We Study Billionaires - The Investor’s Podcast Network - TIP266: David Stein - Key Questions & Answers to Master Investing (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we're really excited to bring you, Mr. David Steen. David is a former chief investment strategist and a chief portfolio strategist for a $70 billion investment advisory firm. Today, he's the founder of a very popular podcast called Money for the Rest of Us, and he has a new book that covers the top 10 questions that master successful investing under the same name of money for the rest of us. David gave an incredible interview here, so we are really excited to get this one going.

Starting point is 00:00:29 So without further delay, here's our interview with David Steen. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Stig Broderson, and as always I'm here with my co-host, Preston Pesh. We have David Stein for money from the rest of us with us here today. David, welcome to the show. Thank you.

Starting point is 00:01:09 It's great to be here. Fantastic to have you here, David. The framework of our conversation today is how to build the optimal portfolio for us as investors. Before we go into details, let's zoom out here for a moment. David, could you talk to us high level about your thought process of building the portfolio that matches both our financial goals but also our individual personalities? Sure. And certainly my background, I spent 17 years as an institutional money manager,

Starting point is 00:01:36 You're working with very high net worth individuals as well as mostly with endowments and foundations. And so I approach investing like a portfolio manager. And what a portfolio manager does is they allocate their money among different asset categories. And so the traditional way to do that is what's known as modern portfolio theory where you have expected returns, you have expected volatility for different asset classes. How do they move relative to each other in terms of correlation? I don't use that approach because what I found as an institutional money manager, manager, much of the data you make up. What's the volatility of an apartment building? What's the volatility of a venture capital fund? And so essentially, it's garbage in, garbage out.

Starting point is 00:02:17 Dversification, obviously, is key, having different asset categories. But in terms of the weight, my approach is more like a hedge fund manager, where you look at the universe of potential investments, you choose those that perhaps have a unique return driver, and you have some confidence in the ability of those return drivers to come through. And maybe the analogy that best fits it is more of what I call an asset garden approach, where the goal of modern portfolio theory is to come up with this optimized portfolio. And as investors, it's very difficult to optimize. We don't know with the exact right answers, particularly when we have a lot of made-up data in terms of some of these more illiquid asset classes that don't have volatility assumptions. Or at least we don't see the

Starting point is 00:02:59 day-to-day volatility that you would with stocks. And so with an asset garden approach, you're not trying to optimize. You can't optimize a flower garden. You have variety. You have variety of plants, variety of flowers, variety of fruits. And we do the same thing with our portfolio. We just want a variety of different asset categories. We have some confidence about the expected return. We'll talk about how to estimate that perhaps later, but just have different return drivers. So that's kind of how I approach investing. It's how I approached it as an institutional money manager in the later years when I was running portfolios and it's how I managed my own portfolio today. So, David, one of the things that I often hear from our audience is that they have analysis paralysis.

Starting point is 00:03:37 There are simply too many types of investments out there and too many scenarios that can unfold. So in fear of making a wrong decision, they don't invest in anything, which is also a decision in itself. So how do you determine investments expected return its potential upside and its potential downside? When I mentioned that we need to look at return drivers, they're really. are three return drivers for most asset classes. And here we're talking about investments, something that has a positive expector return. And let's just take stocks. When you look at the historical returns for stocks, it's driven by first the cash flow, which is the dividends. Most investments have some type of cash flow. That's the first component. The second component is how is that

Starting point is 00:04:21 cash flow growing over the time? So with stocks, it's the earnings that grow. And as earnings grow, a company is able to pay more dividends. And so you have this second element. And those two really form what I call the math of investing. You have the cash flow and the cash flow growth. It works the same way for real estate. You have the rents. How are the rents growing over the time? There's an important component that's a drive return. The third component is what's known as the emotion of investing. What are investors willing to pay for those cash flows? And in a time where the valuation for stocks are very high, like now, then they're willing to pay a lot. In one measure of how much they're willing to pay is the price to earnings ratio. What are investors willing to pay for a dollars or a monetary

Starting point is 00:04:59 value worth of earnings. And as a result, we can combine those three, and this is how the math work. I mean, you can break down the historical return for stocks, and generally, dividends have been three to four percent, earnings growth have been four to five percent, and then the valuation increase, like going back to 1926 or further, is about one percent. So that combines together. So when we're looking at other asset categories, and that's what we are as portfolio managers, if we can get, for example, let's say a 6 to 7% income streamer yield, that's very attractive because then we're not so focused on being dependent on the cash flow growth. And so there's always a balance between how much cash flow am I getting? What does this cash flow need to grow in order to meet my return

Starting point is 00:05:40 expectations? And what are investors paying for it? Now, on your show, you talk about being value investors. When investors aren't paying very much for that cash flow growth, and that's an attractive time for an asset class. And I think sometimes just simplifying the universe and having some rules of thumb or frames of reference to look at asset categories, makes it easier to narrow down the universe. Because we didn't talk about, for example, asset classes that have no cash flow, which I would call, and we'll probably talk a little bit more about this, more speculative asset classes, because you have to be absolutely right, because the only thing driving it is people willing to pay more for that particular category of asset. And yes, David, you have a sharp

Starting point is 00:06:18 distinction between investing and speculation. Whenever I hear your talk about this, you mentioned specific examples of investments would be stocks, bonds, real estate, whereas example of speculations would more include something like commodities such as gold in all futures. We know that our listeners have a strong opinion of what is an investment and what is not. Many people define it differently. Could you please elaborate on your opinion and why you make that distinction? In my view of what's an investment versus a speculation versus a gamble comes from an asset manager named Kingsley Jones. He is based in Australia, founded an investment firm. And his definition was an investment is something with a reasonable expectation will have a positive return. And that's where I go

Starting point is 00:07:03 back to and say, well, investments generally have a cash flow component to it or an earnings component. A speculation is where there's some disagreement whether the return will be positive or negative. And commodity futures is an example of that. You have some investors that believe the commodity will go up in price. You have others that believe it will go down in price. But it's a zero. zero-sum game. The speculators on one side win at the expense of somebody on the other side. No, gold, gold coins. No, gold, what's the right price for gold? There's no cash flow. We can't value gold per se. And as a result, it's a speculation in that the only way that an investor will make money owning gold is if it goes up in price. You can own stocks, and they might not go up in

Starting point is 00:07:43 price, but you can still make money because of the dividend or other cash flow generating assets. And so speculations aren't bad. It's important to recognize that speculations, the success depends on somebody paying more. And there isn't really an objective criteria often to figure out what more is, why it should be worth more other than just underlying demand from other investors. I typically recommend keeping less than 10% of your investments in speculations. I mean, I own speculations. I own some art. I own some antiques. I own gold coins. You can't reasonably say this is going to have a positive expect of return. Now, a gamble is something that effectively has a negative, expect a return, and you do it for the entertainment value. So, David, if we look at the historical returns of major asset classes in the 20th century, equities have performed the best.

Starting point is 00:08:30 While it's a volatile type of investment, we also have many listeners who believe that they can emotionally and financially handle the volatility. Which type of investor should be 100% invested in equities, or is that ever even a good strategy to have? I don't think it's a great strategy. It's like playing the same key on the piano. Why not have a little more variety? There are asset classes out there where you can earn as much as stocks, private capital, for example, venture capital. I have debt investments where I've done direct lending or asset-based lending where the yield is as high as the expectation for the stock market. And so typically younger investors, and when you're starting out, you want to probably start with stocks. We talked about what drives it. It's a great introduction. It's a great way to figure out how do I react when the market

Starting point is 00:09:21 falls 30%. Yesterday, the Dow briefly fell 600 points. And everybody who's on Twitter saying, well, this is the big one. No, not necessarily. It's just volatility. That's normal volatility. And as a stock investor, you get used to that. But it shouldn't be the only asset class. There's so many other interesting asset categories, if you're interested in investing, that you can make just as much as stocks. And so that's why, again, we go back to the three criteria. Now, what is the cash flow for the investment? Has that cash flow growing over time? And what's the valuation? And there are times, and there are securities closed-end funds, for example. This is a type of mutual fund. It trades on an exchange like an ETF, but you can look at the value and see at times that particular closed-dent

Starting point is 00:10:05 fund, let's say invest in bonds in a leveraged fashion. So it has a distribution yield. That's the amount of the dividends paying of 8 to 9% and it might be selling at a 20% discount to the value of the underlying assets. Now, this isn't a theoretical undervaluation like you do with stocks. You know what the stock's undervalued. This is looking at the net asset value, the value of the assets compared to the price and seeing a discount of 20%. One can make much more than a stock market. Now, it doesn't happen all the time, but it happens during down markets. And so I think just siloing only investments or only stocks is sort of take some of the variety and it's some of the fun out of the investing. I've invested in stocks, but I approach it. I like the variety. I like looking

Starting point is 00:10:48 at different asset categories, learning about them, understanding what the return drivers are, and then implementing them in my portfolio. So it's interesting that you would say that. And we talk about stocks, we talk about bonds and other listed assets. But you also briefly mentioned their private investments, which might seem like a black box for most investors. We have a reasonably good idea of how to buy a stock or how to buy a bond or whatever it might be, but there is this huge market for private investments. There are not financial assets. It's something that many investors would be interested in because it's so uncorrelated to perhaps the stock of bond portfolio.

Starting point is 00:11:24 How do you find private investments? There are certainly platforms out there that you can experiment with, crowdfunding platforms, particularly on the real estate side where they're investing in private real estate deals. there are just in your own opportunity in the sense of I have found investments that people have brought to my attention, particularly. I mentioned this debt deal where I lent some money on property. I'll admit that in the private investments sometimes take a little more capital. So as a young investor, you're often not able to get into those opportunities in the U.S. Many of those opportunities, you have to be a qualified investor. And so there's certain income thresholds or asset thresholds.

Starting point is 00:12:03 But I think the principle of not having our entire net worth tied up in the financial markets, the public financial markets is important. I mean, we could get some virus that shuts down the financial markets for days at a time. And so having what I call pockets of independence outside of the financial system, I think, it's important. It could be something as simple as owning a plot of land. I mean, there's platforms out there where you can invest in farmland or you can invest in land directly. When you look at my portfolio, I have well over a dozen asset categories. one because I enjoy it, but two, I typically have about half of my portfolio and assets outside of the financial system. I mean, it could be something as simple as lending money on a student loan or maybe on

Starting point is 00:12:46 unsecured basis, but there's ways that you can invest that you can earn just as much as stocks or close to what you can earn with stocks, but in a way that's not so tied to the stock market with as much volatility. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three-day. in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists,

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Starting point is 00:16:49 Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So let's talk about stocks. What we've seen, especially in the 20th century, is that stock returns have been driven by dividends to a huge extent.

Starting point is 00:17:16 Many investors would say that it doesn't impact the return since the access cash that are not being used to pay out dividends, that's just been reinvested in the business, especially in recent years have been used for share buyback. You argue that the lower dividend payment that we experienced today will result in a lower long-term return on stocks. Why is that? Well, it's because company managers, they can pay out a share of the profits as a form of dividends or they can reinvest it or buy back stocks. And so being less reliant on the income component, so we're going to do a bottom-up estimate of what stocks are returned. Historically, dividends

Starting point is 00:17:54 spend a 4% of that. Now it's two. So if we want to get the historical return, let's say 9%, then we need the earnings growth component to grow at 7%, assuming that valuation stay the same over the next 10 years. Well, when you actually look at how earnings per share have grown, and the right measure that drives stock returns is not overall earnings across the country. It's earnings per share. Historically, there's always been new share issuance as new companies come to market, new IPOs, and there's just more of it. And so generally speaking, in most decades, earnings per share grows less than the nominal growth in the economy because it's interconnected. When we look at in the U.S. earnings per share growth, and this is data from Ned Davis Research, which is a research firm that's been around for

Starting point is 00:18:43 decades. When you look at earnings, it's very volatile. You have periods where they're greater than 10%, you have periods where they're less than they're negative. But if you do a regression analysis, so a statistical analysis and do a best fit line to figure out, well, what have earnings grown on average? Since 1980, earnings have grown 5.3%. So if you add 2% dividend yield to that, you're about a 7% expected return, which is kind of as I, now I also would argue the U.S. stock market is overvalued. And so maybe valuations are not going to get more, maybe they get more expensive, but perhaps they're going to get cheaper. And so I think a reasonable return assumption for stocks in the U.S. is 6 to 7%. Now, you mentioned the buybacks. Buybacks have certainly helped,

Starting point is 00:19:26 particularly over the past five years in terms of just boosting earnings per share. But when you look at what is funding that, it's primarily been driven by new debt. The S&P 500 right now, the companies within that, those 500 companies have $7 trillion with a debt. It's an all-time high. Their interest expense is close to an all-time high, even with very low interest rates. And so when we look at quality of earnings within the U.S., they're becoming more manufactured. It's being driven by buybacks. If stocks are going to grow, you need the revenue growth. You need overall earnings to grow. It can't just be manufactured earnings per share by buybacks. And so those earnings track the overall economy typically, in fact, a little less than that. And that's why I think that 6 to 7 percent

Starting point is 00:20:10 for U.S. stocks is a reasonable expectation. And so then we start looking at other asset capital. categories that perhaps you can get just as an attractive return. Preferred stock. For example, there were preferred stocks earlier this year that were yielding 6%. So you don't have to worry about earnings growth. You could just lock in your 6% return. So, David, one of the reasons why we wanted to talk to you today is that you talk a lot about diversification and the power of diversification. We typically have guests here on the show who specialize within a certain type of asset class. And for that reason, they might and might not also be prone to some of the biases of how much to allocate into that specific asset class. For instance, we might interview a guest who specializes in precious metals.

Starting point is 00:20:53 So not only would that person say that you should buy gold, but you should also diversify into a number of other precious metals. Or it could be a stock investor who would argue that you can be 100% diversified in stocks because you can buy into 10 or 20 different stock investing strategies. How do you think about asset allocation and diversification? Well, I think it's more like a hedge fund manager. One of my virtual investment mentors was a man named Seth Clarman. He runs the hedge from the Boutpost Group. He was one of my private foundation clients had half their money with the Bouters group, but there's a huge amount for an institution.

Starting point is 00:21:30 They had been investing with him since the early 80s. So I would go once a year, around the year 2000, and meet with Seth Clarman and his team and spent years reading through their letters, following the portfolio. And when you see how he and his team invest, they're asset allocators. So they're looking across the universe at the opportunities. And if they see something attractive, maybe they're not an expert in it, but they'll learn the asset class. They'll get experts in. And they'll try to figure out because they see an area of the market where people are ignoring it or they're compelled to get out of it for whatever reason, maybe not economic reasons. And so my approach is to look across the universe and see

Starting point is 00:22:10 what's most attractive. Now, we can start very simply. We can start with stocks. We've just gone through the analysis to assume, all right, stocks are going to reasonable expect to return over the next decade is 6 to 7%. We could be 100% allocated to that. And then the potential downside, when I consider the downside of an investment, is its maximum loss and the personal harm that loss could cause. For a young investor, a 60% loss, if you only have $5,000 invested, it's not going to harm you. Once you get up, let's say you have a seven-figure portfolio, then a 60% loss could be very damaging, particularly if you're near retirement. But you can start with a foundation of stocks. And then if you want to reduce risk, you could add cash. Cash, there is no downside to

Starting point is 00:22:56 cash other than the inflation cost of it. So you're always weighing the volatility downside versus inflation, but that's kind of the foundation for talking about just simple investing. But from there, you can explore all the other opportunities. So I'm sort of asset class agnostic. Now, I'll do the main separation. Well, this is a diversification because there is no cash flow, so it just has to go up in price. Now, that tends to be less than 10%. I just want to go what's most interesting at any given time. So, David, in the next question, I would like to talk about how you manage your portfolio. Our listeners are predominant stock investors and would rebalance if one position grows too big.

Starting point is 00:23:32 If a stock on their watch list suddenly becomes very attractive and other specific reasons for an investor who is invested in multiple individual stocks or equity ETFs, how do you manage your portfolio, if possible? Talk about years to retirement, valuation, and rebalancing. Well, first off, I don't buy individual stocks. That's a key. I have spent decades meeting with trying to identify the smartest stock investors. out there. One of our charges as investment advisors to endowments and foundations was to recommend

Starting point is 00:24:05 managers that could find 20 or 30 of the best performing stocks. Most managers, professional managers, underperform and maybe they find one or two stocks, but to find a number of them gets very, very difficult. Because when you approach buying individual stocks, because the intrinsic value of a stock is the value of its future cash flow, its dividends, which is influenced by its earning. So there's an embedded earnings growth assumption in the price of any stock. When an investor is buying a stock, they're saying the market is wrong, that this stock is mispriced. We don't buy an individual stock because we think it's a good company or has a cool product. We buy an individual stock because we believe the company will grow faster than what the market has priced in. That is

Starting point is 00:24:51 cheap. And I find from an investment perspective that I don't have an informational edge to do that. I mean, I tried. And I'm sure many of your listeners do have that informational edge. I see people go buy stocks because, well, this is a great company. Netflix. They're growing really fast. It doesn't matter if Netflix is growing very fast quickly. What matters is it's growing faster than what the market is assuming, because that's how, that's what the market is. When we invest, we should always ask ourselves, who's on the other side of the trade. Back when Benjamin Graham was investing, most stocks were owned by individuals. So he could get an informational edge. He could do the analysis and say, yeah, this stock is mispriced. But now, when you buy an individual stock, you're competing against quantitative algorithms and institutional investors that spend their entire lives focusing on finding mispriced stocks. I don't have the wherewithal to do that. So, again, I focus on asset category. So if I own stocks, I own global stocks, I own a very cheap ETF. For the more fund investments, I'll focus on closed-end funds that are primarily owned by individual investors that tend to dump them when the market sells off indiscriminately.

Starting point is 00:26:01 And so there I can see undervalued asset classes with investor on the other side of the trade is an individual, often a naive investor. And there I can pick up some excess return. You said an interesting term that you said a closed-end fund. There might be someone who are not too familiar what that means. Could you please elaborate? Sure. So the original mutual fund was the closed-end fund.

Starting point is 00:26:23 So they're just like an exchange-traded fund in that they trade. in that they trade on an exchange. So a manager might decide I want to do a closed-end fund. So they'll do an initial public offering, and so there's a certain amount of shares outstanding. That differs from an open-end mutual fund, which creates new shares every day, and it only trades at the end of the day. A closed-end fund, there's a limited number of shares, and as a result, the price is set by the trading of investors in terms of their buy and sells. The manager strikes a net asset value at the end of each day, but the price, because it's only contributed or determined by investors, can differ from that. So sometimes they trade at a premium. There's some close-end funds that trade at a 40% premium

Starting point is 00:27:06 to the net asset value. It makes no economic sense. But because it's mostly individual investors, institutions can't get enough assets or enough liquidity to close that gap. And so it's an inherently inefficient market. It shouldn't even exist. Expense ratios are high, but it does exist. And so it's kind of a very niche market, but as an individual investor, I want to focus on where can I get an edge? I'm not managing a hundred billion dollar portfolio, a much smaller portfolio. So I can take advantage of a niche opportunity where I can see the undervaluation. I look at investors or traders, right? They want to trade orex or commodities. Why trade an asset class where you're competing against institutions? When you could trade closed-end funding, you're actually getting an income yield,

Starting point is 00:27:52 and you can see the undervaluation. Much more compelling opportunity, in my opinion. Very interesting. So let's talk about another market that perhaps shouldn't exist. I'm very curious to hear your response to my next question. Very few people think about the bond market as attractive these days, especially the government bonds. What is getting a lot of the attention is the even negative yields for government bonds in some

Starting point is 00:28:17 countries. Even in states, it's very, very low. Which role should government bonds play in investors' portfolios today? Basically, to preserve some capital. So the reason why I own bonds is you own them for income. So it goes back to what is that income or that yield to maturity on bonds? Because the best estimate over a 10-year period for bond is its current yield to maturity. If a bond fund or a segment of the bond fund has a negative yield to maturity, just don't own it.

Starting point is 00:28:48 If it's earning zero, you don't own it. The reason why people own long-term bonds and investors is because they believe rates will go down further. Or they're willing to own negative yielding bonds because they believe rates will go down further because you can pick up the pricey appreciation because rates move inverse to the price. Well, that's a speculation. And speculation means you have to be absolutely right to make money. So I want to focus on the income component. And so, yes, and looking at bonds, right now, government bonds probably not terribly attractive unless you're just comfortable, at least in the, in the U.S. with that 2% yield. Now, there are other bonds out there that at times are attractive,

Starting point is 00:29:25 non-investment-grade bonds or high-yield bonds, particularly coming out of the Great Recession. Their incremental yield above government bonds was close to 16 to 18%. You could make more money coming out of the Great Recession, investing in bonds and you could in stocks. So it's just another asset class, but you're right. It makes no sense to own negative yielding bonds in this environment. So, David, if there's one thing we've learned from financial markets in the 21st century, it's that in investing, there's no step-by-step instructions that can guarantee a successful outcome. Instead, I've heard you refer to this as being wayfinders and that we have frames and rules of thumb that give us a sense where we're heading in the right direction.

Starting point is 00:30:06 Talk to us a little bit about this idea. Well, a wayfinder is somebody that's generally heading in the right direction but doesn't know exactly how to get there. And probably the best example is Lewis and Clark. Lewis and Clark were explorers that in the U.S. back in the late or in the 19th century were trying to find a passage, a water passage from the east U.S. to the Pacific Ocean. They had a whole list of tools they brought, very, very long list. Some tools that actually helped them navigate, but they didn't have a map.

Starting point is 00:30:36 They had a, just use these tools to sort of figure out they were heading in the right direction. Investing is the same way. When I have, I mentioned hedge fund managers that I used to research other. money managers, the best investors I know, they know there's no guarantees. They can't guarantee a return, but they have an investment discipline, they have tools that they use, they have some type of framework that they systematically look at investments and helps them make the decision. And as individuals, we should do the same thing. One of the other things that these managers do is they're always measuring themselves. If individuals are buying individual stocks, they should actually be

Starting point is 00:31:13 measuring the performance as a portfolio. We tend to ignore the ones that didn't do so well we sell them and move on. But no, if you're going to be an individual stock investor, buying individual stocks, then measure your performance. Warren Buffett does, right? Every year in the Berkshire Hathaway report, they list out the performance of the stock, which is driven by the underlying holdings. We should do the same thing in our own investing just to quantify it. You know, as wavefinders are having an investment discipline, I believe that's very important, which is why, in terms of how I've invested professionally, and individually, I focus on certain filters, and we've talked about some of those. Now, is this an investment or is it in speculation?

Starting point is 00:31:53 What are the return drivers? What's the income yield? How is that cash flow growing? What's the valuation? How are investors valuing that cash flow? Now, who am I competing with in terms of trading? You know, who's on the other side of that trade? So these are just steps I go through to decide, do I have high confidence that this particular investment will meet my return objective? Very, very interesting. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:35:47 David, we all have different paths to where we are today as investors. You've been heavily invested with a client in high-yield bonds in the late 1990s, and you briefly mentioned before that you also were again in 2008 with very different results. Please tell the audience about, how the various bull and bear markets has made you vulnerable to different biases, and which type of biases investors here in October 2019 should guard themselves against? I started investing professionally in 1995. Even though I had an MBA in finance, I had invested on my own, I probably didn't know, I didn't really know what I was doing.

Starting point is 00:36:26 So the first year I was in the stock market, it was up 37%, which is pretty good return. But I had no historical context. I'd say, the market's up 37%. That's great. But what I found myself doing is relying on historical returns and expectations to invest to figure out how an asset class return. And an example that you mentioned in high-yield bonds. So non-investment-grade bonds, I had a client. They were primarily in government bonds in their bond portfolio. This was about a $200 million endowment. As an investment advisor, my job was to introduce diversification. So I introduced high-ield bonds to this client. without really understanding the driver of the return. For high-yield bonds, the important metric is

Starting point is 00:37:05 how much yield are you getting relative to treasury bonds? And you want to invest in non-investment-grade bonds when that incremental yield or spread is above average. The long-term average has been about 5%. We went into those high-yield bonds with about a spread of 3%. So much narrower, and after a period of strong return. Well, I already mentioned that the best estimate of a return for bonds is its current yield to maturity. So with a very low spread and yield, they didn't do very well because what happens is as the internet bubble crashed in 2000, spreads widened dramatically, which means the value of these bonds fell. And so what I took from that is look at the value. What are investors placing in terms of the valuation on cash flows? So in 2008, coming out of the recession, we were much more confident

Starting point is 00:37:52 investing in high-yield bonds. And so when I talk about biases, my initial bias was just to rely on history. Now my bias is to focus on what are the return drivers and how is the asset class being valued. Now, one of my biases, I would say is I don't, as I mentioned, I don't invest in individual stocks. That's definitely a bias. I'm not saying it can't be done. I'm saying most that do it, fail at it if they actually measure their performance, and they don't go in recognizing that they have to assume that the market is wrong. Now, in October 2019, you know, one bias is people think interests are going to keep falling. And as a result, they're willing to own very low yielding bonds, long-term duration bonds, or long-duration bonds in terms of those that will do very well if rates

Starting point is 00:38:39 fall further. That's a bias. Another bias in October 2019 is people seem to ignore inflation. They think inflation will stay low forever, that the central banks are in control, that there's a deflationary bias. Well, one aspect of inflation, it's very much there's a human component to it. If individuals and businesses start acting like there'll be inflation, they will change the behavior, and we could get inflation. If we lose trust in the central banks, we saw an example just in the last couple of weeks with the repo rate. You did an episode on it. The central bank, the Federal Reserve, lost control of their policy rate.

Starting point is 00:39:10 one of the jobs is to maintain their target interest rate, and they failed at it. And the rate spiked to 10%. Now, they're able to resolve the issue, but little by little, if we start to lose trust in central banks and their ability to control inflation, that could change behavior. We could go into a high inflation environment. I'm not predicting it, but that's a bias. We have a low inflation bias, most investors right now. We should be aware of what inflation is, and that regimes change. And one of the things that I'm always doing as investor is looking at market conditions to understand what the regime is? And is there something that changing and other opportunities arising because of those changes because investors might be panicking or might be overly zealous? That's such a good point.

Starting point is 00:39:54 And especially in this time, it's so important that we know which type of biases that we are prone to, especially if we compare ourselves to other people because they not surprisingly would have the same biases because they're also shaped by the experiences of the current mind conditions. So, David, let's wrap up your key takeaways about the principles of building a portfolio. Which steps would you encourage our listeners to go through? Well, I think it's important to write down your investment philosophy. What is your investment discipline? If you're focusing on researching individual stocks, how do you go about doing that? What are you looking for? What are there steps doing it? If you're focusing on asset categories like

Starting point is 00:40:31 I do, what are the steps that you use? You know, one of the things, that I always want to know is I want to estimate what the return will be for a given investment. So I go back again to those three drivers that we've talked about, the cash flow, the cash flow growth, and how our investors valuing those cash flows. And so that's, I think, an important component. Everybody is just listed out and not just kind of go where everybody's going. One of the things that I see, particularly new investors, get involved in, they kind of go, whatever is the hottest craze. I want to be an investor. Well, next thing you know, there's signing up for a trading academy and learning how to trade, which is just the absolute wrong direction because then there's a phrase

Starting point is 00:41:08 in the investment in the hedge fund space, you're going to get your face ripped off. That means you're going to be taken advantage of. I actually, I met a 65-year-old man who said he needed to invest in himself and he spent $23,000 to join an online trading academy. This was a guy that had never participated in his work-sponsored defined contribution plan, where he could get a 100% guaranteed match on his investments, but he didn't do it because he said stocks were risk. Now he's 65. He wants to retire in five years. He pays $23,000 to join this trading academy. I went to the trading academy. I sat there for four hours to figure out, how do they convince this guy? They basically said, we'll teach you how to invest or trade, but to be a successful trader, you need to take advantage

Starting point is 00:41:51 of naive traders, exploit them. It's in their patent. That's an example of a zero-sum game, a speculation. And as investors, we don't want to be in a position where we have to outsize. other investors in order to be successful. We certainly don't want to retirements based on that. We want to be in investments where we can have a high degree of predictability. We don't have to outsmart other investors because there's cash flow. We can see the cash coming in and we can see that investors have undervalued that cash flow. So have an investment discipline to approach your investing. Fantastic. David, thank you so much for coming here on the show. I would really like to give you a chance to give a hand off here at the end of the episode because you are the

Starting point is 00:42:32 host of Money for the Rest of Us, one of the world's most successful investment podcasts. I'm 100% an avid listener. I'm not just saying that because David is a good friend. It is an amazing podcast. You're also author of the book Money for the Rest of Us, 10 Questions for Masterful Investing. And McGrawil just popped this book October 25th. Could you please tell the audience about your new book and where the audience can learn more about you? Well, the book essentially goes through the 10 questions that we should ask to help us to narrow down where we invest. And we've alluded to many of these questions in this particular episode. But this is my investment discipline. This is my philosophy for how I approach investing. And I think it's a very good framework for

Starting point is 00:43:17 helping us decide where and how we should invest. And so it's basically what I've learned over the past 20 years investing as an institutional money manager, helping individuals invest. And I think it's a great foundation. And it goes into a little more depth, for example, in terms of talking about the drivers of return and how you calculate that. I show what I'm doing in my portfolio and the whole asset garden approach. But yeah, that's 10 questions to master successful investing. All right. Fantastic. And we will definitely make sure to link to that in your show notes together with your podcast. I really highly encourage our listeners to pick up David's book. Already read it and it's a great read. Before we went on the show here today, I convinced David

Starting point is 00:43:59 to participate in one of our TIP live events in Los Angeles, and that will be February 11th with a local chapter. It's going to be a very casual event at a bar that is owned by two of TIP's biggest fans, and you'll just need to pay for your own foods and drinks. But the event in itself is, of course, completely free, just like all the other events are. David will be there if you want to hang out and talk investing. Another cool guest that's also coming, that is to buy a Kyle Lyle from our mastermind group. So please make sure to sign up for the event. You can just send me an email at stake at the ambassadorspodcast.com and I'll make sure to send you more information. David, is there anything else we need to talk about here before we let you go?

Starting point is 00:44:40 No, I appreciate the opportunity to chat about investing. It's been fun. Fantastic. And David, thank you again so much for joining us here on the show and we really hope we can invite you on again. Thank you. All right, so this part and time in the show, we'll play a question from the audience, and this question comes from Leon. Hi guys, thanks for the great program. I have a question on portfolio rebalancing. I have a bucket of stocks, and some of the stock are doing well, and some does not. So over the years, the portfolio goals are of balance. But in order to rebalance it, it seems to suggest that I need to sell away my winners and buy some of my losers. This does not intuitively sound right, so is there a other way to do it such that I can

Starting point is 00:45:24 reduce my exposure and risk. Thanks. So I absolutely love this question, and I think it's very timely for episode here with David. Because whenever you hear about portfolio management, everyone always talks about rebalancing. And yes, for most investors, I do think rebalancing is a great idea. For instance, many endowments and hedge funds had portfolios with multiple asset classes, and they don't pick individual stocks, but they look broadly at their exposure to stock. bonds, commodities and currencies. For them, I think rebalancing makes a lot of sense and also for many individual investors who has a large part of their portfolio in the stock market and also own

Starting point is 00:46:06 bonds. As they become older, they might want to own more bonds and to preserve wealth, and because they want a lower volatility, they continue to rebalance. Now, the idea of rebalancing is to utilize the power of mean version and exposure. So if stocks do really well and bonds do not, you assume this will likely change in the future due to mean reversion, and you make sure to rebalance to have more bonds when they're soon expected to perform better and you sell some of your stocks before they're expected to perform worse relatively. So yes, on an asset class basis, I think it makes a lot of sense to rebalance. What you specifically address here in your question is slightly different and you might need a slightly different approach because you're only looking

Starting point is 00:46:53 at stocks, and you're asking why you should sell your winners and buy more of your losers. And I agree, that is generally not a good approach. The stock market can be very volatile in the short run, but overall, there's a reason why some stocks do better than others. So to answer your question about whether you should rebalance, I would say make sure to conduct an intrinsic value assessment of all your stocks once per year, and be very careful not to be emotionally attached. Make a rule with yourself and then every two or three years after you buy a stock, if it hasn't performed well or not as well as you hoped, consider if you're simply wrong in your assessment of that stock and you would need to sell it.

Starting point is 00:47:38 You would really need a good reason not to. And for the winners, I would suggest that you should not feel shy by any more to that position. As painful as it might be to buy a stock at $15 that used to cost $10, consider if there's a good reason why it has jumped 50% and if it's still a good investment. Sometimes it is. So, Leon, this is really a tough question. I personally look at rebalancing in two different buckets. So the first thing that I would ask myself, am I dealing with an ETF or am I dealing

Starting point is 00:48:09 with an individual company? And this is just if we're talking equities. When dealing with an individual company, it's kind of complicated because you're dealing with a current intrinsic value of the company compared to your opportunity cost of owning something else that would give you a higher yield or a higher intrinsic value IRA as you're looking at all these other companies that you could then take that money after you would sell and then plug it into that other pick. More importantly, it's the opportunity cost of buying the new company with the higher expected yield after you pay the capital gains tax

Starting point is 00:48:44 on the existing pick. For example, one of the reasons Warren Buffett continues to hold so many of his non-operational stock picks for decades is because his tax burden to sell the position and then swap the remaining funds into something else with a high level of confidence that the new pick will outperform the previous pick is difficult and kind of risky to project with a high level of confidence. And he's dealing with significant capital gains. And he's also dealing with companies that are often paying enormous dividends compared to the principle that he originally paid to own it. Now, if you're dealing with a company that hasn't really had any, gains, then the tax burden is nothing and the decision becomes much easier and you can

Starting point is 00:49:24 kind of look at it just from an apples to apples comparison without that administrative friction in order to transfer into the new pick. You saw this, oh, I can't remember the exact timing, but after the 2009 crash, the 2008-2009 crash, Buffett took a pretty big position in Exxon Mobil. And then as the oil prices looked like they were getting ready to drop significantly, Buffett sold his entire position in ExxonMobil. And a lot of people suggest that once Warren Buffett buys a company, he rarely sells it. Well, if he doesn't have high capital gains, he does sell companies.

Starting point is 00:50:02 You also saw this with IBM, where his capital gains on these companies were not very high. His intrinsic value on what he originally had calculated for the business had changed over that period of time. And so he will sell these companies because there's not really any type of tax burden. Now, when you're talking about ETFs, I would argue these decisions may be even more difficult because you're dealing with macro themes driving whether there's opportunity costs or not. For example, if you had some of your portfolio in the S&P 500, it's really difficult to have confidence in how much of your portfolio should have exposure to the overall market versus

Starting point is 00:50:39 all the other opportunities that are out there. I think correlation, when you're looking at the correlation of the S&P 500 versus some other ETF or an individual stock pick really kind of becomes the point where you can maybe adjust your sizing inside of your portfolio because if things are correlated, it might make more sense, especially if your intrinsic values are kind of similar. So like if the S&P 500 were to be valued today, I would argue you're around a 3% return to own the S&P 500 is what your expectation should be moving forward. So if you have another stock pick and it's also at 3%, well, you should probably own the S&P 500. So then it comes down to how correlated is just plowing that

Starting point is 00:51:21 capital into the S&P 500. How correlated is that S&P 500 to all your other picks that are inside your portfolio? So that's kind of how I think through the sizing and the adjustments, the rebalancing of my investments is I'm constantly looking at what do I think it's worth today versus what do I think my other opportunity costs are and what do I think that those are going to get me with respect to an IRR, an internal rate of return calculation as a percentage. And I compare those percentages across the risk-free rate versus all the other investments that I have and how correlated they are. So Leon, for asking such a great question, we have an online course called our intrinsic

Starting point is 00:52:02 value course that we're going to give you completely for free. Additionally, we have a filtering and momentum tool, which we call TIP finance. we're going to give you a year-long subscription to TIP finance completely for free. Leave us a question at asktheinvestors.com. That's ask the investors.com. If you're interested in these tools, simply go to our website, The Investorspodcast.com, and you can see right there in our top-level navigation, there's links to TIP Finance and also the TIP Academy where you'd find the intrinsic value

Starting point is 00:52:31 course. All right, guys. That was all that pressed on I had for this week's episode of The Investors podcast. We see each other again next week. Thank you for listening to TIP. To access our show notes, courses or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional.

Starting point is 00:52:53 This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

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