We Study Billionaires - The Investor’s Podcast Network - TIP486: Macro Investing w/ Cullen Roche

Starting point is 00:00:00 You're listening to TIP. For today's episode, I invited Colin Rhodes back to talk to us about macro investing. Those of us who are raised as value investors have a strong bias not to consider macro. I'm guilty as charged. In this episode, Colin compares individual stock picking to finding the new Michael Phelps swimming in the river, which can, of course, be extremely profitable. But he also argues that we should focus on the current of the river instead, because that is how macro investors think.

Starting point is 00:00:26 I love to challenge my beliefs in investing and life, and I think you will find this episode particularly interesting. Colin started his career reading all above his letters, and he've taken that mindset into macro-dermasting. All right, let's hop to it. 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 Dick Bruterson. Colin, it's always a privilege to welcome you back on our show. Hey, Stig, it's always great to be here. So, Colin, the main topic of today is your book, Pragmatic Capitalism. And in your book, you have a series of principles intended to

Starting point is 00:01:22 piece that puzzle together of the global financial system. So it's no small feat we're going to talk about here today. It's all about how to help us as investors. So let's just jump right into it. Our show is founded on the principles of Warren Buffett. And it would also suggest that if you build anything around the principles of Buffett, you're in turn part of the building on the regional work of Benjamin Graham. Benjamin Graham is the author of The Intellect Investor and Securities Analysis that he wrote together with David Dot. And to the public, he's perhaps most famous for being Buffett's employer, friend, professor,

Starting point is 00:01:56 mentor. You have this wonderful quote from Graham in your book before his death in 1976. sex, and the quote goes like this. In general, no, I am no longer an advocate of elaborate techniques of security analysis to find superior value opportunities. This was a rewarding activity say 40 years ago when our textbook, Graham and Dot was first published. The situation has changed a great deal since, end quote. And the textbook he refers to Graham and Dot would mean security analysis. That's the book he's referring to. Now, I don't want to allude to Graham being a macro investor. That's not the reason why I brought up this quote, you'll probably be offended if I did so.

Starting point is 00:02:34 But I wanted to use it as a segue to into the opening question about the changing world we face as investors, because you argue that to understand the rapidly changing global economy, you must understand the macroeconomic environment. So let's build the foundation for this conversation. Why do we need to understand the macroeconomic environment? Yeah, so it's interesting. My evolution as an investor, I would say, It certainly started with Graham and Dodd and value investing in Warren Buffett, really. I mean, reading Buffett's annual letters, in my opinion, is probably one of the most valuable things you can do. And go back and find, I've actually archived these on my website, Pragmatic Capitalism.

Starting point is 00:03:18 Go back and read the archived ones of his, the previous ones before Berkshire Hathaway. So he has, a lot of people don't know this, but he wrote an annual letter for Buffett LP. for, I don't know, 10 or 15 years. And some of those letters are way more interesting than the actual ones that we read from the that are on like the listed Berkshire website. But you can find all these online. There's so much knowledge and understanding inside of all of these letters. And that's part of why, you know, his annual shareholder meeting is so popular because you

Starting point is 00:03:51 get these nuggets of wisdom that, you know, you can find one paragraph in these things that is just mind-blowingly intelligent and will sort of. build on or transform the way you view the world. But I think that, you know, one of the things that is really interesting about looking through Buffett's career and the transition of value investing into, you know, different factors and more macro-based, I think, perspectives like, you know, I would argue that the typical passive investor these days is really a macro investing approach. You're just taking sort of an approach where you buy, you know, lots of stuff rather than trying to pick the needle in the haystack. And I think a big part of why that evolution has occurred is because

Starting point is 00:04:34 the world is just very, very different than it was in the days of Buffett, not only just in terms of the way information is processed and transferred so much more quickly and efficiently in the markets, but the world has become a much smaller place these days where, you know, back in the days where Buffett was picking stocks, I think you could argue that the economy and especially economies like the United States, they were much more low. You could look at a candy store in Omaha and see how valuable it was relative to all the other stores in Omaha. Whereas today, if you see a store in Omaha that makes candy, well, you have to identify whether that store can compete with stores in New York and Hong Kong and London.

Starting point is 00:05:21 And so the world has become this very, very small place in large part because of technology and just innovations that have made intercontinental trade and international trade just a huge, huge thing where the world is now so interconnected that macro has become much more important. And I think that the main place where we see this is in government policy. Government policy has become much more involved in everything, in part because of all of the same trends. So for instance, there are rumors today about and over the weekend that Deutsche Bank and Credit Suisse are starting to have some financial problems. And I don't know if there's any real truth to these, you know, the rumors there, but the reality is that the Federal Reserve could end up having to be involved

Starting point is 00:06:09 in this because the banks in Europe are now very interconnected with the banks in the United States. And that could create an international payment processing problem where the policymakers in the United States, through almost no choice of their own, have to become involved. And And all of this stuff is just the result of the interconnectedness of the global macroeconomy now where global trade and technology have made us much more interconnect. And I certainly don't want to give the impression that people should not do individual security analysis or anything like that. But I think that in today's world, I think that I like to think of stock picking as sort

Starting point is 00:06:48 of, you know, someone who, if you're trying to pick the best swimmer who is swimming with the tide, well, you could certainly try to find like the Michael Phelps who is swimming in the river. That's your goal. But to me, it's equally important to understand the dynamics of the river. The river is really the thing that is determining to a larger degree how fast all of these people will actually be swimming in the water. And so you have to understand both. But I think as a foundational starting point, I think it's incredibly useful to understand the macro dynamics so that you can at least get a big picture, a top-down view, before then you start to then try to understand, you know,

Starting point is 00:07:28 what are the best individual securities in certain markets. Yeah, and I love Colin how well you present this and how are you thinking in metaphors that might make it a bit more approachable for us as investors to understand this because it is very complex, at least it is to me. Now, one of the things you said, just to continue in this train of thought,

Starting point is 00:07:46 is that we can think of the economy as one of the world's most sophisticated, machines, the human body. What do you mean by that? Well, in a lot of ways, you know, Ray Dalio had this great video. It was like 30 minutes. It was basically, I can't remember with the title of it. I think it was how the economic machine works in 30 minutes. And he went through the, really the way that the economic machine is a lot like any sort of machine that we might build. And the global economy really operate like a very interconnected system to a large degree. And there are things that when you, there are certain inputs that you can input into that system that will then output certain results. You know, like I try to focus on, you know, when I explain things like how, for instance, quantitative

Starting point is 00:08:35 easing works, I like to explain it like it's a systematic process where when the Federal Reserve is doing something specific, well, there is a flow through effect through balance sheets. And when you understand the balance sheets and the flows through that system, you can then understand kind of going back to the same sort of metaphor that we used earlier with the rivers. When the Fed pumps water into the river, for some reason, that flows through to lakes. And it impacts not just the flow through the river, but it impacts the quantity of water that ends up in the lakes. And you can think of balance sheets as being the same sort of thing where income statements

Starting point is 00:09:13 reflect the rivers and balance sheets are reflected by the lakes. And to understand how all of this is going to impact the balance sheets in the long run, you need to understand how the flows work. And so the human body is very similar in the sense that when we put certain things inside of our body that has a certain impact that flows through everything, it impacts all of the different organs and, you know, comes to rest to some degree in certain places and, you know, it can result in whether or not muscle development occurs or whether cardiac arrest occurs or whatever it might be. But there are these very specific flow-through events that impact the system in a very machine-like manner.

Starting point is 00:09:54 And the really tricky thing, though, with investing and the economy in general is that you have the problem of, well, there are brains involved in all of this. And so the brain has an impact on everything. there's emotions that impact all of this. And the emotions impact all of this in a very, really unintelligible way. It's very, very hard to decipher how people will respond to certain things. So, like, you could have a really sound understanding of the flow effects of something like quantitative easing. But if somebody responds to that policy in an emotional way that maybe results in, say, them going out and buying like a bunch of high yield bonds, even though, let's say,

Starting point is 00:10:37 Let's argue that there is no practical reason for junk bonds or high yield bonds to have any different value after quantitative easing. Let's just say investors perceive that flow from the Fed to have impacted something. Well, you could have what is essentially an irrational effect that is just purely psychological. And I think this is one of the things that makes not just investing so hard, but it makes economics really hard because you have this social effect to it where economics is not really a hard science. It's not biological in the same sense that you can look at things. You can perform tests in chemistry and biology that you can't really perform in investing because you can get these

Starting point is 00:11:22 irrational responses. And I think the last two or three years are just a great, great study in this where you can argue that in a lot of ways, there was no reason. for a lot of the things to be going on that were happening in the last couple of years. But you had this strange psychological effect where there were, frankly, just a lot of people who were sitting around at home because of COVID with not a whole lot to do. And they did a lot of crazy stuff. You know, they bought a lot of, you know, these sort of scammy crypto coins or they, you know, they ran up GameStop and AMC.

Starting point is 00:11:59 And so that's the interesting thing is that I like to build these understands. from sort of a first principles perspective where you can understand the economic machine and the financial system as a sort of machine. But then there's this second order effect where you also, you almost have to also be a psychologist and learn, you know, some of the like Kahneman and Tversky techniques where you're starting to think in sort of a second level thinking process where you almost have to, you can't just get the economics right. You also have to get the response mechanism, right, where it's like playing chess to some degree. You know, you could be playing against a horrible chess player, but if you're not interpreting their future moves, well,

Starting point is 00:12:41 you could find yourself in a pretty rocky situation. So you've got to be able to think, you know, a few moves ahead to interpret, well, how is all this stuff going to work? And that's, that's what makes investing, you know, such a tricky thing. To understand macro, we also have to understand the macro concept of investing. Countries that invest well prosper. However, when we as retail investors think about investing, we usually think of stocks and bonds. Now, from a macro perspective, it's not the right way to think about the differences between investment and savings. Could you please paint some color around this? Yeah, so I always loved the, when I first came across from a macro I mean, my background is really in college and a lot of my work coming out of college

Starting point is 00:13:33 was really involved in just studying macroeconomics. And so very high-level stuff. And macroecon, to some degree, is this sort of pseudoscience. And it's interesting, when you compare it to the financial world, there is, in the financial side of everything, there is a lot of jargon. There is a lot of terminology that is just sort of used, I think, more as a salesman. pitch than anything else. But this is also true in macro economics. For instance, the word money in macro doesn't really have very specific meanings. In fact, to certain schools of economics,

Starting point is 00:14:10 it has a different meaning. I mean, like an Austrian economist would argue that gold is money, whereas a new Keynesian economist would argue that gold is absolutely not money, that money is defined by, let's say, like the M2 money supply or something like that. And then you can get into varying debates there where it's like, well, macroeconomists actually have different definitions of money where it's actually like it could be MZ or M1 or M2 or M3. And you start getting into this situation where it's like, well, wait, what the heck is money in the first place? We don't even have a clear definition of this thing. And it's kind of an essential part of the whole puzzle here. And it was really interesting when I first started deep diving into like the, this precise

Starting point is 00:14:54 definition of the word investing. It is a explicit contradiction with the way that financial people typically use the word because in macroecon, the word investing means to spend for future production. And that's usually done by corporation. So when a corporation goes out and builds a factory, for instance, they are spending some of their money for future production. They are hoping to generate an asset that generates a return on investment in the future. And it's interesting from the perspective of your average retail investor, when we do what we call investing, well, what we're actually doing is we're technically just reallocating our savings. We are not building factories or in a lot of cases, what you do on a secondary market when you're buying stocks and bonds

Starting point is 00:15:45 has almost no impact on the actual corporate operations. And so you're really from a technical economics perspective, you're reallocating your savings when you do that. And what the firm does, when they spend for investment, well, that can impact the value of the savings, meaning that when a firm invests well in itself, you know, when Apple builds all of these great innovations over time, well, that actually accrues to the value of savings because those investments have a return on investment that people find more valuable. It has real tangible economic value.

Starting point is 00:16:26 And that's reflected in secondary markets as a revaluation of savings because Apple's stock price will change. But your actual actions of buying and selling the stocks, for the most part, really, really, it does, I wouldn't say it has no impact, but to a large degree, it doesn't have much of an impact on the actual, you know, underlying operations of the firm. And so from a proper economic perspective, what we're all really doing is we're reallocating our savings. And the reason, you know, some people might hear that and say, oh, well, who cares? Like Cullen's just being a nerd about the technicalities of the jargon. And but to me, I actually think it's a really useful way of framing all of this because to a large degree, what we are, quite literally doing when we buy and sell stocks is we are reallocating our savings. And this is literally we earn an income and then we choose how we're going to reallocate that savings from that income into cash or stocks or bonds or these other instruments. And so from the retail investors perspective, I think a lot of people have this tendency to think of investing from an economic

Starting point is 00:17:39 perspective. It's sexy. It's very high risk. Go out and build a factory. Start a company, man, that is a very, very high risk endeavor. I mean, over the course of a 10-year period, 90% of corporations will fail. And so investment spending is a very, very high risk, potentially high return endeavor, whereas most of us, we shouldn't be treating our savings like it is this concept of investing because I think it has this connotation of being a very high risk, high reward type of endeavor, which it certainly can be that. But I think for most of us, it would be wise to step back and say, well, I really am reallocating my savings. And that is a much more prudent and practical process where, you know, I should hold some cash in a bank

Starting point is 00:18:26 account to be able to meet my monthly liabilities. I should hold some money maybe in a in a high-yield savings account in case I need to buy a new car in the next few years, but I'm uncertain of when I'm doing that. I should diversify my assets for retirement because I maybe don't know when I'm going to retire, but I know it's going to generally be in this sort of a time horizon. And so I think when you approach it from that, you get away from the tendency that a lot of people have to think of all of this in this very sort of sexy, get-rich-quick sort of mentality, which is what I think, I think that's the mistake that a lot of people make when they approach the

Starting point is 00:19:02 concept of investing and they're watching, you know, these financial TV shows that sort of sell the same concept of get rich quick and, hey, you're going to buy the next, you know, Solana before it soars or you're going to buy the next Microsoft when it, you know, is at one penny, it goes to $1,000. And so I think even though it's a very technical understanding, I think it's a useful framework to really internalize so that you can approach this from, I think, a more practical foundation. I always like your pragmatic approach to investing in savings. For example, Colin, you don't see the traditional buy and whole equity strategy that's been held for decades without flaw.

Starting point is 00:19:43 The finance system assumes that we accumulate assets from, say, our 20s to our 60s, and while that might be true to some extent, life happens simultaneously. One life cycle could be that we get married in our 20s, buy a house, and have kids in our early and mid-30s. You might start thinking about your kids' college payments in your 40s, planning for retirements, a bit more seriously in your 50s, and perhaps you break a hip or something in your 60s, and perhaps your life cycle is just completely different from what I just described there. But the point is that life happens all the time, and as much as we like to plan it, life

Starting point is 00:20:19 is what tends to happen whenever we're busy planning it. And so how can we make sure to balance a potential? and allocate our savings to have certainty that our portfolio will be there for the big events in our life. Yeah, I mean, this is, this is the problem of life. This is the problem of financial planning and finance really is time. And I think it's, it's been frustrating for me over the course of my career that a lot of investment analysis focuses on how to generate the best type of return and the best risk-adjusted type of return, but we don't really talk that much about generating the best risk-adjusted return across time.

Starting point is 00:21:05 And time is the biggest problem we're all confronting, because we're obviously not only limited by time across our lives, but our lives occur in, like you were saying, these different time horizons. You're going to retire in 30 years, or you're going to buy a house at some point in the next five years. Nobody can afford to buy a house anymore because of, you know, the crazy market that we're living in. But, you know, you plan your life across these very specific temporal horizons.

Starting point is 00:21:37 And you have monthly liabilities or weekly liabilities that you have to meet, whether it's your credit card or your rent or your mortgage. And then, you know, you want to buy a car maybe in the next two years. You want to buy a house in the next five years. You're going to get married in 10 years. You're going to have kids after that. And the kids are going to be graduating with these huge college tuition bills in 18 years. And then you've got retirement that is way down the line.

Starting point is 00:22:06 And then like you were alluding to, you have unknown health problems. And obviously, health care is, you know, inordinately expensive now. And a lot of people can't predict. Well, you know, what if, you know, you break a hip at 60 and it completely transforms your ability to afford all of the other things you want in life. And so you have to, I think not just approach this from this idea of buy and hold or stocks for the long run, because a lot of people, frankly, we just can't afford to only own stocks for the long run because we have all of these short-term time horizons where, hey, it makes sense actually

Starting point is 00:22:44 to own buckets of cash and, you know, even buckets of like, say, intermediate bonds or instruments that are, you know, more short term. And I, it's interesting, I actually, you know, my big focus, I would argue, in the last year and this paper I published in the last month was called all duration investing. And it's actually focused on trying to solve this problem where we're not approaching the world of asset allocation from optimizing return per unit of risk in a sort of standard modern portfolio theory approach. We're approaching it more from the perspective of having money when needed and having money in certain time horizon so that you have greater certainty about your asset allocation and your future

Starting point is 00:23:31 ability to meet certain liabilities. So I actually, I've always loved like bond ladders. And the beauty of a bond ladder is that if you have $100,000, well, what you do if you need a bond allocation is you take, let's say, 10% of all of that allocation and, so, you're So you would take $10,000 and basically you bucket it out from one to 10 year maturities in the bond portfolio. And every year you're going to have bonds that are maturing. You're just systematically rolling them over into a new set of bonds every year. And you don't care what's going on with interest rates really.

Starting point is 00:24:09 You're just systematically rolling this portfolio. But the beauty of it is that you always have a short-term bucket in there where you know the principle inside of that thing is very, very certain. And so to meet cash flow needs, the beauty of that is that you've created this systematic process by which, even though you have much higher risk in the 10-year portion, you have much more certainty in the one-year instrument. And so what I did with this paper that's called all-duration investing is I actually calculated the duration of all assets.

Starting point is 00:24:40 I literally calculated the duration of things like gold and commodities and reits and the stock market is an 18-year type of bond-like instrument inside of my model. And the nice thing about approaching this, this is all, I'm obviously doing a lot of guesswork inside of building a model like this, but I think the nice thing about it is that you can build a framework by which you can then apply time horizons to certain assets and compartmentalize them in a certain way where, yeah, stocks are for the long run. Stocks are that 18-year instrument or whatever. But that doesn't mean that you should just buy and hold a portfolio of stocks because the problem there then is that you don't have short-term liquidity. You know, you find out in a year like this year that,

Starting point is 00:25:24 hey, the stock market goes down 25%. You don't have liquidity inside of that part of your portfolio. And the problem that a lot of people find themselves in in years like this is that they didn't plan for that in the future. And so before the bear market, they came in way overweight the stock market, for instance, and then they find themselves if they need some liquidity, well, then you have to make the worst behavioral mistake you can, which is being a forced seller of stocks into a downturn, because you just need the liquidity. And so for me, there is no, you know, the biggest biases, I think, in investing is being too short term and being too long term. And you can get caught in this trap of, you know, if you're a day trader, well, you're just, you're highly biased by

Starting point is 00:26:12 the short term in a lot of ways. If you're only a stocks for the long run type of thinker, well, you're biased in the long term. And you haven't prepared yourself for the reality that, yeah, we live in the long term, but really life happens in the short term. And you have to plan your financial asset allocation in a way that it matches all of these different time horizons. So there is no, you know, there is no one-stop shop sort of answer to this, whether it's stocks for the long run or or thinking more short term and trying to, you know, turn a long-term instrument into a short-term instrument by day trading because by definition, you can't turn a, you can't turn a 10-year bond into a one-year bond. That 10-year bond is, it's always going to

Starting point is 00:27:01 function like a 10-year bond. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days 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, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses,

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Starting point is 00:31:18 Myth 10 is quite controversial, though perhaps not as controversial. This year, as it would have been, say, 12 months ago. You claim that it's a myth that your house is a great investment. And I just want to bring this up because it's always such a, it's really divisive to make a statement like that. Because to most people, their house is the biggest investment, the biggest investment that will it will make. So knowing that it can make it very, very unpopular, I still have to ask you, Colin, could you please elaborate on why a house that we live in is not a great investment? I know. I get a ton of hate mail from mortgage brokers and real estate people when I say that,

Starting point is 00:31:57 because real estate obviously is made, I mean, arguably more people wealthy in this country than any other asset. And what I'm being specific with there is that I'm not saying, saying that a house can't be an income generating type of instrument that, or especially within a business, like I was going back to the definition of investing earlier, you could build a business where you are literally, if, for instance, if you're a home builder, obviously homes are a great investment for you, where you're actually doing the thing that is generating the future production and generating the return on investment that is very, very valuable. But from your standard retail investors perspective, your home, I think on average over very long periods,

Starting point is 00:32:45 will not be as good of an investment as I think a lot of people tend to just assume. And I think the main function of that is that people don't actually calculate their returns on that investment accurately. Because for most of us, what we do is we go out, we buy a home and we live in it. And a home is really just a, it's a big block of wood that is falling apart. It's a deteriorating asset on valuable scarce land. But the problem is that the actual physical structure itself is an incredibly expensive asset in so many ways, whether it's upkeep and maintenance or, you know, taxes. And if you think of a house in terms of having an expense ratio like a mutual fund does or an ATF, that house is phenomenally expensive per year because of the upkeep and the

Starting point is 00:33:39 time and the taxes involved. And so when you actually back out what I call real, real returns in the book, which is basically that's your after tax, after fee, after inflation return, what you find is that real estate for your average homeowner is actually not that great of an investment because they don't actually quantify all of the real, real after, you know, return that they incur over time. And so most people don't think of, you know, all the time they spent pulling weeds and, you know, hey, the water heater broke, you know, 10 times while I lived in the house or whatever it is, you know, there are all of these real costs involved in owning a home that people tend not to actually quantify when they sell their home. And that tends to be the way that most people think of their return on investment in a real estate purchases that they say, oh, well, I bought my house for $200,000.

Starting point is 00:34:39 And then, you know, 30 years later, I sold it for $600,000. And so I made this fabulous return on investment. And you forget the fact that, well, yeah, but you paid a boatload in taxes over that period of time. And you went to Home Depot a billion times to repair stuff that was falling apart. And so when you actually go in and, you know, and then adjust for inflation during all of this, and what you find out is that real estate historically has only generated about a one, maybe 2% real, real return. And so, you know, there are certainly periods where, you know, you could time the market.

Starting point is 00:35:17 Well, like if you bought real estate back in 2012 or, or let's say, like right before the COVID boom, well, you did really, really well. but if you're somebody who bought it in 2006, your story could be completely different. And so it's not that you can't make money in real estate. It's that I think you have to understand that on average, the likelihood of your home making you rich in an investment sense is a very, very different endeavor than, say, starting a corporation,

Starting point is 00:35:50 which that has the potential, or even I like to talk in the book, a lot about human capital, building skills, investing in yourself in a way that has a very, very high return on investment. To me, those are the things that are the very, very best investments, whereas a lot of the traditional stuff we think of buying and selling on secondary markets, they tend to not be as good of an investment or not even properly termed investment the way that I think a lot of people frame them. Yeah. And I also just I just want to make the disclaimer that I don't want to glorify stock investing by asking the previous question about how it's perhaps not being the best investment. Certainly there are quite a few

Starting point is 00:36:35 challenges by being a stock investor. You know, it's like you read those textbooks. I remember reading them back in school and it's like, yeah, you know, the stock markets, you know, it gives you the eight, 10, 12 percent, whatever kind of yearly return. I was like, wow, that's so much better than the bank. But then as soon as you start investing yourself, you realize it's a lot more volatile than that. And it's not, you're not grinding out one return after the other. That's just not how it works. But Colin, I know that you've been digging into the data. What does the data tell us about the profitability of being in the stock market?

Starting point is 00:37:11 Yeah, it's interesting. You know, Buffett actually talks about this in a lot of his old letters about how you should assume that the aggregate stock market after inflation is probably. probably only going to do like four to five percent, which is, I mean, amazingly, that's like half of the number that you commonly here referred to in the financial media. And because there is this 10 percent number that a lot of people have in their mind of that's just what the stock market does on average. And but when you, again, when you go in and you back out all of the taxes and fees involved in this, well, you find that the stock market really is not really

Starting point is 00:37:48 the place where you generate very, very high returns. And this, again, is like, it's one of the reasons why I focus so much on human capital in the book and investing in yourself. And I literally, I wrote a whole section in the book about how investing in yourself is the absolute best investment you can make because that's the thing where you can actually control so much of the outcome. And that's the, I think the big thing with the stock market is that, well, when you actually put the, that four to five percent figure into perspective, I think it's part of why passive investing in indexing has become. so popular in the last sort of 10 to 15 years because there are specific things about stock market asset allocation that we can directly control. And those tend to be taxes and fees. You can't control what the market is going to do in any given year, but you can control taxes, fees, and I focus on behavior a lot because behavior is obviously something you can control when you

Starting point is 00:38:45 become disciplined about it. And so, you know, I think it's really important to, look at those things that you can control for. And working from this perspective of human capital, building your own skills and investing in yourself, well, those are things you can control. You have a direct control over the amount of knowledge that you build over something. I mean, you obviously can't just go out and become LeBron James if you want to become a professional basketball player, but you can find something that you're good at and you can make real investments in those skills in a way that has a return on investment for you personally. Whereas the stock market and buying, you know, homes and things like that, there tend to be so many variables involved in that

Starting point is 00:39:29 that you can't control. And I think that, you know, when you start to put these things in the proper perspective where you realize, well, mathematically after taxes and fees and all this other stuff, well, these instruments don't do quite as well as I think a lot of the financial media would like us to think, then you can put these things in the proper perspective where you start to say, well, okay, it actually makes very little sense for me to sit around in day trade stocks because after you back out all of these, all of these sort of uncontrollable aspects of it, and actually the more active you are, the less control you have because you're incurring higher taxes and fees along the way, well, it doesn't make sense to actually spend a lot of my human

Starting point is 00:40:16 capital doing some an endeavor like that because the much more probable high return on investment is building skills that other people will find valuable where then I can generate a higher income that becomes a in a sense you almost when you build a lot of human capital you build your own sort of bond you become this high income generating type of instrument where now the return on investment that you're generating is controlled not by a function of what other people are doing, but really by what you're doing. So continue in talking a bit more about stock investing. I wanted to challenge the notion that we as investor are diversified from solely being invested in the SEP 500. It's not something I heard

Starting point is 00:41:03 you say, so I just want to sit the record straight for that, but it's something that I hear being thrown around a lot. I often hear that because American companies have international of revenue, as would be the case with the S&P 500, it's similar to buying international equities. And I kind of feel I'm giving you a bias. And perhaps it's too late, but I would like to continue on this threat here. Because I believe that it's not true. And I hope you being in the meth buster, you can give me some pushback. You know, one example, I want to make taxes.

Starting point is 00:41:33 I read some Spaghetti's books, Capital ideology and Capitalism in the 21st century. And a huge shout out for those books. They are absolutely wonderful. It is also an acquired taste. I just want to make that disclaimer. If you think that 1,700 pages of the world's tax systems and how they developed are interesting, hopefully you won't. But if you do find interesting, perhaps those are the books for you.

Starting point is 00:41:53 But one thing I've learned in those books which surprised me is that the tax rate in the U.S. was 52.8% in 1968 and in 1969. Now, I don't believe that would happen anytime soon. I also have to say, I never believe that the world's countries would agree. and the minimum corporate tax rate, even though it's still up in the air. I never believe that we have a war in Europe in 2022. Things happen. Going away from taxes, another thing I wanted to throw in into the ring is disintegration of supply chains. We see that between the US, Europe, China, and the rest of the world. And this is something that we can expect to continue if we continue to see

Starting point is 00:42:30 increasing conflicts. And again, I am very biased in how I phrased this question, but I really hope you can give me pushback on this. Are we diversified inequities if we're not? We own the SDP 500 only, or would we need to buy global equities? I always like to use an example of like, imagine you were living in London in the year 1800. And you were somebody that was kind of involved in finance. And the financial world was really starting to develop in most of Northern Europe around that period and really turning into something, you know, more like what it is today, where people were actually forming companies

Starting point is 00:43:10 and then selling parts of those companies to the public. But if you lived in Northern Europe or London in the year 1800, well, would you have ever thought of investing internationally? And who knows? Maybe you own something like shares in the Dutch East India company or something, which you could technically argue was like an international company to some degree. But you wouldn't really have thought of ever investing outside of probably like the UK, if you were in that environment. And in the long run, if you were that person,

Starting point is 00:43:45 what you missed out on was literally one of the greatest economic booms in all of human history. Because in the year 1800, there was this little tiny country on the other side of the ocean that was in the process of building an economic monster. And that's what the United States eventually became, was the United States became the biggest, you know, most productive, innovative country and economy in the world over the course of the next 200 years. And so if you had this home bias, well, you not only were invested back in what was known as the world's reserve currency back then, but you, if you only invested in the home bias there, you missed out on all of these other economic booms internationally. And so, look,

Starting point is 00:44:33 I'm a very, I know we have a international listenership here. and I'm based in the United States. So I have a lot of biases because I'm a very patriotic American and blah, blah, blah, about all that. But I still, I look at the United States and I know the history of world reserve currencies and I know the history of world superpowers. And I know that over the course of economic history, the reserve currencies come and they go.

Starting point is 00:45:00 The world's superpowers, they ebb and they flow. And in 50 years, who knows where the United States is going to be? Who knows whether it will be Europe again or China or India or whatever country it might be that is the next big thing? And so from a perspective of allocating assets these days, to me, it just seems like such a no-brainer to diversify internationally because what if? What if you're the person who's only invested in the S&P 500? And sure, yes, you're getting some international diversification because of international revenues. But, you know, with the sort of change in globalization to some degree, you could argue that a lot of these international firms might be forced into becoming much more domestic types of firms. And so you can make an argument there that you're actually losing some of your international diversification.

Starting point is 00:45:52 You know, who knows what's going to happen with all these global conflicts. I mean, we could all end up being, you know, Japanese to some degree where we're more, we all become much more isolationist. And actually, Japan's an incredible example of home bias where if you were only invested in Japan in 1990, well, you suffered through one heck of a big stock market trauma because you didn't own a lot of international stuff. And if you had been a Japanese investor in the 1990s who owned an international stock portfolio, you performed vastly, vastly better than the person who just lived in Tokyo and only bought Japanese stocks in that period. And so to me, I think that's the the real benefit of owning diversifying internationally is that you've got to get away from home

Starting point is 00:46:37 bias because you just never know what's going to happen. I mean, I don't personally think that the United States is going to lose reserve currency status anytime soon or that the United States corporations are going to start to, you know, lose lots of market share. But, hey, I have no idea what's going to happen in the future. And I think that's part of the, one of the big lessons from being a good investor is that you have to humble your self to these unknowns and you have to recognize that there is a certain arrogance in being American and only owning the S&P 500 because you are just implicitly saying, well, I don't need to own all those international companies because the United States is number one and,

Starting point is 00:47:19 you know, rah, bra, rah, you know, I just, I only need to own America. And so I think international diversification has a huge benefit. And this is statistically supported too, that the, especially when you look at the booms and busts of the markets over time, you know, we go through these big ebb and flow cycles where international stocks, for instance, they kicked the pants off of U.S. stocks in the 2000s. And then we've, you know, we've been through this long 15, 20 year cycle where the U.S. has, you know, kicked the pants off of everything international. But, hey, that could be changing right now as we speak.

Starting point is 00:47:55 And to some degree looks like it is starting to transform. And so to me, from a diversity. diversification perspective, I think it not only is supported by the empirical evidence, but it's supported by the historical evidence. Yeah, and I think you bring up multiple good points. You mentioned Japan. We had David Stein on episode 478, and you talked about whenever he entered his financial career, he was looking at a lot of Japan.

Starting point is 00:48:20 And at the time, if you bought a global index, Japan would be 45%. And today, it's less than 5%. It's incredible to think of. And it would be interesting to see, you know, I would imagine like if you were a good patriotic Japanese person in 1989, you would be thinking, I should buy Japanese equities. Why wouldn't you? And, you know, I feel the same way as you, Colin. I have a huge bias with the U.S. companies.

Starting point is 00:48:45 I, you know, I understand the country. I understand the stock market. I have a lot of trust in the country. I can't see that the global serving currency will go anytime soon. But I also think it's important to understand, like, to your point about that gentleman or in 1800 in the UK, it would have been really expensive to have a, I would imagine, to buy equities in other countries at the time. It's not today, you can do that with click of a mouse.

Starting point is 00:49:08 It's not like, I don't know if you would go from four basis points to like eight basis points, which might seem like it's twice as expensive and it is, but it's really from nothing to a bit more than nothing in terms of costs. And so it's just something that I really wanted to pass on to our listeners. Having that humility you were talking about before, Colin, I think that's so important as an investor. And not just look at the past, say, 10 or 15 years, too much money has been thrown overboard from bias, recency bias. Totally.

Starting point is 00:49:38 Yeah. And the cost aspect is a huge one that you bring up where it's just, it's not expensive now to own international equities. And so, you know, another, it's one of those things that you can control and you can control, you know, the level of home bias without having. having to pay, you know, crazy fees that we know detract from total returns in the long run. So, Colin, let's talk about bonds. Historically, bear markets and bonds have been different from bear markets and stocks.

Starting point is 00:50:10 What does the data tell us? And does that change? Again, we don't want to have too much reason to bias. Does that change if we enter a new long-term cycle with rising interest rates for decades, just like we've seen the opposite, declining interest rates since 19. Yeah, well, God, this is an interesting time to be talking about bonds, obviously, because they're going through their worst run in arguably history. Bonds are, they're a different beast than the stock market because buying something like, say, U.S. government bonds or investment

Starting point is 00:50:44 great bonds for the most part, you really, you can mathematically quantify what your returns are going to be over specific time periods. And I think this is another thing that's important with owning bonds is that I think that you have to understand that specific concept of time inside of the instruments where it's very easy, for instance, in a period like right now, to look at a five-year bond and say, well, that five-year bond is down, you know, 15% this year because interest rates have gone from zero to three percent. And I know this is hard for a lot of people to be patient with, but over the course of a five or six or seven, year period, when you let that bond mature, it will mature at par and it will have just clipped the coupon at whatever you purchased it at. And so going back to kind of that idea of like segmenting things in certain time horizons, well, if you were buying like right now, treasury bills right now, you can buy six and 12 month treasury bills right now for 4%, which is a world that hasn't existed for 10 to 15 years. But the kicker there is that, you know, with a six-month bill, you're

Starting point is 00:51:53 going to get a one-time coupon. And so you've got to understand that, hey, this instrument isn't going to do anything for six months, but then you're going to recoup your, you know, your full four percent, like coupon or two percent because it's an annualized rate, but it's going to mature at par. And but you've got to be patient enough to let the instrument do what it's designed to do. And so that's one of the things that makes bond investing very hard. But, you know, it's interesting coming off of zero because the world, I wrote about this a lot back when interest rates were down at zero, that when interest rates are at zero, your interest rate risk is just, it is completely different than when interest rates are starting at four. So because bonds are obviously,

Starting point is 00:52:40 they're protected by the income that they generate. And so, you know, I write about this a lot with the period of the 1970s. A lot of the people that write about that period think that bonds were a terrible investment because interest rates went up so much. But the interesting thing about bonds is that the more interest rates go up, well, the higher income you're actually generating from the new bonds that you're rolling into. And so in a certain weird way, when you're buying a bond that generates 8 percent and inflation's at 8 percent, well, from a nominal perspective, interest rates have to basically continue to skyrocket even more because they have to to generate a negative nominal return now, they have to offset 8%.

Starting point is 00:53:25 And so your five-year bond that, let's just say it has a five-year duration, which is its interest rate sensitivity, when that thing goes up 1%, you lose 5%. If you're earning a coupon of 5% in that bond, well, you lose basically all of your coupon in the annual year that the interest rates rise because it completely offsets your 5% rate. But if that bond, let's say you buy it. and it's starting at 10% rate, well, that bond has to lose the equivalent of two years basically worth of principle to actually offset the interest payment.

Starting point is 00:54:02 And so in a weird way, bonds operate a lot like stocks in the sense that when interest rates rise, the prices fall, their future returns become better. And the stock market functions, tends to function in a very similar way where when When the stock market falls in value, it actually tends to become a higher return generating instrument in the future. And the bond market is very, very similar. And so weirdly, we're in this environment now where, yes, if interest rates continue to soar, then you will continue to incur principal losses. But your math now is vastly improved because now you're able to buy bonds that are yielding 5, 6%, so your starting point is much better protected in this world than it was

Starting point is 00:54:52 in the 0% market. So to me, you know, there's been a lot of commentary about, oh, bonds are dead, bonds are useless in a portfolio. And I always tell people, well, that's actually you could argue that bonds were a far worse value proposition two or three years ago, certainly. But today, I actually think the math is completely transforming. I would argue that bonds are a much, much far superior value today than they were because interest rates have risen. And the likelihood that interest rates are going to continue to rise at the rate that they've been rising, in my opinion, is lower, which actually makes bonds even more attractive going forward.

Starting point is 00:55:32 But again, it depends on your personal situation. Bonds shouldn't be owned by everybody. And not everybody has a need for these short-term type of instruments that are going to provide certainty over very specific time horizons. And so bonds have to be very personalized and customized to people in the same way that, like when I was talking about the bond ladder, I think you have to build very systematic fixed income portfolios that are applied to people's time horizons where bonds for me typically are instruments that you really, you should use them inside. of like a five-year time horizon where you're not exposing yourself to just crazy amounts of like interest rate risk like you would if you owned a 30-year treasury bond. The dynamics of that instrument are just, they are completely, completely different than owning something like a, you know, a six-month treasury bill or a five-year treasury note where you can structure that thing across a very specific time horizon within your financial plan where you actually know from a nominal

Starting point is 00:56:39 perspective, a lot of the mathematical outcomes that are likely there. And that, you know, not to get on a whole other tangent, but for me, you know, I write about this in the book very specifically that I really do not think people should think of bonds as being a real return protecting type of instrument. It's one of the reasons I'm not a big fan of tips and inflation protecting its securities and fixed income markets in general is because bonds to me, their principal protection instruments. They are instruments that over very specific. time horizons will provide a certain amount of principal stability. They are not in your portfolio to generate real returns. Your treasury bill that you can buy today at 4%, there is no chance that

Starting point is 00:57:22 thing is going to beat the rate of inflation. But that's not the goal of the instrument. The goal of that instrument is to give you 4% nominal certainty because you know that if you just leave that money sitting in the bank, you're going to get 0%. And so from a value proposition perspective, a relative basis on a nominal return basis, that instrument is a no-brainer to own, assuming you have a six-month time horizon for that money. 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.

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Starting point is 01:01:16 I would like to continue talking along those lines, because you have this wonderful passage in your book about diversification that I found very useful. And the quote goes like this. Diversification is about learning to hate some of your portfolio all the time, end quote. And it really makes me smile and not in agreement. It's wisely said, and on my end, it's wisdom born out of pain. Because could you, Colin, talk more about how do you see diversification and why the imperfect portfolio you can stick with will perform better than the perfect portfolio you cannot stick with?

Starting point is 01:01:51 Yeah, well, I think that's the thing that a lot of us are seeking is that portfolio that just only goes up. You want to own all the instruments that are just only going, you know, from the bottom. left to the bottom right all the time. And I think that one of the, you know, not only is that obviously just an incredibly difficult endeavor to achieve, but one of the purposes of diversification and generating better risk-adjusted returns or smoother styles of returns over time is that you have to know that in order for diversification to work, you have to have instruments that are uncorrelated. You have to have instruments that, well, let's say the stock market is booming,

Starting point is 01:02:32 maybe your bond portfolio isn't doing that well. And you have to build a portfolio where you do end up kind of hating a portion of your portfolio. I mean, just looking at a stock market, a global stock market portfolio, for instance, in the long run, owning a value portfolio, for instance, in the last 10 years has been a horrible relative performer inside of a total stock market portfolio relative to growth. But now we're seeing the tide kind of change there, where value in the last year, year and a half has absolutely smoked growth.

Starting point is 01:03:10 And so that's part of the beauty of diversification is that there's a lot of people that in the last 10 years could have looked at the value port of their portfolio and said, hey, you know, this Vanguard value fund or whatever it is that you own, this thing hasn't done very well. And I hated it. It goes down every day.

Starting point is 01:03:29 and it's driving me crazy and the growth stuff keeps going up. And you can get into these debates about momentum versus something more diversified and balanced. But to me, I think that in order to build a portfolio in the long run that does well and creates a more stable type of return, you have to build in things knowing that parts of that portfolio are going to do badly over time. But on average, over longer periods of time, when you blend that value position with the growth position, you don't get into the timing,

Starting point is 01:04:06 the market thing. You just kind of know that, well, there's going to be periods where the value stuff does badly, the growth stuff does, you know, badly at times. But if I own all of it on average, it will all on average generate a pretty decent return. But when you blend the two pieces together, what you really do is, and this is the main goal of diversification and especially owning things that are. outside of the stock market, things like cash or bonds or whether it's gold or commodities, whatever it might be, what you're really doing is you're dampening the volatility of the instruments

Starting point is 01:04:40 that are really, really volatile, which tend to be things like the stock market. The stock market in a year, like this year, where it's down 25%, well, you know, owning bonds or gold, you know, nothing's really worked that well. But the investor that owns gold or, you know, commodities or even bonds in this environment, well, what they've done is they've buffered the negative 25% return in the stock market because even though bonds are down, you know, 11% or whatever and I think gold is down 10%. Commodities are up. You know, what you've done there by building this sort of very diversified portfolio through owning uncorrelated asset classes is you have buffered the instrument in that portfolio that is really the most volatile, the one that especially

Starting point is 01:05:30 is going to cause you a lot of behavioral angst. Because if you only owned the stock market component there, you're down 25 percent and you're looking at your portfolio and you're saying, oh, no, if I lose my job or, you know, I need to tap some cash, I'm going to have to take a big, big principal hit in this instrument. Whereas if you own the diversified portfolio, you own a bunch of stuff that, you know, years past, you probably would have hated all of it. You would have hated the bonds. You would have hated the commodities. You would have hated the gold. But now you find yourself on average over longer periods of time in a portfolio that's actually performing more stable where you have optionality, not only from a behavioral perspective,

Starting point is 01:06:15 but from a cash management perspective where you can now better manage your finances because you've created a diversified portfolio of things that, yeah, cash has been trashed for 10 years because it's been earning 0%, but cash has been one of the absolute best things to own this year, even though in real terms it's down, you know, whatever, 7, 8%, cash on a nominal basis is down zero. And so it's been this beautiful part of your portfolio because it's helping you sleep better at night and it's helping you manage your liquidity needs if you have them. So that piece that you hated suddenly becomes the piece of the portfolio that you love. And that's just the ebb and flow of life.

Starting point is 01:06:59 I mean, you know, what is the old saying? Mariety is the spice of life. And it's that's the same thing is true in portfolio management where if you own all the same stuff that all does the same basic performance over time, well, yeah, that might be great in the super long run. And that is the basis of the argument for stocks for the long run. But you can find yourself in these short-term periods where, man, when you're in trouble, you are going to find yourself in big, big behavioral trouble. Because when all those things are correlated, one-to-one, they're correlated negatively in a really, really bad way.

Starting point is 01:07:35 Yeah, and I think to that, now that you mentioned that gold is down 10%, here in Europe, people are pretty excited because gold is up. And that's, of course, because the euro is down 16%. So it really depends on how you measure it, but it also goes to the whole diversification piece in different currencies. But Colin, one thing I learned from following your work and a topic that we covered multiple times here on the show is how the most important form of money in the modern monetary system is issued almost entirely by the private banking system.

Starting point is 01:08:07 And at least I remember, like, doing that the first time. And I was shocked because I had this idea that of this printing press that was running, you know, kind of like what you've seen like from back in the day before all became digital. But anyways, so like whenever I learned that from you, I was like, this is, this is really interesting because in market-based systems such as the US and the European Monetary Union, the government in those countries do not directly control the money supply or create the most money. Will this change with the central bank control digital currencies that we hear about? It's an interesting concept because, you know, just to kind of give a real real,

Starting point is 01:08:45 really high level overview, so people do understand what we really have in most modern monetary systems is sort of a two-tier system where the banks are really the dominant money issuers. We call money that banks make credit, but really from a practical perspective, loans create deposits and deposits for all practical purposes or money. And they're even in most countries, their government backed. I mean, FDIC insured here in the United States, for instance. So deposits are in terms of their comparison to like a dollar bill, they're identical, essentially. And so what you have is this two-tier system where theoretically a lot of people think of

Starting point is 01:09:20 this from the perspective of the government where the government runs and the central bank specifically runs the inner bank market where this is where this is the banking system basically for banks. And so the rest of us all use the primary banking system, which is where we exchange deposits. But when, you know, if I were to pay Stig and Stig banked at a different bank than I do, well, the two banks would go to the interbank market to settle the payment. And that's the bank controlled by the central bank. So it's kind of this behind the scenes sort of banking system. And the old theory is that if the central bank gives banks more money in the interbank market,

Starting point is 01:09:58 in the secondary market, that then they can create more money in the primary market. And that's just not really how it works. The primary function of loan creation is demand for loans and the bank's ability to actually, you know, find credit worthy borrowers to issue those new deposits. So the government, the government doesn't have no control over money, obviously. I mean, they can create financial assets that are very money like. I mean, government bonds, I always argue, are very money-like. They're not technically, you know, like deposits. But when the government, when the government runs huge, huge deficits, what they're really doing is they're giving a bond generally to a rich

Starting point is 01:10:35 person and they're taking that money and then they're spending it into the hands of somebody who isn't as rich, who has a higher marginal propensity to spend. And so they've created an asset that is essentially like a savings account, giving it to the rich person, taking the rich person's money, and then given the money to the poorer person. And in every sense of the word, I would argue that is money printing in the sense of like the sort of traditional way we think of it. Whereas when a central bank creates reserves,

Starting point is 01:11:02 they're not necessarily really printing money because the money that they're printing isn't really in the private sector. It's not going to a depositor and then being spent at, you know, Walmart or some, you know, big box retailer or something like that. But from the perspective of, you know, controlling the money supply, it really is controlled primarily through the banking system. And it would be very interesting from a theoretical perspective whether central banks started to issue digital currencies because in a sense, if you let the,

Starting point is 01:11:37 The central banks run what is essentially retail-type banking systems where they're actually making loans to the private sector. You could argue then that, well, in that instance, the central bank becomes much more like a Bank of America or any regular old bank, where the government then is actually directly controlling the credit issuance and the loan creation. process in a way where they are actually creating deposits and creating money. So it's highly theoretical, but I think it would, in a sense, it would start to really, really transform the way that the modern monetary system is structured, because right now, most of the money creation

Starting point is 01:12:26 on average is controlled by private entities that basically they really compete for depositors. They compete to make loan that result in the creation of deposits. And that's a very sort of market-based function, whereas a lot of what the government does when they create financial assets is it's obviously much more politicized. And you could argue that it's not nearly as market-based, not that the modern banking system is perfect by any means. It's certainly not. You could argue that there are big, big problems in the way that we have these private

Starting point is 01:13:00 competitive banks to some degree. But in general, yeah, wrapping all of this into the government and having the government basically become the equivalent of like a retail bank, yeah, that would completely transform the system because politically it would not only change central banks from being somewhat independent, but into specifically really very politicized money issuing entities. But it would diminish the power of modern private banks significantly. And for us investors, I think it's important to understand that the Fed could, in theory, control the entire yield curve of government debt. One expression or one term that's been thrown around a lot is this yield curve control that we hear about. And perhaps you can start explaining what it is, but also why the Fed allows the marketplace to control long rates of U.S. government bonds. Yeah, it's an interesting question. I mean, so, you know, kind of backing up the way to think of this is that,

Starting point is 01:13:59 The Fed and the way that they control interest rates is a lot like, imagine the analogy of somebody walking a dog on a leash. And at the handle, the man holding the leash has absolute control. They determine exactly where that leash is held, whereas the longer end is kind of like the 30-year bond. And they let the dog wander from side to side. And it can kind of gyrate based on really what it's trying to do is, to a large degree, it's trying to predict where the man is going to walk to some degree. So there's this weird sort of feedback relationship where the man has a certain amount of control over where the dog is going, but doesn't have absolute control over it through the leash. And so interest rates function very much the same way in the current system where theoretically the man could take that leash and he could pull it all the way in and he could basically control exactly where the dog is by grabbing the collar basically and eliminating the leash. right now in the system we have, the most central banks, they don't target the price of long rates.

Starting point is 01:15:05 They let long rates just sort of float. And this is part of the argument why I always say that quantitative easing isn't as effective as a lot of people tend to think because what they're doing is they're controlling the quantity of bonds. They're not controlling the price of bonds. Whereas at the short end, there's a huge difference because at the short end, they specifically control the price. They explicitly determine what the overnight price is. And the Fed or any central bank is such a big, powerful money issuing entity that it is a monopolist, essentially. And it can

Starting point is 01:15:40 banks don't try to fight the Fed on what the overnight rate is because they just quite literally cannot. Whereas the Fed lets the long end float, and banks will try to front run and change long-term rates because they know that the monopolist isn't actually setting that rate. But if the Fed came out and said, for instance, the 10-year treasury bond is worth 3%. The 10-year treasury bond would, it would immediately or within days, go to 3% because the marketplace would know that there's no way they can arbitrage that out because the Fed is going to come in and the Fed's going to set the price and they're going to pay interest on that instrument in a way where they're able to very precisely control it. And so that's essentially what yield curve control is. It's the central bank coming out and

Starting point is 01:16:34 explicitly saying this part of the yield curve is now exactly this price. And they're able to do that because they're the reserve monopolist in that second tier interbank payment system. So it's very sort of controversial because, like, to some degree, like a lot of the theory argues that it's actually good to get market signals from letting the long bond float because the market then is sending a signal. Like when the yield curve flattens, for instance, in an environment like this, like I would argue that what the long end is essentially saying is they're saying, well, we actually expect long-term inflation to be much lower than what the Federal Reserve expects right now. And so with the 10-year yield lower than the two-year today, the marketplace is basically saying,

Starting point is 01:17:20 we are not as worried about inflation as the Federal Reserve is over the course of the next 10 years. And that generally is consistent with a market signal that is saying, hey, the Fed is maybe a little bit too tight here. There are maybe a little more worried about inflation than they should be, which is why, you know, this is the reason why the yield truck tends to be a pretty good predictor. of recessions is because that's the market signal that it's sending. Speaking of the Fed, it is well known that the Fed has a dual mandate of price stability, on one hand, and then full employment on the other.

Starting point is 01:17:56 Do you also argue that the Fed could be seen to have a triple mandate? What is the third mandate and how would the economy look if we didn't have the Fed? That's a good question. Well, we didn't always have the Fed. The banking system before we had the Fed was basically, I like to describe the Fed as a central clearinghouse. The big thing that they do is they just clear payments in the interbank market. That is their, you know, they get a lot of press for doing things like quantitative easing

Starting point is 01:18:27 and changing interest rates. But their day-to-day function really is this interbank clearing process. And they clear trillions of dollars of payments. And they, for the most part, this system works really well. It works really smoothly. And they don't get, they don't really get any credit for that or there isn't a lot of talk about it because it just generally, I mean, the vast majority of the time, it's not a problem. And when it does become a problem, like it did kind of back in like 2008, they're actually

Starting point is 01:18:52 very good at smoothing the functioning of the payment system so that it doesn't become a big problem. And before we had central banks, before we had the Fed, for instance, and the reason we actually have the Fed to a large degree is because in 1906 and 1907 and many panics, Before that, we had private clearing houses where instead of Bank of America and Citibank clearing a payment through the interbank market through the central bank, they would clear the payment between themselves and they would literally meet at a clearing house and they would settle up their debts at the end of the day. And what started to happen increasingly was that

Starting point is 01:19:28 you had private entities that were going in and they were looking at each other doing financial panics and the city bank banker was looking at the Bank of America banker and saying, you know what, we don't trust your balance sheet. We know you have a whole bunch of railroad loans out that are melting and we're going to wait about three months before we decide to do business with you. And as the economy became this more nationalized economy, much more interconnected, that became a huge, huge problem because then you could have Citib wouldn't settle any payments with Bank of America and then all of the sudden Cullen can't settle a payment with Stig because we just happen to both use these two banks that won't work together.

Starting point is 01:20:08 And like, you know, Stig and Cullen might have no problems. Economically, we might be running the most successful businesses ever. But like, we can't settle a payment between each other just because the banks are bad at their job all of a sudden. And what the Fed basically comes in and does is they operate as this third party intermediary where they come in and say, look, okay, guys, you can relax because we actually have seen Bank of America's balance sheet and we know that it's fine. They're going to make it through this. And so we're going to act as the third party intermediary. And that's what they did in 2008. And it actually worked really, really well.

Starting point is 01:20:42 You could argue that, I mean, like, I've been really, really critical of their interest rate policy in the last year because there are legitimate, controversial things that they do. But for the most part, this central clearing process works really, I mean, beautifully to a large degree. So if we didn't have central banks, you would probably still need some sort of third part intermediary because financial panics turn into financial depressions in large part because the financial systems starts, you know, getting mucked up. And that's a huge problem and actually one that central banks are very good at resolving. So, you know, in terms of their third mandate, that really is it. It's to sustain financial stability. And that's a big part of the thing that the Fed is actually

Starting point is 01:21:27 really, really good at that people just don't ever really talk about. And, you know, we can And like I said, you can have lots of debates about whether, like, I think quantitative easing is a bad policy. I don't think they should have ever done it. I think that the way that we control discretionary interest rates with like, you know, basically a group of people meeting and putting their fingers in the air and saying, hey, you know, this is where interest rate should be. I think that's kind of a silly way.

Starting point is 01:21:52 I think there are systematic ways where we could implement this that would, you know, take a lot of the guesswork, a lot of the human element out of it. So there are, I think, fair criticisms of things that they do. But as a financial stability entity in terms of just monitoring and regulating the payment system, they do a pretty darn good job. And they don't probably get enough credit for that because it's just not something that people I think actually know a lot about because we just sort of take for granted the fact that the payment system pretty much always works pretty smoothly.

Starting point is 01:22:27 Colin, as always, your wealth of information. It's just always great having you on this show and learning from you. If the audience would like to learn more, perhaps about your wonderful book, Pragmatic Capitalism, your website that's called the same. But would you like to give any handoff to the audience about whether they can learn more about you? Yeah, so, I mean, like Stig said, Pragmatic Capitalism is the book. I just released a second edition. So it's been a while since I published the first edition.

Starting point is 01:22:56 but updated it with sections on, I would argue that I've evolved more and more into a behavioral investor. I think that trying to control for investor behavior is actually probably one of the most important things we can try to do. So there's updated sections with what I refer to as discipline-based investing and trying to be having more discipline over your investment processes. But yeah, I write the blog that I'm probably best known for is pragmatic capitalism, which is Pragcap.com, P-R-A-G-C-A-P-com. I've started doing little video series where I'm trying to do a lot of the similar stuff where, you know, this is a 250-page book that it jams.

Starting point is 01:23:37 I tried to jam probably way more content into it than I ever could have. I, you know, arguably do some topics that it's just an injustice because I could, you could write a thousand-page book about certain aspects of, you know, that I write about for 10 pages in here. But I've started doing these videos, three-minute money videos on YouTube. They're just little snippets of generally little lessons or recently because of all the turmoil. I've been talking a lot about the macroeconomy, but still starting from a first principles perspective where my goal is really to understand the system for how it works.

Starting point is 01:24:10 And then you can apply these behavioral elements where you're trying to navigate that system, but do so in hopefully a pragmatic approach. That sounds wonderful. And Colin, thank you once again for coming on the show to teach us about the global change in economy and more about why we should pay attention to macroeconomics. This was the 10th time you're on. I mean, how amazing is that? I hope we can bring you on at least another 10 times, Colin.

Starting point is 01:24:36 I know I'm putting you on the spot here, but it's always a pleasure. I love it. I love talking to you guys. Your audience is awesome. I always get great feedback from everybody. So thanks for listening. I hope you learned a bunch. And yeah, I'll look forward to doing it again for sure.

Starting point is 01:24:49 All right, so let's put it in the book sometime. But hey, Colin, again, thank you so much for your time. It's always wonderful to speak with you. Yeah, thank you, Stig. Thanks for listening, everyone. All right, as we're letting Colin go, I'm excited to share an upcoming event hosted by The Investors Podcast Network. We are launching a stock pitch competition for you to compete in,

Starting point is 01:25:09 and the first place winner, we receive $1,000, plus a year-long subscription to a TEP finance tool and more. If you're interested, please visit The Investorspodcast.com, slash stock dash competition for more information. The last day to submit your stock analysis would be Sunday in November 27th. And to compete, please make sure you sign up for a daily newsletter we study markets

Starting point is 01:25:30 will renounce the winners. All the entries can be submitted to the email newsletters at theinvestorspodcast.com. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. access our show notes, transcripts or courses, go to theinvestorspodcast.com.

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