Afford Anything - Practical Investing and the Efficient Frontier, with Joe Saul-Sehy

Episode Date: January 5, 2022

#357: Discussing advanced investing topics with me is former financial planner Joe Saul-Sehy. You may recognize him from the Ask Paula episodes, but we discuss financial topics shared in his new book "STACKED: Your Super-Serious Guide to Modern Money Management" - co-authored with Emily Guy Birken. Subscribe to the show notes at https://affordanything.com/shownotes 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 your time, your focus, your energy, your attention, any limited resource that you need to manage. And that opens up two questions. First, what matters most? Second, how do you align your decision-making around that which matters most? Answering these two questions is a lifetime practice, and that's what this podcast has here to explore and facilitate. My name is Paula Pant. I'm the host of the Afford Anything podcast.

Today, we are going to talk to an esteemed former financial planner who just wrote a book. This book is a very comprehensive, super serious guide to money management. If you are a long-time listener or even a medium-time listener of this podcast, you've heard him many times before he needs no introduction. Joe, Salsi, hi. What's up, Joe? I was going to say, first time guest, long time listener, love the show. So happy I finally got invited on, Paula. Thank you. I know, right? And this is very different. Typically, you and I answer questions that come from the community. Today, the, I don't want to say the tables are turned, but the tables are different. Today, I'm here in the interviewer seat interviewing you, which is an incredibly different format

from the way that people normally hear you on the show. I'm sweating. Bring it, Paula. One of the most common questions that you and I both get when we answer questions that come from this community is how to handle money that people intend on spending in the next three to five years. It's a difficult question because we know that money that's sitting in cash loses purchasing power to inflation, but we also know that the stock market is not a high-yield savings account. One of the first things you discuss in your section on investing is how to contextualize the timeframe of your investments with the type of investment that you should choose and what you should consider. Let's walk through all of these. Let's walk through. Let's start with the long term. Let's start with 10 plus years. Yeah. And actually, can I back up even further than that, Paula? Sure. Because I think this is where people run into trouble with investments is, you know,

lots of the questions that we get, you and I together on the episodes where we're answering the community's question, people ask us what the best investment is. What's the best investment I should choose? And the thing that stinks, especially for people that are listening that are just starting out, and I explained this in the book that I grew up in farm country in West Michigan. And so everything to me revolves around growing seasons. And I think it actually, even if you're not somebody who grew up in farm country like I did. I think we can all agree that we know that when you plant something, there's plenty of places that will tell you the time you should plant, the amount of time it's going to take for it to mature, and then the time to harvest that plant.

And the frustration people have is, so what investment is best? And we experience a lot of FOMO and we see all of these. We see people on Instagram making tons of money on crypto. They're making tons of money on real estate. They're making all of this money. And you go, is this for me? Maybe I should invest in this. What's the hot thing I should invest in? People put money in hedge funds.

Should I do that? What about indexing? Why do I index? What do I do? The cool thing about starting with an approach that's the same as farming is that you start off with your growing season. What's the amount of time that you have until you need to harvest that? And what's great, Paula, is it takes this huge wide world of investments that none of us have time to get to know and to research.

I mean, I'm 53 years old and I have studied far, far more about investing than most people listening. I still don't know a ton about so many different investments. But for me, teaching people how to get rid of all that and instead focus on when do I need this money, that narrows your scope. so, so much. And now you can spend a lot of time, instead of a little time trying to research a lot of things, you can spend a ton of time going deep on just a few options that were appropriate given that time frame that you had. So, you know, that phrase that you always joke about that I say nonstop, begin with the end in mind. If you do that and you know that, it just makes it so much easier. And by the way, then you can do the deep research we all want to do because you avoid all the time not researching all the things that don't matter.

And the other cool thing is, is that you also avoid all these, quote, opportunities that don't fit. So now that you have this narrow lens as you're walking along life and people say, hey, Paula, this is a great idea. You immediately have a filter and you go, yeah, not my thing. And by the way, what's cool about that, it doesn't mean that it's bad, right? You're not making a good investment, bad investment. You're making a, it doesn't fit, so I don't need to research that. If it does fit, now it's cool new information that we can research, but you're going to be able to narrow that field so, so much. So I like starting there. And what I like about your planting seeds growing, a harvesting analogy, your growing up in farm country analogy is that it also illustrates why the approach that most people take, which is to start. by asking about the product is the incorrect approach. Because a lot of the questions that I get, people will DM me on Instagram or they'll leave a comment under the show notes and they'll say, hey, what do you think about X?

What do you think about crypto? What do you think about junk bonds? What do you think about whatever? You know, they'll name a particular type of asset. They'll name a particular product. And that's the equivalent of going to a farmer and saying, well, what do you think about tomatoes? What do you think about zucchini? What do you think about broccoli?

Well, you know, again, it depends on the amount of field that I have to grow. It depends on the length of the growing season. It depends on the climate in this particular location. Tomatoes are going to be better in certain locations than others. And it also, and I know we're going to get into this later, it also depends on what else you're growing, right? How does it go along with the other things that you're growing? Right. Exactly. And how well does it fit with the quality of the soil that you have? Right? So yeah, for all of those reasons, starting with product, if you start with product, but you don't have a framework to evaluate that

product and you're simply asking, well, is crypto good or bad? That's the wrong question. That's like are tomatoes good or bad. Yeah. Crypto is fine. Tomatoes are fine. They're all good. But back to original question, which was if we're looking at long-term investments, the key thing, if we're looking long-term, which is 10 years or more, we want to make sure that we are kicking inflation's butt. That is our number one goal, because if we don't keep up with inflation, we're going to have to save dollar for dollar what we intend to spend. It'll look like we have a lot more money, but everything is going to cost a lot more than it costs today. So we need to get started on that growing season as fast as we can and give our things time to double.

And those two asset classes that have done this very, very well over time are stocks and real estate. And when you compare the REIT index, a REIT is a real estate investment trust, a North American real estate investment trust index against the SMP 500. Over long periods of time, Paula, those have come out nearly even. How they get there is much different. but if you've got a long period of time, those are two great asset classes. And so people ask us all the time, like which one should I use? And my answer today here is lead with the one you're more

comfortable with, but I wouldn't let the other one go because, and we'll talk about modern portfolio theory later, if they're both going to get you there, but there's the chance that you might need some money early on. If we do both instead of either or, and we need to harvest early some of our money, there's a better chance that some of it's going to be ready for us ahead of time. There are, by the way, some exciting asset classes long-term, too, that have recently opened up that I'm really interested in because of the new crowdfunding rules. You know, it used to be that the average person couldn't get into some of these typically very illiquid investments.

But they're exciting opportunities. And I would never lead with these newly available asset classes, but I find them compelling if you're looking long-term to, think about. One, by the way, and is an example when it comes to stocks, we'll talk about all the different types of stocks, but a type of stock that I've really liked for really long-term investing are developing markets. Like, I think developing markets is really interesting. And I think that areas of the world like India and Southeast Asia are just exciting places where the next 20, 30 years are going to be super. They're going to be really up and down and we'll talk about how to put

those in your portfolio, but I think those are great. But even beyond what types of stocks are interesting, because you'll use those in very small pieces, you know, the fact that artwork over long periods of time has also beaten inflation by a ton. And now there are these crown flooding options where you can own either a portion of a painting or you can be in a fund that buys paintings. The thing that I have difficulty with, there's a lot of storage. There's storage. There are preservation and conservation costs. There's all kinds of stuff, which means the fees on these types of investments are sometimes for me hard to swallow. But certainly today, there are, and always, there are new opportunities that are coming about in that 10 plus years that with

money that maybe you can afford to lose, that you could also invest in. So let me ask you about artwork, because as you talk about artwork and you talk specifically right now, you're discussing crowdfunding platforms that allow fractional ownership and artwork, but the topic of art or creative work has also come into the headlines more frequently lately because of the rising popularity of NFTs. However, regardless of whether you're purchasing an NFT or you're using a crowdfunding platform to purchase a piece of art from a famous painter, either way, what you're fundamentally buying is a speculative investment, meaning it's a... It does not produce revenue or produce an income stream on its own.

Its value is contained only in the assumption that other people in the future will pay more for it than what you paid for it today. Yeah. Contrast that with stocks and real estate. Stocks, of course, are companies that generate revenue and turn a profit. Real estate, of course, earns money via being rented out, being occupied. So how should a person distinguish between... long-term investments that are income-driven and that have values like stocks and real estate that have value that is rooted in net operating income versus assets that are speculative in nature,

such as art. Yeah, I remember having a long conversation about this with Kevin Rose, who's been in that market since very close to the beginning has a podcast called Modern Finance. And I love the way he put it, Paula, when it comes to these really speculative thing, if we're thinking about it as money that we need to reach our goal, we shouldn't be going anywhere near any of these speculative investment areas. But if it's money that we have that we're not afraid to lose, that we want to use to hopefully increase our wealth. And think about the strategic word, and I want people to realize I use the word hopefully very strategically there, hopefully grow. Because when you put hopefully in a sentence about investing, that means the standard deviation is,

going to be really high. And people need to realize that as you take more risk on the upside to make more money, there's also the risk that you can lose a lot more money than in these places. If it isn't, if it is something like art is an example, is something that we buy because we appreciate it. There's another cool thing about art, though. It also is a tax shelter. It's a tax shelter for incredibly wealthy people. And that's something that's escaped the average investor, that there's another reason why the ultra wealthy purchase purchase are. But still, incredibly speculative, bat NFTs, when you're buying the latest crypto coin.

If you want to make a lot of money, you have to be in at a time when it is speculative. The more speculative it is, the more money that you can make. If you're starting a business, the way to make money is to have that is to be one of the few investors in a business that does really, really well. However, if it's a really small business, there's a huge chance that it can go really well and there's also a great chance that it could fail. And I'm looking at you, restaurant industry, right? I mean, you see so many people that don't understand odds of success that go and they open up a restaurant and restaurants fail so, so often that it makes them difficult. So I like looking at it as if my investments are a ship. And the

whole of that ship for 99% of this should be based in large companies that are going to float where the economy goes. And you and I really like indexes for two reasons. A, it's difficult to be an investor that beats the average. I would say nearly impossible. Paula would say completely impossible. And we will fight about that another day. But I also agree that even if you can beat it, for most of us, we should pretend that you can't. The other thing I'll like about indexes though, Paula, is that they're self-cleaning. When a company in an index does poorly, the index kicks them out. When I was a financial planner and people bought individual stocks, they may track 25, 30, 40 stocks, which I also think is a mistake. I think if you have individual

stocks, you should track very few so you can go deep with them and really understand the company. But often they haven't looked at them in three, five, seven, ten years. And they haven't, they've never weeded the garden. If you have an individual, You need to weed the guard. Well, the cool thing about the S&P 500 or the total stock market index, whatever the index is, it weeds itself. If a company really stinks, it won't be in the S&P 500 anymore. One of the latest moves, a company and I can't even remember the name, exited the S&P 500 and was replaced by this up-and-coming auto manufacturer named Tesla. Not sure if you've heard of it. So Tesla is hot. And this other thing that I can't remember for obvious reasons, because it's not great, exits. And guess what I had to do as an investor? I had to do absolutely nothing. So if your goal, and by the way,

the number one determinant of wealth is not somebody trading stocks. It's how can you put your money along the efficient frontier, put your money into things that are going to grow with the economy, but put more money in, be able to save more money. If saving more money into the right place is the number one determinant, you can almost put an index on autopilot so you can spend all of your time and all of your focus on how do I put more money into that investment instead of continually trying to weed your garden. So to summarize what you just said, your contributions are the single biggest determinant of your

investment success. And so rather than endlessly iterate the composition of your portfolio, you should 80-20 your portfolio by virtue of choosing index funds and then focus on increasing your contributions, i.e. increasing the gap between what you make and what you spend and then investing that gap. Yes. Thank you for answering your question for me. So we've talked about how to invest money with a 10 or more year time horizon. And as you mentioned, historically, the two asset classes that have performed the best over a decade or longer are stocks and real estate. What should a person do if they have a five to 10 year time? time horizon. In the five to 10 year time frame, stocks will often do really well, but we're not sure.

And because stocks are going to bounce around quite a bit, this is when we start to add bonds to the mix. Bonds are not, Paula, a phenomenal investment. Bonds are a safe investment. And if you're looking for high returns, you're not going to invest in bonds. However, if you start with the end of mind and you want your money to be there, you're going to use a fund that is a stock bond. mix. And there's a couple different ways to do that. You can use a target date fund. I know you like target date funds. I don't like most target date funds because with many companies, target date funds are laden with fees. Huge fees. Think about, you know, Tony Bourdain had a great book called Kitchen Confidential, which is, if you're interested in food at all, it's fantastic. He has a chapter

called Eat Before You Read This. And he says, beware the Sunday buffet. And if you've ever been to a Sunday buffet, what the Sunday buffet really is, is it's all the things in the back of the freezer that the restaurant couldn't sell the rest of the week and they put it out and let you finish it. And they charge you a lot of money for it and they call it a wonderful buffet. And they turn the stuff that's not quite great into a salad, right? They add it to a salad. So this is what a lot of fun families do with Target Day funds.

We have these funds that aren't really that great, but we've got these asset managers and we need to keep them hired and we want to keep assets in them. So we're going to put these suboptimal funds in our target date fund. There's some notable families, by the way, that do not do this. If you're in a Vanguard target date fund, you're doing fine. You're great. Yes, please don't write Paula or me because you have a Vanguard target date fund. You're doing fine. And I should clarify for my own position, Vanguard is the only company whose target date funds I like and recommend. And they are not a paid sponsor of the show. I have no direct financial relationship with them other than being a customer. I think there are other few families as well, but we don't need to get into that.

I would just, and generally, this is easy enough that you can do it without a target date fund. There are funds called balanced funds. There are balanced indexes, which are a stock bond mix. This is the safe approach to make sure that you don't lose money. The problem that you and I have had, and we had this recently on the podcast, Paula, we've recommended people exit positions, not because the positions are bad, but because the goal was coming up. As the goal gets closer, it's super important to make sure that you lock in gains and don't end up wishing that you had sold much earlier. So a question for you, Joe, if a stock bond mix is what you recommend for a five to 10 year time horizon,

then does that mean that anyone who's investing for retirement, if their retirement is more than 10 years out, should not be in bonds? I mean, should a 30-year-old who's planning on retiring at the age of 60 put her 401k into some bond allocation? Oh, I love this, Paula, because there are two answers to this question. The correct answer is yes, and by yes, I mean no bonds in your portfolio. That's in a perfect world. However, when I was a financial planner and now, I will tell you, you, there are very few people that can actually do that or should do that. Because the problem isn't facts. The problem isn't the data. The problem is you. The problem is is that behaviorally, the swings become so big if you have a stock only portfolio that while it's the right decision,

most people can't stay in there. And I'll give you an example. When it comes to looking at how things are going to swing. When I was a financial planner, I would use something called standard deviation. And you can look this up with any investment. So one standard deviation is going to be, one standard deviation is going to be most the time that you'll be between a high and a low. And let's say that we expect your investments, Paula, to do 8%, but you have a 14% standard deviation from that. That means that it could be an average year and you could earn 22%. That'd be fantastic. However, what that also means is it can still be an average year and you'll earn negative 6%. And that's fine.

What is super interesting is that back when the market tanked last March and the market went down, at one point it was down huge, but I remember early on it was down about 14%. And the media was going crazy. 14% for the S&P 500 is within one standard deviation and is. typical of just another day. And yet we had everyone blowing up about how how difficult that was. I love looking at standard deviation for one reason. It's just like when you get on a plane and the pilot comes on and tells you ahead of time. It says passengers were headed to Detroit, Michigan. And by the way, it's going to be bumpy. We expect probably about 45 minutes into this flight. It may get bumpy so you may see me turn on the fast and seatbelt sign. Man, that's cool. That's great.

So I love when I purchase an investment, I go right and I look at standard deviation so that I know that while everybody else is freaking out when the portfolio goes negative, I go, okay, this is expected. This is what's happened in the past. And this is what we expect will happen in the future. And I know that standard deviation goes two ways. It can go up and it can go down. It can get so bad, though, if you're in an all-stock portfolio where let's not use 14%, let's use just 10% to make this easy. if you've grown your portfolio, let's say, to $2 million to retire, so using the 4% rule, which I don't like to use, but let's just use it, you're living on $80,000 a year.

You could lose $200,000 and it's okay. And it's fine. And I'll tell you sitting across the table from the average person, it ain't okay, Paul. It's not good. I would say, no, no, no. This is in the expected range of an all-stock portfolio. And my client would say, but I lost $200,000. You know how long it's going to take me to get that back?

It's gone. I can't get that back. And the answer is, yes, you can. And yes, you will. But that's not what we do, as you know. We blow up the plan. So the answer is to be really truthful with yourself about what your asset allocation should be, what your risk tolerance really is.

And when you design your expected rate of return for the future and you are looking backward from that, you're designing a portfolio that is going to have a plane ride that you can actually stomach. And for me, I don't have a high risk tolerance. I have no crypto in my portfolio. I don't own NFTs. I love them. I think they're cool. I think it's fun to track.

I will probably never have them. I just can't stomach the huge gains and the huge losses. that these positions take. I don't sleep well when I think that overnight things can go down 40% in a night. And that doesn't mean it's not a big opportunity. It just doesn't fit what I'm trying to do. And I think that's the same for a lot of people. So what you're saying is there's a mathematical answer and there's a behavioral answer. Absolutely. Mathematically, stocks and real estates entirely for anything that's 10 plus year time horizon, behaviorally more conservative if that's what you need behaviorally. Absolutely. And I will also.

say in terms of risk tolerance, one factor that influences a person's risk tolerance is also their level of debt. So I can tell you for myself, I have a very high risk tolerance. I have an all equities portfolio. Technically, it's a barbell allocation, so it's all stocks with a huge cash allocation. But I have a portfolio that's all stocks, real estate, crypto. I don't hold bonds. the reason that I do that is because I've paid off all of my properties free and clear. So I have zero debt, not even mortgage debt. The importance of having cash in your portfolio, which is an asset class that a lot of very smart investors say you do not need cash. I love cash.

Because if you're going to have an all cash portfolio, what I love about that strategy, Paula, is it gives you two things that somebody with no cash in all stock doesn't have patience and courage when things go down if you don't have any cash you worry about where am I going to get money this person who lost $200,000 where are they going to go get money if they need they're going to have to sell stocks that are down or they go to a line of credit and they borrow from somebody else but if I have cash on the sideline the ROI of that is fantastic because I get to have the courage to hang in there and let my aggressive portfolio play out. So when you do an all-stock portfolio,

I think it's mandatory to have that emergency fund in place. Speaking of cash, let's talk about the big question that we keep receiving, which is what do I do with money that I plan on spending in the next five years? What do I do with money that has an investment time horizon of fewer than five years? There's a new sheriff in town. Well, first of all, we're worried most about liquidity. So money that you know you're going to need, you want to keep in a liquid play. So unfortunately, and this is not what people want to hear, there ain't a lot of options.

But what we want to avoid are surrender fees, charges to get our money, big tax consequences or investment losses. If we can steer clear of all of those things, that's a win. Our goal is to have that money available. Now, what's neat about the current environment is this new sheriff called the iBond. And the iBonds, it's about time, Paula, that we're able to talk about something other than a money market or a savings account. Because you and I have been bemoaning the fact that you can't talk about CDs. Bonds actually with the market that they're in right now, a lot of bonds are struggling. But I bonds, which go up with inflation, eye bonds are right now a fantastic opportunity.

paying more than 7%. And that's not going to be a first-year cash reserves. Let's talk about what you can do. If you're sitting money for a year that you want to have in a spot that's a guaranteed position that you can get at it whenever you want it,

I would keep money in cash for things that you know you're going to need plus money like maybe a new car, plus money in case you lose your job or whatever your income stream is. But any money after that, that just is your emergency emergency fund, things go bad.

Man, I love having a fixed asset like an I bond. I think that that's a great second tier reserve. It's going to be a little harder to get at. You won't be able to sell it immediately and have, you can't write a check against it. You can't take your debit card and have that money. But I really, really like that as a second guaranteed place to have money now. We'll come back to this episode after this word from our sponsors.

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intentionally under diversifying your portfolio. Can you tell us about this? There are two different paths to success. There is a path that involves using your your income sources and saving as much money into indexes, a diversified collection of indexes. And the second path to success, is actually using your investments and having your investments be the way that you become wealthy. Those are two totally different things. And I'll tell you, by the way, that a certified financial planner will never tell you how to strategically under-diversify.

And there's two reasons. Number one is I'm going to tell you right now how to increase the risk in your portfolio so that you make money. Financial planners, that is not their job, Paula. Their job is to make sure that your money's always there when you need it. So they're going to show you things like modern portfolio theory and the best way to diversify your funds. So diversifying your funds so that your portfolio is very efficient. That's what they do.

So they're going to spread things out more for that reason so that you safely get where you want to go. But then also the second reason is you are very likely to fire them if you strategically under diversifying it goes wrong. Now the cool thing about me, I'm not a financial planner. So I can tell you that because I don't care if. you fire me. That's that's perfectly fine. But understand that your CFPs are hired not to do that. They're hired to show you the first path of wealth, which is how do I save more into this sound well-diversified collection of assets and go the way the market does? And that is sound advice. But there's a second way. Think about what we talked about earlier with standard deviation.

If we can increase standard deviation, if we can increase that up and down swing, number one, And then number two, we are able to research investment opportunities enough that we create a better chance of us winning. So you and I have talked about this before. We both talk to Annie Duke on our podcast. When poker players play, they're thinking about percentages. When a great restaurant, restaurants are so, so ugly. And it's such an easy place to lose money that I remember. a great interview I heard with Nick Kekonis, who's one of the owners of one of my favorite

restaurants, a place called a Linney in Chicago. I've never been there. I want to go there. I don't know that I'm up for an $800 dinner, but if I was going to have an $800 dinner, it would be with Nick Kekonis. But Nick said this same thing very well, Paula. He said that you need to understand odds. So you need to understand what are the risks that I'm taking and how do I make sure that I have at least considered all of the risks that this investment might have. And let's walk through that for a second because I think this is really important. Whenever you invest, whether you're trying to under-diversify to buy things that are going to make you wealthy, or you're trying to just appropriately diversify to get to your goals.

I had this client that was an engineer building highways back when I was a planner. And she told me that before they did any highway project, they would walk through everything that could go wrong. and they would work to eliminate all of those possibilities. And only once they eliminated those possibilities, all those things, would they then begin to build? And yet we see people often say, well, I've heard that you buy what you know. My buddy knows this. So I'm going to buy what my buddy bought.

That is not an investment strategy. And that's not strategic under diversification. That's under diversification, probably. But that's not strategic under diversification. So we talk about strategic, we talk about this isn't an all or nothing game. You don't need to take all of your portfolio and under diversify it. You could have most of your portfolio diversified appropriately. And then if you want your investments to shoot the moon to do better, you cut out asset classes that work against you.

So we already talked about cutting out bonds, right? Right. If we cut out bonds, we're beginning the under diversification process. Oh, good. I've already begun it. Yes. if we start slowing down on the mega cap and the large cap stocks, and I kind of hate the word cap for newbies, you can actually get rid of the word cap and just say companies.

So get rid of, get rid of mega companies and large companies and go with maybe midsize is your largest. And then you're looking at small companies and a collection of small cap value. Or I talked about developing markets. Now, developing markets are going to be a different game because now you're dealing with currency fluctuations as well as what's happening there, the fact that you're an investor, in my case in the United States, investing, let's say, in a place like India, there's a lot of other things going on there. But if I start moving toward my portfolio more towards small

companies and away from large companies, I'm going to raise my state or deviation and I'm going to cut out some of the malaise that happens with bonds or with large cap. What that's going to to do is speed the ship one way or another faster. It's going to make you rich faster and it's going to make you pour faster. Well, and you and I have both done that with afford anything in stacking Benjamins, respectively. Yes. I mean, you and I have both poured a heck of a lot of money and time into starting and growing our respective businesses. And when, you know, when you look at the amount of money every single year that you and I keep putting back into our respective businesses in order to hire more people, in order to get more software,

in order to upgrade our equipment, the amount of money that we keep pouring back into these enterprises in order to grow. I mean, if you were to plot that on any type of portfolio graph, we're heavily, heavily, heavily overexposed to afford anything and stacking Benjamins. relative to the rest of our portfolios. And to your point, we both began in financial media, we'll call it, at around the same time. Look at the number of friends you and I have had over the years who have failed at this. The failure factor is absolutely huge. So strategically under diversifying to have one company could be insanity.

But there are things that you did and that I did in creating our companies that I know, because we've had long chats about these, to increase the odds that we would succeed. I think the more seriously you take how risky it is, it shouldn't be a deterrent as much as something that really helps you, really helps you be real about what type of a commitment it is going to be. And how much courage you're going to have to have and how much patience you're going to have. And when Malcolm Gladwell talks about 10,000 hours, and some people talk about a minimum of five years in an industry just to really get your footing, I think there's so many lessons there. And the main reason I see that most people don't succeed in strategic under diversification is they don't give themselves enough time to swim the moat.

And there's a big moat when it comes to underdiversifying. You have to, and by Mo, if I'm talking about investments and under diversifying your investments, you have to get used to the fact that your investments now on a daily basis are going to swing more than they used to. If you're a small business owner, you're going to have to get used to those same swings, but in a small business, you're going to make the wrong moves. You're going to have to evaluate those moves more often. You're going to have to consistently, and I talk about this a lot, not just when we answer listener

questions, but we detail it in the book, work on your investment policy standards. Don't just make a move once. Ask yourself, how do I make sure that the next time these conditions arrive again that my machine works better and I don't step in it? And if you're consistently working on your machine instead of this point in time, you're much more likely to be successful. We'll come back to this episode in just a minute. But first, Joe, in the first section of this interview, we talked about the investments that you should choose, based on your time frame or time horizon. In the second portion of this interview, we talked about strategic under-diversification.

As we close out in this third and final section, I'd like to discuss the efficient frontier. Now, this is a concept that you've alluded to in some of our Ask Paula and Joe episodes, but we've never actually taken a deep dive into what the efficient frontier is and how a person should use it. So let's start with that basic question. What is the efficient frontier? Oh, I'm going to present this as a fictional story, if that's okay, because this is the way that I envision it. You know, like historical fiction where the basics are truth, but it really is Joe's brain filling in the rest of it. Yeah, that's what this will be.

Okay. So there's like the Game of Thrones of the Efficient Frontier. That's right. There was this really smart man, truly is a very smart man, Dr. Harry Markowitz. And Markowitz is looking at the difference between about the, he's looking at the correlation between risk and returns in a portfolio. So given any length of time, and just, just to make it easy, let's say he said, you know, over 10 years, risk versus return for large company stocks, he took an asset class, large

company stocks. How is it? He had two axes, the one that went up just for people that don't know. know what's X and what's Y. The one that goes north-south. That's the Y axis. Yeah, that one he said, he said is returns. And then the one that went left to right. So on the bottom, low returns, on the top are high returns. And then left for the left-right axis. The X-axis. That is, I love continuing this because it bothers a hell out of Paula. I know this audience. And I know they're fearless leader.

So there's little risk, almost no risk, right? And on the right, there's huge risk. So he makes a plot. There's a dot over 10 years. And the numbers really don't matter. But he's got, you know, like in terms of returns, 5%, 6%, 7%, 8%. And then he has standard deviation, which is really small, middle, and high. And we talked about standard deviation being that wiggle.

So he puts it as a dot. And let's say it's about in the middle of that. And then he said, okay, well, where is cash? Well, cash obviously is going to be low return, incredibly low return, and no risk. So that dot is left and low. And then he went to small company stocks. And now, by the way, he's taken out because he's starting to get fired up. He's taken out a bottle of wine and he's opening the wine because he's starting to think.

This is Joe's historical fiction. This is me filling in the blanks because I get giddy as a money nerd, just think. about him getting this, uh-huh. This is Joe projecting is what this is. So small company stocks, where am I going to put? Where is that? What's interesting is that small company stocks when it comes to standard deviation is really high, meaning there's a lot of really bad years and really good years. But while the returns can be higher than large company stocks over a 10-year period, it isn't the big gain that you had from cash to large cap. So in other words, you've got a nice big gain being in large cap stocks over 10 years,

large company stocks versus being in cash. You get some gain being in small companies instead, but not as much. And he starts to look at this and think, man, this kind of evened out. And I'm not getting as much return for this increased risk. And then he gets this great idea. He goes, you know what? what if I put these together? What if I go 50% large companies and 50% small companies?

And he finds that's another dot. And then he goes, what if I put in some midsize? What if I put in international stocks? What if I put it in a tax shelter? And he starts putting in all of these different dots, right? And he's got this thing full of dots. And he's sitting back because now while he's making his little dot board, he's now finished most of the bottle of wine.

But he's noticed something. There is an invisible line. for any time frame. In this case, for 10 years, there's an invisible line where there are no dots north and there are no dots left. So what does that mean, this invisible line? What that means is for any rate of return, there has been historically a mix of assets that has been the lease risk and the highest return. And it generally isn't having one of the others. So when we get binary questions on the show, and people say, well, should I invest in international stocks or should I invest in large-capped stocks? What Markowitz figured out was that it usually was better together. It's like a Reese's, right? I don't want chocolate or peanut butter. I need them both.

And man, does that sound great? So with any investor, you can take the dot where you're at, figure out, take your investments and plot them along this chart and place. your dot. So that's pretty easy. And by the way, there's plenty of, there are financial advisors that do this. There are sites on the internet to do this. If you look up the efficient frontier, you'll be able to play with this to your heart's content. The thing that frustrates me about it, just as an aside, we use big names like efficient frontier. It is not hard. It sounds really hard. It sounds really complicated. And it isn't. You take your investments, you feed the into your machine, it spits out where your dot is. And then you have three choices. Choice number one is

if you're getting the rate of return that you need, wouldn't it be great to get that same return, but have it be a smoother pathway? Like, wouldn't it be fantastic to get the same return and take less risk? So I'm going to move left. And if I move left, that means, and I move to where those, that invisible line stops. Now, man, I'm at this great spot because I know that historically, I'm taking the least amount of risk and getting the same return I was getting before. I have a smoother glide path to get where I want to go than I had before. How great is that? That's fantastic. More consistent results is fantastic. But if I'm sleeping great at night, then why the heck wouldn't I just go up? If I go up, I can take as much risk as I'm taking now, not increase the risk,

but now I'm increasing returns historically over 10 years. And so I can change my mix to be on that invisible line north of me. So you stay where you are on the X axis, but travel north on the Y axis. Me and my interpreter. But the funny thing is, Paula, neither of those are correct. The real thing that's correct is what we talked about earlier. You begin with the end of mind. You find out what return you want to have, you need to have, and then you go to that efficient frontier and you

place your dot there. But what's cool is what that does, people often ask us too. So which investments in my portfolio are good, which ones are bad? What should I hang on to? What should I get rid of? This tells you all that. Now, it doesn't predict the future. It tells you historically where it's been. And I will tell you that that efficient frontier over time moves very slowly, like a glacier, right? So just because it was the best thing the last 10 years does not mean the efficient frontier is going to be in the same spot the next 10. But this is, in most cases, when I was a planner, this was a great way to get much closer to where we wanted to be and to make these data-driven decisions about what investment classes were important to our portfolio.

So now we have the dot where we're at that's probably not that efficient. We move it usually left and sometimes up, maybe down, but usually left and sometimes up to the. the efficient frontier and we see a different pie, the pie that we need of different types. And once now, as we began this discussion, now I know the comparison. These are the investments that I have now that work. These are the investments I have now that don't work. In terms of class, this won't tell you actual investments. And then on the other side, these are the new ones that I need to add.

And now inside of that asset class, I can make decisions about which investment. are right. So we talked about instead of looking at the entire field of investments that are out there and doing a bunch of research or trying to on all them and you can never do it, what the efficient frontier does and modern portfolio theory does is it narrows it to Paula, you don't have enough large cap growth. And guess what? Now I just go look up large cap growth. And all of a sudden I know that if it fits that asset class, that area, I need to add X amount of money in my portfolio. And by the way, I also know exactly what I'm selling to get it. Fantastic. It is just fantastic. It's data-driven. This research, which was originally formulated in 1952, has had other great thinkers that have added to it. Like originally it was pretty opaque.

Like I think it was probably because, you know, Markowitz had so much wine while he was doing this stuff. He was just getting... That detail is not true, by the way. getting crazy with this. But when we look at some of the other people that came behind him, like Eugene Fama, Fama and French, and the research that they did and some other fantastic thinkers, it is well-proven research that is led to a lot of the way that great investors invest their money now. So how can a person compare their portfolio?

Is there a website that they can go to to plug in your portfolio and see where your dot is in the context of the efficient frontier graph? There are several websites online. And if you do a simple Google search, you're going to find several. All of them frustrate me in little ways. This is when I really like to hire a financial planner to help me. Because sadly, there's not enough public, there's not an, there aren't enough public places that I love. So I can't point you to just one, Paula.

They're out there. Using them, you will be more directionally where you want to. to go than not using one. What are your frustrations with the ones that are out there that are publicly available? Because what you'll find is that they don't, they very annoyingly don't follow asset classes for as long as they should have. Where I've seen robust institutional software that will track an index for a long period of time.

And as an example in some of my favorite public places, it'll tell me if I'm trying to go have data back to 1985, they'll say, well, I'm sorry, we only start. started tracking small cap growth in 1998, so you have to start then. Well, if I really want some long-term analysis to figure out where it is, and don't get me wrong, you're still going to be, you're still going to be close, but I really, I really like that piece of advice. And by the way, this is something, too, that I think is worth delegating and discussing. You and I have talked often, and I have a whole chapter in the book about finding advisors that won't bleed you dry, finding the right financial advisors, Paula.

And I think just having somebody to discuss how this works for you, what investments might make the cut, what investments don't make the cut, I think that's great to have somebody smart in your corner to talk to about this anyway. I want to draw a distinction and borrow a little bit of information from that chapter. There are two different things that financial advisors do. There's advice. and there's asset management. And many advisors will do both.

You don't have to hire somebody to do asset allocation, to do your investment, to place the investment trades under their control. You can find somebody that you can just hire for a couple hours, tell them, I want to look at the efficient frontier. I want to look at where I'm going with my investments. And then with them,

you will come up with the rate of return that you're looking for to reach that harvest, and then plug into some pretty robust software, the efficient frontier. How do advances and changes in the financial markets? So, for example, the advent of NFTs, as we've talked about earlier, the popularity of cryptocurrency, the influence of SPACs. We're encountering acronyms just in the past years. that we have never encountered before, how do these, or do these, fundamentally change the market

to such an extent that our over-reliance on historical data might be no longer applicable as we look to the future? I think it'll always be applicable. And to your point, there are always new advances. And certainly it always applies, which is why it moves, right? But just realize that this movement we're seeing today isn't new movement. it's new in a different area than it's been in the past. Everything was new and exciting before the 2000 downturn.

The internet was new and exciting. And look at what came out of that, by the way. Some of the survivors of this incredibly ugly fire where so many people lost their jobs and lost fortunes, some of the biggest names now in tech that survived that are now huge. But I remember then that that was a huge thing. in the years leading up to 2007. You know, it used to be, I remember in the 1990s,

nobody really talked about investing. You know, people investing in real estate, but it were these late-night shysters that would have these programs where, hey, you need to start buying real estate. And then that became widespread in the early 2000s. I'd say 2003 through 2007. And then we got over leveraged.

And look at what happened then. Now I think real estate investors are smarter. In many cases, lending has changed a lot. The attention to leverage, I think, for a lot of investors is much more. We've gotten smarter in that area. So this is not the first change. It's just a different change. And yeah, it affects it, which is why it's not a single plan and a single look at the efficient frontier

or a single look at your investment strategy. I think that's why I continue to revisit. and I don't revisit what are NFTs or what is real estate or what is a tech company I revisit my investment policy statement

and I incorporate that now that NFTs are here and I'm thinking about investing in them where do they fit in my portfolio is there a spot is there a spot in my portfolio where these fit

or are they outside the scope of what I'm really trying to achieve that's a great value based discussion that we should always be having. I mean, those are super exciting, fun conversations to have. That's also why I don't like using rules of thumb. It isn't that rules of thumb don't work. Rules of thumb will get you there directionally. They're fine. But if we really want to talk about money and we're going to start with where we're headed, we're having these wonderful discussions about where we want to go. And then we look back to today and say, what do I need to do to get there?

And then we look at the investments that get this to the specific place or very close to the specific place we want to go. We then have these great values discussions about how much I want to save versus spend today, what my budget's going to look like, what my investment strategy is. If I use rules of thumb, I miss out on all of this texture that really gets me excited about the whole process. So, Joe, to wrap up, we started this conversation by talking about. talking about investments in the context of time horizon. Then in the middle of our interview,

we discussed strategic under-diversification, and we closed out with a discussion on the efficient frontier. Now, these are more sophisticated personal finance topics, and they're all in your book, but your book has a bunch of j-jokes. And by the way, there might be two and I didn't do them. Everybody's going to think that I did them. My co-author, who's also a friend of yours and she's written four books before this, including a big one called The Five Years Before You Retire, Emily Guy Burkin actually wrote those. And I'm not saying that because she's not here and throwing her under the bus.

She literally has this I'm a saint persona. And she has some of these jokes. And I'm like, everybody's going to think I did it, that this was me. I have some funny stuff in here. But yeah, the jokes are all em. And that's the style of the book. It's a comical book. I mean, the subtitle is your super serious guide, right?

Like, anytime someone defines themselves a super serious, you know they're not going to be. Yeah. And so throughout the book, you've got joke after joke after joke in here, but you don't let that detract from the actual substance. Can you tell us about that in terms of a teaching style? Absolutely. I think this is such a serious topic, Paula, that we need to lighten up and we need to have a growth mentality where we think, what am I missing? What are the things that I don't know? And most of our book, by the way, is stuff that you know. You know a lot of this stuff. And for those people that know nearly everything in my book, it isn't, do you know it? Are you doing it? So how do we create this, how do we create this toome that is going to be something that people use to actually. get things done. And I think the way that we do that is we lighten it up and we make things actionable. So at the end of every chapter, we actually have some things to show proficiency. You check the boxes, that you did these things that we discussed during the book to make sure

that you have it. And some of our early readers said, it's really fun because you finish a chapter and you look at all those proficiency questions at the end. And you go, oh, yeah, I got that. And then the next one, they tell me they're like, oh, my goodness, I don't have any of this. So, no, Number one, it's not a book that you read start to finish. It's a book that you can go into the spot that you really need. And for that, I should probably tell you how we actually came up with this book, like where the idea came from. I was in Powell's bookstore, which I know you've been to. Oh, yeah, in Portland, yeah.

Yes. I recorded a podcast episode with you years ago, crouched on the floor of Powell's because I forgot we were supposed to record. And then you texted me and you were like, hey, you still come. in and I'm like, I'm like, I, and so then I threw in a pair of headphones when I was like,

what's the quietest place I can find? I found just this little like sliver of floor huddled beneath the, you know, almost like I was trying to block air. I was huddled next to a bookshelf. That's awesome. And I remember people would come by and you get really quiet.

Yeah. Yep. And that store is big enough for people that haven't been there that you can find these areas of the bookstore, almost like, you know, when I was at Michigan State, like the stacks of books, right, where you could just, you could go study there and you wouldn't see anybody all day. Powles is this huge place. And I love it as I think you do, Paula, because I can wander Powell's and as a creative person,

I can get so many great ideas. And there are these fuses that connect in these weird ways when I go from one section to another. So I find myself in the kids section, which you can totally believe. And I'm and I'm looking at these books and I see the Hardy Boys Detective Manual. And this book when I was in fourth grade was a book that I carried around and dog-eared everywhere. And my brother and I, we used the heck out of this book. And they tell you right at the beginning that it's written with the help of a real live FBI agent. Like a retired FBI agent. This was legitimate stuff. And my dad worked at General Motors and when he would pull out of the driveway on a a wet day, we'd go analyze as tire tracks. And when my mom would, my mom would touch a doorknob,

my brother and I'd go right over after she left the room with some tape and we'd tape the doorknob to get. You take her fingerprints? To get her fingerprint because you didn't know. Mom could be a little sketchy. Who knows? But I thought, what a wonderful book. If there were a book like that for adults, like you and I, we interview so many people. And the spot I thought was missing was if there was a book that was campy that way, but it was four adults about money, but people could dog ear it and carried around the way my brother and I did this when I was in fourth grade. That would be great. So then I fly home. When we get home, I was 50 years old at the time. And my mom, who has a key to our house, had finally trusted me with all the crap that she'd been saving in her attic,

like the father's son sixth place bowling trophy from this bowling invitational Saturday thing that we had done when I was maybe nine. My little league pictures. But there was also the Cubs scout wolf guide in there. And as I flipped through the Cubs scout wolf guide, I realized something, you know, something I love about many of the fintech solutions today is they're fantastic gameification. And I know and you know that gamification. can take some of these things that are either onerous or boring or just difficult.

And if there's a game attached to it, we'll do it. Like it's the way our brain is wired. And the Cub Scouts did this really well. And the way they did it, they took these, quote, chapters and they gave you tools that you'd need at the top. They tell you succinctly how to do it. Then you had these checkboxes where you had to do things to show proficiency. And then at the bottom, there's a place for your mom to sign that you did it.

then you got a badge. And it was so awesome. So you'd collect all of these skills. And I went, oh, that's fantastic. So every chapter is an achievement. And we made different badges for each chapter. In fact, if you make it all the way to the end, you'll see right at the end there is a certificate from my mom and from Emily and I that you finished everything. And now you got your stacked certificate. But every single chapter, you're trying to get that achievement. And it starts off with your first Benjamin, which is getting yourself out of debt, figuring out how to make goals that you're going to chase, understanding your credit, getting a budget together, then how to stack a Benjamin, the basics of investing, then protecting your Benjamins, and then the part that you and I talked

about today, stacking Benjamins on top of your Benjamins. How do we stack our Benjamins faster? And then how do we protect them with good estate planning, tax planning, and getting the right advisors around us. So that was that was how we created it because I think that gamification works. And I think if we're going to be serious about money, finding a way for us to get some usable tools, whether it's this book or something else, I think is this is something we should all be, be looking for anyway. Well, thank you for spending this time with us, Joe. Yeah, thanks for inviting me back to the podcast. I've always wanted to come on. As a guest. I've, yeah, I've listened from afar. and I'm so happy I finally made it on the Afford Anything show.

That's our show for today. Thank you so much for tuning in. My name is Paula Pant. If you enjoyed today's episode, please do three things. Number one, share this episode or any of your favorite Afford Anything episodes. Share it with a friend or a family member, especially right now. It's the new year. A lot of people are making resolutions to be better with their money in 2022.

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