How to Build the Perfect Portfolio - Part 1 of 2

0:00Tyler Gardner:Every dollar in fees is a dollar that doesn't compound. And over 30 years, the difference between a 1 % expense ratio or management fee and a 0.3 % expense ratio and lack of management fee is not trivial. It is, in most cases, the difference between a comfortable retirement and a stressful one. Hello friends, this is Tyler Gardner welcoming you to another episode of your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing. So let's get started and get you one step closer to where you need to be.

0:48quick note before we dive in august pre-order incentive for my book real wealth is now live and this one is my favorite so far pre-order this month tell me you did at tylergardner.com book and i will send you a draft chapter of a new book that i'm already working on and no not even my editor at norton has seen this writing yet this sneak peek is yours to keep delivered to your inbox in early September. Pre-order today, and you're locked in for every monthly incentive through December 1st. Tylergardner.com slash book. Now let's get into it. Welcome back, my friends.

1:24Tyler Gardner:I am more excited than I probably should be about the next two episodes in a wonderfully, unabashedly, financially nerdy kind of way, and I'm not going to apologize for it. Many of you know I started this whole endeavor a few years back simply by walking through the woods and making short videos about investing, saving, spending, and the psychology behind all of it. But predating that by about two decades, I had been kind of obsessed with a question I think all of us are asking in some form. How do I build the perfect portfolio for me? Does it even exist? Is it universal? Is it something you set up once and then walk away from?

2:04Good news and bad news. The answer to all of the above is yes and no, and it depends on who you are, and it ultimately

2:14Tyler Gardner:depends on who you ask. Over the next two episodes, I'm going to try my best to step back from my own views, which at this point should be fairly clear to anyone who has spent more than 15 minutes with this show, and let 10 of the greatest financial minds ever to think seriously about this question take center stage. And here's what I promise. This is not a pitch. There will be no proprietary products, no funds, no advisor relationships, no subscriptions. What I'm going to do is take the actual academic research, the work of 10 people who spent their careers trying to solve this perfect portfolio problem rigorously and translate it into language that you can absorb on a Monday morning before you finished your first cup of coffee and have absolutely no interest in hearing the words beta, price-to-book ratio, or sector rotation.

3:09Tyler Gardner:Now, the research behind these two episodes comes from a book called In Pursuit of the Perfect Portfolio by Professor Andrew Lowe of MIT and Professor Stephen Forrester of Ivy Business School at Western University. I want to give them full credit up front because this work is outstanding and it deserves to be known. And I want to say something about Andrew Lowe specifically because he's one of the reasons I fell in love with finance as a discipline in the first place. He's put some of his introductory finance lectures online for free, genuinely free from MIT. And if you're curious about finance as an academic subject rather than just a practical one.

3:53Tyler Gardner:He is an extraordinary teacher, and I would encourage you to find them. The book itself, fair warning, is not exactly a beginner text. It reads like what it is, serious academic work by serious academic people. So if you're not familiar with the language and math of finance, it's going to be a little bit of a workout. But if you are up for that challenge, it is one of the best books on investing I've ever encountered, and it offers a ton of great takeaways. So you can read it, or you can trust that I'm here as always to offer you some takeaways from some dense texts so you don't have to read them.

4:29Tyler Gardner:But I encourage you to read it and support that type of work. What I am going to do in these two episodes is I'm going to take the key ideas from 10 of the thinkers that Lowe and Forrester profile, explain what each one believed about building the perfect portfolio, and then and this is the part that I care most about, try to bring it all together at the end of episode two into something you can actually use starting right now. I don't ever want to create something that is purely theoretical, and I always want to provide some simple and actionable takeaways. And here's what I find remarkable about the project of creating the perfect portfolio.

5:11Tyler Gardner:These are 10 of the most rigorous, most credentialed, most intellectually serious people who have ever thought about this problem. And surprise, none of them are trying to sell you their services for two and 20. So if nothing else, you can trust that these thinkers wanted, by and large, what was best for you, the retail investor. Before we get into it, familiar ask if you found the show useful in any way. If you've shared it with a friend who needs to hear the message of low-cost investing, a review on Apple or Spotify genuinely helps. It helps new listeners find the show, and it lets me know I am not just talking into a microphone in the woods of Vermont with nobody listening but a sleeping bloodhound.

5:54Tyler Gardner:It takes 30 seconds. I would be, and already am, grateful. All right, let's build the perfect portfolio. Thinker number one, Harry Markowitz. If this were a movie, and honestly it should be so someone call Scorsese, Harry Markowitz would be the origin story. Markowitz is the father of modern portfolio theory, which he developed in 1952 in a paper so foundational that it's difficult to overstate its importance. Before Markowitz, investing was largely intuitive. You found good companies, you bought their stock, and then you hoped. Markowitz came along and said, that's not wrong exactly, but you're missing something fundamental about how risk actually works.

6:44Tyler Gardner:Here's the key insight, and I want you to hold on to this because everything else in these two episodes builds on it. What matters for a portfolio of stocks is not just how risky each individual stock is. What matters is how they move relative to each other. This is called, as we've gone over together in a few episodes, correlation. If you own two stocks and they both go up and down at exactly the same time in exactly the same proportion, you have not diversified anything. You have just bought the same risk twice. But if you own two stocks that tend to move differently, one goes up when the other goes down, or at least they don't move in perfect lockstep, then the combined portfolio is actually less risky than either stock alone without necessarily sacrificing return.

7:42Tyler Gardner:This is the magic trick of diversification, and Markowitz formalized it mathematically. He showed that risk can be reduced without sacrificing expected return simply by holding a portfolio of assets that aren't perfectly correlated. Now, what does that mean practically? It means you don't need to spend enormous amounts of time obsessing over individual stocks. You need to be, and I love this framing, just close to getting it right. The exact composition of your portfolio matters less than the basic structure of it. Are you diversified across assets that don't move in lockstep? If so, great, you're most of the way there already.

8:27Tyler Gardner:Now, Markowitz also said something that I think gets underappreciated. You also need a very honest understanding of your own risk tolerance. Not what you think your risk tolerance is when the market's going up, what it actually is when you open your brokerage account in October 2008 and the number on the screen has lost 30 % of its value. That is the risk tolerance that matters, and most people discover it for the first time at the worst possible moment. Now, what did the perfect portfolio consist of for Markowitz? Well, he endorsed ETFs for equities and individual bonds for fixed income. He also believed in placing some constraints on how much weight you ever gave to any particular industry.

9:12Tyler Gardner:So you probably don't want 60 % of your portfolio in one sector, regardless of how good you feel about it right now. One more thing Markowitz said that I think is genuinely wise and that gets lost in the noise, your perfect portfolio should always evolve. As your life changes, as you update your beliefs about what's coming, what you need, what matters to you, your portfolio should update too. It is not a set it and forget it exercise. What you want at 30 is not going to be what you want and need at 60. It is a living document. And never forget about taxes. Markowitz was emphatic about this. Any analysis of your portfolio should be done on an after-tax basis.

9:59Tyler Gardner:The number that matters is not what you made, it is what you kept. Finally, and this is my favorite thing Markowitz ever said, the perfect portfolio is not just about investing, It is about all of your decision making, which is, if you think about it, what we've been trying to explore together on this podcast for now the past year and a half. This episode is brought to you by Copilot Money. Here's a test I apply to everything I download on my phone. Not is it good, but is it still on my phone in six months? And almost nothing passes. I have a graveyard of apps I downloaded with real enthusiasm and abandoned in 11 days.

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13:16Tyler Gardner:That's calderalab.com slash Tyler. Thinker number two, Bill Sharp. If Markowitz is the origin story, Bill Sharp is the guy who showed up in the second act and made it all just a little more elegant. Sharp developed the capital asset pricing model, called CAPM in finance circles, yet he himself always called it the CAPM model. So you do what works for you, but he called it the CAPM model. This is one of those frameworks that sounds super intimidating until someone just explains it clearly, at which point it also kind of seems obvious in retrospect. CAPM essentially says the expected return of any investment is related to its risk relative to the overall market.

14:09Tyler Gardner:So if you take on more risk than the market, you should expect more return, or you'd be a ding dong to have taken on more risk. If you take on less risk than the market, you should expect less of a return. The implication for portfolio construction is pretty powerful. You should invest in some combination of a riskless asset, something that won't lose value, and the market portfolio, which is essentially everything. For the riskless asset, Sharpe recommends TIPS, Treasury Inflation Protected Securities, which are U.S. government bonds whose principle adjusts automatically with inflation, so you're protected against the purchasing power erosion that erodes so many fixed-income investors.

14:56Tyler Gardner:For the risky asset, low-cost index funds or ETFs tracking the broad market. Sharpe's recommendation on the equity side is U.S. and international stocks, and on the bond side, U.S. and international bonds, which is essentially what a modern target date fund does. He also added one nuance worth noting, currency hedged global funds, which protect you from the additional volatility that comes from owning foreign assets in foreign currencies. And Sharp is, perhaps above all, a devoted advocate of low-cost investing. He has written extensively about what he calls the arithmetic of active management, the unavoidable mathematical reality that before costs, the average active investor must match the market because they collectively are the market.

15:51Tyler Gardner:After costs, the average active investor must underperform it. Note, that's not his opinion. It's basic math. Sharp also offered two pieces of personal financial advice that I appreciate so much for their simplicity. First, do your homework on your own longevity. I joke about this sometimes in my short-form content when I'm talking about when to take Social Security, but this is a serious thing that most people miss. I want you to figure out, even if it's a complete guesstimate, how long you think you might live. There are actuarial websites that will give you a pretty solid number, based on your health and your family history, about when you might die.

16:32Tyler Gardner:I know we don't want to think about it, but it sharp points out, and as I'll second, you should think about it. Second, be prepared to make some sacrifices for long-term financial stability, which is another way of saying spend less than you make and invest the difference. Unglamorous, but it works. Thinker number three, Gene Fama. Gene Fama is the father of the efficient market hypothesis, which is either the most important idea investing or the most controversial depending on who you ask and what year it happens to be. The core claim of the efficient market hypothesis is that markets price all available information into asset prices essentially immediately, which means that at any given moment, stocks are fairly priced given what is currently known, which means that consistently beating the market through stock selection is, at best extremely difficult, and at worst impossible.

17:32Tyler Gardner:This is, as you might imagine, not the most popular idea among active fund managers. But Fama's contribution to portfolio construction goes beyond just the market is efficient. He and his colleague Ken French developed what is known as the three-factor model, which expanded on Sharpe's CAPM to identify additional sources of expected return beyond just market risk. Specifically, small cap stocks have historically outperformed large cap stocks. Value stocks, companies with low prices relative to their book value, their earnings, or their assets, have historically outperformed growth stocks. And companies with high profitability have historically outperformed less profitable ones.

18:21Tyler Gardner:I know, surprise on that third one. Now, Fama is careful about how he frames this. He doesn't say small cap and value will always outperform. He says they have historically been compensated with higher expected returns, which he interprets as compensation for additional risk. No free lunch. His practical advice? Start with the market portfolio as your foundation. In other words, a total stock market fund than if you want to tilt towards small cap and value companies. But make sure that any tilt is itself broadly diversified because, as he says, you can never be too diversified. Risk exposure is your personal choice.

19:09Tyler Gardner:Just be honest about what you're choosing and why. Two more things Fama said that I think are critical. First, you can only achieve higher expected return with more risk. There's no magic combination of assets that delivers extra return without extra risk. If someone is telling you otherwise, run for the hills. Second, and this one is worth printing out and just hanging on your wall, be extremely careful about making decisions based on past performance. Past performance can be very noisy, even over five-year periods. A fund that has beaten the market for five years may have done so by luck, by a style that happened to be in favor, or both.

19:51Tyler Gardner:Past performance is not evidence of skill at the level of rigor required to make it a reliable basis for investment decisions. Thinker number four, Jack Bogle. I want to pause here and say something about Bogle that I mean sincerely. This man changed the financial lives of tens of millions of people who will never know his name. Bogle founded Vanguard in 1975 and created the first index fund available to individual investors. The idea was simple and at the time considered slightly insane. Instead of trying to beat the market, why don't you just own the market at the lowest possible cost? Let compounding do the work and get out of the way.

20:39Tyler Gardner:The financial industry, which makes its living charging fees for the attempt to beat the market, was not enthusiastic about this idea. Bogle's first fund was mocked as Bogle's folly, and it raised dramatically less than expected at launch. 50 years later, index funds hold more assets than actively managed funds for the first time in history, Bogle won. His framework for investing rested on four elements, risk, time, time, cost, and reward. And of these four, cost is the one he returned to most obsessively. His cost matters hypothesis developed in 2004 is deceptively simple. In investing, you get what you don't pay for.

21:26Tyler Gardner:Every dollar in fees is a dollar that doesn't compound. And over 30 years, the difference between a 1 % expense ratio or management fee and a 0.3 % expense ratio and lack of management fee is not trivial. It is, in most cases, the difference between a comfortable retirement and a stressful one. Here are a few Bogle positions worth noting, some of which I agree with, one of which I don't. He believed asset allocation should shift over time as you age, specifically that your bond allocation should roughly approximate your age. If you're 60, hold 60 % bonds. I don't follow this framework. I think it's too conservative for most people given longer lifespans and the return profile of bonds.

22:15Tyler Gardner:But Bogle is Bogle and founded Vanguard, and I'm a guy who walks through the woods, so take that disagreement for what it's worth. He also said, don't stress about rebalancing and certainly don't do it more than once a year. He said, focus less on the total value of your assets and more on the monthly income they can generate, which is a genuinely useful reframe for people approaching retirement. On international exposure, and this is a fun fact, the famous three-fund Boglehead portfolio, US stocks, stocks, international stocks, and bonds is not actually what Bogle endorsed or recommended. Bogle himself believed you only needed to hold two funds, U.S.

23:02Tyler Gardner:stocks and bonds, and he thought that U.S. companies were sufficiently multinational that you didn't need explicit international exposure. The three-fund structure was developed by Taylor Larimore, a founding member of the Boglehead community in 1999. Bogle's disciple improved on Bogle, or just deviated from Bogle, depending on what you believe. Personally, I'm just a US guy myself, but that's just me. And one more surprising fun fact about Bogle, he actually believed in holding a small slice of emerging markets and gold, which, if you know anything about Bogle's reputation for simplicity, is a mildly shocking thing to discover.

23:42Tyler Gardner:But his ultimate position, the perfect portfolio shouldn't be complicated. Buy, hold, keep costs low, ignore short-term noise, and let time do the work. Everything else is noise dressed up as insight. Couldn't agree more with that last one. This episode is brought to you by Delete Me. I have a rule on recurring charges. If I can't remember signing up, I'm not paying. 11 cancellations later, and 3 survived. Number 3, a password manager. Three bucks a month. The humbling part wasn't the price. It was how many accounts leaned on one password that I invented back in high school. Two, my library card.

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26:58Tyler Gardner:Thinker number five, Myron Scholz. And now we get to the most interesting thinker in part one, I think. The one who's going to now push back on everything you just heard, kind of. Myron Scholz won the Nobel Prize in Economics in 1997 for his work on options pricing, specifically the Black-Scholes model, which is one of the foundational equations and modern finance. He also, notably, was a principal at long-term capital management, a hedge fund that collapsed spectacularly in 1998 in a way that nearly took the global financial system with it. I mention this not to diminish his brilliance, the man is a genuine genius, but because I think it is a relevant context for his views on risk management.

27:48Tyler Gardner:because Scholz, more than anyone else that we've talked about, is actually focused on what can go wrong through just passive investing. Where Markowitz, Sharp, Fama, and Bogle are essentially saying some version of own the market, keep costs low, stay out of the way, Scholz is saying, well, what happens when the market doesn't go as planned? What happens when there's something catastrophic, and are we really telling people not to react when things do go south? He calls these tail risks, the rare but severe downturns, 2000-2008, that can devastate a portfolio at exactly the wrong moment. The years you cannot afford to lose 30 or 40 percent because you're retired or close to it or have a specific financial need that doesn't care about your long-term investment horizon.