The Behavioral Portfolio with Phillip Toews (EP.257)

0:02The Long Term Investor Host:We all need to make smart decisions with our money. The Long Term Investor podcast shows you how by distilling complex financial matters into easily digestible lessons. And now, here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff. Welcome back to The Long Term Investor. In this episode, I'm joined by Felipe Taves, author of The Behavioral Portfolio. and we discuss why good investing is about more than just selecting the right mix of stocks and bonds. You're gonna love some of the things we're talking about. I mean, we talk about why traditional balanced portfolios can be harder to stick with than many people realize, how valuation should influence expectations and why advisors need proactive communication frameworks, not just better investment products to help clients navigate market stress.

0:55The Long Term Investor Host:From time to time, I even referenced some ideas that are going to be in my new book, The Perfect Portfolio. And you can sign up for updates for that book by going to theperfectportfoliobook.com or using the link in your episode description. When you sign up for that newsletter, you get updates from me every other Saturday. There are subscriber-only webinars. There are early sneak peeks into chapters. You can get a direct line to me just by hitting reply to any of these emails. And so it's been really fun engaging with that particular group of people. If you want to join that exclusive group, again, you can go to theperfectportfoliobook.com.

1:33The Long Term Investor Host:And now here is my conversation with Felipe Taves.

1:39The Long Term Investor Host:Welcome back to The Long-Term Investor. Today, I'm joined by Felipe Taves. He is the author of The Behavioral Portfolio. Great book. A lot of great takes that I want to dig into. Felipe, this has been on the calendar for a long time. So thanks so much for joining me. I'm so glad we could put this together. Well, I'm curious, how did you come up with the title of the book to start? Our firm is an asset management firm that focuses on hedged equities and adaptive fixed income. And we were sort of forced into the world of behavioral finance because of the abysmal timing of when people would enter and exit our portfolios.

2:18So we created a division of our company that we refer to as the Behavioral Investing Institute. I've been doing coaching and talking to advisors about this stuff for 14, 15 years. And, you know, as a part of that, though, we came up with this portfolio that we'll be talking about that we recommend. And the idea of the behavioral portfolio is creating a portfolio that addresses the economic realities of markets, but also addresses the behavioral idiosyncrasies of how investors react. And so it's a portfolio designed to address investor behavior.

2:57The Long Term Investor Host:What's interesting to me, you and I met at Future Proof, I believe, last year. And at the time, I was just getting started on my book. And there's a lot of similarities to our belief system, even if those sometimes we might end up in different places. And we'll kind of unpack that as we go along. But the book is intended for financial advisors, or at least it reads that way. And I think you're quick to point out that, hey, advisors have biases, too. And you just mentioned people going in and out of your funds. So maybe let's start there. Like, what are some of the biases that you see most prevalent among financial advisors themselves?

3:31Well, I would say two things about that. First is that, yeah, we're all vulnerable to biases, right? So to think that because we have a CFP or even other acronyms after our name, that we're better than that, it's not true. But maybe there's something even more important going on, Peter. And that is that unless we have a built-in communications framework that's effective at addressing investor biases, ultimately it doesn't matter if we're not vulnerable to those biases because we're going to be forced by our investors to make these bad decisions if we want to keep them as clients, right? So there's that whole thing of like they're very upset.

4:17Let's wait another six months to see if this rectifies. Six months happens, then you make the bad decision along with the investor. But right, the data shows that I refer in the book to several studies that says, oops, no, these flows are just the same for advisors and advisor-driven clients as they are for

4:36The Long Term Investor Host:retail investors. You make an interesting point. For advisors, there's some career risk to staying the course and holding steady and not giving in to what potentially a client wants. I know at Plaincorp, all of our investments are managed centrally. So the advisor doesn't have enough control to sort of deviate. And you're never going to take the human out of human nature, right? And so how can you, whether you are managing billions of dollars or managing your own portfolio, how can you at least build a system around the fact that we're always going to be human? And the system that I think a lot of advisors lean on, and look, we're one of those sets of advisors is a traditional portfolio of stocks and bonds.

5:18The Long Term Investor Host:And I think one of the core focal points of the book is times in which that can be a flawed solution. Start wherever you'd like. Walk me through why this kind of traditional balanced portfolio of stocks and bonds isn't always as great as it seems. I refer in the book to a conventional balanced portfolio as and historical accident. And I think understanding that is potentially super important to then deciding where you're going to go with it. So bonds were created to fund governments initially and then later to fund companies. Stocks were created as a way to share ownership of companies. So these things were really created as funding mechanisms.

6:02At some point, someone said, why don't we put these two things together? They began to be publicly traded. uh jack bogle got on the scene of uh late founder of vanguard uh and talked about 60 40 portfolios and and that's basically the history of the evolution of portfolio construction right so um but what never happened peter is what what never really happened is well first of all we had these limited tools right that's all we had uh so come to work come to today where we've got options, you know, to help hedge against down markets. We've got all kinds of derivatives, all kinds of different tools and products.

6:45And what it has allowed us to do is ask the question, what actually do investors need economically and behaviorally, psychologically from their portfolios? And so that becomes really interesting, Peter, because now you're saying, well, what do they want? Well, they want to not lose their money. I mean, that's number one, probably. They want to have above inflation returns. They want to have some consistency of growth. They want to have returns when the markets are moving higher. And so then it becomes a question of how you build that. But I kind of went ahead a little, Peter, of where we probably will end up.

7:24And I'm going to come back to your question about conventional portfolios and balanced portfolios. So you've got this historical accident. And you ask the question, well, how good a product is that? How effective, reliable is a balanced portfolio kind of conventional approach? And are there times when it actually doesn't work? And so if you ask, what's the most interesting finding that an advisor comes away with after reading the book? Almost every time I have a conversation, Peter, with someone who's read the book, they say, the first third terrified me. Right? Why? Why did they get terrified?

8:00Well, I illustrate a balanced portfolio going through the Great Depression. And it's basically a down market of 13 years. Instead of stocks losing, you know, 57 % as they did during the Great Financial Crisis, there was a downturn of 86 % during the first, like, two and a half years. Went up for five years and down another five years. But I show a balanced portfolio with real-world characteristics of advisor fees and other things like that. over this time period with rebalancing and all the just sort of real world stuff. And that portfolio draws down 72 % of balanced portfolio over about three years.

8:47So, you know, for investors that are on the line, for financial advisors on the line, you ask yourself the question, if three years into a project, you had 28 % of your portfolio left, um how is that navigable and then you you rally for five years uh you're still down 36 percent at that peak and then you have another five-year downturn you end the 13-year period down 68 percent um it's the advisors that look at that say that is not navigable and so then it's a question of asking would that ever happen again or do we really need to think about that or prepare for that my answer is for this and this is for the financial advisors out there you know if you ask the question what is the main thing that your investors really are looking for from you is probably first keep me from running out of money don't don't let me lose everything and so just like if we're responsible breadwinners we make sure we have life insurance, even if we're super young and super healthy and we feel like we're basically immortal.

9:58The way to approach this, Peter, is to not just assume things like that can't happen, but rather say, look, I still want to invest optimistically, but I want to address contingencies in a way that helps me be more secure. So there are two other examples I use in the book, Peter, because to see the Great Depression, it means looking back more than 50 years. And that's really hard to do. So we're not looking back that far, but we're also not looking geographically very wide because just in the last 40 years, Japan went through a 28-year bear market where stocks lost like 72 % over 28 years. So we're also not looking far away from where we are.

10:45there's also a 36 year bond to bear market between 45 and 81 that i don't think we're fully contemplating so the idea is expand our scope and then address those contingencies and and then bringing that back to what i was talking about what our core objective should be it really potentially significantly changes up where we go when we're thinking about portfolio construction so i know i should be a good guest peter and allow you to ask ask questions

11:15The Long Term Investor Host:Well, no, I think it's great. I mean, there's a couple things as I think about the typical audience. So first of all, if you're watching us on YouTube, if you're watching us on Cheddar, you go to the longterminvestor.com. You'll find really detailed show notes of what Felipe is sharing here. You'll get a link to his book. You're going to get a link to some other resources that I'm about to mention or will mention. But what strikes me is really interesting when I think about, you know, we polled the audience and we know that maybe like a third of them are do-it-yourself investors. A third of them are financial advisors.

11:47The Long Term Investor Host:And a third of them are either clients of PlanCorp or clients of some other financial advisor, roughly. So we're at about a third, a third, a third. The do-it-yourselfers have had a really easy 20 years or so. You know, post-financial crisis, I guess we're talking about 17 years. And you mentioned Jack Bogle, the Bogleheads and their simple three fund portfolio. It's just been easy street. And so but I really appreciate you going through in the first chapter where you walk through the hypothetical investor going through the depression. You walk through multiple downturns, including the financial crisis.

12:19The Long Term Investor Host:And it's not to be a doomsayer here. I think it's just to point out that, hey, if you have multiple decades and correct me if I'm wrong in your opinion, but like if you have a 30 to 50 year time horizon, yeah, this portfolio can work out for you. But that is really easy to say in advance, like living through a losing period. in the moment can feel like an eternity. The long term feels like an eternity. People think one year, five year, even 10 years is long term. But statistically speaking, 10 years is not long term. It's not short term either. I'm not being flippant about it. But, you know, that strikes me as something as a group who ought to be leaning forward or turning up the volume on the conversation or people who've just had easy wins with a simple portfolio that's U.S.

13:04The Long Term Investor Host:dominant. The other group are the advisors where there's been an explosion in new RIAs formation and people who don't have robust investment teams to look into some of the things that we might talk about in the perfect portfolio. There's not a single one out there, just the one you can stick with the longest. And so, I mean, you point out why this can be flawed. I think what's relevant about when the book came out as well as today is like, hey, it's been easy for most investors. Now valuations are higher. Like, how do you think about the way in which market valuations ought to be impacting not just the portfolio, but financial planning models that do-it-yourself investors are using or advisors are using with their clients?

13:47Yeah, that's, you know, a fascinating topic because the way we think about portfolio construction is relatively static, right? We look at goals and objectives and we look at long-term returns of different asset classes and a lot of financial planning software is based on that. I will say that there is some financial planning software that does take into account when doing retirement planning projections what expected returns are based on valuations. that, yeah, there are a couple of things that are relatively good predictors or at least help predict to know what returns might be. And so, for example, with stocks, looking at the 10-year average price earnings level is a fairly good indicator of what your returns might be.

14:40And so we can bring this to now right now and look at that. Like the CAPE index, which is Shiller's, by the way, one of the greatest minds in all of our industry. He published Irrational Exuberance in 1999. A great read for anyone that's looking for something and understanding of bubbles. So always good to do it before the big downturn. But, you know, right now, the CAPE index is around 38, which is near record highs. It's the only time it's been higher is in the right, at the 1999 when he was writing the book. So that indicates potentially low returns. On average, if you're just looking at the last 50 years, Peter, where we are on price earnings levels right now means that over the next five years, we would typically have 0 % total gains, not above inflation, but 0 % nominal gains.

15:36Another thing I showed in the book is that for bonds, if you look at the starting yield, that can be a good indicator for what your total return is going to be in bonds over even very long periods forward. So, you know, if you're starting the yield is something like 1%, your return expectation over the next 30 years is meaningfully lower than overall average return in bonds. So looking at that is really important. But the question that is sort of a riddle to solve, Peter, is that what do you do about it, right? So if you happen to be in a scenario where, I mean, really a worst case scenario would have been right around 2021.

16:19Because you did have those very low yields and very high valuations coming into 2022. And so what do you do about it? I mean, that is somewhere I go in the book in terms of like thinking about pragmatic, explicit ways that you can address this in portfolio construction.

16:39The Long Term Investor Host:Now, this is a slightly different direction than where you're going, but it's relevant. So at the beginning of this year, I spent a lot of time episodes, you know, if you're watching on YouTube, Cheddar, if you're listening to us, thelongterminvestor.com is where you can go and I'll link to these episodes, but episodes 239 through 241, we were talking with experts as well as just kind of looking at, you know, solo episodes internally on how we're setting planning expectations. And one of the things I really appreciate, you spent a dedicated chapter, I believe on saying like, Hey, it's important to understand that stock prices are driven by earnings and the prices paid for earnings.

17:18The Long Term Investor Host:Um, and you can go back and easily look at returns and say like, hey, what amount of the return came from cash returned to shareholders in the form of dividends or buybacks? What came from changes in earnings? And what came from changes in the price people are willing to pay for those earnings? And as we sit here recording in April of 2026, we're seeing people not willing to pay as much for a dollar of US earnings as they were for the past several years. And so, you know, unless I've already stolen your thunder, or maybe expand on what I'm talking a little bit about with the earnings, as well as the valuations.

17:52The Long Term Investor Host:And then maybe kind of talk a little bit on how you would propose people take that into account based on where we are today. What you're highlighting, and maybe you use this word, but what you're highlighting is that in a way, what we're paying for earnings acts like leverage in the stock market. And so if you're starting at 15 times earnings and earnings increase by, let's say, 10 percent, but the amount we're willing to pay for those earnings also increases by 10 percent, then we get an outsized return. And so what tends to happen during long-term bull markets is that you meaningfully expand the amount we pay for earnings at the same time that one would assume we're also increasing earnings.

18:49So you might even get a 2x experience, right, where earnings increase 40 % over some time period and your stock market increases by 40%, you know. So what that does is it creates this optimism machine that changes everything. Now, that also affects GDP because you get more spending and it's just all creating optimism. And it's just as if you had leverage on earnings. And the same thing, though, unfortunately happens in down markets, right? So if your starting place is 22 times earnings is how much you pay for each dollar of earnings. And then you're finishing places 10 times earnings, even before you consider any loss of earnings in companies that you're investing in.

19:41you're going to have a 50 % loss in value of your portfolio. And the words that I use that I think is important to understand for stock market investors is that when people invest in the stock market, I think sometimes they think about, they think that there's something really necessarily solid behind it, like bricks and mortar, great management teams, and all that stuff does exist. But really, I'm going to define it, bring it down to one word, Peter. In a word, what you're buying when you buy it in the stock market is you're buying optimism. You're buying optimism because if we're pessimistic about, you know, what do people, mom and pops, you know, brick and mortar businesses, what do they sell?

20:29What types of earnings do they sell their companies for? It's about five times earnings. but we pay on average 15 times earnings on stock market exchange. And so the difference between that mom and pop level and the stock market is that we assume there's going to be earnings growth. And that's what justifies that 15 times multiple. And then when you get into times like now where we pay 22 or 23 times earnings, that's even more optimistic. So really, without anything else changing, as fast as we can go from optimistic to pessimistic, we can go from a great, rich, wealthy person portfolio down to significant deterioration.

21:12So that's, put everything else aside, the main thing you're buying is either optimism or customism in a portfolio. Yeah.

21:20The Long Term Investor Host:And I feel like when you see those expanding valuations, you're seeing the optimism just increase. When you see the valuations decreasing or contracting, you're seeing the pessimism increasing. One of the things that strikes me, And I love it when people reference the importance of earnings, because to me, it's all about the earnings and it's all about what people pay for them. So you and I are on board there. I think when you don't understand that, sometimes it helps. It doesn't help. It creates confusion around what risk really is. It doesn't help that there are dozens of different definitions of risk in academia, in real life, in finance, in non-finance issues.

21:59The Long Term Investor Host:You unpack this a little bit. I mean, talk to me about accurately defining risk. How should investors be doing it? Why is it so important? What mistakes do they make? So it used to be that, you know, it's really interesting to answer that question. If you look at what financial advisors job used to be, it used to just be persuading people that weren't in the stock market to come into the stock market. You know, that was when stocks were not as prevalently invested in across households as they were. or a bit, but you really, you really didn't necessarily, if you're persuading people to come from CDs into the stock market, uh, want to talk about the big down markets.

22:37You know, you'd want to just project optimism in the stock market. And I think part of our industry's problem is that we, we define risk maybe in a way that is not, I'm going to say help accurate or fully transparent. And so the word that I'm going to focus on here, Peter, is the word volatility. Okay, volatility means going up and down. And most people don't have a huge problem with up and down. Most people have a huge problem with down, down, down, but volatility suggests, it conveys this thinking of, even if it does go down, it's always going to go up again. It's just moving up and down. And so the word that we need to think about when we think about risk is we need to think about basically just losing money.

23:29And the reality that's not fully accepted in the investor or the advisor community is that if you're in stocks or bonds, they can actually lose all their value. I think people understand that more with bonds. Bonds are totally fine and they're always okay right up until they're not. if an issuer is not able to pay interest and then all of a sudden becomes insolvent. That's clear for bonds. So what we need to focus on, first of all, is comprehensively think about risk from a broad economic historical perspective. But then we need to define it based on what are the probabilities of not reaching your goals.

24:11And I think, you know, you guys focus a lot on goals-based planning in your firm. But what are the chances of not reaching your goals? And then how can we lower the chances that you don't reach your goals or have significant impairment along the way?

24:26The Long Term Investor Host:Yeah, these definitions are so important. And even as you're talking, I started Googling because I'm thinking, I bet there if I Google definition of risk and finance, there'll be a dozen results that come up. And I'm eyeballing and I see maybe nine quickly. And the real key here is that there are probably just lots of different shapes of risk. I think you've identified one of the most important, if not the most important. Sometimes when we're going through retirement planning, we talk about the risk of running out of money. And on the other end of the spectrum is the risk of dying with regret.

24:58The Long Term Investor Host:And so if you fully eliminate one, you're probably going to put the other one front and center. But there is just general risk of the wrong set of expectations. When somebody invests in a portfolio and they have the wrong expectations in place from the start, they're not set up for success. And risk from an allocation perspective, which you sort of, or an allocator's perspective, sort of what you highlighted, like volatility in the academic sense has some use to us, but I'm sort of with you. I don't think people are nervous by the volatility. They're nervous about the narrative attached to the volatility and like, will I be okay?

25:32The Long Term Investor Host:And so, you know, I really do think this defining risk is really important. And when you make an investment, you really understand its purpose. You know, I always think of like the reason we invest in the first place. So we're trying to grow our savings faster than the rate of inflation without taking unnecessary risk. Now, here I am using the word risk, trying to say like, well, what are we trying to accomplish? What's unnecessary risk? What is necessary risk? There's a lot of stuff to unpack there. But I only know that we have so much time. So let me jump ahead a few steps. We've talked a lot about some of the issues with planning models and framework and portfolios.