Afford Anything - Challenging Your Confirmation Bias, with Economist Larry Kotlikoff

Episode Date: July 29, 2021

#329: Have you ever thought about how an economist views financial planning? Would you guess that it's vastly different from how some financial planners approach this work? Today's guest, Laurence Kotlikoff, is a Professor of Economics at Boston University. The Economist named him one of the world's 25 most influential economists in 2014. Professor Kotlikoff has written 19 books, and hundreds of professional articles and Op-Eds. He's here to explain why economists take a different view than financial planners on investing, retirement planning, and risk mitigation. For more information, visit the show notes at https://affordanything.com/episode329 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every choice that you make is a trade-off against something else. And that doesn't just apply to your money. That applies to any limited resource that you need to manage. Like your time, your focus, your energy, your attention. Saying yes to something implicitly means accepting the trade-offs that come with saying no to all other alternative opportunities. And that opens up two questions. First, what do you prioritize?

and second, how do you align your decision making to reflect that which you prioritize? Answering those two questions is a lifetime practice. And that's what this podcast is here to explore and facilitate. My name is Paula Pant. I am the host of the Afford Anything podcast. For as much as we talk about money, it occurred to me that we have never had an expert in economics on this show. And so today's guest is not only. a professor of economics at Boston University, but also he has been named one of the world's

25 most influential economists by The Economist magazine. Professor Lawrence Kotlakov is a fellow of the American Academy of Arts and Sciences, a fellow of the econometric society, president of economic security planning, incorporated, and the director of the fiscal analysis center. He has written 19 books and hundreds of professional articles. He's a New York Times best-selling author, and his columns have appeared in the Wall Street Journal, The New York Times, The Financial Times, the Boston Globe, Bloomberg, Forbes, Fortune, and many other major publications. As I mentioned earlier, in 2014, the economist named him one of the world's 25 most influential economists, living economists, to be clear. Now, in this upcoming interview, Professor Kotlakov

makes many statements that are antithetical to some of the core philosophies in the financial independence early retirement movement. And that is a movement and a philosophy that comprises a very large base of this listenership in this community. What you are about to hear is not necessarily a view that I myself personally have adopted, nor is it a view that represents afford anything, but, as I have stated multiple times on this podcast, I am a firm believer in never entrenching yourself in the echo chamber of confirmation bias, particularly when the subject at hand is both as high stakes and as within your locus of control as your finances. And so let's hear Dr. Kotlochoff's takes on issues such as inflation, debt,

Active investing versus passive investing, investing in the market versus choosing individual stocks, and broadly, whether you should take your financial advice from financial planners or economists. Here he is, Professor Lawrence Kotlakov. Hi, Larry. Hey, Paula. How are you? I'm great. How are you doing?

Good. Great to talk to you. You as well. Larry, I would like to start by discussing a big picture overview of the current economic landscape as, of course, we had the Great Recession, then we had an 11-year bull run, and now in 2021, we are all a little confused as to what economic era we're currently living in. Could you help us make sense of the broad economic landscape around us? Yeah, I would say it's one of significant and ongoing uncertainty.

We're seeing major increases in prices and inflation. I think the price levels increased about about 5% over the last year. That's huge compared to our recent history. And it could easily turn from 5% to 10% because if inflation gets into people's minds, then they're going to start raising prices because they think other people are, and this is a good time to do it, kind of opportunistic price increases. Then things are off to the races. And then the Fed has to kind of step on the brakes to try and stop it.

and then we get into a recession. So tricky situation. The last thing to say is that the government's not just printing money out the wazoo, but also borrowing money out the wazoo. So federal debt has been going up like crazy. So that's, you know, led to the potentiality for much higher interest rates. So a couple of follow-up questions. Number one, as you mentioned, it's certainly the case that the,

the money supply has increased dramatically. Why haven't we seen more inflation yet? And, you know, when you read these reports of Janet Yellen saying that she doesn't think that inflation, if it happens, it would only be temporary. Why is that sentiment out there? And what are the arguments both for and against it? Like I'm trying to develop a multifaceted understanding of inflation as it relates to our current situation.

you know ultimately companies are setting prices so if they believe that nobody else is raising their prices and that doing so is going to lose them customers then you can kind of jawbone them into going along staying the course of not raising prices but what we're seeing certainly is that the laws of supply demand are crashing through and we have shortages and things like lumber and that's leading to these price increases so what Janet, I call her Janet because she's a close friend and former professor of mine actually is saying is, well, look, we have certain things, certain shortages and we'd expect those prices to go up. But in general, people are still expecting low inflation, and that's what the Fed is

going to try and maintain. And that's what we're predicting. And the long-term bond markets are saying that, too. I mean, she's saying, look, if you look, if you look at the long-term inflation index bond yields, they're essentially zero, and the treasure yields around two and a quarter for a 30-year bond. So the implied expected inflation is two and a quarter, which is kind of with the Fed's target. So people do, markets are buying into what we're saying is going to happen and everything will work out. Can you explain why the markets currently believe that or why the markets are currently

behaving this way? So there's the amount of money, but there's also the speed of which money is circulating. So faster money is like more money and slower money is like less money. So the classic theory about the impact on prices for a given amount of output is that it's the amount of money, the amount of like dollar bills times their rate of circulation, what we call velocity. So if velocity goes down, then, or velocity is kind of based on your expectations. and if people expect prices to go up, then they turn money into a hot potato. They don't want to hold on to it because they don't want to be stuck with worthless money. So right now, velocity is very low because people believe, in general,

that prices are not going to rise very rapidly. But if that changes and that belief can change on the dime, then velocity could go up and this combination of a huge increase in the amount of money that's out there, six-fold increase since 2008, and the velocity going back to what it was, let's say, in 2007, that could support an increase in the price level by a factor of 12. If you look at the historic relationship between money and prices and velocity, if you get back to a typical velocity, we're talking about massive increases in price levels. I see.

So what you're saying is because the velocity of money is low, the idea, the theory is that you can then increase the supply of money and not have high inflation. But the problem with that is that if the velocity of money speeds up, then that increased velocity coupled with the fact that we now have such a bigger money supply could then result in massive inflation. That's exactly right, yes. It's a expectations game. And, of course, we have lots of people around the world who are taking these dollars

and thinking that they're going to be valuable in the future, that we're not going to be running high inflation, but I'm old enough to remember the inflation in the 70s where we had 10% price increases every year for a while. And it just got into people's heads that that's what's going to happen. And that's part of the landscape. That's part of the uncertainty. That's part of why people have to be very careful of how they're investing these days. And it's hard to find things to invest in that make a lot of sense. You know, long-term nominal bonds very risky. You could buy tips, treasury inflation protected securities, which are yielding last time I looked zero in real terms for 30 years. At least you can preserve your money. So maybe a portion of your

assets you want to hold in tips and just hold them in a majority and you'll end up at least having what you have got bet. But if inflation takes off, now you're going to be taxed on the nominal increase in your coupon and the final terminal principle. so you're going to get zapped by taxation on the inflation component of the return. So they're not even safe from that perspective. And then you've got the stock market, which has seemed to be overvalued. You know, the Fed basically printed a lot of money to buy up corporate bonds and other, and mortgages even.

And if they don't think that money that the Fed put out there is going to be coming back in terms of repayment to the Fed, then people are going to realize that that money that's been, print is out there to stay. That's not just temporary. That's permanent increase in the money supply. That only feeds into inflation expectations if you put things together. So, and if inflation goes up, then interest rates go up, then what are we going to have? We're going to have a stock market go down because the stock market doesn't like high interest rates. So here again, I'm saying it's very hard to think about something you can invest in that makes sense. Several follow-up questions are popping into my head right now. First of all, why is it that interest rates are still as low as they are,

given that there are inflation fears on the horizon? Is it purely because the velocity of money is low? Or are there other reasons why current interest rates are still low? We often have crashes. Why? Because people have been irrationally exuberant. They just don't have, get it right. And you got traders who are trading when everybody else's irrationality. if they make money in a pack, that's great. If they lose money in a pack, they're not going to be fired. But if they lose money by themselves, they will be fired. So this is where, in the large part, these traders are setting the market. So that's why you have this kind of herd mentality here. And John Maynard Keynes referred to this as a beauty contest, and who is going to be chosen to be the beauty queen and people are kind of, um, deciding based on who other people are deciding about. You mentioned earlier that we are seeing the laws of supply and demand play out. We're seeing, for example, a shortage of supply in the lumber market have a massive impact on housing prices.

What other supply and demand examples are we currently enduring? And what end is in sight? Well, I think airline tickets are very expensive. So you've got that. You've got restaurant meals, it seems to me, you know, just by... On the supply side, why is that? Like airline tickets, is that labor shortages? Is it fuel? Is it fuel? I don't think it's fuel. I think it's probably just limited number of airplanes. The airlines have just have limited number of flights. And all of a sudden, you have people rushing to go on vacation. They may be unsure about whether this increased, demand for flights is going to be sustained and they may be maintaining a limited schedule. They've certainly canceled flights, certain routes. So they may just be playing it safe until they see that things are really back to normal. If I were an airline, I'd be doing that. And it may take a while to get their people back in place. They probably fired a lot of people

or laid them off. Ground crews may have gone off to do other kinds of jobs. restaurants the same thing a lot of them have closed and then you've got getting the supply chain the food back into the restaurants so I don't know it's like Rimp van Winkle waking up to right much higher prices in the aggregate numbers it's saying a 5% increase that's that's high for our you know what we've been experiencing in the last 10 years or so but it could be much higher still. I know that a lot of companies are very reluctant to raise prices, but when they see other companies raising prices, then it gives them basically some shield. They can say, okay, I think now my competitors are raising their prices. I can raise mine, or even if my competitors don't raise

their prices and I raise mine, I won't upset my customers so much because they'll realize everybody's raising prices. I'm just trying to keep even. So that's the kind of mentality of thinking about price setting that can get into the heads of suppliers. This is a opportunistic time to raise prices. Given that, as you stated earlier, there don't seem to be great asset classes to invest in. You certainly don't want to invest in long-term bonds. And the stock market may be overvalued, possibly. Right.

What should you invest in? Exactly. Well, I think the best asset class is you're investing in paying off your debts, paying off your mortgage, paying off your credit card debt, paying off any student loans, any consumer loans, auto loans, because you can get a really high safe rate of return doing that. That's the best investment going. Another debt that you may not think of as a debt, you might say, well, I don't have any mortgage. I don't have any student loans.

I'm 63. But maybe you have some other obligation like you've decided or committed to paying your grandchild's tuition. Well, that's like a debt. So pay it off. Let's say your grandkid is just 19, okay, you're just 18 and just about to start college and you've got four years of tuition you've committed to. Well, if you take the money that you're going to use to pay that tuition and put in the stock market for four years and it goes down the tube and you still have to pay the tuition, you've just leveraged yourself. You've just put yourself at great risk. better to take the money that you'd otherwise have in the stock market and pay it off today.

Okay, but what do you do if your child is one and you want to cover their college costs, but their college is going to start, you know, freshman year will start 17 years from now and senior year will start 21 years from now. And you don't know how to predict what the cost of higher education is going to be in between 17 to 21 years into the future. I would say these kinds of obligations, which are for sure obligation, not things that you can somehow in your mind get around. I would try and pay them off in terms of long-term inflation index bonds, tips,

or even better eye bonds, which are a form of inflation index bonds that yield a higher return because it's kind of arbitrarily set by the government. I think you can buy $10,000 worth of eye bonds every year, and your spouse can. And as a couple, you can do 20. 20,000 a years, as far as I understand. So I would say immunize those liabilities. And don't worry that you don't have money in the stock market because the stock market is highly risky. If you're going to invest in the stock market, I would try and find somebody who's been

very successful investing in value stocks who really is carefully looking at companies that are really cheap compared to other companies that are doing the same thing in the market. market so that you're kind of like engaged in a hedge here. That's, you know, if you ask me personally, am I in the stock market? Yes. Am I in the entire stock market? No, because I think the entire stock market's overvalued. So I'm investing with somebody who I think is a really good stock picker who's focused

on value stocks and who does a huge amount of research on each company that's investing in. So to be clear, you're a fan of. actively managed funds rather than passive funds? At this point, yes, because I think the overall stock market is fundamentally overvalued in terms of the price earnings ratio, and that it's very much supported by the Fed, and the Fed support may not be there forever. What about passive value funds, value index funds? Well, I think now you're really betting that the stock market is reasonably priced, and this is basically sacrilege for an economist's to say. because economists generally are saying just invest in the entire broad index, 6,000 stocks,

don't try and time the market, just hold the market. And, you know, that's generally good advice, but I'm just particularly concerned that we have an artificially high stock market right now, but it's just a lot higher than can be rationalized by fundamentals. Would a value index or a value ETF be a little bit of protection from that? I mean, in terms of if you wanted to diversify away from a broad market index and into a value index. Yeah, I think that would make some sense. But a lot of these stock pickers, you know, if you're talking about mutual fund money managers,

about three quarters of them underperform the market in a given year. And then the next year, the ones who overperform this year tend to, to underperform the next year. Yeah, the reversion to the mean. Yeah, I think you really need to, maybe they're overconfident. I'm not sure quite why somebody does well, screws up systematically in the next year, typically. But I think you really want to find somebody who really is talking fundamentals in a way that makes real sense.

Comparing this company with another company that's doing very much the same thing, but their price is much more, much higher. This company hasn't been recognized. of the market, but look, the insiders are buying their shares, they're making these sensible moves, you know, really learn, spend the time to understand what it is you're investing in. I think we're kind of in that boat years ago, 10 years ago, 15, year 20, I would have said, just hold the market. You know, that's what I did for many years. But I think we have too many people that are irrationally investing today and too many computer

programs that are robo investing too much money so that I just don't necessarily trust the overall market anymore. What's interesting to me is that you cited the statistic about how many fund managers who outperform one year will underperform the next. And so it seems statistically improbable to find the one fund manager who can consistently outperform over time. why is it then that you still like an active fund strategy? Well, part of it is you can look for stocks that may just be just safer because they've got

less debt, because they've got, you know, very good CEO, they've got a good game plan. They make fundamental sense. Then let's think about the other 20 criteria that we should think about with stocks, you know, price earnings ratio, how much debt, what kind of, you know, management terms, where they've had, dismanagement on the shares. These kinds of fundamentals are they innovating? So maybe you just hold 10 stocks rather than, but maybe you do your homework on 10 stocks that you really like.

Maybe we're in that kind of world at this point. And each of us can spend enough time on 10 stocks, although we may have to research 100 stocks to find 10. The person who's listening to this interview, who wants to learn how to have that level, of insight, that judgment, that decision-making, where do they begin? I'm not like myself a stock picker, right? But my understanding is that there are lots of books out there about fundamentals of, you know,

of stocks and how people are making decisions. We have lots of books about charts and chartists. People look at how, kind of pictures of how the stock prices have done and patterns. don't believe much in that. I think that's a bit ofocus pocus, but there are lots of sources about fundamentals that a good company should have. It shouldn't have a price earnings ratio. It should not be the case that Tesla's got. This company, Tesla, is valued more than all the other auto companies in the country. I think maybe even the world, that just doesn't make any sense. You know, you could see that several months ago. You knew that Tesla was going to drop in value.

in price and I believe it has significantly and it probably still has a ways down to go. So kind of thinking about what sector is this particular company in and how is that will carpets do well, you know, or carpet cleaning machines do well. How does it compare to the other ones out there? Is it coming up with new ones? Does it have a price advantage? Is it doing something sensible? If you're running the company, would you run out the way these guys are running? let's read their annual report. Let's look at their quarterly, hear their quarterly meetings, you know, that they're open to the public. Does it sound like these people know what they're doing? Are they borrowing out the wazoo? These are the kinds of things that this common sense

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Big Bank muscle, fintech hustle. That's your commercial payments of fifth third better. So we've talked about the broad economic landscape. We've talked about inflation, how it may be on the horizon, and how inflation relates to both the supply of money as well as the velocity. of money. We have talked about why interest rates are still currently low and where to put your money given that neither long-term bonds nor stocks are a fantastic idea right now. And so some of what we discussed includes, you know, if you have long-term obligations, perhaps tips, perhaps

I-bonds, and perhaps some element of even individual stock picking if there are particular companies that you think might be good picks. Right. Maybe they pay a dividend. Maybe they're just relatively, you know, blue chip stocks is the old term for companies that were, you know, just stayed companies that were going to be there for a long time. And we're, I had a lot of maybe diversified products, not just one particular product and large.

And we're paying a good dividend and had been for a long time. And so we're reliable. So if nothing else, you would most likely get the dividend as a payoff. And is that dividend as a share, as a ratio of the price of the stock that you, you know, the current price, if that's like 3%, well, that's better than earning $2.5. Maybe on treasuries because that $2.5% the treasury coupon is fixed, whereas the dividend presumably will go up with inflation with price increases. So it's probably more of a real return rather than an honest.

nominal return. But I wish I was a really a great soothsayer and could tell people exactly what to invest in in terms of stocks. But I think the really safest thing is pay off all your debts. A follow-up question to that. Why would a person pay off their mortgage given two factors? Number one, that mortgage rates are at historic lows. As you said, you remember the high rates of the 1970s. Right now, mortgage rates are at generational lows. That's. the first factor. And the second factor is that in an inflationary environment, being a holder of a fixed rate mortgage would be a hedge against that inflation. Yeah, no, absolutely. If you really were concerned about inflation, which, suppose, for example, you wanted to buy an annuity,

and you're aware that the annuity would get paid back in watered down dollars. Maybe you're 65 and you would like to have this stream of income that continues as long as you live because you're worried about living too long. Well, one thing you do is borrow more money on your house, if you could take out a mortgage, and use the proceeds to buy the annuity, and now you've got a pretty good hedge. Because as you just said, well, inflation goes up, you lose on the annuity, but you gain on the mortgage. So it's got a natural hedge. Yes, right now mortgage rates are low, so you certainly, if you're not going to repay off your mortgage or prepay it, you want to, refinance it. If you're going to maintain a mortgage, you want to refinance it a lower rate, if at all possible. But there are still some people that are, that have, you know, paying up

three and a half percent on mortgages. And the treasury return is two, two and a half percent for a long-term treasury bond. So there's a one one and a half percent differential there. And that's a real, real return differential that you can get by paying off your mortgage. So if you really thought inflation was going to be 2% into the future, then you can, if you had, let me put it this way. If you had money in a 30-year treasury and you took that money, you sold the treasury today and took the money to pay off your mortgage, you'd make 1.5% if you're currently paying 3.5%. Wouldn't there be people who would argue that rather than pay off your mortgage, you'd be better off, assuming that you're young, assuming you're, let's say, in your 20s, 30s, even 40s, you would be better off. putting that money into, let's, some type of a broad market fund and holding it long term? Well, let me do it. Let's go the other way, Paula. Suppose you're sending, you know, let's say

you're 30-year-old Paula. I'm 37. Okay, 37-year-old Paula. Let's forget retirement accounts. Let's suppose you have a $200,000 mortgage and $200,000 in a long-term treasury. Now, let's suppose today you sell your treasury, you take the $200,000, you pay off your mortgage today. Right. Yeah. That totally makes sense. But as a 37-year-old, I would never have $200,000 in the long-term treasury. Okay. Suppose then tomorrow, would you want to, would you actually go and borrow money on your house, actually reverse the transaction, borrow $200,000, and then take the money and put into the stock market? Yeah, absolutely. You won't? Well, then you've got a very leveraged decision because if the stock market crashes, and I think it may because I think it's, I think it's,

quite high, and I think it's highly supported by the Fed, you're still going to be stuck with that $200,000 obligation. Right. But the $200,000 obligation would be at a low interest rate, at let's say a 2.5% interest rate fixed for 30 years. And the expected value of the investment in the stock market, let's say I put it into VTSAX, I put it into a broad market index fund, and I planned on holding it for the next 30 years, the expected value is that over time, the long-term aggregate average of that investment would be significantly higher than the 2% fixed interest payment on the mortgage. I wish my economist had on.

So there's a general notion that you're conveying here that stocks are safer in the long run. Right. And that's pervasive in the world of non-economists. Okay. The asked economists about this, people in the area of finance, they'll say no. They're actually riskier because how do we know this? if you actually were trying to buy an option, buy insurance, using the option market,

to buy insurance against the stock market dropping below any particular value, it becomes more expensive. The longer out you're talking about the insurance. So actually, there's no reason to think. There's every reason to think the opposite, that stocks are riskier the longer you're holding them, not safer. So I know that lots of financial advisors, have convinced their clients that they can engage in a bucket strategy

where they take a certain amount of money from the client, put in stocks, and 30 years later, when, by the way, the financial advisor is retired, that money is going to be perfectly safe and it's going to yield this a stark return. But stocks are evolving basically as a random walk, and that means that where they are in the future is not really connected to where they are today.

If they're low today, there's no guarantee they're going to be high to tomorrow, or if they drop today, there's no guarantee they won't drop tomorrow. So the stock market is a very risky thing, and it's not reverting to the mean in any significant matter in terms of the statistical analysis. And, you know, if they were really such a safe deal, nobody would be buying 30-year treasuries at 2 and a quarter percent return or 2 percent of return. So I think that's highly risky. Leveraging, taking money, borrowing on your house, and using it to put in the stock market,

you can do it. It may turn out just great, but it's, according to this, you know, what we see in the market in terms of the history of stock returns and the pricing of options, this is a very risky endeavor. Well, by that same logic then, would it not make sense to never, invest in the stock market until you've paid off your house because every dollar that you're putting in the stock market comes at the opportunity cost of a dollar of paying off your home. Yeah, I could call this as V-Body, a professor at Boston University, causes safety first investing.

I refer to this as upside investing where you take care of your liabilities and you treat money in the stock market as like money you take to the casino, like how you play the casino. When I go to the casino, which has only happened once or twice, I've kind of been forced to because of some kind of convention, I might take $100, leave my wallet back in the hotel room. That's guaranteeing my living standard. The fact that I'm not taking my credit cards with me and going nuts. And I don't, if I make any money at the casino, I don't start spending money while I'm still playing the slots or playing blackjack. I wait until I leave the casino to spend my winnings. And if I have no winnings, I saw my wallet back at the hotel room.

That's setting a floor to your living standard. So this is what, as an economist, I would say, for the middle class is basically the way they should be thinking about investing. They should say, okay, money I'm going to put in the stock market and I'm going to view as casino money. I'm not going to spend out of it until I've transformed it into safe security, like maybe gradually, invested in inflation index bonds or I bonds. I'm going to pretend that it's all going to be lost. The rest of the funds that I have, I'm going to invest really safely, maybe in tips. I'm going to also pay off my liabilities, and I'm going to establish a floor to my living standard and just have upside risk. That's what Svevedoody would call safety first investing. That's what I

would call upside investing. That's the strategy people in the middle class can adopt. it connects to behavioral finance where we have a lot of people who just do not want to have their living standard drop. They're happy to invest in the market, but they don't want to see their living standard ever drop. Well, the way you do that is not spend out of money in the market. You just assume it's lost until you've made it safe. But you let it ride. You know, you let it ride. If it does well, great, if it gets this historic high return that you're referencing, which is absolutely true, mean return, average return, terrific. If not, you at least have your living standard floor secured. Am I being clear on this?

Yeah, absolutely. So my follow-up question then is, if you were to do this, the safety first investing or upside investing, at the time at which you are done paying off your liabilities and ready to begin more aggressively investing, your timeline to retirement would be a lot shorter and therefore your investment allocation would have to be much more conservative because of the fact that you're older at the time that you began. Well, you've been really conservative. because you've got this floor and you're happy with it and the money in the market that comes out is all gravy. So you take it out and have a permanently higher living standard, perfectly safe because you're taking the money out investing at lessening tips so that you

now have a higher floor. So it's a very conservative, this is really a super conservative way to proceed because you're not saying, oh, you know, I got my money in the stock market. I know I'm to do really well. I can spend out of that money, out of those future winnings that I haven't yet accrued because I know historically or any 30-year period the markets earn 6.5% real. It's going to do this for me again like every, it's done for everybody else, like for my parents, whatever. But of course, you know, there's been periods where the stock markets dropped 84, 86, let's see, dropped 80, I think 86% between 29 and 33. It dropped. 50% between 2000, 2002, dropped 53% between 2008 and 2009, dropped 34% in 2020, right? And then came back.

So it's a really, it's a bunking Bronco. And you might, this assurity that it's going to do well, when it drops dramatically, you panic and you'll sell the bottom. So better to say, okay, you know, if it drops, if drops goes up, I'm not going to touch it until I hit the 60 and I'll gradually take whatever, you know, gradually take for the next 10 years the money out, maybe 10% a year for 10 years. And whatever's there, I'll raise my living standard. My floor, my living standards can be perfectly safe. That to me is what we Americans should be basically doing unless we're, you know, super rich. And if, you know, actually, if we're super rich, we might want to be doing this too, because the money that we've got is really money for our kids

and grandkids and descendants, and we have to be their fiduciaries, so we don't want to put them into excessive risk either. If you had a billion dollars, would you put it all in the stock market, Paula, knowing that it could drop 50% overnight? Well, I mean, I would never put, no matter what the amount, I would ever put 100% of my portfolio in the stock market, I would diversify. Yeah, but economics teaches us that the richer you are, the less you should, the smaller the share you should put in the stock market,

because you have less of a floor, If you have $30,000 coming in a year in Social Security and you have just $10 in assets, putting the entire $10 on 29 red is exactly what you want to get as much risk as possible on that $10. You're a bond, basically. You've got a safe, secure living standard and very little that can go wrong if you fully invest in stocks. but if you have essentially no Social Security and a huge amount of, let's say, assets, then you've got to be very careful about how you invest those assets. So I'm saying the rich actually should be investing a small share of their assets in stocks than the poorer of this. Economics has very counterintuitive prescriptions, but once you think about them, they're quite logical.

But what we as economists are saying with respect to personal financial matters, in terms of our advice is almost a complete right angles to what conventional advice is providing on every topic, how to invest, how to think about investment risk, how to do basic planning for retirement. Every single thing is quite different. I know lots of financial planners who are trying their best, but I think the tools of personal finance that they're using are basically product-driven. The tools of Wall Street has provided to practice. practitioners are designed to get people to buy things that are not in their financial interest. What types of things? Like when you say buy things, you're talking about insurance products,

annuities, expensive funds. Well, let me just give you the very basic fundamental way that conventional financial planning proceeds. Let's say I'm a conventional financial planner. You come into my office. The first question I asked you, Paul, is how much you want to spend in retirement? What's your target? What's your goal? What's your replacement rate? you'll give me a number, which is going to likely be too high. Or if not, I'll tell you, well, let's use an 80% replacement rate, which is going to set your target to be too high. Then I ask you how much you're saving. You tell me.

I also ask you how much your assets are. Now, your saving is likely to be too low because most people are saving too little. So I take your assets. I say, okay, up to retirement age, you're going to save what you told me. Say, okay, now tell me how you're investing. You tell me. and I say, okay, we're going to do a Monte Carlo simulation. We're going to draw returns and accumulate your initial assets plus the additional saving every year.

And then in retirement, we're going to decumulate your high level of spending. And we're going to see whether you end up running out of money. And we're going to do this a thousand times or whatever. We're going to run this Monte Carlo simulation. And we're going to figure out your probability of failure. What I'm doing now is I'm simulating three mistakes. You're saving the wrong amount. I'm simulating you're saving the wrong amount.

because you surely are saving too little. I'm simulating your spending too much because I've set your spending target to be too high. And I'm simulating you're never adjusting, you're saving or you're spending regardless of what happens, which is exactly the opposite of what economics says. Economics says always adjust based on where you are, your circumstances to try and have a smooth ride into the future.

This is saying don't adjust. Set your target and stick to it. Okay. So now you have the simulation of three mistakes and with very high probability your plan is going to fail. And then the next thing that happens is the planner is going to say, well, let me invest your money for you in these high yield funds, mutual funds. And your probability, well, Paul, now your probability of failure is much lower.

Your probability of success is much higher. And let's go this way. And you say yes. But what this planner isn't telling you, or what the planner's tool isn't telling you, is that the downside for you when things really go bad is much worse. course. There may be smaller probability of the downside, but when the downside hit, it's a much bigger downside. So had you really seen that, you would have said, no, this is not for me. The basic methodology of economics is trying to have a smooth living standard. It's not to put

things on autopilot to adjust to your circumstances, to adjust your saving to keep your spending smooth, whereas conventional financial planning has got it exactly the opposite. It's, let's keep your saving on autopilot. And by process of elimination, that means your spending is going to be all over the place. Can you elaborate a little bit more on the methodology of economics? So if an economist were to give personal finance advice from an economic perspective, what would that methodology be? So there are four basic principles of economic space planning. The first is consumption smoothing, having a smooth living standard through time. And by living standard, I'm referring to your discretionary spending, apart from meeting your fixed expenses on housing

and taxes and alimony, your child support or tuition payments for your kids, things you really feel you have to pay, that you really want to pay. You absolutely come hell or high water. But the rest is your, you know, your discretionary spending. And you want to smooth that out. The The whole reason we save for retirement is that we're not starving and eating cat food in old age. That's the evidence of our desire to do consumption smoothing. And this idea of consumption smoothing goes back to work by Irving Fisher, a very famous economist at Yale in the 1920s and 30s. Anyway, consumption smoothing is getting a smooth living standard. Then the second thing you want to do, if you're involved in economics-based planning,

is try and get that living standard to be as high as possible. That, in large part, involves getting higher benefits from the government. I'm talking to hear about social security benefits, higher lifetime social security benefits, and pay lower taxes. And how do you pay lower taxes? Well, we have this great mechanism, retirement accounts. We can contribute to Roth accounts and non-Roth accounts, tax deductible accounts, and non-tax deductible Roth accounts. But then there's other things we can do.

We can downsize our home when we retire or where the kids leave. We can move to a state where there's low taxes. We can take in roommates. We can take in our mom or we can go shack up with our mom. We can move into their house to lower our housing expenses. So we're not spending too much on housing. So we're not a house poor. So there's lots of ways, safe ways to raise your living standard.

And economic space planning is focused on that as well. Third thing is pricing lifestyle decisions. If I retire a couple years later, how much more will that raise my living standard? Not just when I'm retired, but now if I plan to retire longer, that means I'm a richer in terms of lifetime earnings are higher. I could actually afford to save less because I'm not going to need to cover as many years of retirement. Let's think about this in a very systematic way. How much does it cost me to retire early or how much do I benefit from retiring later in terms of my living standard? When do I really want to retire?

Let me do it in the context of knowing what the trade-off is. Or if I have another child, how much is that really going to cost? Can I afford the child that extra child? Well, I have to take time off from work. Well, I have to work part-time for 10 years. What's that going to do to my living standard and that of the rest of my family? Anyway, that's economic space planning. And the fourth feature of it is understanding my risk.

And that requires understanding my living standard risk. and that requires running Monte Carlo simulations on my living standard. If I invest this way, let's say 50, 50 stocks and bonds, and I spend rather aggressively through time, well, what's my upside to my living standard if I run Monte Carlo simulations? And what's the downside? Well, thank you so much for spending this time with us. Where can people find you if they would like to know more about you and your work?

Well, my website is Kotlakov.net. I also have a company that does economics-based financial planning software, and that's called maxify.com is our main website, m-a-xifi-fi.com. Great. Thank you so much. Thank you. It's been a great pleasure, Paul. We'll come back to this episode after this word from our sponsors. What are some of the key takeaways that we got from this conversation? Here are five. Number one, inflation is influenced by both the supply and and the velocity of money. Since the start of the pandemic,

the money supply in the United States has increased drastically. I, for one, have always been curious as to why it is that we have not yet, and debatably may or may not, see strong levels of inflation, given the increase in money supply. Professor Kotlakov's answer shed some light

into the nuances behind the multitude of factors that influence inflation, specifically, if the supply of money increases but the velocity decreases, meaning that money is circulating more slowly, then inflation is kept at bay. And right now, the velocity of money, the rate at which money is changing hands, is actually quite low. Velocity is kind of based on your expectations. And if people expect prices to go up, then they turn money into a hoppet data. They don't want to hold on to it because they don't want to be stuck with work. worthless money. So right now, velocity is very low because people believe in general that prices

are not going to rise very rapidly. Because the velocity of money is currently low, the idea at this moment is that you can increase the supply of money and not have high inflation. But if the velocity of money speeds up, that increased velocity plus the increased money supply could result in high inflation. And so the takeaway is that the support supply of money is an important factor but not the only factor in determining whether or not we are about to enter an inflationary environment. The speed at which money circulates, which itself is largely based on consumer confidence, also creates a major impact. And so that is key takeaway number one. Key takeaway number two, even in a low interest rate environment, there is an argument

to be made in favor of paying off a low fixed rate loan, such as a mortgage or student loan. Professor Kotlakov says that the best asset class is paying off your debts, and that sounds counterintuitive when mortgage interest rates are at a rock bottom low, a generational low, and when there is at least a reasonable probability of inflation in the short to midterm future, After all, in an inflationary environment, a person pays off their mortgage with cheaper and cheaper dollars over time, assuming it's a fixed rate loan. And so holding onto low interest rate fixed rate loans is a strategy viewed by some as an inflationary hedge. Dr. Kotlikoff in this interview presents the opposing view. He states that paying off your debt will still get you a better return than T-bills or long-term bonds.

And that it will also get you a safer level of return than putting your money in the stock market, even if you have a long time horizon. Well, I think the best asset class is you're investing in paying off your debts, paying off your mortgage, paying off your credit card debt, paying off any student loans, any consumer loans, auto loans, because you can get a really high safe rate of return doing that. That's the best investment going. He also states that if you have any necessary obligations in the long term, a lower risk inflation hedge would be to keep that portion of your money in either tips Treasury inflation protected securities or iBonds, a form of inflation index bonds that yield higher returns. You can purchase $10,000 of iBonds each year or $20,000 as a couple. And so that is the second idea that came out of this conversation with Professor Kotlakov. And it is certainly a different way of looking at investment options through the lens of risk. Now, to be clear, these are his ideas and not the ideas of this show or this brand,

not the ideas of afford anything. But the premise behind this idea, the notion that stocks are a random walk and that the future is not guarantee. to be like the past, that investing even over a 30-year time horizon may carry more risk than many young investors realize. And it is for precisely that reason that instruments such as T-bills and tips are so attractive to so many investors. It is precisely that idea, which serves as the premise underlying Dr. Kotlakov's statement that the best asset class is debt payoff. and whether or not the specific prescription resonates with you, the premise behind the prescription is an interesting lens to keep in mind

as you go through the work of improving your skill set as a thinker and learning how to simultaneously hold multiple viewpoints in your mind such that you can think critically about money through a variety of lenses. And so that is the second key takeaway. And it brings us to a closely related third, which is the concept of the safety first framework. Here, we're introduced to the idea that a person might want to entirely pay off their home before they invest. That sounds like a radical idea. But if it is the case that the best asset class is debt payoff, then by logical,

extension, why would a person put money into the market rather than pay off their home? Now, I do not agree with this, but Larry, and to be fair, Larry himself did not volunteer that logical extension. He simply laid out the concept that you need to ensure your standard of living first and make sure that you have a safety net that you can draw down on and live off of in the future before, in his view, before you start a number. investing in the stock market. So you know how we usually recommend only investing money that you're willing to lose when you're speculating or when you're getting into something new? Larry takes that same concept and adopts that to even index fund investing. He goes so far as to argue that you

should pay off all your debt first, perhaps even including mortgage debt, before investing in the market. And yes, this means that you would be starting later. But he argues that you would have more of a floor and that everything you invest in the market then becomes extra. So in his view, you would then have a permanently higher living standard. I want to be very clear, these are not the views of afford anything. These are not my views. That said, I am not one of the world's 25 most influential leading economists. He is. And so his ideas, as radical as they may seem, are at a minimum worth understanding. They should say, okay, Money I'm going to put it in the stock market and I'm going to view as casino money.

I'm not going to spend out of it until I've transformed it into safe security, like maybe gradually invested in inflation index bonds or I bonds. I'm going to pretend that it's all going to be lost. The rest of the funds that I have, I'm going to invest really safely, maybe in tips. I'm going to also pay off my liabilities. And I'm going to establish a floor to my living standard. and just have upside risk. This leads us to key takeaway number four,

in which Dr. Kotlakov postulates that the market is overvalue to the point at which it no longer makes sense to just hold the market, which he describes as advice of the past. In his view, algorithmic investing, institutional investing, and robo investing, have permanently changed,

the constitution of investor behavior in the market in such a way that investors behave irrationally and that this irrational behavior is reflected in aggregate market movements, which then show up in passively managed portfolios. The stocks are revolving basically as a random walk, and that means that where they are in the future is not really connected to where they are today. If they're low today, there's no guarantee they're going to be high tomorrow. Or if they drop today, there's no guarantee they won't drop tomorrow. Dr. Kotlikoff goes on to say that he is a fan of actively managed funds as well as individual

stock picking. If a person does turn to individual stock picking, he recommends reading up on the fundamentals of stocks and equity investing and learning concepts such as price to earnings ratio, how much debt a company has, whether or not they're innovating, comparing their product or service against others in their industry, what kind of management turnover exists, if the management owned shares, the sector the company is in, whether they have a price advantage,

are they running the company sensibly, what's on their annual report, do you listen to the quarterly meetings? He recommends doing deep due diligence in order to select any individual stocks that you might carry. Let me pause here and zoom out for, a second, to briefly remind you that, afford anything, the podcast, this is not per se a podcast about money. This is a podcast about how to become a better thinker, how to become a better decision

maker. And it's told through the lens of money management. So this is truly a podcast about metacognition, thinking about how to think. And we do that through the exercise of thinking about how to manage our money. money and our life, which is intricately tied to money, it is for precisely that reason that constantly challenging your own assumptions is crucial to the exercise, the practice of honing the lifetime skill of intellectual rigor. And that, beyond anything, is what this podcast is here to teach. With that macro view established, let's turn to the fifth and final key takeaway,

which are the four central tenets of economics-based planning. Central tenet number one is consumption smoothing, the economic perspective that largely revolves around smoothing out your living standard. By living standard, I'm referring to your discretionary spending, apart from meeting your fixed expenses on housing and taxes and alimony, your child support or tuition payments for your kids, things you really feel you have to pay, that you really want to pay, you absolutely come hell or high water. But the rest is your discretionary spending, and you want to smooth that out.

The whole reason we save for retirement is that we're not starving and eating cat food in old age. Central Tenet number two, get that living standard as high as possible. That may come from the form of higher... income, higher benefits such a social security, lower taxes, or lower expenses. Central tenant number three, price out your lifestyle decisions. For example, if you decide to retire a few years later, how much more will that raise your living standard? And conversely, if you decide to retire earlier, what tradeoffs will you accept in order to embrace that decision? So pricing out your lifestyle decisions is central tenant number three of economics-based planning. And finally, the fourth central

tenant is understanding risk. There is a range of possible outcomes, a cone of outcomes, and you can widen or narrow that cone depending on how aggressively you invest or depending on how ostentatiously you spend. And so those four tenants, consumption smoothing, raising your living standard, pricing out your lifestyle decisions and understanding risk, those are the four central tenets of economics-based planning. And it's a framework for thinking about how you manage your money. Those are five ideas or concepts that have come out of this conversation with Professor Lawrence Kotlakov.

Thank you so much for tuning in. This is the Afford- Anything podcast. If you would like to drop me a note about what you thought this podcast, head to Instagram. I'm there at Paula Pant, P-A-U-L-A, P-A-N-T. If you'd like to discuss today's episode with other people in this community, go to afford-anything.com slash community. We have an amazing, active, engaged community of people who gather in online villages based on shared interests, whether that's debt payoff, side hustles, early retirement, index fund investing, rental properties, whatever it is that you're interested in, there is a place

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