Why a Good Investment Can Be Wrong For Your Portfolio (EP.276)

0:00I am more concerned about implementing a bad idea than missing out on a good one. And so like the FDA, basically they're trying to approve drugs that have minimal side effects. And if you approve a drug that has like great outcomes, but has too many bad side effects, like that's no good. But you also don't want to just not approve a drug just because of a few side effects, like if it can really benefit society. And you're kind of thinking of the portfolio the same way. 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.

0:37And 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. Today's episode is a little different. I'm actually going to share a conversation that was originally aired on the PlanCorp Perspective, which is a podcast that we produce for PlanCorp clients. My colleague Rainey Verby, PlanCorp's Director of Practice Management, put me in the guest chair to talk about my new book, The Perfect Portfolio. But despite the title, this isn't a conversation about the exact funds or stocks you should own. In fact, it's about something more important, and that's how to build a portfolio around what your money is actually for and how to make sure it's one you can stick with when another investment is getting all the attention.

1:28Rainey and I discuss why smart people still make bad decisions, why process matters more than outcomes, and the four questions I use to evaluate any new investment idea. As always, you can find detailed show notes at thelongterminvestor.com. And remember, there is a link at the top of this episode description where you can buy your own copy of The Perfect Portfolio. And now, here is my conversation with Rainy Verbi.

1:59I'm Rainy Verbi, Director of Practice Management at PlanCorp. And today, I'm really excited to be joined by somebody that most of you already know, our Chief Investment Officer, Peter Lazaroff. So Peter is the author of a new book called The Perfect Portfolio. And that's what we're discussing today. So Peter, congratulations on the second book, and welcome to The Perspective. Thanks, Rainey. I appreciate it. Glad to have you here. So the perfect portfolio is a pretty big promise right there in the title. And I think when a lot of people hear that, they think you're going to tell them exactly what they should buy, right?

2:31You're a chief investment officer. You know how to do this. He's going to tell me what stock should be in my portfolio. I don't really do that at all. Tell me a little bit about how you came up with that title and what you mean by the perfect portfolio. Well, the title is actually quite a long story. You're right. I don't believe there is such a thing as one universal perfect portfolio. And the book's original title was actually Your Perfect Portfolio. We have the URL. If you type in yourperfectportfolio.com, it'll redirect you to the book because theperfectportfolio.com was already taken. But another author who is a colleague of mine, we both had manuscripts.

3:09He changed his title to that and he was publishing first. And his book is called Your Perfect Portfolio. No problem. I I still think that the perfect portfolio can be achievable for any one person. It just is not a one size fits all. So like if you and I go out to have lunch today, we might have similar tastes in food, but we're probably not going to order the exact same thing. And even if we do, we're going to have slightly different reactions to it. So the goal of the book is really to help you understand all of the key ingredients to get that perfect portfolio that you can stick with for as long as humanly possible.

3:43I love that. And I think one thing you do is move the conversation quickly away from what's the best investment and really focus on what's the money actually for, which is how I've learned to do wealth management as an advisor the entire time. So why is that the better starting point to you than what's the best investment? You know, none of my answers are going to be straightforward. They're all going to start with a roundabout way. But I think if I had written this book prior to coming to PlanCorp, so I've been at PlanCorp for 13 years. Had I written this prior to coming to PlanCorp, I might not have emphasized this as much.

4:17I think so much of what we do and seeing the impact it has on our clients has really influenced the way that I think about where does investment sit within the broader story that is our clients' lives? Because our advisors are the ghost writers of the novel. Well, I guess it's the biography of our clients. And really, we're sitting there trying to say, what is the life you want to live? and how do we write that story for you? And the investments are an essential piece to it, but you really can't understand what language you're even writing the book in until you understand what the goals are. This is like, where are you from?

4:54Where did that person come from? What are their aspirations? And so investing, what's really fascinating to me is you can get real nerdy and go real deep in the weeds, but when you do so, you start to realize is how the simple, elegant solution is often the best one for meeting those objectives. Because if you keep going back to the why, it's really gonna define a lot about what that perfect portfolio is for you. Right. I think the theme that runs through the entire book is that even smart people can make bad investment decisions. And I think to your point, getting caught up in that research is exactly the thing, right?

5:30Investors don't lack information. They read too much, they read too many articles, They watch too much on television. They hear too much. And following those forecasts and those media can really cause them to make mistakes out of an emotional state when they have all the right information and maybe too much. We have such smart clients. And I feel like one of the things that a successful individual is used to is that like every problem out there is solvable if you just work hard enough at it. If you just pay attention to all the right details. And there's a lot of research studies that I'll reference to in the book.

6:06And I think they're fun. They kind of highlight us silly humans very often. And it's one thing to like point at us silly humans and all our flaws. Like it also addresses how do we like build around those flaws? But one of the things that I pointed out was a study for that looked at the impact on cognitive ability for behavioral error. And typically what the studies found was that the higher the cognitive ability, so the smarter you were, the more susceptible you were to behavioral error. And the reason for that was that you were able to concoct a story in your mind that justified a lot of your decisions.

6:40So, in fact, really smart people are sometimes even more susceptible to this stuff. And then here's the other thing. I mentioned most people who are successful are used to problems all being solvable and being black and white. Investing is shades of gray and more information doesn't always equal better. So another study I really enjoyed from the book looked at horse racing handicappers. And so it took five random stats on a series of horses and had these professional horse bettors that place bets. And I think the success rate was maybe 17 % correct with the five facts. And then they gave them 10 facts and then they gave them 20 facts and they gave them 40 facts.

7:19the confidence level rose in their predictions, but the actual outcomes did not improve. And so there's so often where I feel like people are searching for the answer and they get one news headline and they go really deep on that. But we just, we live in this complex adaptive system where there are millions of interconnected parts. And again, I said, we can go wonky, but yes, but the big implication as you rise to the surface of all that is that sometimes the simplest solution ends up being the best solution. And so what I really enjoyed about writing the book is it took a lot of instances, conversations I've had with clients, understanding investors for the past couple decades that I've been working, where these are things that I know get people tripped up.

8:01And that way, you don't have to make it so personal to you can kind of maybe see yourself in some of the stories. But also, I think just go ahead and learn something about the process. Because when you see the finished product of the portfolio that we build for you, you're going to say, great, there's a list of funds. But when you see the amount of thought that goes into it, I think you come away with a lot of confidence. Absolutely. So to your point, I mean, I think we call the behavior irrational when people make investment decisions, but it's completely rational. It's what a smart person would logic through and rationalize in their own mind.

8:34What do you see as one of the most costly mistakes, the one that damages portfolios more than anything else? The number one thing is a lack of process. And so this is true of advisors. This is true of individual investors without an advisor. This is true of clients with an advisor. When you make an investment decision without a clearly defined process, a process that was defined in advance of you making the choice, you are going to make mistakes. I think a lot of times people judge the quality of a decision by its outcome, really what you should be doing is evaluating the quality of the decision by its process.

9:16And so I don't know how deep you want to go into process, but ultimately I think that simple fact is what ends up getting people tripped up. If you explain to me after the fact, the reason you made an investment decision and to be clear, an investment decision can also be to do nothing. That is, that is a choice. And I ask you how you got to that decision, you can probably come up with a narrative of how, but if I ask you the next time you made a decision, how you came up with that choice, I'm pretty sure it's going to be different. And so we know that process is always going to lead to the smallest amount of variance in outcomes.

9:54Can you make a great decision and get unlucky and have a bad outcome? Sure. Just like you can get really lucky, like you can hit it big and have a stock go up a thousand percent and have put all your net worth in it, it looks like a great outcome, but it was probably not a good decision. So it's just kind of balancing those things. A well-defined process is something I think that we've always taken seriously here, not just with the investment side, but with the financial planning side, with compliance, even with just running a business. Like we're very systematic in a lot of things. I think we owe a lot of that to our founder, Jeff Buckner, who was just kind of a process obsessed freak.

10:30And I say that in the nicest way possible, like really just a strong place to be if you're an investor. Absolutely. And I back it up even one more step from the process and say, you know, it's not the quality of your decision so much as it's the quality of your question. Are you asking the right question? And the one I ask on here all the time is what problem are we trying to solve? Right. And so I think I see clients go through all these iterations of should we have this in our portfolio? Do we need that? And the question is, what problem are you trying to solve? Are Are you trying to solve your portfolio looking like your neighbors?

11:03Because that's a little bit sexier. Do you are you trying to solve taking more risk? What is the underlying problem you're trying to solve in the first place? Yeah. And I think that goes back to like where we started the conversation, like understanding like what is the money for? Like what is the purpose? You know, the perfect portfolio, the book and just the general concept kind of rests on a few ideas. It's that you have to understand the purpose of the money. You have to understand what your own personal limits are. So like there's ability and willingness to tolerate risk. And those are more like technical phrases, but like legitimately, can you sit with this investment for a long time?

11:38I had a close friend who's a similar role as me from another firm call yesterday was talking to me about 30 year real yields right now. You could go out and buy a 30 year tip right now, treasury inflation protected bond, and it might be a great decision. But over the next 30 years, what is the likelihood that that position is going to annoy you? Like at the end of 30 years, you might end up in a better place, but 30 years is a long time. Right. One year feels like an eternity for people to live through. So I think it's like really understanding, okay, what's the money for? Like, what are my personal limitations?

12:11Like, what can I handle? What's reasonable? What's not? It's the third thing I would think is like evidence, like everything we do on investment side isn't based on opinion. It's based on evidence, right? How we interpret the evidence. You could argue as an opinion, but like, no, we, we try to make statistically significant again, inferences wherever we can. And we try to do what we believe is in our client's best interest. In general, when you're going through a process and you're trying to adhere to something like evidence-based investing, you're going to ask questions like, well, why does this investment idea have a positive expected return?

12:45Or what is the chances that this actually improves the portfolio? Like people add something to a portfolio, hopefully because it either enhances return or improves diversification. If it's not doing one of those things, what exactly is it doing? So you're like, right. But just because you think it's doing that, like, what is the process for testing that? Um, you know, another question we'll ask is, is this introducing unnecessary complexity? I don't believe that complexity has to be bad. A really good example. We use separately managed accounts with a lot of clients where if you're not familiar and you're listening and watching us with separately managed accounts, it's basically the same thing as an ETF or a mutual fund, but you're the only holder of it.

13:25So it's like having a mutual fund all to yourself, same mutual fund manager, same strategy, same trading costs. It used to be that they were three, four, maybe 10 times the cost of an ETF or mutual fund, but now they're basically the same cost. That is an added complexity because it adds maybe a thousand line items to your holdings report at tax time. But if it's generating a lot of capital gains or excuse me, capital losses, that can really have a huge benefit. So like big tangent from the like, what are some of the questions you can go through and process that's does it add unnecessary complexity there's sometimes where complexity is good there's sometimes where it's not and then the last one this like circles way back to where you started before i went on on a big tangent where it's like what is the likely is like what's the base rate or like am i extrapolating past success so like when something has done really well am i just chasing that performance like what should i be reasonably expecting from a statistical standpoint i think that is a core part of what i go through in the book where you take that framework.

14:24I tried to give it a clever name, but it's a mouthful. It's called the probabilistic decision protocol. I, boy, and I had AI at my disposal to come up with a better name than that, but that's the best we did. And so ultimately, like there's a lot of lenses that you can look through using that protocol to decide like, hey, does this really belong in my portfolio or not? Yeah. And that's exactly what I was going to go to next. So I'm glad you said it and I didn't have to say those words. I was really nervous about it. Probabilistic is a really difficult word to say. It really is all on its own. And so I think having that framework in the process that you point out is such a big deal because it takes emotion out of the game, which is the biggest thing that we as humans can trip up on, right, is our own emotions.

15:10And to your point, remembering recent victories, those past returns, those things that went really well the last time, even if it was a bad decision with a good outcome. So walk us through that framework because every one of our clients is getting pitched things, right? Oh, yeah. Even if they're not actively getting pitched, they're getting passively pitched on television and everyone around them, AI and private equity, crypto, and everybody thinks this fund is gonna be suddenly the best thing. I mean, remember when NVIDIA was the only stock anybody ever wanted to hold? Right. So walk us through the framework and help us understand how do I decide when a stock has a place in my portfolio.

15:49But I like the way you frame that because in general, I am more concerned about implementing a bad idea than missing out on a good one. And so like that is going to shade a lot of how I go through the process. And the story I always tell connected to that is, and I tell the story in the book is there's a woman, oh my gosh, I should remember her name given that other book. You know, in fairness, this is my first book interview. So I'll really be solid in about a month. But like at the FDA, basically they're trying to approve drugs that have minimal side effects. And if you approve a drug that has like great outcomes, but has too many bad side effects, like that's no good.

16:25But you also don't want to just not approve a drug just because of a few side effects. Like if it can really benefit society and you're kind of thinking of the portfolio the same way, I'm really stuck on her name. I know it's Kelsey something, but we'll, we'll, you know, we'll put it in the show notes. We'll put it on YouTube in the comments. I'll, I'll comment my own answer. And it'll come to me like 15 minutes later. Anyways, so like with the probabilistic decision protocol, I'm generally going to try to avoid bad ideas and be less worried about missing on good ones. And so let's take that first question.

16:58Like, why would you expect a positive return? So when you buy a stock, just a single stock, like you're buying a future stream of cash flows, like that's the economic reason. There are risks involved with that. Like you might want to buy a whole basket of stocks, like the whole market as opposed to one. But there's a reason you'd expect a positive expected return. Whereas something like gold doesn't have any sort, it's not a productive asset. So you're sort of looking at like, what's a speculative asset versus a productive asset. If the only case for owning it is that someone's going to pay more for it in the future, that's not really a great reason to say yes to it.

17:32So that can be like one way to filter out something in the portfolio. um the next piece of like does it improve actually enhance like return or diversification does it actually improve the portfolio proving that something um proving is a big word but like to make a real statistical inference and i won't use stat talk the whole time but like to really do that you need a pretty big data set to make a strong statistically significant inference that something is going to add return um diversification it is a little easier to justify and sift out that data to say, yes, this is a diversifier. But then here's the thing that we face with clients is like, well, will somebody stick with it?

18:10Because if you build the perfect portfolio on paper is very rarely the one you can stick with. And so like you're trying to imagine like, is this actually improving the portfolio? So the biggest diversifier to a stock portfolio is bonds. Makes a huge difference. You want to reduce volatility, you add some bonds. I think most people listening to us would agree with that. Whatever you add to the portfolio next is not going to have nearly the same impact. on diversification and whatever you add after that is going to have a smaller impact. And whatever you add after that, it's, I mean, this is like just the marginal impact of each additional holding is going to go down and down and down.

18:43And so you're trying to weigh, you're sitting there again, being like, okay, if most of investing success is minimizing mistakes, and I'm more concerned about implementing a bad idea than missing out on a good one, the bar for inclusion should be high. I have a friend in the industry who talks about being like the bouncer to club, like you aren't supposed to be letting people in. Like that's a little bit of what that step's about. The third step, does it introduce unnecessary complexity? I gave an example with SMAs earlier, but you mentioned private investments. I think it's a really timely topic.

19:14Private investments, there's a good reason that there's a positive expected return. There are lots of reasons that you could say it could enhance returns or improve diversification, But does it create unnecessary complexity? And I think that we will traditionally approach clients who have over$20 million and say, sure, let's have the conversation about private investments. We have a very robust due diligence process, but a lot of it is aligning that specific client's objective to the end product. And I think you have to understand when you get into that, you're adding tax complexity, you're adding a huge amount of uncertainty of where your returns are going to be.

19:51These are people who are so overweight liquidity that, sure, if they want to take that risk and they understand the risks, they have the capacity to do it. They can handle the additional cost and complexity there. So that's an example where like that's complexity for some people that make sense and not others, just like SMAs don't make sense for everybody. the last one, what's the base rate? Meaning like if we were to pull an outcome out of a hat, what would we most likely expect to happen? And so, you know, let's take a look. I'm trying to think of something that's done really well. Well, you took Nvidia, you mentioned Nvidia had a great run.

20:24If we look at the base rate of what happens for stocks that enter the top 10 of the S and P 500 in the 10 years leading up to that moment in five years and one years, the returns are outstanding. But if you look at the returns one year or five years or 10 years after they enter the top 10, the returns are quite awful. So I'm being like a little like rough around the edges, but like the base rate there would be like returns are probably not going to be that good for that stock. So here's a stock that has a future outcome. Like, yes, it has a productive reason to produce positive return. It could enhance return and diversification.

21:00It could heard it. It isn't that complex to add one stock, but like, are we extrapolating its recent success? Yeah, yeah, we probably are. That's right. And it all to me circles right back to what is the problem we're trying to solve, right? So you did mention SMAs, which I love because SMAs try to solve a problem, which is to generate capital losses to offset capital gains. If there's not a reason for that complexity in the portfolio, it's unnecessary complexity. There is truly a difference there. So what do you see as the common outcomes when people skip that first question of what problem are we trying to solve?

21:34It's so funny when you said that after I'd been down this technical whirlwind, it's like, this is why I am not a financial advisor. I'm our chief investment officer. And I sit with you and any of our advisors who are able to like come back up for air. You know, if I ever say like, what's the money for like the baseline reason that you invest. So like, it would be nice. I can't anticipate all of our listeners and viewers, like what their why is and what their for is. But when you're investing, what you're really just trying to do is grow your savings at a rate greater than inflation without taking undue risk.

22:07And so we in our financial planning models really, I mean, it's probably not clear to the end user, but we're using a couple centuries of real return data. So data post inflation, because if we could just put all of our money into cash and like be good, that'd be great, but we'd have to work forever. Our spending, or excuse me, our savings rate would have to be astronomical. It's just not realistic. And so we're investing to outpace inflation. Stocks historically have outpaced inflation by a little under 7 % a year. Bonds have outpaced inflation by like 1 % to 2 % per year. And when I talk, one of the things I hear from clients, I talk about stocks outpacing by, let's just say 7%, even though it's a little less.

22:46You can look at like these big, very different economic genres of like 60 to 80 years long. Because people are always saying the world is different. And like you and I both know, the world is always different. Right. There are some things, like the thing, you know what isn't different? Human nature. Like us humans, you're not going to take the humans out of human nature. And so like, you know, one of the chapters in the book focuses on history. It talks a little bit about this. It talks about booms and busts. And it also talks about just the routine market declines. But when you think about like, what's the purpose of all this?

23:16There is going to be a personal goal. your portfolio's job is to assist in that. And the reason that you have a portfolio, the reason that you invest, again, just first principle level is just to outpace inflation without taking undue risk. Right. And I think, you know, complexity is interesting because we might think about it differently. A complex portfolio to me is really anything outside of some basic index funds because I like to be a very straightforward, simple investor. I have always told my clients, if you don't understand it and I don't understand it, it's not something we should even be talking about.

23:51Right. So I think it's tough for sophisticated investors because they do understand a lot of the information coming at them. And there are some fundamental layers that make it feel like a more complex portfolio is a more sophisticated portfolio. Can you speak to that a little bit? Yeah, I think there's like sophistication in a couple different flavors that appeals to people who are looking for complexity. Like one is just the number of holdings. Like you assume there are more holdings, it must be doing more work. But when you hold one fund that owns 3 ,000 holdings or 5 ,000 holdings, like that's a lot of holdings, but it's only one line item on your statement.