Afford Anything - Andrew Hallam (Part Two): The Nine Rules of Wealth You Should Have Learned in School

Episode Date: September 6, 2019

#213: It’s September! If you’ve been listening to the show for the past few months, then you know that I’m on what I’ve dubbed my September Sabbatical, in which I’m taking a break from podcast production and traveling the globe. In light of that, we’re digging through the archives and airing some of my favorite interviews on the show, in between airing interviews I’ve done on other podcasts. If you missed the last episode, you might want to listen to it before diving into this one, as Andrew and I go into the finer points of investing here. Seriously. This is one of the most in-the-weeds shows I’ve done to date. If you’re playing catch up: Andrew Hallam is a teacher who became a millionaire in his 30s and reached FIRE in his 40s. His starting salary was $28,000 - net. If you want to know how he did it, and what his first three rules of building wealth are, then listen to episode 212. Otherwise, tune into this episode, where we review his six other rules that can turn middle-class people into millionaires: Understand your inner psychology. Conquer the enemy in the mirror. Learn how to build a balanced, responsible portfolio. Create an indexed account, no matter where you live. Don’t resign yourself to taking this journey alone. Inoculate yourself against slick sales rhetoric. If it sounds too good to be true, it probably is.a While these rules sound simple on the surface, Andrew and I go way beyond that, talking about hedge funds, human psychology, and casinos. This was a favorite among listeners back in 2017 and it’s one of the most enjoyable interviews I did. I hope you enjoy! P.S. - We’ll return to our regular podcast production schedule in October! For more information, visit the show notes at http://affordanything.com/episode213  Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade-off against something else, and that doesn't just apply to your money. It applies to your time, your focus, your energy, your attention. It applies to anything in your life that is a scarce or limited resource. And that leads to two questions. Number one, what matters most to you? Not what does society say ought to matter most.

Who cares? What actually matters most in your life? Number two, how do you align your day-to-day decisions in accordance? How do you live on a daily basis in a way in which your spending decisions and your earning decisions align with your priorities? Answering these two questions is a lifetime practice, and that is what this podcast is here to explore and facilitate. My name is Paula Pan. I am the host of the Afford Anything podcast, and I am on what I am referring to as the September sabbatical. So in the month of September 2019, I am taking the month off and I'm traveling. I was in Croatia for a week, Slovenia for a week, and now I'm spending one week in Washington, D.C.

I am recording this from on stage at a conference called FinCon, which is a conference for people who create digital media around personal finance and financial independence. So I'm recording this from the conference room floor in Washington, D.C. What you are about to hear in today's episode is an interview that I have done with a guy by the name of Andrew Hallam. Now, Andrew Hallam is a school teacher who became a millionaire. On Monday's episode, so the most recent episode that just aired prior to today's episode, on that episode we aired part one of this interview with Andrew Hallam. And so in this episode that you're about to hear, this is part two. This is the continuation of that interview. Now, this interview with Andrew Hallam, I originally recorded a while back.

This is an interview replay that comes from our archives. It's one of my favorite, Andrew Hallam is amazing, super smart, schoolteacher who became a millionaire through saving and investing. And that is a message that I want to promote. That's a story that I want to share. And because we recorded this interview so long ago, I'm very happy that we get to replay this. Normally we're a weekly podcast. We air an episode every Monday morning, but once a month on the first Friday of the month, we air a first Friday bonus episode. And so I thought that it would be appropriate that Andrew Hallam, part one and part two, be the Monday and Friday episode.

the normal Monday episode as well as the first Friday bonus episode for September 2019 for the September sabbatical month. So with that context laid out, here is the second part of our interview with Andrew Hallam, the millionaire school teacher. Enjoy. So let's talk about Rule 4, Conquer the Enemy in the Mirror. What is that? Believe it or not, people have a pretty hard time building any kind of investment portfolio and managing it themselves. The process is simple. All you really need is a U.S. stock index, an international stock index, and the bond index, and you're done.

But what people have a tough time doing is that they can't typically turn off the media. And once they start investing, they think that they should start listening to CNBC. And I call CNVC financial pornography. If you think about it from a writer's perspective, you're a writer, and I'm going to, a writer. And when you're writing for a magazine, so when you weren't writing your blog and you were writing for other people, one of the things that you needed to do is the subscriptions that, they needed subscriptions to attract advertising dollars.

And so you had to, in some cases, things that excited people. And a lot of those things in the financial media are things that frighten people. And those are fabulous. They love those. So predictions that bonds are going to crash this year or U.S. stocks are headed for major dive. And one thing we do know is that you're always going to get these economic forecasters out there in Wall Street Journal and CNBC and there's always somebody calling a financial Armageddon. And one of the things you have to try to do is close your eyes and close your

ears and not actually get influenced by that. Few people are successful at closing their eyes and closing their ears. So the enemy in the mirror is us. We are that enemy in the mirror. Okay, let's talk about how to actually do that. So let's just take this current moment in history as an example. Right now, as of the time that we're recording this, we're recording this in December 2016. The Dow is at 19,800. It's been flirting with the 20,000 mark. The PE ratio for the overall U.S. stock market is fairly high. It's I think 23 or so. So there are a lot of indicators that stocks may be overvalued. And one of the resulting conversations that happens is, are we headed for a crash? Are we headed for a pullback? Are we headed for a recession? And if so, what do we do?

Do we sell net? You know, how do you avoid the temptation to market time when there are indicators that perhaps the market is overvalued? Well, I'll sort of answer that on two fronts. One thing is very difficult to do is to predict when markets are going to drop. And there's a firm called CXO Advisory that over a 12-year span took 6,400 market forecasts by economic experts, high-profile economic experts, and decided to track them to see how well did they do. And this time span included 2008, 2009, where we had that market crash. And their success rate was less than what you would get flipping a coin.

I mean, you might as well ask a kindergarten kid where they think stocks are really going to go. If the P.E ratio of 23 is frightening. But we had a P.E. ratio in 1996 of about 23, yet we had four more years beyond that where there was a solid bull market that just continued to roll. And so we were really looking at a period from 1982 to the year 2000 where the S&P 500 average just over 18% per year. So anybody looking at the financial indicators and looking at this irrational exuberance, which it was called in 1996, famously, would have pulled out at that point in time, would have missed four more really good years of investment returns, really good years of investment returns. one of the things it's just so important is to ignore all of that stuff, close your eyes and

close your ears, just stuff them with wax. And it's a really tough thing to do. But interestingly, the no-nothing investor typically outperforms the investor who does have knowledge about the markets. I'll give you a great example. Vanguard has products called Target Retirement Funds. And I think they're the greatest thing since sliced bread. And they're often available in 401K platforms as options.

People can choose to buy them. And someone whose investment savvy might say, you know, I'm not going to buy one of those Vanguard Target retirement funds. Now, I'll explain what they are. Their fully diversified portfolios wrapped up into a single fund. So you'll have a U.S. stock market index, an international stock market index, a bond market index and a little bit of an international bond market index. And once a year, Vanguard rebalances those portfolios.

So all they do is they bring them back basically to the same allocation that they were at 12 months previous. So some of those indexes would have risen in value, some of them would have fallen in value, and all they do is rebalance those back to the original allocation. And over time, they slowly increase the bond allocations in those portfolios. because people want a less riskier portfolio as they get older. So if somebody chooses the Vanguard 2035 fund, it's designed for someone, more or less somebody who is interested in retiring around the year 2035.

But what Morning Star has found is that people who invest in a target retirement fund like that, an all-in-one portfolio, it costs about 0.14% per year, which is really, really, really cheap, does the rebalancing for, them, those people typically say to themselves, you know what, I don't really know a lot about investing. So I'm just going to buy this and I'm just going to add my money every month. And what's so fascinating is Morning Star actually takes funds and lists what their performances

had been over the past year, three years, five years, 10 years, 15 years, et cetera. But what they also do is they look at the dollar weighted returns of the average investor in those same funds. So I'm going to give you an example of the S&P 500 over the last 10 years. The S&P 500 is average about 7% per year. So Vanguard's S&P 500 index, pretty close to 7% for the last 10 years, and that includes 2008, 2009. But according to Morningstar, the average investor in the S&P 500 during that same 10-year period has only averaged the return of about 5% per year. Can you think of why? trying to time the market. It is exactly what they do.

They listen to economic news. Those same people are looking at a circumstance such as what we have today, and they're saying, okay, we have potentially political and, potentially we have political instability. We have the price earnings ratio of the market's fairly high. We've had a Walmart run since 2009. I'm going to take some money off the table. But then something happens such as what happened from 1996 to 2000. to the year 2000 where that freaking market just kept going up 18%, and then another 18%, and 15%.

Invariably, what that person ends up doing is they climb back in. They take some of that cash and they put it back in later. They second guess themselves. And people end up doing a little bit of buying high, selling low instead of just putting their money on autopilot, investing it every single month. A lot of people get into that process of trying to time the market based on what the media is telling them. Fear and greed end up manipulating them.

But if you look at a target retirement fund, here's the beauty of these crazy things. If you look at the past 10 years and we've had a volatile market for sure because slap dab in the middle, we had 2008 and 2009 with the markets drop a lot. All Vanguard did was just rebalance them every single year. But a person that was dollar cost averaging, so they have their 401k and they're just adding money every single month, the same constant amount is coming out of their bank account. Their eyes and ears are closed. They don't know a lot about investing.

Let's buy this all in one portfolio. Well, they ended up buying with the same amount of money every month, fewer units of that fund when the fund value rose and more units of it when the fund value dropped. And so what's really amazing is that the average investor in Vanguard's target retirement funds over the last decade has actually outperformed the fund itself. So the fund may have had an average return of 7% per year,

meaning that if you just lumped money in seven years ago and left it, you may have, let's say, 6 to 7% return. But the person who was adding money every single month, the average investor in that fund ended up making more like 8.5%. And that hasn't happened with those individual indexes so much, like with the S&P 500, because people that put together individual pieces of a portfolio and build them themselves, they're typically the same people that are watching the media a little bit more and reacting to it.

That absolutely makes sense. If you're putting in $500 a month, that same $500 will buy more when stocks are cheap and less when stocks are expensive. I shouldn't say stocks when the cost of the fund is cheap. Yeah, and dollar cost average doesn't necessarily juice returns. and that if you have the market goes up every single year for a five-year period and just keeps on rise, you're not necessarily going to get that situation where the person who dollar cost averages ends up making a higher annual return than the fund itself would have made. You would make about the same. But when it's volatile, and here's a wonderful thing about volatility, volatility is your friend.

stock market crash has got to be for most investors. A stock market crash or periods where the stock market is performing dismally is one of the greatest gifts of all time. And I say most investors, when I say that is when we look demographically at the population of the United States, the vast majority of that population is going to be between the ages of 20 and, let's say, 55 to 6. Now, if you're going to be selling your investments at some point in the next year or two or five, let's say, you do want the markets to rise. If you're a retiree, you want the markets to rise. But if you're a buyer, you do not want the markets to rise. I know the thing that would make you happier than anything in the world, Paula, is if someone could guarantee you that property values would not rise, but rents would. Of course. We can't stop corporate earnings. Corporate earnings are like the rent.

Corporate earnings are going to keep on plugging through. So those companies are going to be valued more and more intrinsically. They're worth more and more. Most years on aggregate, they're worth more and more if you look at the intrinsic value. The stock market will reflect that intrinsic value long term, but it doesn't reflect it necessarily short term. So it's wonderful when we can get a stock market crash or we can get a period where the markets are flatlining. If we're continuing or if we happen to be in that phase of our lives where we are investing money. Okay. So how do you square that with not trying to time the market?

If the market does crash, do you buy more or do you continue to hold steady and put in the same $500 that you've always put in? It's easy to just do the same thing, put the same $500. in what opportunists will do and I would be one of them is I get a little bit greedy when markets drop and so I would pick up extra I would pick up extra work I love the market crash of 2008 2009 and I was squirreling getting all I was doing as much as I could to I was tutoring I was getting extra money I was pouring more money into the markets I rebalanced my portfolio so I was selling some bonds to end up buying into the stock market on the cheap, which is much what a Vanguard Target retirement fund would do anyway, just to maintain a constant allocation. So it's not like

I knew when the markets would rebound. I was hoping that the markets would stay low for years and I could just keep on plowing money into the markets. But this might sound crazy to a lot of your readers or listeners, but unfortunately the markets rose and I was a bit disappointed. I think my listeners understand that, you know, and I've found the same thing my in that I view recessions and I view pullbacks as motivation to save and invest more. Oh, they're fabulous. Because markets will drop always further than they ought to drop. But it is.

I mean, admittedly, it is inherently contradictory. On one hand, you know, the advice that is backed by statistical data is don't try to time the market. Just maintain a consistent allocation, you know, dollar cost average into the market no matter what. Be the no-nothing investor. Plug your ears, put your blinders on. And yet, also when the market drops buy more, I mean, you can see the inherent contradiction in it. Sure, yeah. And it's, for most people, just continue doing what you're doing.

If you're putting a set amount every single month, great. And if you end up getting a windfall for some reason, psychologically, it's really hard to put that extra windfall into the market when it has dropped. and especially if it's had two or three bad years in a row. Psychologically, that's really tough. So that whole idea of conquering the enemy in the mirrors to try to get around that. It's hard to do. And we know that it's the right thing to do. We know we should feel very, very comfortable putting money into the markets when it drops.

But what most people do, and I say this, most people do it, they stop investing. They stop. So 2008, 2009, there are a lot of people that both sold. and or stopped investing? What if you have the opposite problem? What if you have a difficult time putting money in the market when it's high? And again, we'll look at right now as an example. As of the time of this recording, the Dow is close to 20,000.

P.E.s are high. We've been on a bull run since 2009, as you said. And interest rates have been held artificially low for a very long time. I mean, we have all of these indicators of potentially being in an overvalued market right now. So let's say you were to get a windfall right now and you want to put it in the market, but you're hesitant because you're not sure if this is the peak, if we are in another 2006. It's so hard to say when peaks will be because what we do know about the markets is that they always hit new highs. That's what markets do. So on aggregate every two out of every three years on

average, the markets do rise. And so you're going to be hitting new peaks all the time. So that's, That's one thing. But two, the entire world is not expensive. And so here's the beauty. If you have one of those, if you have a diversified portfolio, let's just assume for argument's sakes, you have three funds. Independently, you have a U.S. Vanguard U.S. index, you have an international index, and you have a bond index.

And if you're putting money in every month and you are purchasing one of those three indexes or all three of those indexes every single month, one of the things that you want to be looking at is what your goal allocation is. So let's just say for argument's sakes that your goal allocation is in terms of your equities, half of the equities are in U.S. stocks and half of them are into international stocks. Then you're actually taking what's called a neutral global capitalization risk because the U.S. stock market constitutes about 50% of the world's market capitalization. international stocks constitute the other 50%.

So when you're putting money into the markets, whatever that allocation is, it could be 70% U.S., 30% international, 60, 40, whatever it is that you choose to have, make sure that you maintain that year after year after year, this is your set allocation. And so here's the thing, when the U.S. market, and it's had a fabulous run,

it's been doing really, really well. International stocks have actually lagged to that. And so if you're one of those people who's investing every single month. And you want to maintain a constant allocation. Well, you haven't been putting your money into the U.S. index. You've been putting it into the international index. Because the U.S. index has been leaving the international index behind,

which has been shifting your allocation more and more heavily into U.S. stocks. And so your international allocation will be lower. And for that reason, when you're putting your fresh money in, you are in essence you are rebalancing by purchasing the laggard and when we do talk about price to earnings ratios one of the great measurements isn't necessarily a p.E. ratio because a p.e. ratio just looks at the previous year's earnings but we look at something called a cyclically adjusted price to earnings ratio which looks at an inflation adjusted level of earnings that have been averaged over many years. It's also known as a cape rate.

C-A-P-E. And studies show that when we look at a given market and we look at its cyclically adjusted price-to-earnings ratio, when we look at the historical average. So in the United States, the historical average CAPE ratio is 16 times earnings. Currently, the actual CAPE ratio in the United States is 23 times earnings, ironically. You mentioned 23. And so when a market is priced higher than its historical cyclically adjusted price to earnings ratio, that market usually does not have a good decade ahead of it.

But when we have the opposite, where we have historical cyclically adjusted price to earnings ratio and the current CAPE ratio is actually lower than historical average, such as what we have with international stocks, we have a decade ahead that most cases, will be outperforming. So the entire world market isn't expensive. Maybe the U.S. market is, but the international market definitely isn't. And this brings us back to that,

conquering the enemy in the mirror. Some people are going to listen to me and they're going to be saying, I'm not putting money in the international index for all kinds of problems in Europe. The international index hasn't done anywhere near as well as the U.S. index has. Exactly.

That's what makes investing so difficult. And the important thing to do is maintain that constant allocation. Put that money in. You really would be buying more of an international index today than you would be a U.S. index, not based on forecasting, but based on maintaining that constant allocation. And the lovely part of this is that if you bought a Vanguard Target Target target retirement fund, the management at Vanguard would be doing that with your fresh money anyway. It would be doing exactly that.

So this leads to a couple of questions here. So first of all, if you were to simply try to mimic your target allocation, meaning every month when you put money into your accounts, you are directing that money at the laggard, either U.S. stocks or international stocks or U.S. bonds or international bonds. You're directing that to wherever, to the shortcoming. If you were to just do that, you wouldn't actually need any of this information about the Cape ratio. I mean, you would just take a look at your. Yeah. You would just take a look at the percentages in your portfolio and then put money at the lagging percentages and you wouldn't actually need any knowledge about it. That's exactly right. All that really matters is your portfolio allocation and maintaining that. So you either maintain that with purchases or you maintain that by rebalancing at the end of the year if those purchases aren't doing its job at the end. But there's the beauty of that Target Retirement Fund because Vanguard will do that all for you. Right. So that automates it essentially. It automates it. You just put your money in. And that was going to be my follow-up question as well as, is it better? And we had this, we got this question on a previous podcast episode. It came from a listener. She asked if it was okay for her to rebalance her portfolio by virtue of buying the laggard rather than selling the asset that was high.

It makes a lot of sense. It makes a lot of sense. But what my wife and I have is she is American. And so her money, and I'm fully capable of building a portfolio with independent indexes. as we have with my account. But we own a Vanguard Target Retirement Fund with her. Her account is entirely in a Vanguard Target Retirement Fund because it's that easy. And somebody buying or building a portfolio of their own with the isolated index funds, they're not really going to beat its performance

on an equal risk-adjusted level. So why bother? That's one of things. I think that the Target Retirement Funds are the most wonderful thing going. What if you wanted more diversification? We're, I guess, going deep into this one now, but what if you wanted more diversification than what, than the four funds that are within a target retirement fund? So, for example, what if you wanted greater exposure to emerging markets or frontier markets or small caps? You could do that, but it's not necessarily a guarantee that you're going to earn higher returns. So, and the big question, second question is, why would you? I suppose, and I suppose that the challenge to the person who was saying this would, that they would need the data to back it up. But I suppose the premise for that desire would be the assumption that greater asset diversification, meaning greater diversification in terms of asset class, geography, possibly even industry, would ultimately lead to either greater returns.

or greater protection from downside, you know, better risk-adjusted performance at any rate? I think it would be theoretical idea that is portfolio variance optimization. I think that's what they call it. And you can look at a series of back-tested studies that suggest that, yeah, you might actually have an advantage when you are building that individual portfolio where you'll take, okay, we're going to take the small cap component of my stock market. is going to per my portfolio will be let's say as heavily valued as my large cap as heavily valued as my medium cap and I'm going to have a higher emerging market component so in some ways it's

somewhat more diversified because you do have these different asset class sizes that have shifted a little bit but this mean variance optimization which theoretically does work and does produce outsized returns hasn't done so. over the past 10 years. So it's really interesting how you can look at back-tested studies, like a data mining process and see that something has actually outperformed in theory. And then often when people start to try it, they end up not doing as well as just a plain market capitalization,

sort of couch potato portfolio of index funds. But isn't 10 years a small sample size? 10 years is a small sample size. But at the same time, we don't have large, sample sizes for these actual funds historically either. We have theoretical data on how these markets would have done, but how would those funds have done? So even then, we're not really certain.

Either way, there's not going to be a lot more necessarily over a 50 or 60 year investment time horizon that you're going to be getting out of it. And one of the tricky parts is that if it doesn't perform well, so you use sort of mean a very optimization strategy and it doesn't perform well over five or six years, most people actually give up on it. If they see that the Couch Potato portfolio is actually outperforming it, just a basic or a basic Vanguard Target Retirement Fund is outperforming it, they'll entirely give up on it. And so that's a problem too. Very few people have, and you're absolutely right, Paul, that 10-year time period is a small time period, short time period, but very few people can actually

underperform for even two or three years in a row before capitulating, completely giving up and then going onto something else. And so when we often try to tweak things, and this brings into question the whole smart beta concept where you have exchange trade of funds with the promise that they can actually outperform the market. The tricky thing is when they don't let them, and they will go through long periods of outperforming. And when people do choose these methods or choose these smart beta funds, there are people that aren't quite satisfied with market returns. They want something better. And those same people have a really hard time underperforming for four or five or six or in an example I was giving you a 10 year stretch. So yeah, it's fascinating. It's so fascinating.

I just choose to think there are better things to think about. Yeah. You might as well think about increasing your income versus sweating over what might end up being if you're, lucky, very small incremental advantages, which may end up being disadvantages. So it's not a given. So a lot of thought and effort and intellectual brain power goes into something that, you know, could be utilized more effectively in terms of wealthability measure somewhere else because it's not a sure thing. You know, and that is the conclusion that I have come to as well after spending far too long thinking about this, is that ultimately I'm trying to optimize around the edges when if I just earned an extra five or $10,000 a year, that increase in earnings would outperform anything

that tweaking around the weeds would. Yeah, because the tweaking around the weeds could end up being time spent, intellectual brainpower spent, and it could end up being too detriment. Absolutely. It's like, well, I bought it. That's not a guarantee. Absolutely. So it's interesting when you have like the whole smart.

beta aspect of funds too where you have those funds that promise to beat the market. So they're factor-based, right? So you'll wait your portfolio where you have equal weighted index funds or fundamentally weighted index funds. So what does that mean? And so let's say you have an equal weighted index fund, just as an example. If you take Vanguard's S&P 500, it has 500 stocks in it, but they're not all weighted equally within that index. So when Apple was the, I'm not sure if it still is, but about a year, two years ago, Apple was the largest company in the United States. And so when Apple moves as a stock, it has more of an influence on the S&P 500 than say

Wells Fargo would, because Wells Fargo would have a smaller market capitalization weighting than Apple would. And so in theory, we have these theoretical back tests suggesting that if we weight an index differently so that it's equally weighted, so Apple would be as equally weighted in the index as

a firm like Fassanel, which is a small company that they sell building supplies. That historically, when we look at the returns, an equal weighted index historically has outperformed. And so we can also look at things like momentum indexes. So indexes that are built with stocks that are actually increasing their prices quickly.

Based on the rate of growth. Yeah, exactly. And so obviously there's a higher turnover for those kinds of index funds or those kinds of index funds. Because if companies' business growth is not increasing exponentially, then they'll go drop from the index and they'll add something else to it. And so with these factor-based models, with these different indexes that are put together in a complete portfolio, it's called factor-based investing. And when we look historically in theory, theoretically, a factor-based portfolio will outperform a market capitalized portfolio over virtually any 15, 20-year historical back-tested period. But then the tricky part is that, well, once that knowledge is actually available, then what typically ends up happening is now people start buying those funds,

so those companies start to put together those actual indexes, so more and more of, let's say, equal-weighted indexes. And what ends up happening is that a lot of those smaller companies now, the price-to-earnings ratios, and this is where you have the difference between real-life application and theoretical, the price to earnings ratio of some of those slightly smaller companies that wouldn't be as heavily weighted in the index as say Apple would be,

they start to creep upwards. And so then again, you have that idea or that concept whereby that might not perform as well in the future. Right. So then the smaller companies become overvalued as a result of people flooding into factuated indices. And there's that, yes. And so again, we've got elephantitis. It's the same kind of.

It's the same kind of thing. Yeah. We've got funds becoming victims of their own success. Exactly. And we do know that once the academics end up getting out and suggesting that, you know, historically, this actually does work. We do know that the potency of that outperformance is strongly diminished after that point. And it's often still there.

Like Larry Swaydow wrote a really good book on factor-based investing. And he said the outperformance component. it still exists after. So he looked at what point in time was this information made public sort of on that academic front. And after that point in time, did these actual products

continue to outperform the market or would these factor-based portfolios continue to outperform the market? And he found that yes, but not by as much. And so now what you end up having, though, is more and more people. So most of your listeners,

most of them probably don't know too much about this concept of factor-based investing. But the more they learn about it, the more they might realize, oh, I want a piece of that pie. And so now they start investing in it. And then invariably, the price-to-earnings ratios of those specific factors become artificially higher than they ordinarily would have been. Hence in the future, there's that theory that. And it actually is kind of holding true.

When you actually do look at these performances, they are starting to perform not as well as they would have done historically. So a guy like Burton Malkiel, for example, the guy who wrote a random walkdown Wall Street, he is definitely opposed to them for that reason that I outlined. So it seems to me, though, that so I've never heard of factor-based investing before this conversation right now. And intuitively, it makes sense, right? Intuitively, it makes sense that if you were to own an equal weight of all 3,500

stocks that are in the U.S. broad market, yeah, it makes sense. hold them at equal weighting so that no given company can unduly influence that portfolio. So in theory, I get it. And I also understand how it would then cause some companies to become overvalued. So then it seems like the next natural progression from that would be for somebody to create a value-oriented factor-based investing. Yeah. And what they do is when you build a full factor-based portfolio, portfolio. We have a series of factors and one of the factors is size, so small cap stocks. Okay. The second

factor is value, value oriented stocks. Another factor is growth. So obviously stocks with companies that are increasing their net earnings at a rapid rate. And then we have momentum. So actually price momentum as well. So you have these variety of factors and when you build them into a single portfolio, so the theory goes, You build it into a single portfolio and rebalance those components once a year. So you're buying obviously a little bit more when you're balancing a little, you're buying a little bit more of what hasn't done well and selling a little bit of what has done well. In theory, these are the factor-based models that I was talking to you about when I said that when we back-test these, they have strongly outperformed the market going forward,

strongly outperformed historically a cap-weighted model. I'm sorry. I think I missed that. So if you were to have all four of those within a portfolio, it would outperform the standard cat-based model of U.S. Total Stock Market Index Fund? Historically, yes. Okay. But in practice, maybe not. And why is that?

Why is there that difference between historic theory and practical application? What ends up happening is they become popular. Now, as soon as you're buying these factor-based funds that are now becoming popular, valuations within them start to shift. And so when we look at the back tests, the back tests are done without looking at real-world metrics. What have people actually done when they've been purchasing these things? And how would those purchases have affected the price-to-earnings ratios of the stocks within

each of those factor-based funds? So we don't have that. We only have it relatively static, not in a real-world environment. And then what Bert Malkiel would argue, as does John Bogle. John Bogle actually calls it witchcraft, which is kind of funny. He calls it a marketing gimmick because he says that when you look at it, in theory, yes, but then there's what human beings actually end up doing to these products as they purchase them. And the price to earnings ratios of these actual stocks end up shifting beyond what they would normally have been in a theoretical model.

Right. That makes sense. So when you're looking at historic performance, you're seeing how it did when it wasn't influenced by humans. Exactly. But if we were to apply that to the present day or to the future, we would be applying it in a way in which we ourselves are influencing it. Correct. Schrodinger's stock. It's interesting, isn't it?

Wow, yes, absolutely. We'll come back to this episode after this word from our sponsors. So we, the Afford Anything community, we have a great community going on Facebook. But the issue with Facebook, the issue with Facebook groups is that a lot of institutional knowledge gets lost because the threads aren't searchable. And there are limitations to the way in which people can connect. So for a long time, we've been looking for a different platform that we can use for organizing a community. I've been looking through the app store, like looking at other community platforms. And I noticed one in particular that I really liked that was run by Mighty Network.

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asset classes. So you have a bond component. So one of the things that I suggest is a short-term bond market indexes. And then, of course, a U.S. stock market index and an international index. I really like short-term bond market indexes for a couple of different reasons. One is that they'll almost always be inflation. One of the reasons they do is that they're comprised of short-term bonds, which when they expire, they're replaced by other short-term bonds with either one, two, or three year maturities. And so no matter what happens to interest rates, if interest rates for newly released bonds end up rising, wonderful.

Your bond market index gets to capitalize on that fairly quickly. Whereas if it's a broader bond market index or if it's a long-term bond market index, that increased interest rate isn't going to have as much of an effect on the actual index itself. So another reason is that if bond market prices drop, so this can always happen at any given time, bond prices can drop. That's going to affect a broad index or a long-term bond market index much more so than it would affect a short-term bond market index, which is continually pushing, picking up new bond market indexes as their other short-term indexes expire. So the price drops, they pick up at the cheap.

stepping back for a second, assume that somebody who's listening is 25 or 30, and the psychology of witnessing your portfolio drop is not a concern. They have a very aggressive and long-term mentality behind their investments. Is it necessary to hold bonds at all? Or could you be 100% in equities? I think you could be 100% in equities, and it depends on the person's, disposition. It could definitely be, definitely have a full equity oriented portfolio and it depends on so many things and so many factors. If I meet to a school teacher, for example, from Colorado, and typically Colorado-based teachers have the fabulous pensions, because the pension is very much

bond-like, there is an argument to suggest that they may not really need to have bonds or not much in terms of that bond allocation in their portfolio because they already have that stability of a pension. So you could say much the same thing if you have a real estate investment portfolio. You have a real estate portfolio, different places, properties such as you have. Oh, there's an argument to suggest that if you want, you could perhaps keep as little as 20, 25% in bonds in your portfolio as long as you're okay with the volatility. And you could just leave it at that if you're okay with the volatility. Could I be 0% in bonds and 100% in equities if I was okay with the volatility? You could be.

So when you do look at long-term, what's really interesting is when you actually look at those long-term historical charts on 4% withdrawal rate, although an equity portfolio is obviously the riskiest, it's the portfolio that ends up over a 30-year period when you're drawing down 4%. you have a very, you have the actually the highest odds of not running out of money, the money lasting in perpetuity with that 100% stock market portfolio. I don't know if the studies that went back went back as far as 1929. So I'm not sure if they actually covered that where there was a 90% drop, but the studies that I have seen, the back to the studies go back at least 80 years. That's good to hear, because I like the idea of being, uh, 100% in equities. The counter argument that I have always heard against that is that by virtue of

having at least a small bond allocation, you will be able to rebalance thereby picking up cheaper equities when the market declines. That's true. But if you use something like a portfolio visualizer, you use a, again, we look at backtested things, but we can look at back tested studies, they do suggest that typically when we're looking at long periods of time 30 years plus the 100% equity portfolio outperforms the 80-20 and the 70-30. So yeah, all right, when the market's dropped, you can end up rebalancing your portfolio doesn't go down as far, but your portfolio typically ends up a little bit higher before that drop occurs anyway. So it's really that largely that emotional component that having that bond allocation. But then there's also that factor. There's that Black Swan or there's that 1929 where that short-term bond market index might be a really nice blessing in that circumstance.

I will tell you about a couple that I know, Billy and Acacia Catterly, and I talk about them in my book, they had a restaurant and Billy was a broker. And he woke up one day and he said, you know, I don't like what I'm doing. I'm selling actively managed mutual funds and I'm buying index funds and this isn't cool. So he said to his wife, I want to wrap things up. And they owned a restaurant, Acacia ran it and they decided to sell it. And this would have been 1992. And so they sold their house.

They sold their restaurant and put everything into an S&P 500 index. So 100% stocks, and they were about 37 or 38 years old at the time. Billy decided that they would withdraw 4% of the portfolio value each year and live on that. And of course, some years he was able to withdraw more in terms of a dollar value, depending on how the portfolio had done. In other years, he was able to draw or he withdrew less in terms of a dollar value. But he said that that 4% rule, he would stick to. that and that was the maximum amount that he'd take out. When I asked them about it, he didn't actually

end up keeping it at that four. He often ended up selling, they often ended up selling just 3%. It all depended on the year or what they were spending. But here's a really cool thing. In 1991 and 1992, when they started this, they had $500,000 after they'd sold everything. And so they put that in the S&P 500. And so in that first year, he's able to take, they were able to take out just less than about $25,000. I think they took a lot out a little bit less than that because they were down in the Lake Chappala area of Mexico where it was really, really cheap and really, really awesome on so many levels. What I ended up doing was I looked at how that portfolio would have done if they stuck to just

taking out 4% per year. As they explained to me, they took out a little bit, they took out less than that, typically. But I looked at what would have happened if they just took that 4% out? And so I used something called a portfolio visual. It's available for free. And I looked at what would happen if we just constantly took this 4% out of their portfolio. Between them and now, they would have taken out $1.3 million from that original $500,000 portfolio. And I wrote about them in my book because this was really amazing.

A lot of people have a tough time imagining getting their heads around that saying, wait, they started with 500,000. Over the past 25 years, they've taken out 1.3 million, and they still have money left? Based on the analysis that I did with Portfolio Visualizer, they would have $1.8 million left in that portfolio. And that's going through, they went through the dot-com bust, and they went through the Great Recession. Exactly. They went through all of that. and they just adapted.

So they were an example of a couple that when I talked to them, we spoke about risk assessment and such, and they're very comfortable with the volatility because they know statistically the odds of performance are better with a full equity portfolio. They just have to have a really strong stomach. Interesting. So even in retirement or early retirement in their case, they achieved financial independence. went to 100% equities, even if they had taken out 4% every year, they would have been fine. Absolutely. They would have 1.8 million today if they had taken up 4% per year. That's interesting. How can a person access portfolio visualizer?

Portfoliovisualizer.com. Oh, awesome. Cool. I'll link to that in the show notes. Yeah, do. And I don't know how long they're going to offer it for free, but I use it all the time with my writing. Nice. I'd like to move on to the next rule, but I've got one last question about building a responsible portfolio. Because you've mentioned before the three cornerstones of total U.S. market, total international market, total bond market. We had a guest on the show earlier, many episodes ago, who made the argument that a person, an American who is earning in U.S. dollars, and plans to live in America their whole life, so there's no currency questions. Could invest entirely in the total U.S. stock market index fund and just leave it at that

because U.S. companies are so tied to the fate of international markets, you know, Coca-Cola, Nike, Google, I mean, they do significant business in other countries. What is your opinion on that? Well, it's a valid point. If you take Coca-Cola, for example, about 74% of their revenue comes from non-U.S. Denominated currencies because they do business. Most of their business, most of their sales is actually overseas, which is kind of cool. So there is that argument.

John Vogel is one. It keeps much of his portfolio, if not all of his portfolio in U.S. stocks. That's the same rationale that he uses. So as the founder of Vanguard, he uses that argument, says, all I really need is the U.S. stock market. If we look at Warren Buffett in terms of his heirs and what his, let's say his wife, when she, I'm not sure if you know this, but when Warren Buffett dies, he's asked the trustees to put his estate in a portfolio of index funds.

I had heard that. Yeah. And it's a broad stock market index and a little bit in a bond market index. And there's no international component. And so for much the same reason. And back to that whole enemy in the mirror thing. There is theory and there was practice. And there were very few people during 2008, 2009,

who I know in theory, we all know in theory, it's wonderful to be buying when markets drop. And everyone can tell you that. We need to do it. They need to say, or many people will say, I would do it for sure. But very few people actually did it. A lot of people looked at me like I was completely mad.

I was on a plane coming back from Bali and I was sitting with a mutual fund manager, believe it or not, on this airplane. And he's asking me, we started chatting, realized we had a lot in common. He asked me, what are you doing? I said, I'm buying with both hands. He said, what are you doing? He says, I've gone to cash because I think it's going to go lower. And I ended up bumping into him because his daughter went to our school and I ended up bumping into him at a softball game. He was writing a book about money.

He was writing a book similar to what I was writing. He was saying forget about speculation, but he couldn't forget about speculation. And so when you have that U.S. market, back to that, and that's all you have, and that drops a lot more than the international market does. And if a diversified portfolio is that which can keep you a little bit more grounded because it doesn't necessarily drop as far, it has less volatility, again, here's another argument for the bond allocation. investment behavior has a huge impact. Investment behavior has a bigger impact on performance than portfolio allocation. Investment behavior has the biggest impact on performance. And so people sometimes have to ask themselves some really hard, tough questions.

Could they really handle that volatility? Because a U.S. stock market index would be more volatile than a diversified portfolio. And I can see it working the other way around too, where if the market has hit a new high and you're at the peak of a boron, or if you are in a long-term bull run as we are now and you're worried that you're at the peak, you might not put your money into the market. But if you see that international funds are lagging U.S. funds as they are right now, then that would affect your investor behavior. you would put that lump sum into an international fund. And so at least you would get it in the market and get it working. Exactly. And my recommendation, close your eyes, close your ears, buy Vanguard's Target Retirement Fund.

You'll be 99% of the people who are speculating and buying factor-based stuff and trying to guess where things are going and look at what's overpriced and going with it's underpriced because managing your emotions is such a hard thing to do as that fund manager proved. We'll come back to the show in just a second, but first, do you like to sleep? Yeah, who doesn't? All right, so when you're sleeping, you want to be comfortable. And having really comfy hotel quality sheets that can help you sleep well is awesome. I mean, who doesn't like that, right?

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R-A-D-I-U-S-Bank.com slash Paula. Radiusbank.com slash Paula. So Rule 6, I mean, we've almost already covered it since Rule 6 is to sample around the world to get to indexing. Right. I broke it down into section. So I started out with an American investor and how would an American investor actually build their own portfolio of index funds?

and I actually used a Harvard-based doctor by the name of Chris Olson. Really fascinating guy. I could talk about him for half an hour, but I won't. He built a portfolio of Vanguard Index funds, and I went through that process and how that portfolio would have done and how he would have rebounce it each year that followed. So I updated that for the second edition of the book. And then at the end of that, I said,

but if you don't want to do it on your own, as an American, you can really move into this next chapter where I get into robo-advisory firms. And so that's where I look at, firms that do much what Vanguard does with those target retirement funds where you just give them your money and they rebalance your portfolio for you. Okay, so let's talk about that. So that's the new Rule 7 is based around Robo Advisory Funds. What is your opinion of them? I love them. Really? I love them. Yeah. Anything that takes the speculative component out of the hands of the individual investor, if an individual investor has the courage to say, All right.

I understand I am the enemy in the mirror. It takes a lot of emotional control and maturity for a lot of people to get to that point to say, all right, I am often my worst enemy. I can hand my money over to this investment firm. And for 35 basis points or 0.35% per year, they will build the portfolio for me. All I do is send the money. They will rebalance it on an annual basis. and I never have to think, speculate, worry.

Statistically speaking, those sorts of investors have done well, much like they have with the Vanguard Target Retirement Funds. As much as we like to think that more sophisticated investors do better by building their own portfolios, all the studies in the world say they don't. But going back to small percentages add up to a big difference, going back to that earlier concept, I mean, Robo Advisory Funds are, more expensive and charge higher fees than just putting your money in a Vanguard target date fund or in an array of Vanguard index funds. That's true too, but behavior trumps costs. And so when we do

look at actual performance of funds, we have the typical American will underperform their actively managed fund by about 1.6% per year. And that's just based on behaviors. So that's after costs, that's just a behavioral lag. And the typical American will underperform their index by about 1% per year. So if you are paying somebody 0.35% to build that portfolio and to rebalance it, it's well worth the money. And again, it comes back to chapter four, conquering that enemy in the mirror. But having money with a robo advisor wouldn't necessarily ensure that you're not also trying to, to build your own portfolio funds on the side, right? Could you have like a fraction of your money

with them and then a fraction elsewhere and then a fraction elsewhere? Theoretically, people could be doing that, yes. I mean, in the same way that you could with the target date retirement fund, right? You could have a fraction of it in a target date retirement account, but then also have money elsewhere and money elsewhere and some more in small cap and some in mid-cap and some in meat meats. Yeah, and I think ultimately by doing that, I think in most cases, I'm not going to say in every single case, but in most cases, people doing that would be doing themselves a disservice. It doesn't sound very optimistic. I guess essentially what I'm hearing from you is that robo advisors are beneficial if you use them in a way that would save you from yourself.

Correct. But if you find loopholes to your own strategy, then you're still no way. better off. That's right. Interesting. Okay. The strongest pro-robobvisor argument that I have heard, and I've always shied away from them because, you know, you look at Betterment, Betterment just puts you in Vanguard

funds, but it charges an additional fee on top of the natural expense ratios with Vanguard. So, you know, I've always said, why bother with Betterment? I mean, why not just cut out the middleman, go straight to the source, just go directly to Vanguard, save yourself the added fee. The argument that I have heard, the most compelling one that I've heard, is that a robodiviser like Betterment would take care of tax loss harvesting. What do you think of that argument? Forget the behavioral component. Is the tax loss harvesting alone a sufficient reason to pay the additional fee?

In itself, I would say that there is an advantage of tax loss harvesting, but, it's nowhere near as large as many of these firms claim it to be. And it's really, really tough for me to tell you exactly what it is because it depends so much on the actual individual and their account, what else they have, may have going on. There is an advantage, but it's not as big as what is claimed. But the biggest advantage, really, I'm just going to come back to the behavior because a tax loss harvesting advantage will not constitute an advantage of 1.75,000. percent per year. That's why the biggest advantage really is in taking the emotional component

out of it and having somebody investing that money for you in a way where you're not going to be swayed by your fear and greed. It's huge, Paula. It's huge. It's so interesting. They're looking at individual performances for index funds and seeing that people don't even get the performance of their index funds. DIY investors don't get close. Morningstar does something that they put out every year called Mind the Gap. And it's a report where they look at dollar weighted averages.

And it's really eye-opening that most people don't get anywhere near earning the returns of the very index funds that they own. And why is that? They listen to media. They speculate. They say the market's high,

so I'm not putting this, I'm getting out. It's speculation. It's the enemy in the mirror. All right. Rule number eight, avoid seduction. Yeah, it's a funny thing. It's when something sounds too good to be true, that there's always a cost associated with it.

And so you have things like investment newsletters that will report to have. the ability to find you great undervalued stocks and here's our performance and here's how well we've done. And there's a firm called Holbert's Investment Digest. What they do is they actually look at newsletter performances and they see, well, how have they done? And recently what the founder of Hubbard's, I think it's called Holbert's newsletter or financial

Digest has done is he has poked a lot of holes in how a lot of these newsletters that claim, if you'd followed our strategy, you would have made X amount of money. And he's looked at it and said, you know, we've been following and tracking that actual newsletter because that's what he does. They track newsletters to see how they do. And we don't come up with the same numbers that you come up with. We don't even come up with numbers that are close to what you were coming up with. So he's coming up, Mark Harlebert's his name.

He's come up with some really cool articles about that. And he's suggesting that, you know, as he has done in the past, investment newsletters, typically most of them, first of all, they don't last very long, but typically they don't outperform the market. So very, very rarely. And then there's that sustainability component. Can they continue to with their picks? And very few of them do no more so than you would get by basic chance. So again, it seems like any temptation to deviate from the tried and true index fund strategy

just doesn't pan out over the long term. It doesn't. And rich people are, it's funny because a lot of high income people end up falling for things like hedge funds. And if we look at the HFRX hedge fund index, so it's a collection of US and global hedge funds. And we actually compare them with the average actively managed mutual fund or with an index fund or balanced index fund by comparison, even though they are available just for the elite. So we often think, oh, they're just the country club group. and they're very, very special, very special, talented managers. They have disastrous performance track records compared to even just the general basic,

actively managed mutual fund. So I did a, I wrote a piece on hedge funds, and I took the most popular, the 50 most popular hedge funds, and I looked at their performances, and they too performed very poorly. I think I focused in on like the top 10 or the top 15, the most 10 or 15 most popular. and they had also underperformed, on aggregate, underperformed a balanced index fund and a basic index fund. So the whole idea of that that chapter is looking at promises that people will give you and to really be very, very careful of false advertising and these pie in the sky concepts. I mean, there is a reason Warren Buffett's wife is going to have her money when

Warren Buffett goes on to his ultimate reward fully in an index portfolio. He knows the statistical odds of that are best. And so he's not messing around with it. He's not investing with any hedge fund managers. He's putting it all in index funds. A basic question. What exactly do hedge funds invest in? They can buy anything.

They have far fewer restrictions than with a typical actively managed fund. They could put everything, if they wanted to, they could put everything in a single stock. And actively managed mutual fund, they have regulations associated with them to protect investors. And so there's only a certain amount or percentage that they can put in any given individual stock. It has to be a certain amount of diversification with any actively managed fund. It's available to the public. But a hedge fund is typically for accredited investors. And so a hedge fund manager can do anything he or she wants.

They could put everything into a single stock. They could short the market if they want. So essentially betting that the market will drop and then sort of collecting on that, if it does, they could end up buying any kind of private enterprises with it. So pretty much anything and everything is game with a hedge fund. And so I guess the promise or the sales pitch of a hedge fund is that these are managers who are very, very good at managing money, probably similar to the promise of an all-star fund manager. They're very good at managing money and they will take care of yours.

Yeah, that's the theory. And it's fascinating how a good friend of mine was friends with a big hedge fund manager in Singapore. And after getting a few drinks down this fellow, the guy ended up sort of slurring that he had his own personal money invested with Vanguard and not with his actual fund. Wow. And that's very common. Jason's Wig who writes for the Wall Street Journal actually talks about that as well, where he's found and gotten into conversations with active fund managers and with hedge fund managers,

and he's found exactly the same thing. They often invest in index funds. So I just actually looked up, so I have the world's 20 biggest hedge funds here, and I looked at the three and five-year returns. And so a hedge fund will grow large, obviously, if it has marketed itself really well and it has performed well. So people are then attracted to it. And so what I did was I looked at the 20 biggest hedge funds, and I looked at the 20 biggest hedge funds, and I looked at how they had performed during this time period ending October 31st, 2015.

So I looked at three-year returns and five-year total returns. And so to give you an idea, the S&P 500 during that five-year period ending October 31st, 2015, gained a total return of 94.4%. The 20 biggest hedge fund average was 38.4%. If we look at a three-year period, the S&P 500 ended up gaining total of 55.7%. The 20 biggest hedge funds averaged 20.73%. So even a Vanguard balanced index fund, which takes far less risk, outperformed the average hedge fund by quite a bit during both the three and 10-year periods ending October 31st, 2015. And if you want to have a look, what's really cool is check out or just Google.

Your readers can Google HFRX hedge fund indices. And you'll be able to see historical returns of both global and U.S. hedge funds. They're reported returns. And it's fascinating because they're not very good. So the emperor wears no clothes. I'll put that in the show notes, all of the resources that you've mentioned. Larry Swedro's book on factor-based investing, portfolio visualizer, Holbert's Investment Digest, all of that is all going to go into the show notes.

The question that I have, I've often wondered, given how much evidence there is that index funds outperform actively managed funds. I've often wondered why actively managed funds still exist. If hedge funds consistently underperform a basic vanguard total stock market index fund, why would they be in it that seems to defy supply and demand almost? It does. And I think we can ask the exact same question about why there are wealthy and accredited investors in casinos. Are there? Sure there are. Sure there are. There's the promise of a jackpot. There's a promise that there's just that possibility of finding that very special person, whether that very special

actively active fund manager whether you can maybe find that Bill Miller who will take you on that 15 year run or Bill Ruan who ran the Sequoia Fund and did fabulously from 1971 up until

his death around 2010 or 2011 I think it was. He was a fabulous value fund manager and had luck along the way. So this is a really, really long stretch. So there's always that hope. As John Bogle says, Hope springs eternal.

But can hope consistently spring eternal in the face of your refutable statistical evidence against it? Casinos are a volume business, and the majority of the people who go to casinos to gamble as an aggregate are probably not going to be highly sophisticated financial minds. You're probably right there in the United States, and that's why I do look at. at casinos abroad where you have, say, the Singapore casino where you need $100 just to get in the door. It's like an entry point. And in some of those tables that you're playing, they're dealing with massive, massive sums of money. People are literally winning or losing millions of dollars, and many of them winning or losing millions of dollars every day.

these people are really successful business people, the Chinese business people, Taiwanese business people, too, Singaporean business people, very, very wealthy people, very, very accredited. But we know that the house wins on aggregate, but they still pour into the casino. And so is it that the Taiwanese and the Chinese and the Singaporeans, is it that they're less evolved than the average person? absolutely not. I think that it's a kind of microcosmic example of human behavior, as much as we might like to think that as we grow intellectually and we understand the framework and we understand the efficient market theory and how difficult it is to be the market, there's that human component that we cannot dismiss. That's the part that lures us and tempts us to end up crashing our boats up against the rocks or just allows us to underperform by a couple percentage points a year.

And those small percentages pack big punches. They do. So rule seven is robo advisors. Rule eight is peek inside a pilfer's playbook. Oh, okay, right. Well, you know what, a fun thing that I did with that one with the peek inside the pilfer's playbook is one fun thing I did is I write for the Big Globe of Mail. It's Canada's national newspaper.

and I have a column here. And in Canada, what we have is our banks sell index funds and they sell actively managed mutual funds. And what I did was I joined a Facebook group for the condominium that we live in. And I put this thing out there saying, hey, I'm looking for four people to go into a different Canadian bank and ask them to build you a portfolio of index funds, keeping in mind that the banks actually have index fund products and actively managed products. And I said, I want you to take in an iPhone and I want you to record the conversations. And so I ended up offering 50 bucks to four people that would do it. So four people volunteered and they went off to a different one of these.

We have six really big banks in Canada. So they basically have the lion's share of the market. So sent investors into four of them, supposed investors and recorded the conversations. And it was really fascinating because in Canada, actively managed mutual fund costs are about 2.5% per year. I mean, we pay the highest mutual fund expenses in the world right here in Canada because we're really polite. Canadians always say please and thank you and nod and smile. I think that's got to be one of the reasons. Anyway, it was fascinating because listening to the arguments and how none of the advisors wanted to put the investors in a portfolio of index funds.

They all argued against it. And so I was able to write about this for the global mail and then I retold this story within the book. And it is fascinating because there are a series of tricks as I take you through this peek inside the Pilfer's playbook. What strategies would the typical financial advisor use to keep you away? from index funds. Because index funds are great for the investor, but they're not as great for the firm that's selling them. They want to get you into actively managed mutual funds because that's where they'll make more money. The firm makes more money. They make their trailer fees and sometimes even commissions. So essentially the concept of peeking inside the Pilfer's Playbook is

learn the opposing arguments. I mean, kind of very much like being a lawyer, you want to be able to state the opposition's case almost better than they can? That's exactly it. Okay, so what is their case? What are the arguments against buying index funds? Well, they'll look at past returns, and so often they'll cherry pick funds that have beaten the indexes, and they'll say, look at these funds. They've beaten the market over the past five or six or seven years. So these are the funds that we're going to end up putting into your portfolio. And of course, as we know, we have the S&P persistence scorecard, which I love looking at. It looks at every six months it comes out and standard and pores puts this thing out where they'll look at the comparison between

actively managed products and passive index funds. And they'll see which were the top 25% of performers over the past, say, five years. This is called what the S&P? Yeah. So it's called performance scorecard? It's SPIVA. So it's SPIVA. S-P-I-V-A. S&P Dow Jones indices. So what you'll have is they'll look at whether past performance matters. And so they'll look at the top 25% of actively managed funds within one time period, say it's a five-year period. And then they ask the question,

what percentage of those winning funds are still winning? And invariably, they'll measure then the next time period. And you'll usually get anywhere between sort of three to six, percent of them that continue their winning ways. And again, I quote Jason's wife from the Wall Street Journal on this because he says it so nicely. He says one of the stupidest things in the world is to pick a mutual fund based on its past performance.

But that's exactly what when you look at peek inside at Pofor's playbook when you walk in or when you're speaking to a financial advisor who tries to sell you on actively managed funds, one of the first things they'll do is they'll show you funds that it beat in the market in the past. And they'll try and sell you on those suggesting that they will continue their winning ways in the future. Invariably, they very, very rarely do. God, I just, the thing that strikes me, the thing that I keep coming back to is that study after study continues to bear out precisely what you're saying, which is that over the long run, broad market index funds, low fee passively managed funds, outperform, actively managed funds,

actively managed funds for a wide variety of reasons, including, I mean, just off the bat, actively managed funds are already starting with a disadvantage because they necessarily have to have higher fees in order to support all of the management and administration. And they have more turnover, which depending on what accounts you're using, leads to greater taxes, a greater tax burden. So right off the bat, they would have to outperform an index just to be able to break even in terms of what it can deliver. Right. Right. And so they have to consistently, not just outperform the index a little bit, but they have to outperform it a lot to be able to

justify their existence, to be able to justify those fees and that risk. And that has never happened. And there are so many studies that prove that. And again, so the thing that I keep coming back to, this is a rambling question now, is how? How can anybody actually make the opposing argument? It's really tough to do it, but people can be very persuasive. People with silver tongues, and there are a lot of people that don't really bother to, I mean, they spend more time trying to research what toaster they're going to buy than what financial products are going to use to build their portfolios.

So there's still a lot of people who are very intimidated by the stock market, intimidated by financial investments and intimidated by, they're intimidated by the knowledge that a financial advisor presents. And so often those financial advisors talk circles around them and they nod and say yes. And so I think until this is actually taught in schools and taught well in schools, I think we will, even after that, we'll probably always have actively managed products and hedge funds because there will always be those who are number one ignorant, but number two, there will always be those whereby hope springs eternal back to that casino thing. Wow. All right. Well, thank you so much for coming on this show and for spending all this time with us. My pleasure. Where can people

find you if they want to learn more? My blog site, Andrew Hallam.com. And so people can ask me questions there. I also have a Facebook page at Millionaire Teacher. I often post my writings too as well. So I link them in to Millionaire Teacher at Facebook. So they can check me. out there and ask me questions. And if I can help them out, I will. Thank you, Andrew, for spending all of this time with us. I loved this interview. What are the lessons that we've learned from this conversation? I'm going to review the nine rules of wealth, because I think that's the best way to recap everything that we covered across both episodes. So here we go. Here's a recap. Rule number one, spend like you want to grow rich. And what that means is, if you truly want to

grow wealth to reach financial independence, don't blow all your money. The more money that you spend on crap, the less money that you have to invest. And it goes back to that whole idea that you can afford anything but not everything. You can afford to spend like you're rich, or you can afford to invest so that you become rich. But you can't necessarily afford both, at least not all of the time. Andrew also talked about the Hippocratic rule of wealth, first do no harm, that ties back in with this message that he kept iterating and repeating throughout the interview that you are the enemy in the mirror. One of the best things that you can do is just not harm yourself. Don't be your own obstacle. And that starts with being very careful about

how you spend your money. It starts with that recognition that every dollar you spend on a bigger house than you need or a nicer car than you need or fancy designer clothes and vacations and all of that. All of those dollars are dollars that you can't spend investing and therefore they're dollars that you are robbing your future self of. That's not to say that you should never spend money on anything. There is a certain wisdom to living in the present, but keeping that in mind at all times is rule number one of the nine rules of growing wealth. Rule number two is to use the greatest investment ally that you have, which is time or specific specifically compound interest. And most of you who listen to this show are very sophisticated.

I don't need to explain compound interest to you. You get it. So don't forget about it. And remember, compound interest can serve you not just in the broad market, but also if you have real estate investments or if you have any outside market investments. Because let's say that you've got some rental properties and they're cash flow positive. Well, guess what? You could choose to spend that positive cash flow on like shampoo. and cigars and caviar. Or you could choose to take that cash flow positive wealth, that spare money that your houses are kicking off, and reinvest it. You could reinvest that money into aggressively paying down your mortgages. You could reinvest that money into putting it in the stock market. You could reinvest it into making another down payment. Really, what you choose

doesn't matter. Your contributions to your investments matter far more than, you know, the nuance, couple of percent details of, you know, X versus Y. So all that is to say that compound interest can work in your favor even if you are not a market investor. Although to Andrew's point, Andrew, of course, is a market investor and he wants to emphasize that compound interest in the market is just an amazing ally. So you'll never be younger than you are now. And that is all the more reason to really ramp up your investments now. Rule number three, small fees pack big punches. And the takeaway of this rule is to be very cognizant about the fees that you are paying in your investments. You have your expense ratio. You have your 12b1 fees. You have more fees than you

might be aware of because you don't write a literal check for those fees. That money is just deducted from your total returns. And that means it's out of sight, out of mind. It's invisible. You don't feel the pain of parting with that money. So this human psychological trigger, loss aversion doesn't kick in. And when you don't feel that loss, it can be very easy to continue paying these invisible fees for a long time. But those small fees pack a very big punch. And especially over the course of 10, 20, 30, 40 years, that can add up to tens of thousands of dollars. So TLDR, be cognizant of your investing fees. By the way, I say TLDR like all the time now. I know it doesn't actually make sense to use it as an acronym in speech, but I don't

care. I really love it. Hey, everybody, it's Steve, that guy who does stuff for Paula. If you're like me and you're not a literary agent, you're not a journalist, and you're not into all the Instagram memes, you don't know what TLDR means while I looked it up. Quick Google search Wikipedia shows TLDR stands for too long, didn't read. TLDR is a shorthand notation added by an editor, apparently a literary editor or not an audio editor, and it indicates a passage appeared to be too long to invest the time to digest. So not only are you learning the nine rules of wealth, but you're also getting schooled on shorthand notation. Sorry for the interruption. Back to you, Paula. Cool. Then we get to rule number four, which is conquer the enemy in the mirror.

And this is where we started today's episode. So if you're just joining us for the first time, If you haven't listened to Part 1 yet, I encourage you to go back and listen to Part 1. That's where we heard Andrew's story and it's where we heard the first three rules. Today's episode begins with Rule 4, Conquer the Enemy in the Mirror, which means don't time the market, don't try to outsmart the market, be aware of the fact that it's incredibly difficult to take control of human emotion. That's true, regardless of whether you are the typical person that you read about, the person who buys high and sells low because you are scared by a recession and, you know, irrationally exuberant by a bull market. That's the scenario that you always read about. And then to the questions that I kept asking, Andrew, I wanted to ask questions about the other

side of the coin, the contrarian viewpoint, people who have a fear of heights, you know, people who, and I can relate to this because I'm one of them, people who look at the market and say, wow, everything's expensive, the PE ratios are really high. Could we be at the, you? top of the bull, could this be the top of the bubble? And that is yet another expression of market timing. And so again, regardless of whether you're a contrarian or not, your job, your goal, is to resist the urge to let your emotions sway your decisions. And that is the art of conquering the enemy in the mirror. You know, I've been really intrigued by the art and the science of decision making lately because it occurs to me that the whole.

whole theme of afford anything ultimately is a theme that's based around decision making. Like I intro every episode, you can afford anything but not everything. So what decisions will you make? And decision making truly is it is both an art and a science. It pulls from cognitive psychology and behavioral economics. It pulls from all of these disparate fields. There's a lot that we can learn about the way that our minds process information and use that information to arrive at conclusions. And I'm fascinated by that. And that's part of the reason why I've invited some of the recent guests that I have onto the show, like Billy Murphy, the former professional poker player.

I wanted him to come on the show because what he could explain to us about poker, the mindset that he cultivated, the decisions that he made, I thought was just another kind of way to push into some more insight as to how humans can make decisions. And that's a theme or a topic that I want to continue to cultivate. as the show goes on. But at any rate, that being said, in the context of Andrew's interview and in the context of Rule 4, conquering the enemy in the mirror, the reason that people are their own worst obstacles is because people often make bad decisions. And typically, those bad decisions happen when emotion overwhelms our better judgment. And so tuning out and not listening to the talking heads and counterintuitively taking the lazy approach, can actually be the best approach because it allows you to keep yourself from getting in your own way. So that's rule four. Rule number five, build mountains of money with a responsible portfolio.

That's rule number five, and what he means by responsible portfolio is well-balanced. Asset allocation is one of the greatest determinants of your portfolio performance. I mean, I know I sound like we keep repeating the same mantras, but it's your contributions, so how much money you put in, your asset allocations, so how you spread that money around, and your fees, how much you pay to do all of this. If you can just nail those three things, you'll be relatively solid, particularly if you have a long time horizon. And by the way, as Andrew mentioned, even if you are in your 60s, I think he said this in part one, the previous episode, even if you're in your 60s, you still have a long time horizon because you're you, want your portfolio to last until you're 100, so even if you're 60 today, you still have 40 years ahead of you.

So rule 5, build mountains of money with a responsible portfolio, means think about how you want to diversify your assets, think about what asset classes you want to go into, write them down, and stick to them, and particularly stick to them when the enemy in the mirror, you, your emotions, are trying to convince you to change your mind. Rule number six, sample around the world ticket to indexing. And what Andrew is talking about in this rule is to make sure you're diversified across a number of different nations. So if you are a U.S.-based investor, he thinks that you should have an international allocation. As we talked about in today's interview, this is kind of a controversial topic because there are some people who

like convincing arguments as to why you don't necessarily need an international allocation. And there are some very accomplished investors, Jack Bogle being one of them, who doesn't have international exposure. So, you know, again, this goes back to decision making. I mean, I'm not going to tell you what to do, but I'm going to put the information out there. I'm going to present his idea as I've done. I'm going to present the counterarguments as we've done here on this podcast. And it's ultimately up to you to decide what you think, you know, how you want to make sense of point counterpoint. Should you have an international allocation? Maybe, maybe not. If you did, would it affect your investor behavior? Because as Andrew says, investor behavior is the determinant

of how you'll perform. I mean, if not having an international allocation is going to cause you to just not put money into the market when the U.S. market reaches new highs, then there's an argument to be made for going international. On the flip side, if having an international allocation is going to cause you to flinch every time we hear about Brexit or Iceland or Greece, then, you know, maybe if do the thing that is going to get you in a position where you're going to make big contributions into low fee funds with a reasonable asset allocation. Just do those three things. and put them in tax-advantaged accounts for things. And if you do that, then, you know, the rest of it is really all about understanding your own psychology,

you know, understanding how you can make the decisions that will give you the highest likelihood of not tripping yourself up. I guess that's really the key takeaway to all of this. That's the key theme that keeps coming up over and over throughout every single one of these rules. know yourself and make the decisions that allow you to work around your own parameters. Rule number seven, no, you don't have to invest on your own. If you want somebody to do it for you, as Andrew says, the easiest way to do it, the set it and forget it method, is just go into a Vanguard Target retirement account. They're low fee, they're reasonable.

And I'm going to read you a quote from his book, actually, because I love this paragraph. He says, quote, if a deranged mutual mutual. mutual fund salesperson decided to toss me off a bridge, my wife wouldn't have to worry about her money. She would rather dine on dirt than manage it herself. Fortunately, Vanguard does it for her. And that is how he intros his discussion about target date retirement funds. So, interesting visual, but he's right. Like the target date, and I normally don't recommend them because at a lot of brokerages, target date funds have upcharges. They've got all of these extra fees. But at Vanguard, their target date funds are super low cost.

They are about the same cost as you just putting together all of those things yourself. So if at the end of all of this, you want to just kind of be like, la la la, la, la, just give me the easiest answer. Target date retirement funds, set it and forget it. We're done. End of story. Rule number eight peek inside a pilfer's playbook. And largely what Andrew means by that is understand. the mental playbooks that salespeople, financial salespeople, brokers, advisors who do not have a fiduciary duty to you,

understand the arguments that they are going to make, be able to make those arguments better than they can. And that will really do two things. Number one, it's protection. It will give you a layer of protection from getting swayed by a very charismatic and persuasive salesperson. And number two, and perhaps more importantly, if you can make the opposing sides argument better than they can, it shows that you've truly considered that viewpoint. You've truly considered that framework, that mindset, that argument, and you have arrived at the conclusion that you are going to take another approach. And that's how a decision should be made. I mean, don't just do something because you heard it on a podcast. Do something because you've weighed the alternatives and you've decided. decided that X approach is the right one after thoroughly learning about the alternatives. So go ahead,

learn what the pro-high fee, 2% expense ratio with a huge front load, like learn what those arguments are, the ones that support buying those expensive funds so that you will know why you're not doing it, if indeed that is the choice that you arrive at. And finally, rule nine is avoid seduction. And essentially all that means is if it sounds too good to be true, it probably is. But I assume those of you who are listening this deep into the podcast, I assume you probably know that because you are not the type of people who fall for the get rich quick, easy money kind of scams. But, you know, keep that in the back of your head. If it sounds too good to be true, it might be.

Thank you so much. I hope that you enjoyed that conversation with Andrew Hallam, the millionaire school teacher. Andrew is an amazing person. He's absolutely fantastic. I'm very inspired by him and by his story and honored to have him on the show and really rather honored to know him. Andrew and I have known each other for many years. He reached out to me when I first started Afford Anything.

Back in 2011 or 2012, he was one of the first other people in this. space that I connected with. And so super happy that he has chosen to share his story. And I hope that his story inspires people who make the equivalent of a school teacher's income to know that you too can become a millionaire and reach financial independence. So thank you again, Andrew. So as a reminder, I am recording this from on stage in Washington, D.C. at a conference called FinCon, recording this in front of a live room of people, so that's what you're hearing in the background. It is currently the month of September 2019,

and I am on what I'm referring to as the September sabbatical, meaning I am taking the month off. We're not creating any new shows, so we will be re-airing interviews that come from our archives, such as this two-part episode with Andrew Hallam. And we will also be airing interviews that I've done on other podcasts. So coming up on Monday's, this upcoming Monday show, we'll be airing an interview that I did on the ChooseFI podcast.

So you'll hear Brad and Jonathan, the host of that podcast, you will hear them interview me. So basically the tables are getting turned. I will be in the interviewee seat. That is coming up on this upcoming Monday's episode. So make sure that you hit subscribe or follow so that you don't miss that episode. You can follow my travels during my September sabbatical, during my month off when I'll be traveling.

You can follow those travels on Instagram. at Paula Pant, that's P-A-U-L-A-P-A-N-T on Instagram. Thank you again for tuning in. My name is Paula Pan. This is the Afford- Anything podcast, and I will catch you in Monday's episode. See you there.