Who Causes Stock Market Anomalies? (w/ Victor Haghani) | #429

19:30Rational Reminder Hosts:And also, it's the fact or what we think is the fact that the return chasing behavior is operating on a lot more capital than the momentum strategy than time series momentum is in general. The beautiful thing about time series momentum, in terms of why I think it generally doesn't get too big, is because it just seems ridiculous. I thought the thing was we're supposed to buy low and sell high, and this strategy is sell low and buy high. That when time series momentum is working, people are like, oh, this is great, I love it. But as soon as it stops working, as soon as you go through one or two years where time series momentum doesn't work, people are saying, I knew this was the stupidest thing ever.

20:15Rational Reminder Hosts:Of course, it would never work. And they pull their money out. Now, I think people's attitudes are changing over that. Probably there's been so much research and talk. I think people are sticking with it maybe longer than before. But I think it just has a bit of trouble in attracting large amounts of capital for the long term because it's just something that people like as long as it works. And when it doesn't work, they flee. And that has that impact. But I don't know. At some point, this time series momentum could just be the dominant force and then everything would be different.

20:48Victor Haghani:The performance chasers, the extrapolators, are they creating the momentum factor?

20:53Rational Reminder Hosts:Yes, they'd be creating. It's their impact that's creating that evolution of prices that allows the momentum guys to make money.

21:01Victor Haghani:So they're cumulatively buying more and more of the asset class, pushing its price up and up. And the momentum folks are seeing that signal with their more defined lookback period. And they're buying the thing that's going up.

21:12Rational Reminder Hosts:And they're getting ahead of it. You could think of them as like front running that trend on average. It relies on the momentum guys not having too much impact.

21:21Victor Haghani:So that works until it doesn't, which sucks. People get whipsawed and they lose a bunch of money in momentum and then they bail on momentum. And the fact that that happens, it's almost like a bit of a risk premium story. Not different, but people get blown out of momentum and that's why that it has continued to work. Is that the right mechanism?

21:38Rational Reminder Hosts:I think that's one explanation. There's another explanation too, which is worth discussing, which is that when we talk about risk assets, when we talk about equities and things that are like equities, risk assets, The other thing that we know is that volatility tends to be skewed, that we have high vol when the market goes down and low vol when the market is going up and when it's grinding higher. And so momentum also happens to be correlated with the strategy of vol targeting. If you're doing vol targeting where you reduce exposure when the market becomes more volatile and you increase exposure when the market is calmer, then you're also following a bit of a momentum strategy.

22:24Rational Reminder Hosts:Not a bit. You're highly correlated with somebody who's following a momentum strategy. that vol targeting in our opinion is a very rational logical thing to do it goes back to the merton share it goes back to normal scaling logic of the higher my sharp ratio the more exposure i want which means the higher the expected risk premium i want more and the higher the risk i want less and so vol targeting to the extent that momentum is rhyming with vol targeting I think it kind of makes sense that it also is working and that it's helping to generate better risk adjusted returns for investors. If you're following momentum with risk assets like equities, like oil, like REITs.

23:07Rational Reminder Hosts:So there's that also, which I think is really, really important as well. We wrote an article a while ago where some investment bank was saying, you know, what you really should do is when VIX goes above 30 percent, when volatility is above 30, you should really load up on equities. which is the opposite of vol targeting. And we kind of showed just through the simple back test of how the strategy would have done, that doesn't generate a higher sharp ratio. And we also talked about that logic as well. So maybe for somebody who's thinking, oh, when the market goes down and vol goes up, I want to buy.

23:40Rational Reminder Hosts:Well, when the market goes down and vol goes up, you want to sell. When the market goes down and expected returns are higher, you want to buy. And so you have these two competing factors and it kind of depends on how much of one versus the other has happened. So it's better to separate those things than to simply say, when vol goes up, I want to buy. It's more like vol goes up, you should reduce and expected returns go up, you should want to increase.

24:05Victor Haghani:Maybe just for the benefit of listeners who didn't listen to your last episode or have not heard us talk about the Merton share, can you talk about the Merton share logic behind the statement that you just said.

24:13Rational Reminder Hosts:So Bob Merton and Paul Samuelson attacked the lifetime consumption and portfolio choice problem in the late 60s. They came up with this solution where under a very stringent and unrealistic set of assumptions in terms of how risk assets behave and all that, but it gives us a good rule of thumb. The amount of exposure you should want to have to risky assets in your portfolio is proportional to the expected risk premium that those risky assets are giving you. You have to have an expected return and know what the safe asset is offering, divided by the risk of those risky assets where you're measuring risk as variance.

24:57Rational Reminder Hosts:Also, you would scale that based upon your own personal degree of risk aversion. So there's a constant in there that's like your personal constant that you would divide by your degree of risk aversion. And that Merton share, as we call it, that also is actually the same as is a more inclusive version of the Kelly criterion, where the Kelly criterion is the Merton share where that coefficient of risk aversion is equal to one. And that gives you the Kelly criterion, which comes at the problem from a different place, but winds up in the same place. Another way to think about the Merton share that might be easier is that the amount of risk that you want is proportional to the sharp ratio of the risky asset portfolio that you want to invest in.

25:43Rational Reminder Hosts:And then that's the amount of risk you want. And then to figure out how much exposure you want, how much of those assets you want, then you would divide by their risk. And that's why we wind up with risk squared with standard deviation of return squared and the denominator. Again, it's a rule of thumb, but it ties expected utility theory to the investment process. You can get more general and more realistic, but that's the simple rule of thumb from Bob Merton and, well, Paul Samuelson's paper too. But I think Bob, we call it the Merton share because I think Bob kind of came up with it. And then Professor Samuelson was his mentor.

26:20Rational Reminder Hosts:They published joint papers at the same time, but I think that Bob came up with it in continuous time first is what I understand, but I'm not sure.

26:28Victor Haghani:Yeah, I don't know. I've seen it called the Merton Samuelson share too. I don't know how much it matters. I've never heard Bob complain about it being called one of the other. Yeah, either way. Yep. A really good explanation. And it's really interesting how that ties into momentum and the persistence of momentum because people are changing their asset allocations as risk and expected return evolve. And that is driving momentum. And momentum should then persist unless it becomes the dominant where most of the capital sits, I guess. Yes. Super interesting.

26:58Rational Reminder Hosts:When we were talking about, you know, other investors that could do better, one simple strategy that actually does really well is a value and momentum combination. So combining fundamental long term cash flow investing signals with momentum. So value and momentum gets a much higher Sharpe ratio when you combine those two. And this really goes to kind of explain in some ways very satisfyingly the results from the Asnes et al. paper. I forget when it's from, but value and momentum everywhere that I think has had an impact everywhere on people's thinking. I mean, I think that was a really seminal paper.

27:39Rational Reminder Hosts:It certainly shaped our thoughts a lot at Elm. What do you think your model adds to our understanding of markets? There's a vast, vast literature of these heterogeneous agent model approaches to the markets and from the Santa Fe Institute to Northeastern universities. And there's all kinds of contributions here. And I think that the two things that we really add to our understanding about this is that number one is that we're presenting this in a way that's much easier for people to understand that it is not heavy math here. All of the most recent papers use a lot of heavy math, and they're really hard for most people to comprehend.

28:21Rational Reminder Hosts:And then the early papers were more like stick models. Larry Summers and DeLong Summers, etc., Schleifer kind of had a stick model early on because they were just kind of showing the general contours of what things look like in a multi-agent setting. So one is that we've made it more accessible. Then the other one is that we've made it more general. So nobody, as far as we know, has built a model that has six or seven different kinds of investors in there. You know, we have the three that we talked about. We have a value and momentum investor. We have a by the dip short term reversal investor.

28:55Rational Reminder Hosts:We've modeled like a more anticipatory investor in there as well. So this kind of generality of the broadness of it going and allowing you to put in any kind of investors you want and was going to help people who want to take the research further and put in more realistic investor types and make the simulation more and more realistic.

29:16Victor Haghani:You mentioned the value and momentum insight. How else did thinking through and writing down this model affect your views on asset allocation?

29:24Rational Reminder Hosts:That's perhaps the main one. But I think when you come to appreciate how important extrapolators are to what's happening in the world, maybe it's a little bit of to a man with a hammer, you know, every problem is a nail. But it just feels like understanding these extrapolators and how much they can affect behavior creates a lot more humility in terms of what the markets can and might do. And also kind of gives you this focus, you know, in terms of trying to understand what's putting more focus on them than on any other investor type and behavior in terms of trying to understand what's going on.

30:01Rational Reminder Hosts:So, so, so many people, long-term market observers, they look and they say, gosh, I don't understand what's going on. We have higher interest rates. We have this bad government deficit. We have tariffs. We have global political instability, all these different things we have going on. And they're like, I don't understand why the market is 20 % higher after all these things have happened. What is going on? To us, thinking with this lens on, it's like, well, one simple explanation is that until recently, U.S. companies were buying back over a trillion dollars of their stock per year. There were no IPOs, flows into 401ks and so on.

30:45Rational Reminder Hosts:We're also running at like a trillion dollars. So here was a couple of percent of the total or more than a couple of percent of the total U.S. market disappearing or being bought by exogenous demand each year. Combine that with people just seeing these returns. And I mean, I don't know how many people I've heard just say, just keep all your money in equities because you're going to get 10 % a year. It's been 10 % a year for 100 years, and it's going to be 10 % a year forever. However, that's self-reinforcing for a long time.

31:19Victor Haghani:Sure is. For some indeterminate amount of time.

31:24Rational Reminder Hosts:Another thing that we kind of tried to play around with in the model is there is some time when there's probably some time when you can get a lot of supply of equities. When it looks like the long-term expected return of equities is below government bonds, we would anticipate that companies will issue a lot of equity. when it really becomes clear, when equity becomes cheaper than debt, company treasurers, company CFOs, company CEOs and boards pay attention. And they're like, OK, we should raise equity. There's a lot we can do when equity costs less than debt. And we still have the market would need to go up quite a bit more to get there.

32:04Rational Reminder Hosts:But there is some boundary condition, I think, that's out there. Japan hit that boundary condition in the late 80s. Boy, did they issue a lot of equity in the late 80s in Japan, right? They issued a lot of equity in that run-up.

32:16Victor Haghani:We got a ways to go still is what you're saying.

32:20Rational Reminder Hosts:We have a ways. Maybe it's another 50 % up, all else equal, or a percent or two higher in interest rates. You know, if we got 10-year tips at three and a half, 10-year treasuries at six, we'd see more equity issuance if the market stayed here, that is.

32:37Victor Haghani:They didn't go down. Very interesting to think about. But I haven't thought about U.S. stock market valuations in a while because whenever we talk about it, the market just keeps going up. So it's like, all right, maybe we're contributing to the extrapolation by no longer talking about it. Exactly. You did a great article on long, short direct indexing. Can you talk a little bit for listeners just about what that is before we start asking you questions about it?

33:02Rational Reminder Hosts:There's been so much over the last couple of years in the U.S. on different kinds of strategies to help people defer their taxes or in some cases pay less taxes. What we've had for quite a long time are direct index tax loss harvesting programs where you give your money to a company like Parametric, which I guess is now owned by somebody else. And a lot of companies are offering it. And they put you into a portfolio of individual stocks like the S &P 500. And then when individual stocks go down, they sell them and then they try to buy them back later on to realize losses as much as they can and to try to track the S &P 500 over time while realizing losses.

33:45Rational Reminder Hosts:Well, more recently, it's this strategy that people have thought about in the past is taking that to another level of let's go leverage long stocks and run a short position against them. So instead of just taking$100 and buying$100 of stocks, I could take$100 and control$300 or$400 of stocks. And I can get a lot more tax losses in that way to offset gains that I might have elsewhere. And this is called leverage long short tax loss harvesting because it's using leverage and it's using shorting. But it's still tax loss harvesting with individual stocks. It's grown quite a bit. There's been a bunch of articles about it.

34:25Rational Reminder Hosts:So we've been writing about this for a while. We started off writing about direct index tax loss harvesting, and we made the argument that most investors shouldn't really have a lot of capital gains if they're long term equity investors. they shouldn't have a lot of capital gains to worry about other than the fact that they are selling some stocks over time to consume. The point of the wealth is to spend it. So you have to sell over time stuff that you have in a taxable account and realize some gains. But overall, if you are invested in stocks, you don't have a lot of capital gains. You're getting a lot of deferral just naturally.

35:05Rational Reminder Hosts:But if for any reason you do other kinds of investing, maybe in hedge funds or other things and you get realizations, you have a lot of capital gains, you might want to try to reduce your payment of them over time and defer those gains into the future. We've written about this. And with respect to direct index tax loss harvesting, we've said, well, after you figure out the fees, because this carries fees, and after you figure out the extra risk that you're bearing, you might be just as well off owning ETFs and doing tax loss harvesting on your ETFs, own Vanguard Broad, total market. And if that goes down, replace it with the S &P 500 index fund and do something like that, or maybe own the different sectors of the S &P 500 and do something like that.

35:50Rational Reminder Hosts:And that takes you to about the same place. You have less risk. Probably it's slightly better, but you just have less complexity. You don't wake up one day with a 400 stock portfolio that you don't know what to do with, where you have corporate actions and all this stuff that you have flexibility by having a simple portfolio and you're getting about the same result. When there started to be more interest from people in leverage long short direct indexing, we analyzed that and we came to a similar conclusion. Well, the conclusion that we came to in our research was that if you don't believe that the long shorts are going to generate alpha, we don't really think is worth doing.

36:32Rational Reminder Hosts:The fees are much higher than in the unleveraged version because here you have higher fees from the manager and you also have a long short friction that Fidelity or Schwab or whoever the custodian is charging to run the longs and shorts. That if you don't believe that there's alpha in this long short strategy, then probably it's not worth doing. I mean, we're not saying it's terrible, but it's just probably not worth doing. And again, you get all this complexity and you're kind of locked into this portfolio and it's kind of messy for however long you're doing it. That was our conclusion. We think there are special cases where this stuff can make sense for people.

37:11Rational Reminder Hosts:Like for instance, if you have a lot of short-term capital gains, that some of these strategies could make sense to try to reduce those and create long-term capital gains out of them and get a conversion for US investors. Or if you're living in California and you're going to move to Alaska and you know that you're going to do that And, you know, it's like, I just want to defer my gains for a few years because I'm going to a low tax state. You know, maybe that could make sense, too. But in general, for most people and for young people in particular, we don't think it's really worth the squeeze.

37:42Rational Reminder Hosts:It's interesting because, you know, we've written about this stuff and journalists have talked to us about it. The last time a journalist was talking to us about it, she was saying, well, can I quote you in this article? And I was like, that people that get quoted in your articles really get some nasty stuff said about them in the public domain. So please, if you wouldn't mind, please don't mention my name. I've had enough bad things said about me over my life. She said, well, but you have this research. And I was like, yeah, I know. But still, like, if you don't mind. So then she said, well, who else could I talk to that's done this research and feels the same way that you do?

38:17Rational Reminder Hosts:And I was like, oh, my goodness, there's nobody really that I can think of. There should be somebody. And then I started to think, well, maybe we're just all wrong about this stuff. I don't know. But that's what we think. We're not crazy about all this stuff. There's no holier than thou stuff going on here. You know, we're just saying that if you don't think there's alpha there, then you don't really want to do it. If you think there's alpha, great. But then you kind of have to ask yourself a little bit the question of if you thought there was alpha there, why weren't you doing it to begin with?

38:43Rational Reminder Hosts:And you might say, well, I thought there was a little bit of alpha, but not enough to overcome the fees. And OK, you know, that's fine. But I think there has to be this question of, do you think that somebody can run long shorts in a systematic way and generate alpha? Maybe. It's tough. We know that Rentech does it. We know that there's a bunch of people out there who do it. And generally, whoever you can be sure of that does it doesn't take outside investors. So we know that it's possible, but in general, it seems as though when somebody really cracks that nut, they very quickly send everybody's money back.

39:22Rational Reminder Hosts:So if somebody is still taking money to do it, maybe they found a way to do it in scale. It's possible, but everybody's entitled to their opinion about the alpha. We're kind of more alpha skeptical. You know, I mean, that's why we're invested in broad index funds for our clients so much. So we're like alpha skeptics in general anyway. So why the hype around the products? people love to pay less taxes. I mean, I think some people would like rather pay somebody a fee and pay less taxes and be in the same place than not paying the fee and paying more taxes. And, you know, I think that some of the purveyors analyze the tax benefits in a fairly optimistic way, you know, like maybe, oh, you're going to roll this until forever and then you're going to get step up in basis or we're going to do a 351 into an ETF.

40:10Rational Reminder Hosts:I don't know how people are marketing it. But if you're an RIA, you're like, hey, I've got this great thing for you client, you know, I'm charging you some money to be your RIA. Here's this shiny new thing, you know, people like shiny new things. This is not even close to the weirdest things going on in our marketplace today. Like we should be saying, why are people buying these buffer funds? You know, it's like, the things of why are people doing X? This is like...

40:36Victor Haghani:I've got one for buffer funds.

40:38Rational Reminder Hosts:This is like almost defensible. This is in the zone of defensible. Like we're saying, it's not quite worth it on a risk-adjusted basis. Like we're not saying it's terrible. There's other stuff that's terrible.

40:49Victor Haghani:On your perspective on this, you guys do run an ETF, but you've got clients, like effectively wealth management type clients. And so you come to something like this from the perspective of, let's do the research and see if we should be using it. Is that the right way to characterize it?

41:04Rational Reminder Hosts:Well, we actually built a direct index tax loss harvesting product and we ran it on some of our own money for a couple of years. And we were just thinking about because people were asking us to do it and we built it and we thought it was a good version of it. And we're like, oh, we don't want to offer this to clients. We would rather clients get about the same amount of expected tax losses or tax efficiency, but keep it simple and not get into this whole thing. I mean, one of the big problems with direct index tax loss harvesting is that always in the back of your mind, you're going to be wondering, everybody knows kind of what these direct index tax loss harvesters trades are going to be.

41:41Rational Reminder Hosts:IBM is down. Somebody's going to harvest that. Everybody's going to harvest that. And there's a trillion dollars in these programs. When we're wondering about how is Jane Street and Citadel and Rentech and all these guys, how are they making money every single day of the year without ever losing money in general? You know, not twice these days, but close. That might well be part of it. When Goldman Sachs and JP Morgan are making billions of dollars on their trading desk, you got to wonder and throw in there Millennium and Ballyasni and all these guys, you got to wonder if you start to underperform in your direct index tax loss harvesting thing.

42:19Rational Reminder Hosts:If you're underperforming, you're going to be like, oh, this is terrible. This is what's happening. And you're going to be really bothered by it. And if you're outperforming, you're going to be like, oh, I got lucky. You know that the direct index tax loss harvesting guys are not doing any analysis. they're just trying to do the tax loss harvesting and manage the tracking error so when it goes well it's like oh this is great i got lucky when it goes badly it's like oh i got picked off by

42:44Victor Haghani:citadel that's interesting and that's uncomfortable and that's like a big reason

42:49Rational Reminder Hosts:that we just thought oh this is so uncomfortable if you're really reporting your returns properly to investors it's just going to be super uncomfortable to be saying oh you underperformed by 75 basis points. And we don't know why. It was just bad luck. And then it's like, oh gosh, I don't want to do that.

43:07Victor Haghani:Yeah, the tracking error. The comment about maybe the tax loss harvesting trades are priced in. And so you're giving up whatever tax benefit there might be to asset pricing when you trade.

43:17Rational Reminder Hosts:Yeah, a little bit of frictions. I mean, we know trading has frictions. And when a lot of people are doing the same thing, it has impact. But I don't know. We've never done any research on that. It's just a hypothesis. a speculative hypothesis.

43:32Victor Haghani:We like simplicity too. When your research and analysis supports the simple answer, we're always excited to see that. Yeah, definitely. Why isn't a crystal ball enough to beat the market?

43:45Rational Reminder Hosts:This is one of our favorite bits of research that we did. It kind of sat with us for a long time. We did this research where we wanted to test out something that Nassim Taleb had tweeted about long ago. He said, give a man the front page of the Wall Street Journal a day ahead of time every day of the year, and within a year, he'll be broke. It's like, wow, that would be so interesting to try to test this out. So we created a game where we give people the front page of the Wall Street Journal a day ahead historically and let them trade on that in stocks and bonds and see how they do. A lot of those days are employment days and Fed announcement days.

44:22Rational Reminder Hosts:So there's real news. we ran the experiment with real money, mostly with MBA and finance graduate students to begin with, and some practitioners. And then we just opened it up. We've had 100 ,000 people or more play it since then for fun. And it's really hard to generate a good return. Turns out that on average, people didn't do very well despite having this newspaper a full day ahead of time. Part of it, I think there are two things mostly going on, or three things maybe. One of them is people really had a hard time sizing their bets in a sensible way. People oversized their bets. They were sure that stocks were going to go up because they could use leverage in our experiment.

45:03Rational Reminder Hosts:And so they would be like 40 times leveraged and the market would go down 2%. And that was it. They lost 80 % on that day and they couldn't come back from that. So one is that the sizing just didn't correspond to sensible sizing or proportional to how clear the signals were. Like sometimes the signals were pretty clear and other times not. And people didn't size like that so much. That was one thing. Second thing was that many of the people who played the game really wanted to trade stocks. But the news is much more economic and Wall Street Journal news is much less ambiguous when it comes to bonds.

45:39Rational Reminder Hosts:When you get something that's like the economy is stronger than we thought, well, that could be good for stocks or that could be bad for stocks because interest rates might be going up. But it's bad for bonds generally. And so we also found that people had a predilection to speculate in stocks more than bonds and they would have done better in the bonds in general. People did better in their guesses on bonds. And then, you know, people just had some difficulty parsing the news. When we brought in some senior macro type traders to play, we got six or seven of those guys to play it and they did well.

46:10Rational Reminder Hosts:But they only had a hit ratio of like 60%, but still they did well. They had a good sharp ratio in the end after 15 things and they like doubled their money on average over 15 sets of bets. So it was possible to do well. Quite a lot of experience was needed. I think if you gave the front page a day ahead of time to a bunch of macro traders, they would make good money over time. They wouldn't be making their money grow tenfold. They doubled their money after 15 of these. Those were some of the interesting findings. And then of course, I think you'll probably ask, you know, we had this idea like a year later to let the AIs loose on it and to let the AIs play.

46:49Rational Reminder Hosts:And that was as much fun as anything. Since you brought it up, I was going to ask about it.

46:55Victor Haghani:Yeah, you have to. How did the AIs perform relative to the humans?

46:59Rational Reminder Hosts:We got the AIs to play and we'd spent a lot of time trying to make sure that they weren't like cheating, like figuring out, oh, that front page was from this date and figuring out what happened exactly on that date. So we're pretty sure that they didn't do that. And we're also pretty sure they didn't do that because the first time that we let them loose on it, they didn't do very well. They had a good hit ratio, but they took too much risk. They didn't size things correctly. Now we were using the free versions and this is what six months ago or so. So we were using free versions as of six months ago.

47:28Rational Reminder Hosts:You know, we weren't using Fable. When we then went for the paid versions of three of them, because we couldn't get a paid version of Grok going, the paid versions of Claude, Chachi PT, and Gemini did better than the more free versions. And then when we told the AIs to read our book, The Missing Billionaires, and to think more about sizing, then they did even better. They probably became a little bit overly conservative. But they did a really good job on figuring out whether the markets would go up or down and how strong. I mean, they were smart. It was impressive. But they got the sizing wrong to begin with, which was interesting.

48:03Rational Reminder Hosts:If we probably did it today, they'd probably do better because the non-premium versions are probably much better than the best versions were back then. But it was really interesting to see that generation of AIs play the game and do well, except also struggle with sizing a bit.

48:19Victor Haghani:How much attention do you think normal investors should pay to the news?

48:25Rational Reminder Hosts:In terms of investing, very little. in terms of human experience, in terms of our life as humans. I think it's important to know what's going on in the world to be good citizens and all of that. But I think as an investor, kind of close to zero. I think as an investor, you just don't need to be following the news very much at all. I think that a sensible long-term investing strategy, even if it's a dynamic asset allocation variety just doesn't really need to follow the news very much at all. Very little. I think that as people, though, we have a responsibility to follow it somewhat.

49:05Victor Haghani:Got to be informed to some extent.

49:08Rational Reminder Hosts:Isn't it just amazing, even when we're following the news, just how little we are really seeing of what's going on in the world. I don't even know the last time that I heard about what's happening in Thailand. No idea. Every once in a while, it's like, this happened in South Africa or this happened in India. We get such a narrow version of news and I don't know what we could do about it because there's just so much news. How much of it could we consume anyway?

49:36Victor Haghani:That's an interesting question. Not all of it, probably.

49:39Rational Reminder Hosts:Yeah.

49:40Victor Haghani:How do you choose? How concerning do you think the amount of leverage in the U.S. stock market is currently?

49:47Rational Reminder Hosts:Leverage is something that we built into our model for our who killed the random walk paper, and then we didn't wind up using it at all. We kind of left it out even though we built that in. But leverage certainly exacerbates all of the instabilities that we have. I think that the leverage is concerning, particularly the leverage that we have embedded in leveraged ETFs, which we know have to do systematic trades at the end of every day, where when the market or stock or whatever the thing is based on goes down, they have to sell. And when it goes up, they have to buy. Margin interest is pretty big, but I don't think margin interest is terribly concerning.

50:27Rational Reminder Hosts:It probably helps that Fidelity and Schwab are still charging like, I don't know, 9 % for margin. And so I think that makes it clear to many people that you don't want to be running leverage longs for long. Then we have this absolute explosion in options trading. that is effectively potentially a lot of leverage. When you go back and think about October of 1987, that Black Monday and how the Brady Commission or whatever was like, yeah, you know, this got caused by portfolio insurance and the trades that needed to be done. And, you know, the portfolio insurers need to sell 60 billion of stocks.

51:05Rational Reminder Hosts:And that set the whole thing off. I think that the market can absorb things sometimes and other times it doesn't. I think the leverage is concerning. not massively concerning, but concerning. There's more than meets the eye from just looking at the margin figures. All of a sudden, you hear about something like the situational awareness situation. I never knew about that lever. I had no idea. Who else is out there with leverage and leverage long shorts? Fidelity and Schwab are kind of saying, hey, going back to the leverage long short direct indexing, they're saying, we're a little bit concerned about this.

51:41Rational Reminder Hosts:We don't want too much more of this on our custodial balance sheet or in our custodial system because they're a little bit worried about it. So sometimes the markets can really deal with a certain amount of leverage, but that same amount of leverage sometimes can be problematic.

51:57Victor Haghani:Situational awareness, just for any listeners who don't follow the financial news as closely as we do, was a fund that was highly levered, invested in AI-related stocks, and had a fabulously large downfall or decline in the value of its holdings.

52:11Rational Reminder Hosts:Yeah, I guess not downfall, but decline. Yeah. And it's like a lot of leverage that we didn't know about.

52:16Victor Haghani:I know listeners will have caught on to the comment about the daily resets on leveraged ETFs because we've had some discussion within our podcast community about how from the investor's perspective, daily resets are actually not a terrible thing, even for a long-term investor. But you're talking about the effect, I think, on volatility and asset prices in the market. There is a recent paper looking at the effect of leveraged ETFs on the Korean stock market recently. And they do show that in that case, it's a smaller market, obviously, different environment than the US, but they did significantly increase volatility, which is pretty interesting.

52:52Rational Reminder Hosts:Boy, that Korean market, that's incredible. Yeah. Things spill over. There's all kinds of interrelationships, which is all pretty highly non-linear, all this stuff. We have the butterfly effects where like a small thing can really get things going with these interrelationships.

53:09Victor Haghani:So when does it make sense to borrow to invest in stocks or any other risky assets?

53:14Rational Reminder Hosts:So first of all, the iconic, sensible case for leverage involves young people where they have a lot of human capital, where hopefully a lot of that human capital is not highly related to the stock market. So they have human capital and it doesn't have a super high beta, so to speak. And they don't have much financial capital. And they're like, okay, well, how much stock should I own? They're like, well, I should own 50 % of my total wealth, my financial capital, my human capital in the stock market. And it's like, well, I just have a little bit of financial capital, so I should be leveraged. This makes rational sense.

53:52Rational Reminder Hosts:The problem though with it is that leverage is expensive in general. It's also the leverage is pretty variable in terms of cost. But we talked just a moment ago about Fidelity and Schwab, E-Trade. I don't know. I mean, every brokerage sort of has their own cost of leverage, which tends to be on average really high for offering leverage through brokerage accounts. There are a few places that have lower costs of leverage and also sometimes futures are implicitly giving you leverage at a lower cost than those high costs of 9 % or whatever at Fidelity and Schwab. But it's hard to be an individual investor and to be borrowing at less than 1 % over treasury bills or 1.5 % over treasury bills.

54:37Rational Reminder Hosts:That's the very best that you can do on relatively small size, which is kind of the case of the person who doesn't have much financial capital. That person doesn't have$50 million to have it interactive brokers and get the overnight rate plus 50 basis points. That person is going to be at one and a half percent over the overnight rate. And so now it becomes a question of, well, if the expected return of stocks is just two or three percent higher than the risk-free rate, does it really make sense to borrow paying one and a half percent? Because that one and a half percent is a sure cost. The three percent is a risky expected return.

55:17Rational Reminder Hosts:And we need to kind of haircut that to make it risk adjusted. There just tends to not be a lot of juice there. depends a little bit on the environment. Right now, we're in a low expected return environment. Levering up probably doesn't make sense for most people. It could make some sense for some people, but in general, we'd say it probably isn't worth the complexity, the risk of losing most of your savings. It kind of hurts. You're 27 years old and you saved up a couple hundred thousand dollars and all of a sudden you have$30 ,000 left because you were leveraged doing something sensible, But still, that pain is tough.

55:54Rational Reminder Hosts:And, you know, you need to be monitoring it and keeping the exposure constant and all of that. So in some places, the deleveraging happens automatically. You know, you don't get a chance to make a margin call, you know, to top up or to do it yourself. Net, net, net. We would say that for older people that have a lot of financial capital relative to their human capital, probably it doesn't make sense to leverage. And for younger people, it's more of a borderline call and maybe just keeping things simpler and not doing it makes sense. And just focusing on getting the savings into the market is going to be more comfortable.

56:28Victor Haghani:Spent a lot of time recently reading about leveraged ETFs, like just long leveraged index ETFs. The spreads above the risk free rate are around 50 basis points, which is not crazy. But of course, you're paying the 1 % or whatever it is, or 80 basis point fee to get access to that. it's not really that cheap, but it's maybe better than margin rates at brokerages.

56:50Rational Reminder Hosts:You do have non-REIT. It's certainly better than Fidelity or Schwab, but I mean, it starts to look like going long futures. In the product, it's closer to that.

56:59Victor Haghani:The thing that I realized looking at these over the last couple months is that the live history of the US equity leveraged ETFs has been through a period of time where interest rates were super low and equity returns have been super high. And so people look at these products and they're like, wow, I want to leave her up because look how good the returns are. But if you go back just a little further in time, rates were higher, realized returns were lower. And some of the products that did exist back then in the mutual fund wrapper, they do have slightly higher fees, but still they've underperformed or they've just now broken even with just a regular US equity ETF going back to the 1990s.

57:37Victor Haghani:There's a pretty severe recency bias where the products that people can easily see and access look really, really good, but it's because of a very specific set of factors over that period of time and it's not always going to work out that well.

57:48Rational Reminder Hosts:If you're going to do that you don't want to have any cash sitting around you don't want to have 30 % of your account in cash and then have 70 % in a leveraged DTF which a lot of people can do that but yeah I think leveraged DTF futures some of the low margin cost brokerages all can get you to probably 1 % over risk-free rates but even if expected returns of equities is 2 % over risk-free rates, that doesn't mean you should do it because you have to think about what's the risk-adjusted return at the margin of owning the equities. And in general, that's always going to be lower than the expected return.

58:23Rational Reminder Hosts:The risk-adjusted return is always lower. It can never go the other way because risk is always a cost. It just starts to get really marginal, I think, very quickly. In a different world, a different environment, you know, if CAPE were 15, earnings yield was high and interest rates were low and risk premium was high, it could look a bit different, but there's plenty of risk. If you're close to 100 % in equities, that's a lot of risk. That's another thing I would say is that's just a lot of risk. It doesn't feel like a lot of risk today, but one day you'll wake up and it's going to be a lot of risk.

58:55Rational Reminder Hosts:And it's a lot of return. If markets keep going up and you had 100 % in equities, you'll do really well.

59:01Victor Haghani:The human capital argument for young people is also really interesting because it makes sense like the Merton share argument for leverage makes sense for a young person. But then you start thinking about what does the human capital, the young person actually look like? Is it really bond-like for someone entering the workforce? I don't know that it is.

59:18Rational Reminder Hosts:I don't think anything is totally bond-like. There's always going to be some beta in there. A lot of times, you know, the person that's thinking about leverage is the person who has high beta human capital too. It's the person working in tech, the person that's got a trading job, you know, in Wall Street or something. So many of the people are people with high beta human capital. You also have all the people that are kind of just doing it for a living, influencers and so on that are out there. And it's not totally clear what their human capital is deriving from other than things that are pretty economy sensitive.

59:53Victor Haghani:There's the beta for sure, but then there's also the tails. Like you look at software developers right now, there's just a lot of folks who I think are realizing their human capital was a lot riskier than they maybe thought it was just because of what AI is doing to that profession. So you've got a new book that you mentioned early on in this conversation, Get Rich Once and Other Financial Wisdom for Our Younger Selves. So to finish off our conversation here, what financial wisdom would you give to your younger self?

1:00:20Rational Reminder Hosts:Oh, I'm embarrassed to say this, but I would say read a book like this. Do something proactive to make a plan and to really think about your finances. And I say that it sounds so obvious in a way, but I can tell you that when I started in Wall Street in 1984, I went for a really long time without thinking about my personal financial situation. I was busy. I was doing well. I was dating. And I just didn't do it. And I had learned this stuff in university. You know, I studied finance and university, but there was like some kind of disconnect between leaving university, working in Wall Street, where I just didn't think about this stuff.

1:01:03Rational Reminder Hosts:And so I would say, whether you read our book, there's so many ways today to make yourself really financially literate and to give yourself enough financial sophistication so that you can make a plan, you can make a lifetime plan, you can get your financial affairs in order. And you can do all of that in the time it takes to watch one season of your favorite Netflix series. In 10 hours, you can just really have your whole situation sorted out. This is how much I really need to save. I'm doing the best with my 401k match or whatever we have in Canada. All of these things, they are simple, but it just takes some time.

1:01:43Rational Reminder Hosts:We should all be doing that. And besides our book, there's so many other, our forthcoming book, there's so much other resources out there for people to use to get there. There's parents, there's other elders, there's other colleagues, there's other friends. It's just a question of being intentional and devoting that time to it because it's amazing how many of us didn't do it and how many people are not doing it today.

1:02:06Victor Haghani:You said you were embarrassed to reference your own book as the resource. I don't know, man. I was doing an interview for a newspaper recently and they asked me the same question and I thought about it and I was like, you know what? They should listen to this podcast. Absolutely. If you're producing good information, you should tell people to consume it. It's not an embarrassing thing.

1:02:23Rational Reminder Hosts:So many of my friends are huge fans of your podcast. Absolutely. It's a great way for people to get educated and there's great stuff out there. It's just being intentional about going after it and doing the right thing.

1:02:36Victor Haghani:It matters. We hear, and it's not just our podcast, like you said, there's lots of good stuff out there, but we hear from people who they'll email Cameron and I, and they'll say, like you changed my life. You completely changed the course of my life just by having good information and they're making financial decisions more confidently now. And it's like, it matters, but the resources are out there. You just have to dedicate the time to consuming them.

1:02:56Rational Reminder Hosts:Super rewarding for all of us, for sure.

1:02:59Victor Haghani:A hundred percent. Well, that's a good place to finish, Victor. We really appreciate you coming back on the podcast. This is a great conversation.

1:03:05Rational Reminder Hosts:Thank you both very much. Hope to see you guys in person before long too.

1:03:08Victor Haghani:Definitely. That'd be nice. Thanks, Victor. Thanks guys.

1:03:15Victor Haghani:That was something. Yeah. Trying to think like, how do you encapsulate the conversation? I wrote down a line and he basically off mic said the exact same thing, which is there's so much to talk about in a market portfolio environment. Yeah. And it's true. Yeah, it is true. We covered so much ground. I love talking about super nerdy stuff. You were messaging me as we were going about how their nerds are getting their fill and they were, but the whole conversation about direct indexing, super interesting. his paper on who killed the random walk also fascinating just thinking about where the different market anomalies come from and where the different return premiums come from that we see in the market and kind of thinking about who is responsible for that what's going on at the investor level is causing the anomalies that we see their little study they did on whether you can predict returns from tomorrow's news super interesting like that's such a cool experiment to run i mean tomorrow's news today i had no idea they've been done that many times but that was pretty amazing.

1:04:14Victor Haghani:And even AI couldn't really take advantage of it. I love the discussion on leverage. That's something I've been looking at quite a bit recently. And I think Victor's thoughts are so good. He applies that just the Merton share thinking so well to so many of these topics. I'm glad that we talk a little bit about what the Merton share is and what it means and why investors should care about it during the conversation. So Victor, we mentioned the introduction. He is the founder of Elm Wealth. They've also got an ETF out through their firm that's doing position sizing based on merchant share thinking.

1:04:45Victor Haghani:So they're using expected returns and volatilities over time to change the allocation between equities and fixed income, which is kind of neat. But they've also got a wealth practice as I understand it. And Victor was one of the founding partners of Long-Term Capital Management, which is a very academic hedge fund. a bunch of academics were involved that collapsed in 1998 quite spectacularly. To say the least. To say the least, yeah. We talked in our last episode, episode 270 with Victor about kind of that experience and how it shaped his thinking in the rest of his career after that event. But I remember the first time Victor reached out to us, I knew him as a character in that story about long-term capital management.

1:05:29Victor Haghani:So he was in the book. Yeah. So I was blown away when he reached out, but he's very thoughtful. It's neat to see him doing research that's getting into some journals. Great thoughts from him on all those topics. Good guy and great communicator. So it's really nice to have him on. Yep. Anything else? No, I think that's good. Thanks everybody for listening, of course. Yep. I hope everybody enjoyed the episode.

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