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Bogleheads on Investing with Victor Haghani and James White, ”The Missing Billionaires”: Episode 64

Post on: November 27, 2023 by Jon Luskin

Victor Haghani and James White are co-authors of “The Missing Billionaires, A Guide to Better Financial Decisions.” Victor is also the founder and CIO of Elm Wealth and David is the CEO, where they implement these concepts for their clients. This fascinating book discusses investment decision-making and risk-sizing and how to make better financial decisions with your wealth.

This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax-deductible donation to the Bogle Center is appreciated.

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[00:00:10] Rick Ferri: Welcome everyone to the 64th edition of Bogleheads® on Investing. Today, our special guests are Victor Haghani and James White, co-authors of a new book called, “The Missing Billionaires: A Guide to Better Financial Decisions.”

Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads® on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.

We have two special guests on our program today, Victor Haghani and James White. They are the co-authors of a new book titled, “The Missing Billionaires: A Guide to Better Financial Decisions.” This is not another “me too” book by an investment adviser rehashing common rules of thumb. There is a significant amount of original thinking and deep thinking packed into it, and they challenge a lot of the conventional thinking in the financial services industry.

Victor is the founder and Chief Investment Officer of Elm Wealth. James is the CEO of Elm Wealth, but prior to that James was trained as a mathematician. He joined the hedge fund industry as a quantitative analyst, became a trader, and ultimately a portfolio manager.

And Victor worked at Salomon Brothers in the 1980s and 1990s and became a managing director in the bond arbitrage group under John Meriwether, and then was one of the founding partners of Long Term Capital Management, an extremely successful hedge fund that exploded in the late 1990s and almost took down the entire financial system.

You could tell by listening to their voices that they have learned a lot in life, and they have been humbled by the markets. And quite frankly, those are the people that I learned the most from. So, with no further ado, let me introduce Victor Haghani and James White. Welcome to the Bogleheads® on Investing podcast.

[00:02:28] James White: Thanks for having us on.

[00:02:30] Victor Haghani: Thanks, Rick.

[00:02:31] Rick Ferri: Let’s start with getting to know you both. James, can you tell us how you got to where you are today as the CEO of Elm Wealth?

[00:02:39] James White: Well, I was a mathematician to start, I studied math in school. Had no professional background in financial economics academically and you took a relatively standard route through the professional trading world. I started off as a quant and a researcher, building complicated models for valuing exotic options. Became a trader first, a market maker, and then a portfolio manager at a hedge fund.

And as I built some wealth, I became more and more interested in the questions of how to manage it well, and one realization I came to which I think Victor will agree he came to also is the realization that the things we were doing as professional traders didn’t look very much like best practices for managing one’s own wealth.

And the practices were much less transferable than one might otherwise think. And so that was really what brought Victor and I together. And this mutual interest in managing our own wealth and in particular in questions that I had become interested in both from the professional trading side and from the personal wealth management side of optimal investment sizing.

[00:03:58] Rick Ferri: Thank you for that, James. Victor, you have an illustrious background.

[00:04:03] Victor Haghani: I don’t know if that’s the word I would use. I’ll take you back to the beginning. I was born in New York. My dad was from Iran, my mom American. I grew up in the States and then actually lived for a few years in Iran until the revolution, then lived in London. I wound up going to the London School of Economics, studied finance and econ there, and then found myself at Solomon Brothers in New York in those crazy 1980s.

After a few years in research, I was asked to join the trading desk, working for John Meriwether, and I worked for John for the rest of my career at Solomon where I became a Managing Director on the arbitrage desk. And then as a co-founding partner of LTCM where I worked through the 1998 implosion and then cleaning all of that up.

Then I took a long sabbatical. My three kids were really young. I was 38 and I needed to regroup and refresh, and I got to just have a great 10 years of freedom, spending time with my wife and kids, reading a lot, thinking about what I do next.

And eventually I wound up deciding that I thought there was really a need for a smart, low-cost wealth manager that brought the ideas that I had studied in academia to people to be able to get the benefits of those things. I lived in London for a long time and then moved back to the states about five years ago, and I’m living out in Jackson Hole, Wyoming, while James is in Philadelphia doing all the heavy lifting for our company. And yeah, I’ll stop there.

[00:05:30] Rick Ferri: Well, I say illustrious because you are mentioned in a few books. Michael Lewis’s “Liar’s Poker,” which is the game they used to play at the Solomon trading desk and also books on Long Term Capital Management. The one I particularly like is “When Genius Failed,” by Roger Lowenstein, which are really great reads.

I think that when you get into your book and you really start to understand it, it seems to me that a lot of the lessons that you were talking about earlier, James, about what was happening in the institutional world doesn’t really relate to personal wealth. And one of the concepts in the book that you bring out right at the beginning is the idea of risk sizing.

So, I want to start talking about the book, and we’re just going to go through the book. There are several parts to it. There’s a lot of math in it. Okay. So, you can kind of skip over the math and get to the real nuts and bolts of what these two are really saying. And there really is a lot of great information in here.

So, we’re going to go through some of that today. We can’t go through it all because there’s just so much of it. The book is divided into four parts, and those parts are investment sizing, lifetime spending and investing. There are sections on human capital, risk tolerance and how they intertwine with the markets, and market risk and return. Basically, they call it where the rubber meets the road.

And finally, there is a last section of the book which is interesting. It’s a lot of financial puzzles and pulls together a lot of the information in the book. And the last thing in the book is just an easy to read list of the core points that they’re getting at. So, let’s start out with James: what does investment sizing mean?

[00:07:08] James White: What we’re really trying to get across there is the idea that for many people a very large part of the investment process, maybe most of the investment process, is focused on the “what” question. What to invest in? What stocks to buy? What index funds to buy? Questions like that. And there’s a general assumption that if you find something really good to buy, then you should just kind of buy as much as you can of it, more or less.

And investment sizing and our focus on investment sizing is really trying to get across the idea that the question of “how much” deserves equal weight with the question of “what”. There are a lot of “how much” kinds of questions that are natural in finance, not just how much of an investment I should have but how much mortgage should I take out? How much gain should I realize?

There’s a lot of questions in which rather than framing them as a binary – I should buy this or I shouldn’t buy it, or I should take out a mortgage or shouldn’t take out a mortgage – framing the question not as “should I do it or not do it”, but framing it as “how much of this should I do” is a much richer way of thinking about investing questions. Investing in broader financial decision-making questions.

[00:08:37] Rick Ferri: There was an interesting section in the book closer to the end, but I’m going to pull it to the beginning, where you say you should avoid over-investing in highly confident assets, which basically means the more confidence you have that this risk is going to materialize into a high return, you actually should invest less in it. That’s an interesting concept. Victor, can you explain this?

[00:09:02] Victor Haghani: Sure, what we’re saying is that if you’re really, really confident that you’ve got a great investment, then you should recognize that your wealth is actually higher than what’s written down on paper today in your brokerage account. So, if you’re really, highly confident of something being a wonderful, wonderful investment for you, you’re richer.

And if you’re richer, then your downside if that investment doesn’t turn out as you expect is greater. We shouldn’t just measure downside from where we start, but we should be taking account of the attractiveness of the opportunity set that’s out there and also obviously our human capital, too. But normally taking account of how good the investments are doesn’t really materially change our decisions.

It’s only when you’re super confident, and we give the case of somebody that’s very bullish on crypto assets who feels very confident that they’re going to see 100-fold increase or a 20-fold increase with risk, though, that it might not materialize. But they’re so bullish on it that they don’t really need to own very much of it to be very wealthy. And if things don’t turn out like that, they’ve sort of taken a big hit from their expected place.

[00:10:20] James White: I’d just like to add that the assumptions here were not just that you’re super confident, but that you are super-confident, and the expected returns are super-high.

[00:10:29] Victor Haghani: Yeah, you’re super-bullish and super-confident.

[00:10:32] Rick Ferri: You could be super-confident that a zero-coupon treasury bond in 10 years is going to mature at the expected par value, and that’s not a risk. But what you’re talking about is the more confident you are in a risky asset that at some point you should actually invest less money in it than it may be if you were less confident. I just found that to be extremely interesting.

Let me ask you about why people ignore facts when they’re investing. And, I look at active versus passive debate between active mutual funds and index funds, and for decades active funds have underperformed index funds. In fact, I wrote a book called “The Power of Passive Investing”, and I did the history of this active versus passive debate going actually back to the 1920s. There’s data back there, and the data is clear and consistent for 100 years that if you just index the markets – I know you couldn’t do that back in the 1920s and 1930s – if you could have, you would have outperformed.

Now this data is everywhere. Standard and Poor’s indices puts out the SPIVA report. Morningstar puts out a report every year. Vanguard puts out a report. And yet, active management still persists. What’s going on?

[00:11:46] Victor Haghani: Let me take a crack at that. I think that it’s really just baked into human nature. Hope springs eternal. We tend to find it really difficult to objectively assess our own capabilities and abilities.

We just hate to view ourselves as being average. So, I think that so many people who are attracted to active investing and owning concentrated portfolios, they would not argue with Sharpe’s arithmetic of active investing that all active portfolios combined equal the market portfolio, and hence will earn the market return minus fees.

And it’s even worse than that because on average all those portfolios are riskier on average than the market portfolio. So, you’re getting hit from fees and you’re taking more risk, and we know from what we talked about in the book that risk is as real a hit to your returns as is paying fees or taxes.

But I think it’s just this human nature thing that, yeah, I know that it can’t work for everybody, but I’m going to make the right decisions and get the right active managers. And of course, it also doesn’t help that 99% of the people who work in the financial industry are on the active side of things one way or the other. And there’s only a small group of people that are proponents and write about sensible investing. I don’t want to call it passive investing.

It’s really active investing versus highly diversified, sensible investing. It’s not passive. You’re making an active decision to invest in low-cost index funds.

[00:13:26] James White: I’d add a different element. We wrote an article once called, “Is Vanguard more Rolls Royce or Hyundai?” That was premised on a thought experiment by one of Vanguard’s former CEOs, Bill McNabb.

And he highlighted, we thought very rightly, an element of consumer behavior which is that we’re just very used to as consumers the idea that when we pay more for something, we’re going to get a higher quality thing. He says if you buy a Rolls Royce, it really is more car than a Hyundai. And that consumer instinct works well for many things but doesn’t work with investment.

[00:14:06] Victor Haghani: We take a few pages to address criticisms of market cap weighted index investing. And some of the criticisms of index investing are so weak, and we thought it would be good to at least have that in there in the chapter called “into the weeds”.

[00:14:24] Rick Ferri: That was a great list that you put together of all of the fallacious arguments against indexing and why those arguments don’t really make any sense.

Let’s go back to the idea of risk sizing. How does the individual investor use this risk sizing idea? How do they decide how to choose the percentage they should have in various riskier assets or how much of a mortgage to take out?

You start this whole analysis by looking at something called a lifetime expected utility, and you really spent a lot of time on this equation. So, it is a little complicated. I’m going to ask James to break it down to a third-grade level so that I can understand it.

[00:15:07] James White: Yeah. So, one disservice that many people are done is that when a lot of people encounter concepts of utility in Econ 101 or wherever they encounter it, it often seems like it’s just this very abstract mathematical formalism that is very hard to intuit and that doesn’t really get at anything real.

But we have a strong view that that’s more of a pedagogical flaw, and that actually what concepts of utility are getting at is something really fundamental in human nature. In a parable we use in the book is that, for example, I’m a big rock climber. And when I’m driving back from a day of rock climbing, I often treat myself to some gummy bears.

[00:16:00] Victor Haghani: Sorry, they’re the candy type of gummy bears, right?

[00:16:04] James White: Yeah, the Haribo gummy bears. Specifically, the sour ones. And I have a pack of them. I’m in the car, and the first one is really good. I mean, it’s really, really good. And the first several are really good. But then, by the time I get most of the way through the pack, they’re still good. I’d rather have another one than not, but it’s just not the same. And by the time I’m down to the last one, I’m really almost indifferent between eating it or not eating it.

The fancy term economists would use for this is diminishing marginal utility of consumption. In this case, specifically with respect to gummy bears. And we argue, and we believe, that this is not just some random abstract thing. But this is really deep in human nature and that our experience of consumption for our desires to be self-regulating really has to be like this.

If you think about the opposite, let’s say the more I had of something, the better and better it got. That really leads to behaviors that look like addiction, not self-regulation. So, this concept that we experience diminishing marginal benefits from consuming things, be it gummy bears or anything else we think is a really deep part of human nature.

In the book, we’re really interested in one thing we consume which is money and the diminishing marginal benefits of spending. And at a very high level, you can think of a lot of the ideas that are in the book are just being motivated by this recognition that we experience diminishing marginal benefits from wealth, from spending. And in making financial decisions, we need a framework that accurately accounts for that feature of our nature.

And the – what we call – the lifetime expected utility framework, or when we talk about discounted lifetime expected utility of consumption, we’re really just talking about accounting for that feature in a systematic way.

[00:18:26] Rick Ferri: Victor, can you give us your comments on how you might use this utility function to determine what your allocation to equity might be?

[00:18:35] Victor Haghani: This risk aversion that James is talking about, it’s particular to each one of us. We have our own risk preferences, and the idea that we talk about in the book is to try to calibrate your risk aversion in the context of things that are easier to think about than the more complex decisions around investing in stocks where your views of the behavior of stocks and stock markets is going to be pretty nuanced and complex.

So, we start off by saying try to imagine different kinds of coin flips that you do where you’re risking some of your wealth, and that allows you to calibrate your degree of risk aversion and then to apply it consistently once you come up with your expectations for the expected return and risk of investing in equities relative to a safe asset. And maybe this is a good place just to say that the overarching approach of our book, we talk about it right in the beginning.

We say we’re trying to teach the reader how to fish. We’re talking about how to fish. And we’re not giving any recommendations specifically about what you should do in investing, but rather to give you a framework to make all these different decisions that are right for you. And I think that that’s a real departure from many books in personal finance that if you feel like you’re pretty typical, then put 60% of your money into equities and of that 2/3 in US equities. We don’t do that. We really are saying, let’s help you to think about the framework for all of these decisions that you’re making under uncertainty.

[00:20:04] Rick Ferri: Let’s dig into this uncertainty idea a little bit, because you do deviate from Boglehead® belief on asset allocation. I mean, most Bogleheads® follow a fixed asset allocation like you say, 60/40 or whatever is right for them based on their needs and tolerances for risk and many other factors as well. But you’re not advocating for that in your book. You’re using a variable asset allocation strategy based upon market valuations relative to someone’s risk aversion. So, it’s two things, market valuation and risk aversion.

[00:20:42] James White: So, I’m going to come at it from two directions, the formal theory and also intuition. Intuitively, I think it’s clear to most people who’ve thought about risk in a substantive way that you need to get compensated for taking risk. And that the amount of risk you want to take should be proportional to the amount of compensation you want to receive.

Let’s say the only things in my opportunity set are the broad U.S. stock market and long dated TIPS. Well, if long dated TIPS have a real return of 3% and the broad stock market has an expected real return of 3%, why should I take all of that equity risk to get the same real return I can get risk free? On the other hand, if I think TIPS have a real return of 0% and the broad stock market has an expected real return of 5%, maybe I should take quite a lot of risk to get that very large pickup in expected return between the risk free asset and stocks.

So that idea is pretty intuitive, we think, and it also agrees with what the formal theory says, which is that the amount of risk you take should be proportional to the risk premium, which is the excess return you’re getting relative to the risk-free asset.

How that translates into your investment portfolio will depend on what you believe about the expected returns for equity markets, vis-a-vis risk-free assets. If you believe that that risk premium is constant and you believe that the risk of owning equities is also roughly constant, then you would want a constant equity allocation.

On the other hand, if you believe that the risk premium varies over time or that the risk of earning equities varies over time, then that would both logically and philosophically imply optimally having a time varying equity allocation.

[00:22:50] Rick Ferri: From a Boglehead® standpoint, we do know what the real return from TIPS are. I mean, that information is available minute by minute. But what we don’t know is what the expected return of the stock market is at any given time. And if we wanted to estimate what we thought it would be, we do know that there’s a lot of variation around that and that we could be wrong and could be wrong for a very long time. So rather than being wrong, we’d rather just have a fixed allocation and rebalance to it periodically.

Victor, can you speak to this idea?

[00:23:30] Victor Haghani: So, we recognize that this idea of dynamic asset allocation is a departure from how many investors in index funds feel that they should do their asset allocation. But the idea that you should have exposure that reflects a combination of your view of the future in terms of expected returns and the riskiness of investing in stocks and your own personal risk aversion is pretty conventional thought within academia.

And even John Bogle himself had written in a number of places that it’s important to quantify and to estimate the expected excess return you’re going to get from owning equities. And he wrote a paper, I think it was in 2015, where he went into some detail about how he likes to estimate the long term real return of the stock market using a combination of the dividend yield and earnings growth to come up with a very, very long-term expected return.

So, when we make decisions that we always want to make good ex-ante decisions. Ex-post, the whole idea of making decisions under uncertainty is recognizing all of the uncertainty that’s out there. And so, it shouldn’t surprise us or make us criticize their own decisions when we get a bad outcome.

One really strong example that I like to think about is imagine that you’re betting on a biased coin and the coin has a 60% chance of landing on heads. And you decide how much you want to put at risk in that coin flip. So, you do that for a while and then somebody comes and says, “OK, now I’m going to give you a different coin. Now, this one is programmed to just give you a 55% chance of landing on heads.” And you say, “OK, fine.”

Well, obviously I’m going to bet less on this less favorable coin. So, you bet less on it and then it turns out that you got like 60% of the time heads came up. Because that’s just the lucky outcome. You flipped it 10 times and you got six heads, even though the probability was 55%. And then you would say, “oh gosh, I wish I didn’t reduce my betting size when I found out that this was a less attractive coin. Well, sure, we always wish that we could have more money. But you still made the right decision regardless of the outcome. You know the outcome could have gone the other way, too. So, I think separating decisions and making good decisions from the outcomes is really, really important in making good financial decisions under uncertainty.

[00:25:59] James White: And I would add that you know that’s really the same whether you are using a static or a dynamic asset allocation.

[00:26:06] Rick Ferri: Oh, it is a complex idea, so I’m going to reframe it to say that it sounds like what you’re saying is if you take a fixed allocation to a risky asset and the riskiness of that asset is changing, then you need to change your asset allocation so that you have a consistent amount of risk allocated to it.

[00:26:28] Victor Haghani: Right. And if I could just speak to that for a second. You make an asset allocation based on current conditions. Maybe the expected return of equities is 5% in excess of the safe asset and you’re seeing daily volatility of 1% a day, the markets moving around by on average 1% a day and you decide how much you want to allocate.

Well, if the market starts to now move around by 2% a day, in our view, you should reduce your exposure to equities, and we would just call it making the right perspective asset allocation decision based on the circumstances.

The important thing, and the real difference between just having a systematic approach to adjusting your allocation based on expected return and risk, is that built into this approach you also have the time that you’re going to go back and get yourself back to the old asset allocation. The higher allocation to equities. And then when you get into some period when the market is just moving around by 0.5% a day, you would even have more equity exposure in that environment. So, you’re moving your exposure around.

And sure, the market tends to be more volatile when it drops, and you’re going to reduce exposure there, but you’re going to get back in. And history and common sense shows us that that this is a really good way of investing. If you’re doing it as part of a systematic program where you’re looking at the riskiness of the market and you’re making adjustments when it gets riskier or less risky, you’re decreasing or increasing. And the same with expected returns relative to the safe asset.

It’s a very comfortable kind of way to do your investing over time, we think, because you’re responding to the world. You’re not just basing it on the last 100 years of history as though the future will be the same as it was on average over the last 100 years.

[00:28:15] Rick Ferri: Well, I get what you’re saying that taking an allocation to stocks based solely on a risk tolerance measure without any consideration to the amount of risk in the stock market at the current time may be a flawed approach in your view. However, your second alternative or your alternative to that, you still agree doing a fixed allocation to stocks, bonds and cash also works.

[00:28:40] Victor Haghani: Absolutely, yeah, absolutely. That’s better than the third alternative, which is spending your life doing all kinds of active trading. And based on what’s happening in the news cycle and what you’re seeing on CNBC, et cetera. Yeah, I think this static asset allocation is a very close second to what we’re suggesting.

[00:28:58] James White: I would say in general, our experience with advising people about investing is that conditional on what you’re doing, being sensible to start with, then the best can be the enemy of the good in that doing what you’re comfortable with, again, conditional on it being sensible to start with, is legitimately and rightly a really important factor in how people should be investing.

[00:29:22] Rick Ferri: There are a lot of thought-provoking ideas in the book, and one of the ideas that you talk about is are you a bond or are you a stock? And what this is talking about – human capital – is what you do for a living risky? Meaning your income can go up and down with the economy.

Let’s say that you own an auto dealership, for example. Or you work at an auto dealership. You know when things are bad, things are bad for you. Or you work in the healthcare industry where people get sick regardless of how bad things are. So, in one case, the person who works at the auto dealership is a stock, and the person who works in healthcare is a bond. So that has a lot to do in the book, and you make the case in the book, for how risky your portfolio may be or at least be a consideration.

James, can you talk about this?

[00:30:13] James White: This is another area where what you get intuitively and what the formal theory tells you converge really well. If you come back to thinking about wanting to follow a proportional spending policy, then it’s pretty intuitive that if I have an income stream which is very fixed or which is very knowable, doesn’t vary very much with the market, then that’s very different than if I have an income stream which is highly variable. For example, being a doctor or a professor where I’m 35, and I have a very predictable income for most of the rest of my working life, at a minimum level at least.

And what I’m earning has very little relationship to market returns. That’s a much better position for taking equity market risk than if, for example, I’m a stockbroker, where my earnings naturally have a lot of market volatility in them. So, if I think of my human capital is basically just the present value of my future earnings, and I think of that as an asset, well, if I’m a professor that’s going to be like a very low-risk asset on my balance sheet and I can take a fair amount of additional risk. Whereas if I’m a stockbroker, that asset looks just like owning a lot of equities already. So, the amount of financial equities I want to own will be less because on my balance sheet including capital, I’m already owning a lot of equities just through my income, basically.

[00:31:59] Rick Ferri: Well, now that you know what your asset allocation should be, whether you do it dynamically or you do it statically, one part in your book talks about whether you should just lump sum get invested, or whether you should gradually dollar cost average way over. Victor, could you talk about this?

[00:32:15] Victor Haghani: From a cold logic point of view, you should figure out where you want to get to and then just go there. That makes the most sort of rational sense. But what we’ve come to find, and what we often advise clients, is that just having a plan for putting that money into the market over some period of time might be a lot more comfortable.

So, putting in 1/52nd of it each week for a year or 1/12 per month for a year or doing it over three months, that you’re not giving up a lot as a long-term investor to average your way into the market and to reduce the possibility of being left with the bad taste that you invested it all right at the beginning and then the market is down 5% the next month. And it just leaves you with some discomfort about the whole process.

So even though it’s not logically optimal to scale it in over time, it can make sense to do that for people that are so inclined. What’s really important, though, is not to follow a plan that might have you never investing it. So sometimes people say, OK, I’ve got this money, I’m going to go 20% of the way to where I want to go right now. And then for every 5% lower the market goes you put in another 10%. So, I’m just waiting for the market to go down 25% and I’ll get myself all the way to where I want to go.

And that can be super costly to people if you follow that sort of thing. Like you want to follow an approach that gets you into the market in a reasonably short period of time. Maybe three months, six months, maybe on the outside a year. That’s going to give you enough time to be able to look back and say the glass was half full rather than half empty and give you some comfort that you didn’t make a really bad timing decision.

[00:33:58] Rick Ferri: And in another part of the book, you talk about management fees and the cost of a 1% AUM fee. James, can you discuss this?

[00:34:10] James White: There are two things that are really pernicious about it. One is that the expected returns we earn from risky markets are risky. But the management fee is not risky. So, a 1% management fee is not offset by 1% higher expected returns. You actually need much higher expected returns such that the risk-adjusted extra return offsets the 1% certain management fee.

But I think you can also think about the context, the magnitude of a 1% management fee, when thinking about and a common proportional spending policy for most people. What the exact right spending policy is, is going to depend on an individual’s age and portfolio and financial circumstances and everything.

But it’s typical to see spending policies in the vicinity of 3% to 5% of wealth. And in that context, the 1% management fee, that’s equivalent to 1/3 of your annual spending or 1/4 of your annual spending. That’s just that’s an enormous amount.

[00:35:40] Rick Ferri: We’re going to get to a spending policy in a minute, but before we do that, I’m going to pull forward from the book the chapter on taxes. And I want to talk about taxes because they are a cost to the portfolio. And so, Victor, can you talk about taxes?

[00:35:55] Victor Haghani: Sure. So, in terms of taxes, we really talked about taxes in two ways in the book. One of them is just that taxes can be like fees. In other words, that some investments are much more tax-efficient than other investments, which can be very tax-inefficient. Just thinking about the tax efficiency of what you’re investing in is really important as you’re thinking about the expected returns and risk of what you’re doing.

And, of course, bearing in mind that in many cases taxes, capital gains taxes in particular, take away your upside but leave your downside fully exposed. The government does not partner in losses, it’s only in gains. And so that’s important to think of in terms of riskiness.

Now, we devote some discussion to this question that so many people face of, they have some highly appreciated, low-basis asset in their portfolio. Maybe it represents a really big part of their portfolio. So many people have Apple from the 90s, and basically the basis is close to zero and it’s done so well that it represents maybe 30%, 40% of their total portfolio. But they can’t really, they still love the company, and they just can’t bring themselves to sell it and pay the taxes.

And this is basically a question of quantifying the cost to you of this extra risk of having a concentrated portfolio versus paying taxes sooner rather than later, or perhaps not at all. And so, you want to use this framework that is explicitly putting a cost on risk in order to figure out what the right thing to do is. You don’t want to look at just the central case and figure out where you’re going to have more money. Like, OK, well, I’m just going to hold this forever, I’m going to get a step-up basis, and so obviously I should never sell it. No, you need to take account of this riskiness as part of the whole decision, too.

And what we’ve found is that very often, it does make sense even when you believe you’re going to pay zero capital gains tax far into the future, that it still makes sense to reduce sometimes these highly appreciated positions to get yourself to get your risk of your portfolio closer to where you want it to be. And it’s not a binary thing. It’s not like sell all of that and pay taxes on all of it. This framework that we put up in the book helps you to figure out how much to do that would be optimal and that would really increase your expected welfare.

And it’s not just in the case of an appreciated position in a single stock like Apple. It also can happen when you made your investments in the market a long time ago in an ETF for an index fund. And that’s appreciated so much that instead of having 60% of your money in the market, now you have 80% exposed to stocks.

And you’re less bullish on them than you were 30 years ago when you put that money in there. It can still make sense using this framework to sell some of that to get yourself closer to where you would want to be if you were starting your portfolio today. So, thinking about these tax decisions is a great application of this expected utility or this risk-adjusted framework that we put up in the book.

[00:39:24] Rick Ferri: The second part of the book is about spending, and it’s a really great part of the book. It brings out a lot of good ideas about spending and what money is spent on. James, can you give us some highlights?

[00:39:37] James White: Yeah. So, you know, one of the really big picture things we hope we leave readers with is just the idea that investing and spending need to be thought about together and not separately. And that as advisors in our investment management practice, one of the things that we see causes real problems is when people don’t do that. When people’s investment choices are really divorced from their spending. And we think investment advisory practices often encourage that, unfortunately.

To see why investing and spending are so linked, we start by talking about how an optimal spending policy should be proportional to wealth. And we’re not advocating that somebody change their spending every day as their wealth goes up and down every day. But I think you can see how in the big picture, if you’re spending isn’t somehow proportional to your wealth, that can lead to a lot of problems.

If your wealth falls a lot, and you keep spending the same amount, then obviously that’s going to rundown your wealth quickly. On the other hand, if your wealth grows vastly and you keep spending the same amount, then you’re just significantly underutilizing your wealth. So, if you accept that even just in the very big picture, you want this proportional relationship between your spending and your wealth.

Well, that creates a relationship between the volatility of your wealth and the volatility of your spending. And one of the things that we would say constrains your risk aversion that links your investing policy and your spending policy is that you want there to be this relationship between the amount of variability you can tolerate in your spending and the variability of your investment portfolio. Otherwise, it’s almost impossible to follow a proportional spending rule.

[00:41:44] Rick Ferri: Victor, can I get your comments on spending?

[00:41:47] Victor Haghani: Yeah. I mean, as James said at the beginning, that ultimately our spending has to be linked to our wealth and to the performance of our wealth. And if we’re taking risk, then we have to acknowledge that our spending in the long term is going to have to reflect that. But yeah, in the in the short term you don’t need to be adjusting your spending quarter by quarter, depending on your portfolio returns. But it’s just such a powerful example to think about this relationship between investing and spending and risk. And I just want to give you a really quick example just to really see how surprising some of this can be.

Imagine that that you have this investment portfolio, you really like it, and you believe that it’s going to have a 5% real return. So, you invest all of your money in this portfolio, and we acknowledge it has a 5% expected real return. And let’s say you know you have $1,000,000, you’re retiring, we’ll put Social Security off to the side and say that’s covering you.

The only thing about this portfolio is it’s got a 5% average annual return – arithmetic return as we call it – but it’s really risky because you built this portfolio up of the stocks that you really liked. Unlike most of our listeners, we’re taking the example of somebody who has a really concentrated portfolio.

And we know that individual stocks can have 30% to 40% or even 50% volatility per annum. So, here’s this concentrated portfolio, it has 30% volatility of returns per annum, but it has this 5% return that you feel good about after inflation. You have $1,000,000 and you say, OK, I’m going to spend $40,000 a year adjusted for inflation. We can just ignore inflation, imagine it’s zero. I’m going to spend $40,000 a year, which is less than the 5% return.

And the question is, after 25 years of doing this, what’s the most likely amount of wealth that you’re going to have? What’s your median wealth after 25 years? And it’s very surprising to many people that the answer to that question is $0. There’s an over 50% chance that after 25 years you have zero wealth.

And the way to see that is to recognize that if you’ve got this 5% return and one year you go up 35% and the next year you go down 25%, that’s averaging out to 5% a year. But your compound return is getting killed by all that volatility. Instead of a 5% compound return, your compound return is just a half a percent a year.

Because you go to 135%, then down 25% takes you to 101% after two years. Meanwhile, you’re spending $40,000 a year, so you’re diminishing – in the central case – your wealth is being diminished. Then once your wealth is diminished enough, like after 10 or 15 years, then it really starts to get diminished quickly. You go broke as in the sun also rises slowly at first and then all of a sudden. And that’s exactly what it looks like. It’s sort of a toy example, but it really shows a lot of things going on in terms of this importance of having an investment policy that makes sense and a spending policy that’s connected to it in a meaningful way. Otherwise, you just get dissipated so quickly by not having those in sync.

[00:45:00] James White: If you think about capitulating as basically de-risking not because you want to, but because you feel like you’re forced to. One thing that often causes that we think – and that systematically forces people to de-risk at the bottom and then not get back in because they feel like they were forced into it – is because they had a relatively risky portfolio, but were not able to follow a variable spending policy.

And so, if you just think about your portfolio risk from a psychological standpoint as many investment advisors encourage; the questionnaire, how tolerant are you to losses? People think “Oh, I’m very psychologically tolerant to losses.” But then when you have a big loss, before you were spending 5% of your wealth, the market falls a lot. You were heavily invested. Now you’re spending 10% of your wealth and people just think, “Oh, I just can’t afford to lose anymore. And so, you’re forced to de-risk.

Whereas if you are able to vary your spending policy so that if your wealth fell 50%, you’re able to cut your spending a lot, too, you wouldn’t suddenly be spending twice as much of your wealth every year and be in that position where you are forced to de-risk just to avoid losing anything more.

[00:46:26] Rick Ferri: There are a few ways in which you could immunize this risk. One is to have set amount of income coming in. Social Security, perhaps an annuity, you can get income from bonds, and a lot of people rely on dividend income from their stock. But you’re not an advocate of using dividend income as a way to immunize basic needs. Could you comment on that, Victor?

[00:46:53] Victor Haghani: Sure. Look, subsistence and basic needs, those are expenditures that we just can’t take any risk with. That is exactly what they are, by definition. And so, they need to be covered somehow by very low risk investments. And so, we think that you should be allocating some amount of your portfolio into government bonds, maybe it’s TIPS, maybe it’s an annuity depending on your circumstances, to really cover those in a very low risk manner.

More generally, we feel that trying to think about spending policies and investment policies in terms of income versus capital makes things unnecessarily complicated in some ways and leaves us at the mercy of different dividend policies from different companies. It’s going to lead us to less diversified portfolios, and I think it’s just going to lead us to various suboptimal decisions. It’s just better to think really simply and clearly about expected returns on a real basis, after inflation, and not to think about income in nominal terms and dividend policies, and all of that.

I think that can really lead us to income-focused kinds of investing, take us to the wrong place very often. That income and capital are fungible – away from some tax issues sometimes – and we should really be agnostic to how our returns are coming. Are the returns coming in the form of capital appreciation or dividends, the important thing is how risky are they and what our expectation is for how big the total return is going to be relative to safe assets and after inflation.

[00:48:31] Rick Ferri: Right. OK, it’s time for the Lightning Round. And this is where I ask you about certain asset classes and you tell me what your thoughts are. So, let’s start. Victor; T-bills. Why are T-bills not the risk-free rate?

[00:48:48] Victor Haghani: Well, we think that for people that have a long-term horizon, they should care about the long-term inflation adjusted spending that their wealth can support.

And that means that the safest assets are things like TIPS and with Treasury bills, we’re not locking in a real rate of return. Historically we can see these periods where investors lost a huge amount of their purchasing power by being in Bills in the late 1940s. And then just very recently, people have lost 25% of the purchasing power of their wealth if they had their money and T-bills from the period when rates went all the way down to 2% and below.

[00:49:27] Rick Ferri: Next asset class is foreign equity. Should people include foreign equities in their allocation or not? James.

[00:49:35] James White: We think you should for several reasons. The philosophically most diversified portfolio is the global market cap portfolio, just like if you’re only looking U.S. stocks, the most diversified portfolio to hold is the market cap weighted portfolio of U.S. stocks. International equities offer a meaningful extra dimension of diversification for people.

And we think that’s especially important because outside of liquid investments, most people in the US are already very heavily tilted to the US. Your human capital is all in the US, your residential real estate is usually in the US, any investment real estate you have is usually in the US.

And liquid global markets are really the only place where you can get this meaningful diversification away from the US very efficiently.

[00:50:28] Rick Ferri: Victor, let’s talk about home ownership. Is owning a home just a place to live, or is it an investment?

[00:50:35] Victor Haghani: It’s both. But we think that it makes sense to think of it as an investment that you’re renting from yourself and to take account of that in your overall asset allocation with your financial assets, your house, and your human capital.

[00:50:50] Rick Ferri: James. Commodities, artwork, collectibles, cybercurrency; investments that have no cash flow.

[00:51:00] James White: Pass.

[00:51:02] Rick Ferri: Pass on them or pass the question?

[00:51:04] James White: I was joking, but with the kernel of truth. We think assets like that are just much more difficult to analyze. And for us, we choose not to invest a lot in them. If you have your own forecast of expected returns and risk for assets like that, then you can incorporate them into the framework we talk about in the book just like with other assets, but we think getting to those estimates for assets without cash flows is more difficult and more uncertain.

[00:51:34] Rick Ferri: Last one. Victor, factor investing.

[00:51:38] Victor Haghani: Well, we wrote a lot about that in the book. I think that just for a quick yes or no, we would tend to pass on that. We think the extra complication, the extra worry is probably not worth it. If it is worth it, it’s worth it in a really small way.

[00:51:54] Rick Ferri: Two more questions. The ultimate two fund portfolio. You have it in your book. A total global equity fund and a long dated TIPS fund. James, can you comment?

[00:52:06] James White: If you believe that the assets you’re investing in have normally distributed returns, more or less, and make other standard assumptions about your utility function, but let’s just say that for normal assets and normal risk preferences and whatnot, there’s a really nice result that you can decompose the investing process into two steps.

One is take all of the risky assets in your opportunity set, whatever they may be, but for us it’s global equity markets, but for any individual, whatever they consider in their opportunity set. And the first step is find the portfolio of risky assets which maximizes the Sharpe ratio, which basically means it maximizes its ratio of excess return to risk. Then you take that, you treat that as your risky portfolio, and you can use a rule of thumb, what we call the Merton Share, to figure out what fraction of your wealth to put into the risky portfolio and then what fraction to put into the risk-free asset.

[00:53:19] Rick Ferri: So, you just explained the Tobin Separation Theorem.

[00:53:22] James White: That’s right.

[00:53:23] Rick Ferri: And the last question is for Victor, the name of the book is called, “The Missing Billionaires.” How did you come up with that?

[00:53:30] Victor Haghani: Well, “The Missing Billionaires” goes back to a TedX talk that I gave about seven or eight years ago, where basically I tried to use the fact that large pools of capital tend to dissipate really quickly. That today, there are very few billionaires in America that trace their wealth back to wealthy ancestors, grandparents, great grandparents, whatever back at the beginning of the 20th century. So even though the investment environment in the US was just amazing over the last 125 years, that families that had $5, $10, even $100 million back then have not really been able to maintain and preserve and grow that wealth in a way that you would have expected a good number of them should have been able to. And then we’d have all these extra billionaires today.

Now we’re not saying that’s a shame that we don’t have even more billionaires today, but it’s indicative of a problem in decision making under uncertainty, problems in good decision making, we think.

And so that’s the puzzle that kind of motivates the discussion in the book. I mean, once we talk about the missing billionaires in the first 10 pages or so, we get on to the subtitle of the book, which is a little bit more boring, but is really the main aspect of the book which is baking better financial decisions. A guide to better financial decisions.

And the missing billionaires is really this sort of parable that’s a jumping off point that helps to hopefully convince our readers that there’s something that we need to do better and that some of these sub optimalities in our decision making can be really, really detrimental over the course of decades. You don’t notice the problem over the course of a few years, but we start to get into decades, and you really see dissipations in your wealth.

[00:55:20] Rick Ferri: Well, we’ve run out of time, but we could probably go on for two more hours. So, Victor and James, thank you so much for being on the Bogleheads® on Investing.

[00:55:29] James White: Thanks for having us on, Rick.

[00:55:30] Victor Haghani: Thanks Rick.

[00:55:31] Rick Ferri: This concludes this episode of Bogleheads® on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads® Wiki, Bogleheads® Twitter, listen live to Bogleheads® Live on Twitter Spaces, the Bogleheads® YouTube channel, Bogleheads® Facebook, Bogleheads® Reddit, join one of your local Bogleheads® chapters, and get others to join.

Thanks for listening.

About the author 

Jon Luskin

Board member of the John C. Bogle Center for Financial Literacy


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