of kind of that we were thinking about tail risk, that we were thinking about credit risk, that we were very concerned about it and wanted to have limits on it.

46:00And that was kind of a trade that really was very attractive. And it wound up being a trade that helped to complete markets because people weren't doing these CCT versus Li... These treasury bill versus LIBOR swaps, which let other people get into a nice asset swap position if they liked Italian credit. So that was kind of something that we were doing that was a little bit creative. We had Italians working for us in London. We had connections into the Italian treasury. We kind of did a lot of homework on Italy. We probably weren't as knowledgeable as other trading houses. Like, Salomon Brothers might have had more connections into Italy, just given it was a much larger organization.

46:46But that's how we approached that. And it was kind of a typical iconic trade that we were doing. Again, with this whole layering, trying to find different trades that kind of made sense on top of each other. You've written so much, as we'll talk about later, about the importance of position sizing. And one of the obvious criticisms of long-term capital management is that the scale of these bets, even when they were really smart bets, and when they would eventually be proven to be smart, was just so enormous. And it's one of the things that keeps coming up in Roger Lowenstein's account in his book, When Genius Failed.

47:25And he was saying that someone complained that if Italy had gone bust, you would have lost basically half of the fund's capital. I don't know if that's true. He was talking about the Royal Dutch bet, with Royal Dutch and Shell. And he said, basically, you were betting something like$2.3 billion, half of it on Shell and the other half short on Royal Dutch, betting that the spread would contract. And Lewenstein writes, Higani struck a gargantuan trade with borrowed money, and then suggests that, as he puts it, Higani was beginning to believe in his own invincibility, and Higani felt he could never lose, and he pushed and pushed his partners until he got his way.

48:05And he kind of describes you as a sort of an enfant terrible and mercurial and how you, you know, for years, ever since your success at Salomon, you've been kind of pushing colleagues to double and quadruple their positions. And I'm just wondering if you think that's sort of fair in retrospect, or, you know, if there was hubris because you were so good at what you were doing, or, you know, if it was sort of the recklessness of youth, or if you actually think he's wrong. And sorry, I'm not trying to be rude by quoting this to you. I think they're really interesting questions about position sizing and sort of, as you said later, at what point even really good investments turn out to be bad investments because you just have them at too much scale.

48:49Right. So, in terms of the book, I mean, the book was written shortly after 1998. He didn't talk to any of us. I don't know who he talked to, but he didn't talk to any of the... He didn't talk to me, he didn't talk to any of my partners that I know of. And one of the things about LTCM is we operated on a consensus basis. We had a portfolio management committee, a risk management committee, an executive committee, we had these committees, and basically, John would only approve things where there was a plurality of people that were in favor of different things. So, you know, it wasn't like I was running my own books.

49:29I mean, I take responsibility for lots and lots of losses in 1998. But I think that Loewenstein, you know, A, created a lot more kind of, you know, drama and personality than there probably was. That's my opinion, but I don't know. I mean, I don't know, maybe other people feel differently. But I think the really important thing here is that I don't think that our positions were too large. I don't think that they were obviously too large in any ex-ante kind of metric. That ex-post, it's easy to say, oh, there was just so much leverage and so on. And I think that even in his book that he talks about what was the leverage that we had after we had lost 80 % of our capital.

50:17Well, after we lost 80 % of our capital, our leverage was roughly would have been five times as big for the same position sizes. We had cut positions, or maybe he was even looking at what was our leverage when the consortium of banks bought out the fund at down 90%. Well, it was 10 times bigger than it was before we lost 90%, and then with some adjustment for the positions that we had cut by then. But the risk-taking that we were taking on and off balance sheet was pretty similar to the risk-taking that was happening at other institutions around the street, whether it was Goldman Sachs, whether it was Citi, whether it was Morgan Stanley, the daily variability of returns, the percentage of open interest that we had, all of those things I think were pretty reasonable.

51:07And I think that he kind of misses what were the more interesting lessons from LTCM. and, you know, I don't criticize him. I think it was really hard to understand. I didn't know, you know, when I, if you want to know what I think are some of the main lessons from the whole thing, you know, I mean, I wasn't thinking about them this way, maybe until 2010. So, you know, it takes a long time for, to gain perspective on things, you know, and I think that that book, you know, was just written way too soon, was written, you know, without being able to talk to a lot of people, but mostly was just written way too soon to be able to get any sort of wisdom out of the events.

51:49One of the things that, you know, if you could help me unpack some of this, because I think there are really, really valuable lessons here, and you've thought so deeply about the lessons, and you have an inside viewpoint that's unique. I'm thinking first, as we go through some of the lessons, think about the Russian default, right? and that I guess triggered in many ways a lot of the problems that led to the 90 % or so loss in 1998. Tell us about that and how, in some ways, it's just a reminder that weird and wild stuff happens, just as your family getting kicked out of having to flee from Iran because of a revolution.

52:31I'm having trouble articulating it, but there's something very, very important here about the intrinsic uncertainty of life that that default shows you. How do you think about that? Yeah, well, first of all, you know, I think, you know, we had spent time in Russia, we were thinking, you know, we're thinking about what trades to do there. And, you know, the trades that we had in Russia were, we hoped, were hedged in terms of Russian credit, that we weren't investing in Russia with the feeling that Russia was not going to default. Unfortunately, they defaulted in a way that was surprising to many observers.

53:09They defaulted on domestic debt, and they didn't default on foreign debt, which felt like they defaulted on ruble debt, they didn't default on dollar debt. And that was pretty unusual because they could create rubles, but they were going to run out of dollars to pay the dollar debt. Ultimately, they never defaulted on the dollar debt, which is fantastic, even though their bonds traded down 90 % to like 10 cents on the dollar. So that happened. We realized that was a possibility. We didn't have very large positions in Russia. We didn't lose a lot of money on Russia, but the Russian default was the spark that set off this huge risk-off move all around the financial system.

53:53So the Russian default had everybody pulling back balance sheet, pulling back other trades, and that's where we had our major losses. And then we had extra losses from once it became clear that we were in trouble, then our position started to lose more money because people kind of realized that these positions were likely to get liquidated in the near term. And so they got pushed further. So, yeah, I guess that's how I would describe the Russian default in terms of the cascading events. I often, because I'm a worrier, I often worry about what you describe as these low probability, high consequence events in your book.

54:34And as you mentioned there, there are pandemics, there are depressions, there are wars, obviously countless other things, revolutions, decisions by government to nationalize industries and the like. And you talk in the book about, you remind us that there was a 90 % drop in the US market from 1929 to 1932, plus six other episodes in which investors lost 40 % to 50%, two since the turn of the millennium. Then you talk about the 22 % daily one-day plunge in 1987. You talk about the fact that the Russian and Chinese markets didn't survive in the first half of the 20th century. And so I'm just wondering now with your sense of history and having gone through these cataclysmic situations, How do you think about positioning ourselves as investors just to make sure that we survive these low probability events?

55:28I think that it's probably a good time to talk about there being a really big difference between LTCM and personal financial decision-making. And I think that it's important to make that dichotomy and not to mix the two things together. So think of LTCM as a pool of capital where many investors all over the world are allocating a small amount of their wealth to trying to do fixed income and other kinds of relative value trades with lots of leverage, where the trades that they're doing have a positive edge, they hope they're going to work out, they feel like really good trades, but they're using a lot of leverage.

56:10And because there's a lot of leverage, there's a real possibility of getting wiped out or having very severe existential losses to the fund. Well, running that business seems fine, that you're running the business on behalf of a bunch of institutional investors that are giving you 1 % of their capital. They know that they could lose 1 % of their capital. They're hoping that they get 10 years of 10 % returns over the risk-free rate, whatever. And so that's where I say that the positions that LTCM was running were not irresponsibly large. There was not too much leverage. They were reasonable relative to the context of the markets and the world at that time.

56:55Ex-post, they lost a lot of money. And of course, they were too big from that point of view. If they had been smaller, they would have lost less money. But I think that you make investment decisions, and those investment decisions, I think, were defensible. That's where I think that the narrative that came out wasn't really the right set of lessons. It's okay to run capital with leverage, trying to make good returns for investors that are devoting a small amount of their capital to that. The systemic problems of LTCM had to do with the fact that it turned out that everybody else had on similar positions to LTCM.

57:34Goldman had position sizes that were four times bigger than LTCM's positions in certain of the big positions. All of the different shops had many of these same positions on. In fact, it's probably the case that liquidation within Citigroup of the arbitrage desks kind of set off the widening of all the spreads that ultimately resulted in the distress and crisis of late 98. So when it comes to personal financial decision-making, you just don't want to use leverage. You just don't want to be in a situation where you're going to lose all of your money and go bankrupt. You want to do everything that you can to minimize those chances.

58:20And so So reducing concentration, trying to maximize diversification, not using leverage, those are really important things when it comes to personal financial decision-making. And LTCM is a different kind of thing than personal financial decision-making. And I think one of the big lessons I think that people should take from LTCM is how was it that I had so much of my money invested in LTCM. Well, that doesn't really get covered by Roger Lowenstein. He was ignorant of that idea or that thought. Another really interesting aspect of the whole thing is how we made this decision in 1997 to try to go private, sending so much investor capital back, trying to go private and trying to get over the hump to where we could mostly have the capital you know, behind the trades.

59:20And I think that was a fateful decision. I think probably on an ex-ante basis, we should have reached a different decision. You know, we didn't. You know, I think those are kind of the really interesting things. I think the question of running capital in such a transparent way that depends on all of the dealers and all of the brokers and banks, you know, rather than running it inside of an institution is another good question. You know, should hedge fund, should leveraged hedge fund activities be in these big independent pools of capital? Well, the record is showing, well, it works pretty well.

59:56It's been working pretty well for the last 25 years. But I would say that running relative value leverage pools of capital that way is probably not a great business model compared to those pools of capital being inside of larger activities, larger organizations. Maybe the pod shops are good examples of where they've really managed to get a lot more diversification where they have relative value trading, they have macro trading. I don't know what goes on exactly in the pod shops, but I think those are the more interesting lessons about LTCM. And I think that nobody wants to write a book today, but today the book would be really different than what Lowenstein wrote, where he was just rushing it to press as fast as he possibly could.

1:00:37It was like, this is the big story. I got to get this book out right away. and you know i think that it's you know it's interesting but i don't think it really um harvests the the most valuable lessons which is i say i think have taken time to become more apparent i don't think i could have written a better book than him at the time yeah i mean it's a it's a good book in some ways and in some ways it's become a a classic because it's a good reminder that however smart we are the markets are kind of wild and that things can go wrong And so I think it's a useful morality tale. I mean, I keep coming back.

1:01:12I think I quote this at the start of one of the chapters in my book that I love that quote from G.K. Chesterton, I think it was, where he talks about, yeah, here it is. He says, the real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality, yet it is a trap for logicians. It looks just a little more mathematical and regular than it is. Its exactitude is obvious, but its inexactitude is hidden. Its wildness lies in wait." And I love that, right?

1:01:47I mean, it's such a humbling reminder that like, however smart you guys were, and I mean, you guys are incredibly smart, and you were doing this very logical thing where you're sort of playing these bets as things converge, but there's a wildness that lies in wait. I don't know, does that quote resonate for you as deeply as it does for me? Very much so, yes. Go back a minute to this question of the lesson you've shared before about how much you should have invested or shouldn't have invested. Because I think it gets at one of the themes that I found most helpful about your book, which is a theme I wrestle with the whole time, which is how much we should be exposed to certain bets.

1:02:30We'll get to this more as we talk about Elm, this whole question of how you think through your allocation. I'm curious what you learned about the question you raised of how much skin in the game is right for you. Yeah, well, in, I think it's chapter eight of our book, we go into this in great detail. And I think that I didn't do a very good analysis in the 90s when I was at LTCM. I think that it was fair to say that LTCM investing in it looked really attractive, but I just wound up with an inappropriate amount of exposure. That's where there was a mistake, not the position sizing of LTCM itself, but in my exposure to LTCM, I feel that I easily could have realized that I was just taking too much risk of too big of a loss.

1:03:24And I think part of it was that I was just thinking about how much I had invested in the fund, which was somewhere I had somewhere around 80 % of my family's liquid net worth invested in the fund. And I kind of thought maybe that's okay to have 20 % that wasn't. But I didn't also account for the fact that I owned a lot of the management company, or I owned a fair share of it. We were a bunch of partners, but that was really valuable too. And if the fund went down, the management company was going to go to zero, and the management company was pretty valuable before all of those things happened.

1:03:59And then also, I had human capital, that I had earning potential, that I was getting paid to work at LTCM. And if I left LTCM, I could have gotten, if LTCM continued to be successful, but for some reason I wanted to do something else, I could have gotten a very high paying job outside of LTCM. And my human capital was also going to be really connected to the success of LTCM. So putting all those things together, I look back and can do some kind of quantitative expected utility analysis and find that I really should have been thinking more about maybe having 50 % of my wealth in LTCM in the fund, or even less than that, perhaps.

1:04:39And so, you know, I think that kind of thinking, thinking really deeply and broadly about how much skin to have in your own game is a really valuable lesson for everybody, you know, for, not for everybody, for many people that face that choice, you know, it could be working at Anthropic, you know, it could be working at SpaceX, or it could be working at a hedge fund, you know, whatever, or private equity firm. You know, I think those lessons are valuable for everybody. And I think that we can make better decisions ex ante by really being thoughtful about the cost of risk. You mentioned just now this concept of expected utility.

1:05:15And obviously, for some of our listeners who are much more economically oriented than I am, they'll know a lot about this already. And there's a beautiful quote you have, I think, in the book, that the notion of expected utility, You quote Daniel Kahneman saying that John von Neumann's expected utility hypothesis is to this day the most important theory in the social sciences. This is such an important concept, and it's something that I think a lot of us, myself included, have never really got our heads around. Can you explain it and why it's so important as a framework for making financial decisions, to be guided by this concept of expected utility?

1:05:54And if you could explain it in a way that a nine-year-old English literature student would understand, that would be very kind and compassionate of you. So, decisions are choices. You know, that when we're making a decision, we're making a choice between different alternatives. And we need to be able to rank those alternatives in a sensible way. So we need to have some kind of an objective function, some kind of a criterion that allows us to rank different outcomes relative to each other. Now, in financial decisions, we're normally thinking about uncertainty of outcomes, gambles, we could call them.

1:06:32And the question is, how should we rank different gambles against each other? What's a better gamble? What's the worst gamble? you know, sometimes it's really obvious, you know, one gamble can look better than another gamble. You know, it's just clearly dominated, right? So if I said to you, you have a choice, I'm going to flip a 50-50 coin, if it comes up heads, you know, your wealth is going to go up by 20%. If it comes up tails, your wealth is going to go down by 10%. That's one gamble. And then another gamble is the same, except you only make 15 % if you get heads. Well, clearly, you know, making 20 % heads with the same amount of loss as dominant.

1:07:09We don't really need anything too complicated to measure that. But what if I said to you, you know, that in one flip of the coin, you know, in one case, you're going to lose 10%. If you get heads, you're going to make 20%. That's one gamble of your whole wealth. And here's another gamble where if it comes up tails, you lose 20%. Okay. But instead of making 20%, you're going to make 42%. So you get a little bit more than double the profit, you get double the loss, it's still 50-50, which one do you prefer? Well, how would you compare those two things to each other? Well, you would say, gosh, if I do that second flip, I have a higher expected payout, right?

1:07:50My expected payout is 50 % chance of increasing my wealth by 42%, a 50 % chance of losing 10%, sorry, losing 20%. So, that's, what is that? That's an 11 % expected gain, right? 50 of one versus 50 of the other. That's an 11 % expected increase of my wealth. And in the first case, it's just a 5 % expected gain in my wealth. And you might say, oh, well, maybe I should, should I go with the one that has the higher expected gain, the higher expected amount of money? Well, maybe not. Maybe I just don't want to lose 20%. Or maybe I do want to do that. But we could certainly go to an extreme of how about 50 % chance I lose all my money and a 50 % chance I double my money.

1:08:39Do you want to do that bet? It's like, well, no, now you've got to the point where I just don't want to lose all my money. I don't want a 50 % chance of losing all my money. So clearly, we need some other metric or objective function besides expected value, that whatever has the higher expected value can't always be the better thing to do. And this idea of how to have a better objective function goes all the way back like 400 years to Daniel Bernoulli in Italy, in Switzerland. And I won't go into that, but that's really where the idea had its origin. And then it kept developing on and off and eventually got really solidified by von Neumann Morgenstern and their famous treaties on games and probabilities that they wrote in the 40s.

1:09:26But the basic idea is that what we really are trying to maximize isn't our expected wealth, it's our expected happiness, our expected welfare. And the more money that we have, the happier that we probably are, but that happiness is not going up linearly. It's going up slowly and more slowly, the more wealth we have. So the first million dollars makes us real happy. The next million dollars after that makes us, you know, taking us from one to$2 million of wealth makes us really happy too, but not quite as much as that first million. And the next million that takes us to 3 million less so. And every million still makes us happier probably, but at a slower and slower rate of increase.

1:10:07And so that gives us the objective function, this utility or this happiness curve, where we can map wealth or money into happiness or utility, and then try to maximize the expected utility that we get from gambles. And that will allow us to rank different risk-taking gambles, different investments versus each other. That's what all that expected utility is. And I think that that quote from Kahneman is amazing. I think it's true. I think that it's like one of the most important insights that we have in economic thinking is that what we want to maximize is our expected utility. And it doesn't just apply in money.

1:10:54It applies in all kinds of decisions. I think that when scholars think about the First World War, they're like, well, how did we get into that mess? How did the decision makers make that mess? And it was like, well, probably what happened, it seems from historical record is there was a great focus on the most likely outcome. That the most likely outcome, it was going to be short, the different sides each thought they were going to win, but it was going to be short. And if they didn't win, they weren't going to be much worse off than they were to begin with, but that there was this tail event of a multi-year, multi-million loss of life war that was there and was a low probability.

1:11:36They saw it as a low probability, but it was such a big consequence that if they had been thinking about an objective function that was concave in that way, where this tail, left-hand tail thing was so negative that, you know, maybe they would have come to a different decision rather than like, perhaps focusing on the central case, the most likely case. Let's take a quick break and hear from today's sponsors.

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1:15:05And I use it. And really, I think you should too. For the first time ever, you can try NetSuite Next for free. If your revenue is at least in the seven figures, go to netsuite.ai slash tip. Built for every industry, ready for every boardroom, netsuite.ai slash tip. All right, back to the show. How has this insight in some ways kind of shaped your life and your approach to investing? Because it sounds like once in a while we figure something out that becomes so profoundly important that it ends up kind of pervading everything we do. And I see it running through the book, and I'm not sure I've really got my head totally around it.

1:15:48I mean, I can see you saying, you know, good decisions are those that maximize expected utility. And you'll talk about, you know, how you shouldn't be position sizing with the objective of maximizing expected wealth, but should be guided by expected utility. So I can see it's running through your investment decisions about position sizing, but it feels much more profound and pervasive for you, this concept. I think the fact that risk has a cost because we get marginally less benefit from more than how much it hurts to have less, that I think that coming to terms with the fact that risk has a cost and that we need to build that cost into our decisions is important.

1:16:28I think it has a lot of impact in my financial decision making, it probably doesn't come that much into my day-to-day decision making. What am I going to have to eat? Or am I going to go for a run? Or those things. But it comes into play in my decision making. If I were younger, it would come more into play because we have more consequential decisions when we're younger. We have these career decisions. We have these decisions about partners. We have really big, big bigger decisions when we're younger than when we're maybe in our 60s. It's one of the... I think it's one idea that has shaped my thinking.

1:17:05I think it's one thing, you know, that separates 63-year-old me from 25-year-old me. I mean, I learned about utility and university, but it didn't... I rediscovered it, you know, it's something that I had to rediscover and see its relevance. I mean, it was kind of poo-pooed a bit back then, you know, as just being so subjective and, you know, unusable and so on. And it kind of also got, I mean, the whole idea of utility was somewhat held back by its conflation with utilitarianism, which is quite a different thing, you know, the idea that we could make social choice decisions by adding up different people's utility, which is a fairly discredited political theory.

1:17:46But, you know, I think there are other really big ideas that probably shape my day-to-day existence more than expected utility, but expected utility is up there. And I think it's just absolutely critical in any discussion of good personal financial decision-making. If I think about the main principles of good financial decision-making, putting a cost on risk into your decisions, having a cost on risk is present in almost everything. It's present in buy versus rent. Buy versus rent isn't just about where am I going to wind up with more money at the end. There's a risk component to buying versus renting also.

1:18:25Questions of paying fees and taxes, risk is very central there. Should I realize a capital gain to get to a better portfolio where I have less risk, or should I try to defer the capital gain, but take more risk? So I have to put a cost on risk for that. How much should I invest in the stock market? Very much a question of not as much as I can possibly get, because at some point, that's too much risk. I want to get the right amount of exposure to assets that have a risk premium. So it is really central, but I think away from my financial life and trying to help people with their financial decisions, it comes into play a bit, but yeah.

1:19:05Tell us, Victor, about your journey after long-term capital management, because you've described it as a kind of 10-year sabbatical you took after you left in 1999, and before you set up Elm. But actually, your investing journey is really fascinating and instructive then. I wondered if you could talk about the sort of arc that took you through, as you put it before, trying to be David Swenson after leaving long-term capital to where you are with Elm. Because I think there are so many lessons for us as you sort of nursed your wounds after long-term capital. It was such a cataclysm that it gave you this opportunity to go back, and think about really how you wanted to play this game in a more resilient way.

1:19:50And so I'm really interested in the journey that you took. Well, you know, I made this really intentional decision to spend 10 years at home, you know, being a father, being a present husband, and doing fun things and re-educating myself or educating myself, I should say, you know, just trying to become educated by reading more and learning more broadly than where I was. And so I had in mind, you know, about 10 years, my eldest child was six years old, seven years old at the time. And I was like, okay, when he goes off to university, I had three children, when he goes off to university, maybe I'll be able to start working again.

1:20:26And I'll probably be doing something in business. And you know, you don't, you know, it's not like I was a professional athlete where I was atrophying, you know, I kind of felt like I would stay about as valuable as a worker 10 years hence as I was then. So yeah, I had this idea of a 10-year sabbatical. I had enough wealth left over from LTCM, thankfully, to not have to work. And I just said to myself, the only thing, I want to do something different when I start working again. It just can't be proprietary trading at a bank. It can't be working at a hedge fund. It has to be something different.

1:20:59And so there were different parts of my life over those 10 years. There was looking for what I was going to do next. So I was trying out different possible professions. I was looking into becoming an arbitrator, which I really love the idea of arbitration. I found that I didn't have enough legal training to do that successfully. I got involved in Lloyd's of London. I thought maybe I could get into property and casualty insuring. That seems really interesting. And Buffett certainly seems to think it's a great thing. So I tried out a bunch of different things. That was one part of my life. One part of my life was just enjoying life, enjoying my children, learning how to fly, fishing in Alaska, just doing really fun things with my kids all the time, reading and learning.

1:21:44And then this other part of my life was like, okay, well, now I better start thinking about what I'm going to do with my family's savings. When I was at Solomon, I was too young and they took half my comp and put it into Solomon stock. I didn't think about investing. Then at LTCM, unfortunately, I didn't think about investing enough. I put so much into LTCM and the rest was just in safe assets and some real estate. And now I felt like I really needed to think about personal investing. And so on that journey, the first thing I did is I looked around at people I respected and emulated what they were doing, which is a lot of people were being mini David Swenson's, following the Yale model, hedge funds, private equity, venture capital, some angel investing, hedge fund investing.

1:22:26And I felt like I could do that because I kind of knew the players, knew the strategies, knew the industry, had probably enough wealth to be able to get into some of these different vehicles. And I started to do that and did that for a number of years. I guess I did that until around 2006 or so. And it was kind of wearing on me. It was taking a lot of time. I was getting a lot of papers piled up on my desk. I was on too many calls. I was filling out too many subscription and redemption forms all the time. And then I had this conversation with my accountant, David, where I was like, David, my taxes seem so high.

1:23:02I don't get it. I haven't made that much money this year. Why does it look like I have this 50 % tax rate? And we started to go through the different investments that I had. And I realized that a lot of these alternatives for an individual US taxpayer were super tax inefficient, that there would be fees that I couldn't deduct against the income. There were just miscellaneous itemized deductions that you couldn't take away from income that you were getting. There were short-term capital gains. There were all kinds of things. I was like, wow, this is crazy. These investments don't have a high enough return to get over the hurdle of their fees and of this tax inefficiency.

1:23:43And I think that was like this aha moment where I was like, gosh, it is taking up so much of my life. It's so tax inefficient. I got to get back to what I learned at university and become an investor in the market portfolio. And that started this journey of, okay, I'm going to start moving to index funds. I haven't made any private equity or hedge fund or alternative investments since 2007, I don't think. And pretty much, away from supporting some of my kids' ventures here and there a little bit. I've been an index investor. But once I started to invest in index funds, I realized there were still a couple more questions to answer.

1:24:22How much to have of US versus non-US equities? How much equities to have in total? I was shaped by living through the Japan bubble of the late 80s. And it's like, gosh, I don't want to just be so passive that one day I wake up and 60 % of my portfolio is Japanese stocks trading at 100 PE. And also, So by that time, I had lived through the TMT.com era as well. And it's like, I don't want to have the same equity exposure when tips are yielding 4 % and the earnings yield on the whole equity market is 3.5%. I want to have very little equities at that time. And so this led to this idea of trying to combine the best features of passive index investing, low cost, diversification, liquidity, transparency, with a few of the ideas of active investing, being focused on long-term valuations, being focused on risk, momentum, being a proxy for risk, but taking some of the best ideas from active investing so that I could be eyes open to this index investing, to this harvesting, hopefully, of risk premia over time.

1:25:33And I felt that I could have more exposure to equities on average if I was managing that exposure up and down than if I just had to commit to some number today, like I'll be 55 % in equities forever, just felt like a weird thing to do to just say, I'm going to be, no matter what's happening in the world, I'll always have 55 % in equities or 75 % in equities. Just felt so wrong and counter rational counter theory that just is like, well, how, that yes, stock investing can be passive. I want to own the market portfolio of stocks. I don't want to be a stock picker, but asset allocation can never be passive.

1:26:12It always is a decision of where on that capital asset pricing line do you want to be? Do you want to be 100 % in equities, 120, 40? And that goes all All the way back to the 1950s, it's not a new insight. It's always been the case that asset allocation, how much to have in risky assets versus safe assets is a dynamic thing that expected returns, risk change over time. Maybe your risk aversion changes over time as you lose money and you get closer to a subsistence level of wealth and income, maybe you become more risk averse. So all those things came to play for me in going this way. And ultimately, it led to the founding of Elm in 2011, because a bunch of friends were saying, this seems like a good way to manage that low cost public market exposure.

1:26:59Most of my friends were still doing private investing and alternatives, but they had some public market exposure, and they were happy for me to help manage that. And that really led to Elm and led to our low fees, because it was like, I thought to myself, if the shoe were on the other foot, and I was going to one of my friends to manage some money for me, what would be a fee level that would just be a non-issue? And I was like, well, 12 basis points, one basis point a month, that seems low enough that nobody should care. And indeed, nobody has cared. If anything, people say, your fees are too low, how are you going to stay in business to keep managing my money?

1:27:33It's kind of remarkable. I mean, it's wonderfully fair. And it's sort of, in some ways, part of what's interesting is so the opposite extreme of long-term capital management, right? Where it was 2 % a year and 25 % of the profits as an incentive fee. And so this conversion to index funds is really, really interesting. But I want to, I mean, I wrestle with this a lot. I write about this in my book, right? That there's a part of me that was converted by interviewing Jack Bogle many, many years ago and him talking to me about how difficult it is for active managers to outperform. And then there's a part of me where, because I interview a lot of great investors and have done over the last 30 years, I'm so seduced by the possibility of beating the market.

1:28:17And so I sort of have this schizophrenic approach where I kind of half index. I always tend to index my wife and kids' money because I don't think they should suffer from my delusion. And then my own approach is sort of a slightly schizophrenic mix of indexing and then owning very concentrated, long-only funds run by friends who I trust who own like nine stocks or 10 stocks, something like that. Sort of more the Buffett-monger approach. But I sort of wrestle with how best to do this. And I mean, one of the things that I've often, you know, for many years, all I did was I would just split the money equally, the indexing money between Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Index Fund.

1:28:59And I'm like, okay, done. And then at a At some point, I started also in certain accounts to buy the Vanguard Life Strategy Growth Fund because I was like, that's so cool. This is like Bogle said to me, the simplest thing on earth is just own one fund. And it would be an index fund that's a balanced fund that owns some bonds, some US bonds, some US stocks, and some foreign bonds, some foreign stocks. And I love the simplicity of that. And then I see your approach, which is like a different way of kind of cracking this indexing idea with a sort of dynamic asset allocation. Why is your approach smarter than the fixed allocation?

1:29:39Or say, that Vanguard Life Strategy Growth Fund, which just has 20 % in bonds, more or less, like forever. Unpack that for me, because I love the idea that you've sort of, after all these years applying your brilliant, very mathematical game player's mind to this game, you found a way of indexing, but you've given it a little twist to improve it. Sure. So first of all, I would say that once somebody kind of sets up a static portfolio that makes sense for them in the near and medium term, that's pretty good. I mean, that what we're doing with dynamic asset allocation, I think has two benefits relative to that.

1:30:21But overall, I think that you're 90 % of the way to what we're doing if you just do the static indexing and you're comfortable with it. First of all, what we're doing is we're saying that, or we're recognizing that asset allocation should always be a function of what's the expected return of the risky assets in the portfolio relative to the safe assets, how risky are they? And what's your level of risk aversion? Now, your level of risk aversion is probably a constant through time, but the riskiness of the market changes. Sometimes we're in a very high risk environment. Other times, it's very peaceful and tranquil.

1:31:02And both the expected return of stocks and the risk-free interest rate are both changing over time. We can just look and see the changes in the long-term real interest rate. Tips have been at minus 1 % a little while ago, and now they're at 2.5%. So to think that the risk premium, the long-term expected risk premium is not changing would be unusual for people to really believe that. And I think most people feel that the expected return of equities relative to safe assets is something that varies over time. Sometimes it's better, sometimes it's worse. And so it's only logical that your asset allocation should change.

1:31:42I mean, if you were betting on a coin, and I said to you, how much of your wealth do you want to bet on this coin? It's got a 60 % chance of coming up heads. And you say, oh, I would like to bet 10 % of my wealth on that. I say, okay, fine. And you do that for a while, you get a few flips. And then I come back and I say, okay, William, sorry, I'm changing the coin now. Now this coin just has a 55 % chance of landing on heads. Well, it just wouldn't make sense to keep betting 10%. In fact, what would make sense would be to bet 5 % of your wealth, because now the edge is half as big as it was when you were betting 10 % of your wealth that you thought was the optimal amount to bet.

1:32:19So changing your asset allocation with changes in risk premia and with changes in risk just makes complete logical sense. How is it different? I mean, this is something I wrestle with a lot when I'm trying to explain your approach to friends of mine who manage money and just do it with index funds or just do it with dimensional funds, for example, that have factors. How is what you're doing different than market timing? Because there are times where when I've had a fixed allocation in index funds, I think it's allowed me to own things that I couldn't bear to own if I exercised my own judgment because I'd be like, oh my God, I got way too much of these super overpriced stocks stocks, and I would avoid them.

1:33:00Actually, I had exposure to some of the best stocks of the last few years that I wouldn't have had if I had been making my own judgments. So I'm wondering how you... It's sort of the problem that Joe Greenblatt identified when people started to manage money for themselves using his really rational systems, and they would just sort of sabotage themselves. I don't know if I'm articulating this well, but I know you understand my question better than I can ask it. Yeah. So I guess the question is, what do we mean by market timing? I think that's really at the heart of the question. I think that in general, what people mean by market timing is making short-term trading decisions that are based on an attempt to predict near-term market price movements.

1:33:50That's not what we do at Elm. That's not the approach that I just described in terms of using a long-term expected return for stocks relative to a safe asset and the level of risk. Now, we're changing the asset allocation over time, but we're responding to these long-term observable metrics rather than making short-term price predictions based on what we think the next employment report is going to be or what the next thing that the Fed is going to do. I think that market timing, as people think about it, is like trying to beat the market through a market inefficiency, to generating returns through outsmarting the market, getting ahead of the market.

1:34:30We're just trying to have an asset allocation that is responding to what the market is offering in terms of return and risk at each point in time. So at some level, you're kind of looking at these things and you're saying, oh, what Elm is doing is it's changing its asset allocation. What market timers are doing is they're changing their asset allocation. So these two things must be the same. But there are many things that kind of look the same, you know, that look the same, you know, from some vantage point, but, you know, are totally different in terms of how they operate, what the assumptions are, what the rationale is.

1:35:08And, you know, this is a case where I think that, you know, they're really different. You know, as I say, market timing is a very specific kind of approach to investing. And that's not what we're doing at Elm. I hope that I've been able to explain that well enough. Yeah, it feels similar, as I was kind of trying to get the nuance right in my own head and preparing, it feels similar in some ways to what Howard Marks talks about when he's discussing recalibration. And he would sometimes quote Peter Bernstein saying, the market's not a very accommodating machine. It won't provide high returns just because you need them.

1:35:42And so there's this sense that you're changing the way, the speed that you drive, depending on the conditions. Is it foggy? Is it people being too reckless out there? So, I mean, it makes a lot of sense to me. And I think this has been part of my worry about indexing for all of the years that I've been doing it is that, and maybe part of the reason why I couldn't be all in is that I started investing in the late 90s where you saw people going absolutely nuts. And you were like, well, I don't want to have all my money and the stuff that's going nuts, you know? And so, I mean, intellectually, just the idea of recalibrating based on the conditions that you see out there seems wise to me.

1:36:21Yeah. I mean, not to stretch the analogy too far of what I was trying to say is like, you walk into a casino and you see two people sitting at a blackjack table, and you say, gosh, it looks like those two people are both playing blackjack. They're both gambling in a casino. But it turns out that one of them is a card counter and is varying their bets in a way to try to take advantage of when there's an advantage to the players. And the other person is drinking some Manhattans and is just playing around and putting money down and betting. And so they look like they're doing the same thing. But the one is really just having fun in the casino and enjoying himself and he's got negative odds.

1:37:06I'm not saying that market timing has negative odds or whatever, but I'm just saying they look like they're doing the same thing, but they're being driven that when we think of one versus the other, they're really in two different activities. And so to the extent that what we mean by market timing, or when people say market timing, what they mean, because market timing is like a pejorative, that it's like, oh, that's market timing. We know that market timing doesn't work. And, you know, I think that market timing is really hard. It's really hard to know what the Fed is going to do next and what the reaction of the market's going to be to what the Fed does next or what the employment report is going to come out at and what's the market reaction going to be.

1:37:44That's really, really hard. And I think that market timing, justifiably, people are skeptical of it as an investment approach. But, you know, what we're doing, I think, makes a lot of logical sense to most people. And that's why people come to us. What we're doing kind of resonates as being sensible. And, you know, I think that when somebody says, oh, well, isn't that just market timing? That's really what somebody is saying, who it's not resonating with. You know, when they look at it and they're like, oh, well, that's market timing, you know, they haven't dug deep enough, or it just doesn't resonate.

1:38:15To them, it just looks the same as the other thing. I get it. But, you know, I think that that's the response that we have to it. Yeah, I think it's not an accusation I'm making. It's more a matter of like, clarifying the nuance here, because it is different, but it's a sort of kissing cousin. Tell us about the... Well, I don't know, is the card counter a kissing cousin of the guy that's drinking the Manhattans and playing blackjack? Yeah, I mean, they're both sitting next to each other, but I don't think they would think of themselves as being terribly related. And again, I don't mean to say that one is negative, but that's more what it's like, so I don't know about the kissing cousin thing.

1:38:51I mean, they look the same, and I think it really pays to try to understand what the difference is. Robert Leonard Talk to us about the Elm ETF, which is a really, really interesting product, partly because it's also very good value, not quite as cheap as the separate accounts that you run, but it's something like 0.24 % a year, I mean, really low management fee to get this approach to dynamic asset allocation. Can you talk about the current posture as a way of giving us a sense of how these various principles work, what you're doing in terms of the baselines, the targets, using CAPE ratios, international diversification momentum.

1:39:35How are all the kind of principles that you've come to embodied in a sort of tangible way with what you're doing with the ETF? Sure. So, yep, we have this Elm ETF, it's on the New York Stock Exchange, and ticker is ELM, and also the website is elmfunds.com to get more information about it. And the ETF has about 600, just under$600 million in it. And as you said, the expense ratio is 24 basis points, but that 24 actually includes the six basis points or so of the average expense ratio of the ETFs that we hold because the Elm ETF invests in other low cost ETFs that have about a five or six basis point average expense ratio.

1:40:17So the full charge of kind of the management fee to compare with our separately managed accounts, it's 12 and the separately managed accounts here, it's more like 18. And so that's a high level picture of it. In terms of asset allocation, the ETF has a baseline of 75 % in equities, roughly 40 % US equities in the baseline, and 35 % non-US equities, roughly. And looking at the asset allocation today, it's about 15 % underweight US equities. So instead of 45%, we're at about 30%. It's about 14 % overweight non-US assets, so about 34 % instead of 30%. And then that leaves it about 10 % overweight fixed income, which is split between treasury bills, tips, and an aggregate bond index, but mostly at the moment in treasury bills.

1:41:16The way that we arrive at the asset allocation is, as I was saying, looking at two signals or two metrics for every asset class. The first one is, what is the expected return relative to safe assets for the asset class? That's the long-term expected return of US equities relative to a comparable US Treasury. So when we look at US equities, we say, oh, wow, the earnings yield, the cyclically adjusted earnings yield of US equities is around three, just over 3%, three and a quarter or so. 10-year tips are around two and a quarter. So it looks like you're only getting about a 1 % higher expected return from owning US equities than you would get from owning tips.

1:42:00Now, maybe that's underestimating the risk premium, but when we look around at other observers from Goldman Sachs to research affiliates to Vanguard to BlackRock, et cetera, that more or less that is the consensus is that the long-term expected return of US equities is relatively low compared to long-term real rates of tips and so on. So that's one metric, and that is what leads us to be underweight US equities. The other metric and leads us to be a bit overweight, non-US equities, because in those markets, earnings yields are quite a bit higher, PEs are quite a bit lower in non-US markets compared to US markets.

1:42:39And then we take account of risk. Are we in a high risk or a low risk environment? Our proxy for risk, we use one-year trailing moving average momentum as a proxy for risk. We could have used other things, that's just what we've been using and we like it. It's a longer discussion, why that as opposed to using option implied volatility. But anyway, we like it. And it tends to give you a very similar signal most of the time. And based on that, we're in a low-risk environment pretty much across the board, US and non-US equities. So that moves us to have more of those equity markets. And so we're not that underweight US equities, and we're a little bit overweight non-US equities.

1:43:19And that takes us to today's asset allocation. Now, if markets its drift downwards over time, that risk metric is going to go into a high risk state, and then we'll have a lot less equities. We're pretty far away from it today, but we can get there pretty quickly. And then we would have a lot less exposure, and maybe that would be the beginning of a turning market, or maybe the market would go back up, and then we'd be back in a low risk environment, and we'd add, and we'd wish that we hadn't reduced, but we'll add and go back to where we are because it's just a fully rules-based, automated, transparent system.

1:43:55And that's consistent with the fees that we charge. We're not sitting around trying to read the tea leaves, we're just trying to apply some really sensible, logical criteria to the asset allocation. I guess as I think about the connection to what Howard would talk about, it's sort of recalibrating based on the conditions, adapting to the conditions rather than making an active prediction about which direction it's going to go. Is that a fair nuance? I think it is. I mean, I think that Howard Marks is very much driven by what the opportunity set looks like. And as he likes to say, in 2008, they saw tremendous expected returns and they allocated a lot of capital and it turned out great.

1:44:38And when expected returns look really low, they're happy to not allocate capital. In his case, he's looking at, they're able to kind of look at relatively senior parts of capital structures and see what they're offering. Maybe in their business, there's even a greater ability to estimate long-term expected returns, and they have a great expertise at it. So I think that what Oaktree does and what Howard and Bruce and so on have done is very much a dynamic asset allocation driven by what is the return to risk ratio look like on their domain of expertise of investing in very often senior secured or senior types of claims on big good businesses.

1:45:27So yeah, they've done great and that's exactly what they do. It's expensive and hard and it requires a lot of expertise and it requires people that can read covenants and understand them and have deep legal experience. And so they have to charge a pretty high fee and it tends to be pretty tax inefficient for individual investors for taxable investors. But it's a fantastic product for their investor base of mostly non-taxable institutional money. So it's been fantastic. When you think about the different ways that you can create a better mousetrap using index funds, you look at something like dimensional funds, right?

1:46:07Where they have factors like tilting things towards small companies or cheaply valued stocks based on low price to book or more profitable companies, for example, or positive momentum or low historical volatility or whatever, all of these things that people like David Booth at Dimensional Funds has done or that Cliff Asness has explored. What do you think of those strategies? I know it's a big question, but when you think of the kind of dynamic asset allocation strategy that you've used or the use of factors like that. What just made you think, no, I don't really want to bother with those sort of factors.

1:46:42I'm not totally convinced. Well, for those factors to work, you need somebody to be losing money. And not only do you need somebody else to be losing money relative to you making money, but you also need to make extra money to cover the extra risk, because there's extra risk in non-fully diversified portfolios. So we have what's called Sharpe's arithmetic that I'm sure many of your listeners know about, or John Bogle reframed it as the cost matters hypothesis, which is that all actively managed portfolios, all portfolios that diverge from the market portfolio, when you add them up together, they have to give you the market return less fees.

1:47:26And so the first thing is that if you're running these different factors, that it's zero sum against somebody else. So there has to be somebody else on the other side that's like, oh gosh, either I have some kind of weird risk, I have some particular risk preferences that make it okay for me to be losing money by taking the other side of these trades that dimensional or AQR is doing, or they just don't realize that they're losing money, they're either doing it rationally or irrationally, one of the two, fine. But also, there's this risk corollary to Sharpe's arithmetic, there's the risk matters hypothesis too, which is that all of the actively managed portfolios, all non-market portfolios when grouped together have an average risk level, which is greater than the market risk level.

1:48:13So not only is there the fact that it's all zero sum, not only is there the fact that the fees tend to be higher on this kind of investment activity and the transactions costs tend to be higher, but also there's a risk component too. And so when we put all those things together, we're like, eh, probably not worth it. That these things definitely existed, you know, these premiums certainly existed in the past. We're not questioning the fact that over the last hundred years, you know, owning low price to book was a great thing to do. And, you know, all of these different factors that have been found have been great over the last hundred years, but how are they going to be, you know, in the future?

1:48:53I don't know. I mean, I think that for us, it's just not worth it. We just don't see it as particularly being worth it to do it. We're not like super negative on it. People do it, it's fine. But it didn't get over our bar of just simplicity, broad diversification. Another problem with this stuff is that when it doesn't work, that people just tend to exit. So it might make a lot of sense, even if it makes sense in the long term, if your investors are just going to give up the goat on it and be like, oh, gosh, this value stuff has lost money for five years. What are you guys, crazy? And then they're out and then value comes roaring back over the next three years.

1:49:34You haven't really done your investors a service by drawing them into that, just knowing that people generally will flee these types of exposures when they go through a period of multiple years that are bad. So we just felt like, let's keep it simple. There's enough diversification in our portfolio. Let's not assume that there's going to be other people that we can find to be on the other side of these trades that are willing or unknowingly losing money. And there's also this risk dimension and fees and so on. So that's where we are. Before I let you go, Victor, I want to take a sense from you as you look back now, I guess, Did you say you're 63 now?

1:50:1664, actually. I might have said 63 in a moment of optimism. Yeah. When you look back now on this kind of really amazing journey you've been on that we've described over the last hour and a half or so, are you sort of glad you went through those periods of turmoil and it was kind of a really important part of you becoming the person you are today? Or, I mean, are there great benefits to have gone through it? or could you have learned those lessons a different way? Or like, what's your perspective on how it's helped you or how it's made the ride tougher? Or what you've just learned from dealing with that kind of adversity along the way?

1:50:56Well, you know, I guess in looking at the past, you know, it's like, well, if I get another run through the whole thing, you know, so much could be different. And right now, you know, I feel very happy with the way my life is, with my relationships, with my children, wife, friends, all of that. And so I wouldn't want to go back and take another stab. I wouldn't want to just restart the clock. If I could selectively change things, like I could change one thing, but not change anything else, sure. I mean, I think that I would certainly want... I would have loved it if somebody would have given me the Missing Billionaires book when I was starting off in Wall Street instead of giving me reminiscences of a stock operator, which I didn't really ever figure out the meaning of at all.

1:51:42What do you think it actually would have changed? Like if you really, I mean, would you just not have been optimizing for sort of maximizing your wealth? What would you have done differently if you - Yeah, well, I think the whole LTCM experience would have been different if I just came into it with a greater appreciation of maximizing expected utility, etc. I think that even if the decisions LTCM made were the same, my decisions would have been different. But I don't know. It's not at the top of my list for my wishes. At the top of my list for what I wish is not like, oh, I wish that LTCM had gone differently.

1:52:24That's not really super high on things that I would want to change. I would have liked to get another five years with my dad. That That would have been really good. You know, so if the genie comes and was going to give me some stuff, you know, I kind of feel like I'm happy with the way things are now. I feel like I've learned a lot. I don't know if I would have learned the same things from reading a book, you know, probably would have been reading a book and having somebody hit me over the head with the book. You know, it's not just enough. You know, it's not just enough for somebody to hand you the book.

1:52:54They really have to tell you, you know, you better take this to heart. you know, I've, I, so yeah, I mean, I think it's been, I'm happy with the journey. I kind of hope that I haven't hurt or disadvantaged too many people over my years. And yeah. Do you have advice for people dealing with tremendous adversity? Because you saw your father who obviously dealt with adversity, but also in many ways had a very blessed life. You've dealt with adversity, but also have had a very blessed life. Like what, I mean, if you were to share, I don't know if you're spiritual, if you're philosophical, if there was stuff that you learned from your father that helped you get through, like what advice would you share that we can draw on when it's our turn in going through the ringer?

1:53:44You know, I think there's two places that I go, two books or two thinkers that I think about in terms of adversity. The first one is the book by Daniel Gilbert called Stumbling on Happiness. I highly recommend everybody to read it. I think it's fantastic. And, you know, the basic thesis there is that we generally get through most things and reset to our kind of normal level of happiness for most things. And it's an excellent book, you know, and I think that it's stood the test of time well. The other book that I would recommend a much heavier but much more inspiring read is Man's Search for Meaning by Viktor Frankl, where he speaks of the meaning of, you know, our search for meaning, that we can find meaning in three different ways, according to him and his experience.

1:54:35You know, one is by being in a flow state. So, he was early to the flow state before Mihail, Csikszentmihal, you know, and I think that's a really good insight. We can also find meaning in loving and giving to other people. But the really unusual insight from the book is that also through suffering, we can find meaning. And, you know, Viktor Frankl talks about his own personal experiences with how he dealt with adversity, tremendous adversity and suffering, but found that there was meaning for him in that. And so, I think that Viktor Frankl is really heavy, and maybe that's too heavy. Maybe that's too much.

1:55:17That's what you need to do when you get too much adversity. But for the normal kind of adversity, like losing a lot of your money in a hedge fund kind of adversity, you can just go to Daniel Gilbert for advice on that, which is you're to get back to your kind of normal level of happiness pretty quickly from something that's, you know, didn't exactly go the way you wanted it to go. Yeah. So anyway, those are the two things that I would think about. But the main one is, you know, time heals all wounds, which is more the Daniel Gilbert perspective, and so true. Have you found that to be the case?

1:55:52Like, when you look back, I found, you know, because I went through a sort of brutal period when I was about 40 when the financial crisis happened. I got laid off at Time Magazine and I like kind of, I don't know, it's just, there was also, I mean, I think part of what's difficult is that you have a sense of shame, you know, because I'd been editing the international editions of Time and suddenly you're like, oh my God, you know, like I failed and I wasn't really used to failing at stuff and failing very publicly. And you, you know, as I was reading your story this week, I mean, I think part of what was so difficult was you were failing so publicly, you guys, who had always succeeded.

1:56:31And I was kind of wondering, like, I mean, this is something I talked to Bill Miller a lot about after the global financial crisis, you know, the sense of like having to deal with, you know, he was talking about the pain of more than 100 people losing their jobs because of a mistake that he'd made and, you know, losing shareholders money. And I was sort of surprised when I said to him, you know, you know, does it feel less painful now? And he's like, no, the pain's just as alive. And I suspect all these years later, if I asked him again, I think it probably has gone to some degree. So I'm wondering like how, you know.

1:57:04Yeah, that's strange. You know, I think that, I mean, I don't know how you feel. I think it took 10 years. Just two or three days ago, I'm an England supporter, having lived there so long, two or three days ago, we had to watch England suffer that defeat. And that night, I was so upset. I felt I just was so disappointed. I felt bad for the players, for the fans, and all of that. And already, I'm getting over it really, really fast. And I talked to my son, who's a big supporter. He's like, I'm over it already, dad. I'm okay. And I think that it's, yeah, I think that the Bill Miller story is strange.

1:57:42It's just strange. I don't think that that does not seem to be the empirical evidence, you know, and that's why I say, you know, have a read of the Dan Gilbert book, you know, there's just a lot, there's a lot of evidence that we kind of get that time heals all wounds. I mean, I can still remember when my father passed away, what that felt like. And I have not felt that, I have not felt that for years, you know, he passed away, getting close to 30 years ago, and it's completely transformed my, how I feel when I think about my father, but I can remember what it was like in the first few months after he passed away, even though he was pretty old and had lived a wonderful life.

1:58:25It was very painful. Yeah. So yeah, I do think that, as I say, time is the salve for most things. It seems anyway, maybe some people are different, maybe we're not all wired exactly the same, but for most people, it does seem like that's the case from my experience and from what I've read. So do you think in some ways the key is just sort of perseverance? That if you just keep plugging away, you know that in some way, if you're willing to take that beating sooner or later, you know, the good times will pass, but the bad times will pass as well. And so if you can kind of, as my friend Matt McLennan would say, you know, the key is to survive the dips.

1:59:07Is that sort of, in some ways, the moral? I guess so. Yeah. Yeah. I think, you know, just, you know, just getting that, you know, just getting that longer term vision, you know, of seeing what your future self is going to be like. For me, you know, whenever something is making me unhappy, I say to him, I get a parking ticket and I'm like, well, as soon as I've paid it, it's going to start drifting. You know, I'm just not going to be upset about this the day after tomorrow. I won't even remember this the day after tomorrow. And by thinking about myself in two days hence, I can stop worrying about it today because I know where I'm going to be and I can just put that aside and move my mind onto something else.

1:59:46So, you know, I guess, you know, I don't know that what I'm saying, you know, pertains to the deepest, darkest moments of despair in a person's life. And I think that when we talk about depression and clinical depression, you know, this is a pathology and it's not what I'm talking about. But for most cases, in more normally functioning people, I hope that's the way that we're mostly built and wired. It's hard to say about other, it's hard to know how other people experience life's ups and downs too. And you said that you were going to tell us something about your mother and Lucille, who sounds extraordinary.

2:00:26And so before I let you go, share with us one important lesson from your mother, because we've heard a lot about your father, and she was obviously remarkable too. Yeah, well, yeah, I think the most remarkable thing about my mother is that she says that these are the happiest years of her life. She's 92, and she says she's happier than she's ever been. And I went online to find out just how unusual this is. And actually, it's not that unusual that for people that are getting older, quite old, after 90 years or whatever, late 80s, that for people that are not having an acute and chronic pain and suffering from a health point of view, which my mom doesn't have, that very often they do report as being the happiest years of their life.

2:01:16And it's wonderful that that's how my mom feels. When she says it to me, I don't question her. I embrace it and I love it. And yeah, she's having some really good years right now and I hope they continue. But it's wonderful to see that and to think about aging and potentially replicating that too, if possible. But yeah, that's something about my mom. That's not what I was going to say about my mom earlier, but that's a better thing to say about my mom right now. Yeah, it's a good note to end on. And I was happy to see that one of your kids has actually named her business after your mother, right?

2:01:50Yeah, yeah. My daughter named her business that's trying to make a better for you nutritional drink for elderly people. She's named it Lucille after her grandmother. My mom is having this moment of fame as people buy the drink and as my daughter markets it. It's wonderful. That's really good. Well, we just provided free advertising for it. And so the Higani tribe fights on another generation will endure and thrive. So it's been a great pleasure chatting to you, Mitch. I've really enjoyed it. Me too. I can't believe how long we've been talking. It just has gone by so quickly. It's really been very, very enjoyable.

2:02:28I'm a very verbose man. But it's been great chatting. I don't think that's where the fault is. It's over here. But anyway. It's been a real pleasure. and I hope we'll get to meet in New York or London before too long. It'd be great to see you. Thanks so much. Take good care.

2:03:08Investing involves risk, including possible loss of principal, and past performance is not a guarantee of future results. Listeners should do their own research and consult a qualified professional before making any financial decisions. Nothing on this show is a recommendation or solicitation to buy or sell any security or other financial product. Hosts, guests, and the Investors Podcast Network may hold positions in securities discussed and may change those positions at any time without notice. references to any third-party products services or advertisers do not constitute endorsements and the investors podcast network is not responsible for any claims made by them copyright by the investors podcast network all rights reserved