How to Build the Perfect Portfolio - Part 2 of 2

0:00The single most reliable destroyer of long-term investment returns is not market volatility. It is the investor's response to market volatility. People who did best in 08 were the ones who did nothing. The people who did best in 2020 were the ones who did nothing. The people who will do best in the next downturn, whenever it comes, whatever causes it. And I guarantee very little, but the people who will do best will be the ones who built a portfolio they understand, at a risk level they can tolerate, and then left it alone. 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.

0:51So let's get started and get you one step closer to where you need to be. quick note before we start september's pre-order bonus for my book real wealth is something i've wanted myself for years and never been able to find so i created it it's called the real wealth money calendar 12 months five action items per month all on one page because most people i know already know what to do they just don't necessarily know when and they don't have accountability so this is your 2027 on one page, 60 moves in the month you actually need to make them. Pre-order real wealth at tylergardner.com book. Let me know you did and your money calendar will be in your inbox in early October.

1:37Welcome back, my friends. If you're joining us for the first time, I would strongly encourage you to go back and listen to part one from last week before continuing, because what we're building on here is cumulative. And if you didn't catch last week's episode, that's okay. This is part two of how to build the perfect portfolio. And when I say perfect, I don't necessarily mean for you. I mean, according to 10 of the world's greatest academic and finance minds ever to write and think about such a topic. The research for these two episodes was largely sourced from Professor Andrew Lowe and Professor Stephen Forrester's book, In Pursuit of the Perfect Portfolio.

2:20And as I mentioned last week, if you're a finance nerd like me and you want to do a deep dive into some intro to finance, you can find Professor Lowe's intro to finance videos online completely for free as he's open sourced some of his introductory finance courses. And he's one of the first people who got me truly excited to go into finance and portfolio management. So if today's episode resonates, I'd highly encourage you to check him out because I'm merely as always passing knowledge and research down the line. Now, what's amazing about looking at 10 of these thinkers over two episodes is each thinker is going to add another layer to our thinking.

3:01And the goal by the end of today's episode is going to be to leave you with something genuinely useful, a framework built on the best thinking in the history of investing, translated hopefully into a language that doesn't require a PhD to understand. And for those of you who are with me in part one, welcome back. For those of you who are not, here's a quick recap. In part one, we covered five thinkers. Markowitz gave us the mathematical foundation of diversification. What matters, he said, is how assets move relative to each other, not just how risky they are individually. Sharp told us to combine a riskless asset with the market portfolio and keep costs low.

3:50Fama said markets are efficient and tilt towards small cap and value if you want, but never forget you can only get more return by taking on more risk. Bogle operationalized all of it with the index fund and reminded us that cost is the one variable we can actually control. And Scholz pushed back on all of them, not to say they're wrong, but to say, hey guys, have you thought carefully about what happens when everything goes wrong in an index fund at once? Today, we cover five more of the world's greatest financial minds. And then, and this is the part I have been looking forward to, we're going to pull all 10 together into the five things they mostly agree on that you can take home and actually use starting today.

4:42Before we get into it, Familiar Ask, if you haven't left a review on Apple or Spotify, I would genuinely appreciate it. It helps new listeners find the show, and it tells me the microphone in the Vermont woods is pointed at something other than my dog who's been asleep since roughly the second paragraph of episode one. Let's get in to part two of how to build the perfect portfolio. Thinker number six, Bob Merton. Bob Merton is, intellectually speaking, one of the most formidable people on this list. He shared the Nobel Prize in Economics with Myron Scholz in 1997 for his work on options pricing.

5:22He has spent decades at the intersection of financial theory and institutional practice. And he has thought more carefully than almost anyone about the question that actually matters to most people listening to this podcast right now. Not how do I maximize returns, but how do I make sure I don't run out of money before I run out of life? Like Markowitz, Merton believes you should try to maximize returns for a given level of risk. But Merton expands the definition of risk considerably. It's not just stock market volatility. There are many more risks than that. Inflation risk, your own longevity risk, the risk of a medical emergency, the risk of outliving your savings, and all of these can be reduced in different ways through diversification and careful planning.

6:18Here's the center of Merton's thinking, and I find it both beautiful and practical. Your perfect portfolio in an ideal world is ultimately your own risk-free asset, not the market, not a diversified fund, something specifically calibrated to meet your specific needs indefinitely with zero risk attached. Now, that's his optimal end state. And if you can accumulate enough savings so you could convert the entire thing into something like an annuity that covers your needs for the rest of your life, that would be awesome. It would be a guaranteed income stream that you cannot outlive, that covers your actual expenses, that renders the question of market volatility essentially irrelevant.

7:09At that point, you have won, says Merton. The game's over. You don't need to take any more risk. But, and I know you know this, this is where Merton gets practical. Most of us are not going to get there entirely on our own. If it looks like your savings won't be sufficient to generate the income you need, that's when you need to invest some of those savings in riskier assets to try to close that gap. Not because risk is good, but because the risk of not having enough is worse than the risk of market volatility. Merton shares a car analogy with us that he loves, and I like it too. You want to get from point A to point B.

7:51That's the goal. You don't need to know what's under the hood. You don't need to understand the engineering. You just need to arrive in whatever vehicle gets you there without breaking down. So for the purely practical-minded, Merton's actual product at Dimensional Fund Advisors consisted of a global stock index and two TIPS bond portfolios with intermediate and long durations, which, and I want you to notice this, is essentially identical to what Bill Sharp was recommending in Part 1. They used different intellectual frameworks to get there, but they arrived at the same practical destination.

8:31The one thing I'll say honestly, Merton spent years at Dimensional Fund Advisors, which is a professional investment management firm. So when he says that most people need professionals to manage this for them and that the annuity is the ideal product, I'm not saying either of those statements is wrong, and I think he's genuinely right for some people, but I also think many people listening to this podcast can manage a two or three fund portfolio on their own without paying anyone to do it. The glide path and target date fund approaches that we've talked about in different episodes and that he endorses are excellent.

9:11And Vanguard, Fidelity, Schwab offer these things at very low cost without requiring an advisor relationship. As always, Merton concludes, don't stress about whether your portfolio is 70-30 or 65-35. The only question that actually matters is whether the portfolio can sustain your desired income for as long as you need it to. And if it can't, then take on the appropriate amount of risk to get you there, but no more. This episode is brought to you by Anthropic. The best business advice I ever got was to fire myself. Stop being the entrepreneur and start being the CEO, which sounded great until I realized I had my hand in everything and had for years, and couldn't tell you why.

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11:23If you're currently looking for a financial planner, there are three things a percentage-based financial advisor is hoping you never think about. One, it's not necessarily harder to manage more money, yet these advisors will often charge you more just because you have more. Same asset allocation plan, same phone calls asking how the kids are doing, and yet the fee continues to grow. Number two, and that line they feed you, the we do better when you do better, sounds great until you realize that the fastest way for them to do better might be to put you in riskier assets than you wanted or needed.

11:53And number three, and notice how they may never tell you the fee in actual dollars, only the percentage. Because once it's not in dollars anymore, it doesn't feel like dollars anymore. Facet works differently. One flat annual membership fee based on the services you need. No percentage, no commissions, just a dedicated team of CFP professionals who help you figure out what you want your money to say about your life. Head to facet.com slash Tyler to book your intro call, and you'll still have time to make it to Bed Bath and beyond. I'm not a member of Facet. I have an incentive to endorse Facet as I have an ongoing fee-based contract for cash compensation, as well as a percentage of equity in Facet based on this endorsement.

12:30Facet is an SEC-registered investment advisor. All opinions are my own and not a guarantee of a similar outcome. Thinker number seven, Marty Leibowitz. Marty Leibowitz spent decades at Pimco and Morgan Stanley and is one of the most respected fixed income investors alive. His contribution to this conversation is less about what to own and more about how to think, which is why I love that he's on this list. Specifically, how to think about risk in a way that is honest about who you actually are. He starts with a question that's going to sound overly simplified, but it isn't even remotely simple.

13:12How much risk can you actually take on? Not how much risk you think you can bear, not how much risk you'd like to bear in theory, and certainly not how much risk you said you could bear when your last advisor handed you a 20-question survey that asked how you'd respond to market downturns, and you proceeded to fill it out from the comfort of your living room on a Sunday morning while sitting in pajamas watching bananas in pajamas with your kids. See, the problem with pronouncing a pajamas is that show's name doesn't work as well. Anyway, this is a judgment-free zone and always will be. Leibowitz wants you to figure out how much risk you can actually absorb without making a decision you will regret.

13:54Panic selling, abandoning your strategy, or permanently impairing your financial situation. In my own book, I start with how to practically invest a thousand dollars and this is what we learn at the$1 ,000 level. Again, not theoretically, but once you actually have skin in the game. And at the$1 ,000 level, we can learn these lessons far more cheaply than we can at the million-dollar level, but it is crucial that you do this with a couple dollars invested to learn how you actually react. Leibowitz frames this in a really helpful way. He wants you to think like a pension fund manager. Specifically, he introduces the concept of the funding ratio, the relationship between what you currently have, the assets you've accumulated, the income they could generate, and what you'll eventually need, the present value of your future financial obligations.

14:49If your funding ratio is high, meaning if you have significantly more than you need, you can afford to take more risk because you have a cushion and a bad year doesn't change your outcome. Conversely, if your funding ratio is low, if you're closer to the edge of what you need, you cannot afford to take as much risk because a significant loss could be genuinely damaging rather than merely uncomfortable. Now, as you might have picked up, there's something in this framework that we need to explore further, and Leibovitz is honest about it. This is one of the mechanisms by which wealth compounds and the rich simply can get richer.

15:29If you have more, you can take more risk. More risk historically means more return. More return means you have even more. The wealthy do in fact get wealthier partly because they can absorb volatility that would devastate someone with fewer resources. This is not a moral observation, it is a structural one. Leibowitz also explores the CAPE ratio here that you may or may not have heard about over the past few years in the endless news cycle that the sky is, as per usual, falling. CAPE is the cyclically adjusted price-to-earnings ratio. Developed by Robert Schiller, who we're going to meet next, CAPE takes the price of the overall stock market and divides it by the average corporate earnings of the past 10 years adjusted for inflation.

16:19When CAPE is high relative to historical averages, as it has been in recent years, it has historically suggested that future returns will be lower, as in things will, as any basic statistics class will tell you, revert to the mean. Note, this doesn't mean, however, that the market will crash tomorrow, just that the expected return over the next decade is likely to be below average. Leibowitz, like Merton, argues that just because you can take on more risk doesn't mean you should, especially when assets are historically expensive. His final points, if you already have enough to cover what you need, you should be in safer assets.

17:04Period. The game is not to maximize return. The game is to not lose what you've already won. Additionally, you need to go beyond market returns and consider taxes, estate planning, and life events as they affect your portfolio. Do not ignore inflation and have a contingency plan for how you will deal with a serious adverse event, because at some point, you will. Thinker number eight, Bob Schiller. Schiller won the Nobel Prize in Economics in 2013, And if you've ever heard the phrase we just used, the CAPE ratio, or cyclically adjusted price to earnings, that is Schiller's. He is one of the most interesting figures in modern economics precisely because he sits at the intersection of finance and psychology, a behavioral economist who takes seriously the idea that markets are moved not just by information and incentives, but by stories, stories, emotions, and collective delusion.

18:10For the record, as some of you always like knowing where I stand on these things, I couldn't agree with Schiller more. If you think that data is all that drives us to do what we do, take a basic course on Schiller and behavioral economics and call me in the morning. To me, the market has always been mostly a reflection of our current state of greed or fear. Period. period. Schiller's view of the perfect portfolio begins with a principle that will sound familiar by now, diversify broadly, but not just across asset classes, also internationally. He does endorse an international holding because no one, and Schiller means no one, including himself, can reliably predict how any one country's stock market or any one asset class is going to perform.

19:03Humility about prediction is the foundation of Schiller's perfect portfolio construction. His starting point is U.S. stocks, but he places heavier than typical weight in stocks from around the world where CAPE ratios are relatively low historically, meaning international markets where stocks appear cheap relative to their own earnings history over the past decade. This is where Schiller gets distinctive. He is explicitly using his own valuation framework to make allocation decisions. He is, in the technical sense, a market timer. He believes that buying cheap assets and selling expensive ones is a rational strategy if you're patient enough and diversified enough to execute it, and if you're basing your valuation on a 10-year average of price-to-earnings of the overall market, and not just on whether the stock was higher or lower last night.

20:02He also recommends bonds, specifically tips, and, as should be clear, his enthusiasm for inflation protection is consistent across every thinker we've explored so far. He also would add commodities, which have lower correlation with stocks and therefore add genuine diversification. One of Schiller's most interesting practical recommendations is to avoid investing in stocks in the industry in which you are employed. And this actually applies to a lot of you and the conversations I've had with you over the years in regards to how much you all are willing to take on in your own company's stock options without treating it like another portfolio holding.

20:46The reason Schiller cautions against owning too much in your own industry or job is subtle but pretty crucial. If you work in tech, and you also own a lot of tech stocks, you now have a double exposure to tech risk. If the sector struggles, you might lose your job at the same moment your investments are declining. You don't, Schiller suggests, need to compound your professional risk with your financial risk. He takes this so far as to suggest that someone heavily exposed to a particular industry might even consider a short position in that industry, essentially a bet that it will decline, as a hedge against your professional exposure.

21:31Now, that's a sophisticated strategy, and it's not right for everyone, but his underlying logic is sound. Schiller is fundamentally an optimist about the power of diversification and a skeptic about the predictability of any single market or asset class. His framework asks you to be humble, patient, and globally minded, and to pay attention to whether what you're buying is historically cheap or historically expensive. This episode is brought to you by Bilt. You've heard me talk about Bilt as the loyalty program that lets you earn points on rent wherever you live, and they just leveled up even more.

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24:16I also just got back from a weekend with college friends where I brought a box of Element. And by the end of the weekend, it was doing three separate jobs, getting everyone upright in the morning, putting us back together after disc golf and swimming, and standing in for coffee at four in the afternoon. I came home with an empty box and 11 new text threads asking where they can get it. Head to drinkelement.com slash Tyler, become an Element Insider, and you'll get four boxes for the price of three. That's drinkelement.com slash Tyler. And for the record, even though I love the iced tea, it does nothing to diminish my feelings about mango chili and watermelon salt.

24:52Thinker number nine, Charlie Ellis. Charlie Ellis is the author of Winning the Loser's Game, which is one of the most important books ever written about investing and which I recommend without reservation to anyone who asks me for a single book on the subject. The central metaphor of Ellis's work is this. Professional tennis is a winner's game. Points are won by great shots. Amateur tennis is a loser's game. Points are lost by mistakes. So if you want to win at amateur tennis, the strategy is not actually to hit great shots. The strategy is to hit the ball back, keep it in play, and wait for your opponent to make an error.

25:39And as a very brutally mediocre pickleball player, I can assure you I have won way more games than I should using this exact strategy. Investing, Ellis argues, is a loser's game for individuals. The way to win is not to make brilliant moves. It is to avoid mistakes, hit the ball back over the net, by keeping costs low, staying diversified, and resisting the temptation to act on emotion and just let time do the work. His recommendation, index funds, especially if you want a good chance of being in the top 20 % of investment outcomes over the next 20 years. He goes slightly further than Bogle on the international side, recommending different types of index funds, including low-cost international funds that are benchmarked to the MSCI EIF, which stands for Europe, Australasia, and Far East, and is essentially the major developed market stock index outside the US.

26:42So if you currently own a total international stock index fund, you most likely own the EIF. Ellis is also equally emphatic about costs. Any turnover in an actively managed fund in a taxable account creates tax liabilities. So every unnecessary transaction is a leak in the bucket. So it is your job to minimize those leaks. And if you have an overly active advisor who trades your account daily, you might want to give them a call today and say that Charlie Ellis sent you. But perhaps the most important thing Ellis says, and I want to dwell on this because I think it is genuinely profound, is that the most important aspect of creating your perfect portfolio is that it should depend entirely on who you are.

27:30I know that sounds incredibly obvious, but I can tell you directly from the amount of people who message me and ask how I invest as if that will somehow tell you how you should invest, that blows my mind. I have a million variables acting on my life that you don't. Your age, your dependence, your knowledge, your income, your spending habits, your existing assets, your emotional relationship with risk, your access to information, your core values about what money even means in the first place. The punchline here is that there is no universal perfect portfolio. There's only your perfect portfolio.

28:11And investing is not just about maximizing return. It is about you, your values, your history, your goals. And the portfolio is simply the financial instrument that helps you get there. Thinker number 10, Jeremy Siegel. Siegel is the author of Stocks for the Long Run, which is one of the most widely cited books in investment history. His central argument, backed by nearly two centuries of data, is that stocks, over long time horizons, have been the superior asset class. Not every year, not every decade, But over the kind of time horizons that matter for retirement savings, stocks have consistently delivered real returns that bonds simply cannot match.

28:57His framework for the perfect portfolio starts with one argument. Make sure you have reasonable expectations. No, equities are not going to return 20 % per year. No, if you're 50 % stocks and 50 % bonds, you're not competing with an S &P 500 fund. Historically, U.S. stocks have returned somewhere around 7 % annually in real terms after inflation. That's a reasonable baseline expectation. Plan for something like that. If you get more, fantastic. But if you plan for more and don't get it, you got a much bigger problem on your hands. And I'll tell you what, it's not the market's fault. His second principle, the longer your investment time horizon, the greater the proportion of your portfolio that should be in stocks.

29:46This is consistent with every thinker we have covered. Time is the mechanism that allows you to absorb short-term volatility in exchange for long-term return. Siegel's core holding is low-cost stock index funds, with at least one-third in international. His recipe specifically calls for 50 % in world index funds, 30 % to the US, 20 % to international, and the remaining 50 % in strategies designed to enhance his returns. High dividend stocks, REITs, which are real estate investment trusts, essentially a way to own real estate through the stock market without actually buying property, top global companies, sector strategies, and stocks with low price to earnings ratios relative to their growth rates.