Behind The Scenes: How Peter Views Portfolio Construction (EP.145)

0:28We all need to make smart decisions with our money. here. I am regularly doing interviews for other people's podcasts, but never have I shared those interviews here on my own. So I'm going to take an interview that I did just a few weeks ago on Investapals podcast, where we are talking all things portfolio construction and investment management. So what does that mean? Well, I share how I think about designing portfolios, when to deviate from an index strategy, and a lot of the ways in which you can remove bias from building a portfolio. So if you like this episode, if you like this idea of me sharing other interviews that I'm doing, please leave me a comment wherever you get your podcasts.

1:13And as always, you can find links, resources, past episodes by visiting thelongterminvestor.com. Without further ado, here is my interview on the Investapal podcast. Hi, everyone. Welcome back to the Investapal podcast. I am joined today by Peter Lazaroff. Peter is the CIO of PlanCorp and BrightPlan. He oversees over$6 billion in AUM, helping over 1 ,500 clients nationwide. He also has a book out, interestingly, with a foreword from Sam Altman called Making Money Simple. Peter, great to have you on today. Cameron, thanks for having me. I know as a CIO, correct me if I'm wrong, but probably a big portion of the job is figuring out not necessarily what to invest in, but more so how to structure the portfolios overall for the company.

2:08So as a starting place, I'm curious to hear how PlanCorp, how you approach designing portfolios, and how that can end up varying if it's for an individual versus a model, more of a fund approach? It's a really interesting question and topic. I always feel like there isn't a perfect portfolio that's a one-size-fits-all for everybody. The perfect portfolio for each individual is really the one that they can stick with through thick and thin. And Plaincorp thinks about portfolio construction first with investment philosophy. So really rooted in peer reviewed academic research. I think without the philosophy, that's sort of what gets you or forces you to deviate from whatever portfolio you have established in the first place.

2:54And so that philosophy is really important. We could spend hours on the academic papers, but I'll save our listeners on some of that. But when I do think about portfolio construction, whether it's for a Plaincorp client, whether it's for myself or the whole, it always starts with the total market. So as an allocator, regardless who you're investing for, the reason that's a good starting place is that that's likely what you're going to benchmark to. And so what is the total market? Let's just call it the global stock market. And we know that all investors combined, when we take everybody's holdings and mush them all together, and then we average them out among each other, then the average investor holds the market portfolio.

3:35And that's great. I mean, we're benchmarking ourselves, we're quoting market returns. The market portfolio is a really, really, really good portfolio. I don't think you can ever have someone honestly tell you it's a bad portfolio. Is it the best portfolio? Maybe not. And so here's where I start to think about, well, how is the investor different than average? If the market portfolio is the portfolio the average person holds, does the person I'm designing a portfolio have a longer time horizon? Does it have smaller liquidity needs relative to the size of their portfolio? Are they working? Are they not working?

4:12What's their human capital look like? A lot of this is objective information. There's also the subjective stuff where how nervous do people get when markets go up and down? How concerned are people about tracking a given benchmark? And how good is that person about understanding what a good benchmark is or a bad benchmark is? If you're benchmarking everything to the S &P 500, yeah, I mean, you could find a lot worse benchmarks, but it's definitely not the best. That is just one segment of a global market. So I think when you're thinking about portfolio construction as a starting point, it has to be rooted in a core philosophy.

4:50We take an evidence-based approach. You don't try to forecast the future because I got books lined on the wall that people can't predict the future in any sort of discipline. And so why try here? And then taking that starting point of the total market and figuring out where do you want to be different? If you're a US investor, you might want to own more US than what a market portfolio would own because you're saving US dollars, you're gonna be spending US dollars. In most countries, the investors have what's called a home bias in terms of they allocate more. We're part of a group called Gaia, the Global Association of Independent Advisors.

5:27And so we are benchmarking our portfolios to other independent advisors across the globe. And they all have home biases to Australia, to England, to wherever, to Singapore, to Japan. You see it everywhere that home bias is one reason to deviate from the market portfolio. You might also have the ability to look different than a benchmark. So you might say, hey, I want to own more of companies with certain characteristics than what I would get in the market portfolio. A really popular one that you see advisors talk about all the time is our value stocks. So maybe I want to own more cheap stocks than what I would get in an index fund.

6:05That doesn't mean I'm going to not own the growth stocks or the expensive stocks. I'm just going to own less of them in an index. And as a result, every single day, every single quarter, every single year, my performance is going to look different than the benchmark, than the average portfolio. I'm doing that hopefully in exchange for higher expected returns. But if I want to look different, and I'm okay with the risks associated, well, then you start to tweak the portfolio that way. Those are just two very, very broad examples of how you might start to deviate from the average portfolio from the total market portfolio, depending on your needs.

6:40What it appears you're describing is like an index strategy, more of like a top-down strategy, where you might start with that total market ETF or fund, I'll call it, and then you will take an ad to exposures within that. So more of like a playing with allocations within a total market fund, so to speak. Is that accurate? Yeah. And what's really different today than say even 10 years ago is just the array of products in which you can capture the total market along with some of these adjustments. And so you might say, hey, let's go back to my example where if I want to overweight value relative to what you'd get in an index fund, you could go out and buy a total market fund that has a value bias, or you could buy the total market fund standalone and then a value fund standalone.

7:30Now, there are advantages and disadvantages to doing both from strictly a quantitative basis. But to go back to your first question, if I'm building a portfolio for a client who's gonna open up a quarterly statement and not have me sitting right next to them to explain it, might it be easier to see that, say, let's just random numbers. We're gonna say we put 70 % in a total market index that's gonna perfectly track the benchmark on their performance report. And then we put in a value fund 15%, and then we put another 15 % in, let's say, a small cap fund or a profitability fund. that aren't going to track the benchmark.

8:07Hopefully they beat it over time, but they're going to win, they're going to lose. There's nothing that wins all the time. When they open up their statement, they're going to see that thing that is perfectly tracking the benchmark and say, oh yeah, that's my market exposure. And these other pieces, oh yeah, those are the things that are going to hopefully enhance return over time. And they're supposed to be above or below the benchmark every time. But if you go out and buy that fund, it has it all wrapped together, which arguably could be better from a tax perspective, could make it easier to manage for the advisor.

8:36Well, if they open it up and the one fund they owned is down versus the benchmark, they're saying, well, the whole thing's broken. Everyone's like, no, actually 70 % of it is okay. So there are some nuances to how you build a portfolio such that when your clients aren't right next to you and able to ask you questions right away, they can understand what they hold. So that's where the, again, more subjective piece of portfolio construction comes in to my job and in my experience. I've always taken the mentality of an 80-20 portfolio, but not 80-20 equity fixed income. I do 80 % goes into an equity sleeve.

9:13So let's call it the S &P Retroal Return Fund. And then 20 % is my fund basket where I lose all my money. Like I bought First Republic Bank last year and I went to zero and I kicked myself for that one. But it's like scratch that edge. Like I have most of my money in a index strategy I know is reliable. It's going to return 8 % to 10 % a year. and then I'll go and make those bigger bets, those thematic choices in that 20 % sleeve where I'm introducing my own bias into it. I love that you do that, Cameron. I tell people all the time who take an interest in investing that that's a perfectly healthy thing to do.

9:46And I imagine if somebody is listening to this podcast, they probably have a high degree of interest in investing. And I used to do individual stocks in a small sleeve. When I came to PlanCorp, I swore them off. And I gotta tell you, both in 2020 and in 2022, too. Like when you're in a bear market or recession, ooh, is it hard not to want to buy stuff when they're so cheap? Because basically, if you buy something that isn't going to go out of business, you can make a killing. But ultimately, what I do in my own portfolio is extraordinarily boring. And I tell a lot of people, yeah, let your boring money do the boring growth.

10:19A lot of investing success really just comes down to minimizing mistakes and doing anything in your power to make sure that compound interest goes uninterrupted. And so you just leave it alone. If it's interesting, you are definitely doing it wrong. But if you want it to be interesting, carve out a piece. And so you said in 80-20, my personal feeling, and there's no black and white, this is all opinion, is you carve out a starting percentage. And if you lose it all, that's it. You don't keep adding. In your case, you don't continue to maintain the allocation at 20%. You just put some sleeve over there.

10:50And hopefully you beat the long-term boring portfolio. And if you don't, you've sort of isolated yourself from a big mistake that could really hinder your ability to not just reach your financial goals, but to take advantage of the different opportunities that you come across in life. So the way that you guys think about it, again, starting from that original total market lens, do you take the approach more on like a quantitative? You mentioned value. So I'm going to gear towards that side. Is it thinking more around like a value camp or like a quantitative lens? Or are you guys looking more at like fundamental research and taking bets on like either macro views or like individual stocks you think you're going to outperform?

11:30So we're definitely in a more quantitative camp. We have three equity strategies. We have an all index strategy. And I really do feel like a plain index portfolio is the right portfolio for a lot of people for a number of reasons. Some of them behavioral, maybe most of them behavioral. Others of them, when there's some degree of risk in their financial plan where you don't want to introduce any sort of sequence of return risk from tracking error. And so those are two very common or people who are like, hey, I want it really simple. I don't want anything complicated. Those are people who are in an index portfolio.

12:07The vast majority of our clients take a factor approach where you're still gonna own the overall market. You're still gonna be extraordinarily low cost and passive in the sense that we don't make any tactical bets or any thematic bets, or there's no macroeconomic analysis going on. but we are relative to an index fund gonna be over-weighted towards portfolio characteristics that have differing expected returns. The way I always talk about it with people is saying, hey, let's just pick any two random stocks out of the S &P 500. Or actually, let's just think of all the stocks in the S &P 500. Should every single stock individually have the same expected return?

12:46Would you expect every return in the index to have exactly the same return? And most people are gonna say no, unless they're very stubborn. And so you can acknowledge that there are differences in expected returns. The evidence would suggest that there are some characteristics that are more robust. So value being one of them, although values had a really rough run in the US values doing okay internationally, profitability or quality, which are different depending on who you are and what you're benchmarking against. Some people have mixed feelings about size, momentum is another factor that people usually look at where things that are doing well tend to keep doing well or things that are doing poorly tend to keep doing poorly.

13:25Low volatility is another popular factor. There's like over 300 factors. You're kind of looking for things that are working not just in the research time period. You want an out-of-sample data set that can show you, hey, this works. You want to see it work across multiple asset classes. And in many ways, I like to think of it a little bit like the FDA is approving drugs where they're going through all these tests and they want to approve a drug that's going to have a net benefit on society while minimizing the bad side effects. And in a portfolio, I led off the conversation saying the index portfolio is a great portfolio.

14:03You can just say I'm going to do that. And anything that has a little bit of good research on it that might help my portfolio, I'm really just worried about all the bad side effects. And so that's minimizing type one error. And that's just saying, hey, let's be all index. On the other end of the spectrum, if you say anything with a great back test deserves inclusion in the portfolio, well, then you're suddenly going to have a real messy portfolio. A lot of different holdings, a lot of change. In general, PlanCorp, myself, a lot of our decisions are made through the lens that we're more concerned about implementing a bad idea than we are missing out on a good one.

14:38And so when I say most of our clients are taking a factor approach and there are over 300 factors out there, we're really honed in on three or four. Very robust, working across all sorts of different asset classes and out of sample data. There's really strong economic intuition to why they work. And now we're kind of getting into a little bit of you're making these long term choices, knowing that there are going to be periods where it doesn't work, and that that's normal, and that you are trying to build something where if there is no perfect portfolio other than the one that you can stick with, how do we build a portfolio that we know will underperform a standard benchmark for extended periods of time.

15:16I mean, value in the US loses in 20 % of all 10-year periods. 20%, that's a lot. And we just went through a period. So trust me when I say coaching people through that 10 years on paper doesn't seem like that long, but it's an eternity in the moment to live through. And so how much do you overweight towards those factors is a question of one, what do we think people can stick with? And two, what is really necessary? If we think small value is going to outperform the overall market. You could just go 100 % small value, but boy, are you going to be unhappy in those periods where it's not working out.

15:50So it's a delicate balance. We've been in business for over 40 years. The first 10 years in business, all we were doing was flat fee financial planning. So we've been investing for a little over 30 years. The philosophy has remained consistent. It's part of what drew me to PlanCorp. I think if you're changing strategies all the time, you're not going to be there when it shows up to work. financial theory tends to work extraordinarily well in the long term. But like I said, the long term is an eternity to live through in the moment. Absolutely. Back when I was a quant as a day job, I would build up multi-factor models and test out the sleeves.

16:23We'd have four factors or five factors within a value sleeve, right? You're focusing on PE or dividend yield or what have you. And I could never be a value investor anymore. I know all the books written back in the 60s and 70s focus on that. I mean, the data tells me something else for the past 20 years. As much as I want to focus in on it, I never can. And what I find interesting to your point on the home country bias, I'm in Canada and Canada is a fake, we have a fake stock market. It's 80 % of, you know, in terms of count is like mining companies and energy companies, which the government doesn't want anything to do with.

17:01And then you have a small camp, which make up the vast majority of market cap of the oligopolies. So these oligopolies are like the banks, the telecom companies, the railroads, the grocery chains. And if you actually run a strategy, so there's the TSX is about 250 names. Then we have the TSX 60, which is like the top 60 by market cap. If you do like the TSX 10, like the real oligopolies, and you look at that relative to the TSX in general, I think it outperforms the S &P actually. If you're a retiree, you're just going to put your money into these oligopolies, which are a proxy for quality. So the quality factor here plays very true versus in other geographies.

17:48The US is probably growth. I haven't done it in a while. I haven't done it in a while, but I imagine... It definitely is at the moment. It has oscillated over time, but it is at the moment, yeah. Yeah, I could see now you own the S &P, but the S &P is a quasi-tech. benchmark right now because of Magnificent 7, NVIDIA. And to your point, you really have to, I think, manage that risk where you are capping off your return. But when the indice ends up turning south because people care about valuation all of a sudden and NVIDIA trails off, it's going to be a massive drag on people's portfolios. Yeah.

18:24And it's something I think we hear a lot of people worry about today. There's always something to worry about. It actually is great for content creation when people are worrying about something. You on this podcast, me on mine, having something to talk about, coaching people to stay the course, because again, it goes back to the fact that financial theory works. There's just a lot of noise in the interim. And it always seems like this time is different, but the things that are the same, the human behaviors, the human emotions, those are all the same. And what I tell people often is that as long as the CEOs of these companies like money and shareholders want profit maximized, that's really all you're betting on when you invest in the stock market.

19:06And if you're getting into individual issues or sectors, that is different. And in the case of the S &P 500, it is pretty concentrated in the top 10 stocks relative to history, not outlandish, but in the past, the top 10 stocks has been all financials or all energy. It kind of goes through cycles. But one thing that is generally true, at least in the S &P 500, can't speak beyond that, is that people often look at those top 10 holdings across the decades and they were innovators. AT &T was an innovator. It was a tech company. And it's just the definition is changing constantly. The research would show you that once you're in the top 10, that your returns tend to be pretty poor.

19:46What got you to the top 10 is big growth, big returns. At the end of the day, though, all of these companies, whether they're in the US or any international market are all so diversified internationally with their revenue that the stock market does not equal the economy. And as a result, also people sometimes mistakenly mix politics with their portfolio, which is a real recipe for disaster. So you got to try to avoid that. And a lot of it just keeps coming back to the boring stuff. And the boring stuff, we might not make many changes to the portfolio over a long period of time. And Josh Brown talks about like the role of advisors to be like a bouncer at the club and like not let bad investments in.

20:27I think that's somewhat aligned with my like, hey, I'm more concerned with implementing a bad idea than missing out on a good one. But when you're constantly bombarded and your very human nature tells you that you need to do something because you're in danger, it's just a tough battle. And so when we think about portfolio construction, we have to acknowledge those human behaviors and not pretend that everybody's a rational investor. And sometimes that means even if you have two sets of exposures that are identical, but are constructed with different funds or have different looks, you want to take into account that behavioral nature.

21:02When someone opens the portfolio, how are they going to react? How are they going to feel? And I think that's something that nobody really talks a lot about. And certainly, I'm in a number of CIO forums and study groups, and people don't talk about it as much as I think they ought to. And maybe my background, I started as an advisor. I had all these conversations. I remember working with people through the financial crisis, even what I'll consider to be the most hated bull market ever following the financial crisis through the pandemic and then this last bear market. And you just can't pretend that human nature doesn't exist.

21:38And rather than do that, try to build something that works around human nature and maybe even leverages it for good. What do you think the most common emotional element that they factor into building their portfolio is like an overconfidence? Like I think I'm so smart and I know better than the stock market does, which is essentially a collection of everyone's opinion. Yeah, overconfidence definitely rears its head for both asset allocators, advisors, the people they are advising, like the end clients and then retail investors who don't have any guidance. It manifests for all those people in different ways.

22:14But ultimately, overconfidence in the precision of models. So I think a danger that I could have and that even you and Investapal could have is precision in the models and confidence down to the decimal point. Does the decimal point matter? Does the 1 % matter? In the grand scheme of things, no. We can't know that it's perfect. You can be overconfident in other people's abilities. I think a lot of people sometimes see a really smart person talk about markets. And how smart you are doesn't really matter, especially because investing isn't like a one on one thing. It's a one versus everyone thing.

22:50And so unless that one person could win in trivial pursuit and jeopardy versus the whole world, that person doesn't really have an advantage. Generally, the only way you beat the market is you have better information than everybody else, which is extraordinarily rare. And I would argue, until you've seen like some of the crazy, crazy things that hedge funds do, you can't even fathom what information they have. So you either have to have better information or be better at interpreting information. And that's not just stock market information, by the way. That is the overall psychology of the market as well.

23:24You have to know what the average investor thinks the average investor thinks. That's second order thinking. It's just very difficult to be able to master all that. But yet people read one article in the Wall Street Journal or watch one clip on social media or see one thing and they think all of a sudden they know enough about it. It's so accessible. Information is so accessible. I think that investing should be an evidence-driven practice, just like medicine is. And WebMD did this too. My dad was a pediatrician. And when WebMD came up and people spent time on the internet pre-diagnosing themselves, but not necessarily doing it right, it was a thing.

24:03But suddenly you get cancer and you're not WebMDing that, you're talking to your doctor. Investing is so easy to do. There's no barrier to entry. And there's so many people who are trying to make you believe that if you listen to them or read them, that you will make money or they have the secret. And people just, they're looking for that certainty. Our brains crave certainty and it just makes it so much harder. Yeah. There's always a role for Nostradamus in the financial markets. Everyone has an opinion. It's funny when I got started, I think I had that overconfidence. And then you start to think more about how big psychology plays into the market in general.

24:37And you do really have to think that second order thinking on, okay, I am at the opinion this is happening right now, or that this is already priced in, but has like the rest of the market caught up with that thinking? Are they going to, have they already thought about it and they don't care about it? And it's just a bunch of probabilities going on in your head where, so, you know, we should be in a recession right now, but like, does the stock market not care about it? Does the stock market think that it's going to be a soft landing. It becomes very difficult. And then to your point, what was that CFA study a long time ago?

25:08It's like asset allocation is responsible for like 85 % of portfolio returns. Yeah, it's almost 90%. Yeah. Yeah. So it doesn't even matter what stocks you're picking as long as you have like the right blend of exposure to your point. Right. And it really could be a lot easier than people make it. Why do they choose to make it harder? I think it seems like a complex problem requires a That's just not the case. And the more that I've learned on the deep complexities of investing, of human behavior, biology, of psychology, of physics, all of which intertwine here for investing, the more I'm learning, the more I'm realizing the simplest solution is often the best.