Today on Rational Reminder we take a deep dive into the evolution of modern portfolio theory. We kick the show off with some updates and reviews on some of the brilliant shows and books we are watching right now. A key item from this selection is Stolen Focus: Why You Can’t Pay Attention and the points it makes about the value of flow state for learning and creativity. After this week’s news stories, we get into the main topic, and Ben starts with a breakdown of portfolio theory as it was laid out by Harry Markowitz in 1952. From there we talk about research that shaped the current understanding of portfolio theory, exploring the distinction between the mean-variance efficient portfolio and the multi-factor efficient portfolio, and how they theoretically combine to make the market portfolio. One of the biggest takeaways here is that your financial asset portfolios can look the same in terms of asset allocation but the person with more macroeconomic risk in the remainder of their financial situation is taking on more risk. Additionally, even if somebody is the perfect candidate to be the mean-variance investor and they could theoretically tilt toward value, it doesn’t necessarily mean they have to. We wrap up our conversation by inviting our good friend Larry Swedroe onto the show to speak about his love of reading and share his methods for incorporating what he learns from books into his work and thinking.

Key Points From This Episode:

• Updates: Shows, books, upcoming guests, reviews, and our reading challenge. [0:00:22]

• A review on Stolen Focus: Why You Can’t Pay Attention. [0:11:00]

• News stories for the week: Wealthfront offers thematic ETFs and more. [0:18:47]

• Moving onto the main topic for today: How modern portfolio theory has changed since 1952. [0:23:00]

• Lessons to be taken away from Markowitz’s 1952 portfolio theory. [0:25:09]

• How the math changes when you have a risk-free asset in your portfolio problem. [0:26:59]

• The capital asset pricing model: the other foundational portfolio theory principle that comes from the mean-variance model. [0:29:08]

• Portfolio advice that stems from mean-variance optimization. [0:32:46]

• Building a tangency by expressing information beliefs. [0:36:06]

• Findings from Michael Jensen’s 1967 application of the CAPM. [0:37:04]

• Why diversification is important according to Markowitz’s portfolio theory. [0:38:02]

• Why the CAPM does not accurately reflect the relationship between risk and expected return. [0:39:49]

• The origins of multi-factor thinking and examples of multi-factor models. [0:41:10]

• How the allocation of the multi-factor efficient portfolio creates a third dimension. [0:49:29]

• How the theory predicts how people behave in aggregate. [0:52:44]

• Takeaways from today’s discussion to keep in mind when building your portfolio. [1:00:00]

• Larry Swedroe joins us to talk about the importance of reading. [1:03:32]

• The many subjects that Larry reads about. [1:04:12]

• How Larry’s reading habit works. [1:05:12]

• How to capture ideas you read for later use. [1:05:57]

• Larry’s storage system for all the books that he reads. [1:08:38]

• The effectiveness of making a public commitment to read more. [1:12:13]

Read the Transcript:

Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore. Portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 193, another good episode lined up for you. And you know what, Ben? Two weeks from today, so today's Monday the 21st of March, Lisa and I will be at the Masters.

Ben Felix: It's very exciting. I know you're excited.

Cameron Passmore: It is very exciting actually. It's our first trip, been over two years. Haven't been to the airport in over two years, and some of the rules have been to travel back to Canada from the states, but it's going to be super interesting. We get to go on the Monday. So, we're allowed to bring cameras. I think it's a much more casual environment, so we're just praying for good flights and good weather when we're there.

I have a couple of TV shows for you. I don't know if you've seen these yet, Ben, or not, but one of them is WeCrashed, which is the story of the rise and fall of WeWork. Just came out on Apple TV this past week, so we watched a bit of it on the weekend. There's three episodes out. It's quite a crazy story. I mean, they almost went public a couple years ago, at what? $40 plus billion. Ended up going last year at 9 billion. Currently worth about 5 billion. The character man, Adam Neumann, the founder and his wife, Rebekah Paltrow Neumann, unreal characters.

If they're like that at all in real life, it's incredible that they actually pulled this off. What a crazy story. Yes, Rebecca is a cousin to Gwyneth Paltrow. So, we watched that, three episodes are out. Another one we started watching is Super Pumped, which is on Showtime, based on the Uber founder, Travis Kalanick, so we talked about that book last year. Show's created by Brian Koppelman, who is the creator Billions. So, this show has a very Billions feel to it. And again, this story, he is something. Absolutely no regard for laws and rules.

And basically he represents this movement to what is inevitable, which turned out to be true, I guess, with Uber, but they just crushed it through San Francisco, then Portland, then New York City to get people to drive for Uber, but also ride in an Uber. It's in both cases incredible what they pulled off. They're both now billionaires and started with, and you see this in the show, absolutely nothing but a dream. Another I wanted to highlight is a book, holding it down for those who are watching YouTube, which this is a book that we both were sent a copy of by a listener, Jorge Diaz. It's a book called Car Leasing Done Right.

As listeners know, I've been a fan for a long time of leasing, and I find often that many people just don't get how car leasing works. They just don't understand it. And as Jorge starts the book, he says, "I love promoting car leasing over financing for one simple reason, it is better in all categories, except when you have to drive a lot." And I agree. He goes on to say that the right lease contract is one where the term kilometers and coverage give you the most cost effective way of consuming the vehicle.

And that's what this is all about. Leasing is about matching up the least to how much of the car you're going to consume over the right amount of time. And it goes through, and it's a really easily readable book in a couple of hours. It goes through the very simple math on how leasing works, gives examples of a bunch of different popular vehicles and add-ons you can put on the vehicles such as winter tires and floor mats, and all these things that people talk about all the time. Explains how to negotiate the lease, how to get out of a lease, how to take over a lease. And it's excellent for anyone who does lease a car.

I think it's worth the time. Goes with things like the adjusted retail price, the PDI, the interest rates, taxes, how residual value works. He answers questions. Should I include snow tires in my lease? How much are different items for a typical car or a luxury car? What's worth putting inside the lease? Should you take the lease and protection? His answer is yes, you should take it. I haven't because I don't have kids in the car which puts a lot of wear and tear in the car, and I'm a little fussy with a car, so I don't take it-

Ben Felix: You're little fussy.

Cameron Passmore: He makes the argument that if you have kids, I mean, when I had young kids, the car got beat up a lot more, so certainly it'd be worth it, but he proves it mathematically, which is really, really good.

Ben Felix: I always get nervous going into your car because you are fussy.

Cameron Passmore: When is the best time of the month to negotiate a new lease? It is a lot last few days of the month, he says. Another really interesting part, and I talked to someone about this, this morning. I said, "What about lease takeovers?" And he shows mathematically that people on average save between 2,200 and $4,600 on the cost of the car when they do a lease takeover. The more someone has put down as a down payment on the lease, therefore driving the price of the monthly lease payment down, the more you save as someone who's taking over that lease.

He gives examples in the book of people that save over 10K in lease takeovers. Back into the book, all kinds of cool data points. Like, what is the average down payment people put on all these different models of cars? What the average payments are. What's the average term? There's all kinds of different term periods for all kinds of different cars. Anyways, bottom line, great resource, great read. Thank you, Jorge. Gave us a nice shout out in the book. And yeah, highly recommend it.

Ben Felix: I have not read my copy yet but I plan two. And I think it'll give the material to make a YouTube video on that topic, or just something I've wanted to do for a long time, but didn't have the Canada specific data to back it up.

Cameron Passmore: Talked to a friend last week whose vehicles coming off lease and the dealers calling him actively to come in and flip for a new one. He's like, hmm, something's up with this. And it's because the value on the market is worth, and it's a four year old vehicle, it's worth almost as much as it was new. In leases, it's all about who gets to keep that equity. Like, are you going to give me that chunk of equity back in my next car? And if you don't know this, that's where dealers are able to make a better spread.

Ben Felix: Yeah. But you can just buy it, right?

Cameron Passmore: He's going to buy it out for sure.

Ben Felix: Yeah. I've heard a lot of people doing exactly that for exactly that reason because the used car market is so crazy.

Cameron Passmore: Well, look at my car. I bought it two years ago. Now I've got 17,000 kilometers on it. Well, I bought 20,000 of kilometers per year on it when I got it. So, now I'm way under mileage. It's therefore it's way over value of what I've been paying as a consumption amount. So, I'll have that decision to make when it comes up off lease in a year and a half.

Ben Felix: But even mileage aside, the used vehicle market is just crazy right now.

Cameron Passmore: Totally craziness. And it's really messed up by chips. I listened to a podcast with the head of EV, electric vehicles for Ford, with Barry on the weekend, Ritholtz, talking about how the average car has like 300 chips in it. The average electric car has 3,000 chips in it. So, you start to understand the impact of the chip shortage. Therefore, used car prices are going up like crazy

Ben Felix: Upcoming guests in the next few weeks, we have Bill Janeway, who is phenomenal talking about venture capital and investing in innovation. And three weeks we have Professor Sebastien Betermier, who's a professor at McGill. You hear some of it come out in the topic we're going to talk about today, but that was a very powerful discussion for my own thinking out financial markets. It's kind of like an extension of a conversation, of part of the conversation we had with John Cochran, except that Sebastien has papers that show empirically that a lot of that insurance market hedging role that financial markets play.

Sebastien has the evidence to back that up. And it's just fascinating. In five weeks, we have Gerard O'Reilly, the co-CEO and CIO of Dimensional. So, good guests coming up.

Cameron Passmore: Good guest lineup. Quick update on the reading challenge. We now have over 400 participants who read almost 800 books. They've earned almost 1,300 badges. We have 97 reviews written in there, and they're really it. For the most popular books, Balanced by Andrew Hallam, Morgan Housel's book, The Psychology of Money is number two, and Dr. Anna Lembke's book, Dopamine Nation. There's still time to join. This is something to help motivate you to read more, if that's one of your goals. Just go to The Rational Reminder website and click on the tab 22 in 22.

For the reading challenge, we have later, in this episode, Larry Swedroe is going to join us for a little discussion about reading. I think if you've been listening at all, you know Larry, long time friend of ours, guest speaker of ours. He's been on the podcast and in the community a number of times. He's the director of research for Buckingham Strategic Wealth, and he joins us from his home in St. Louis, Missouri. You can always connect with us @rationalreminder on Instagram, on Twitter and LinkedIn, and on Peloton @CP313 and hashtag rational reminder. Maybe we can talk about some of the reviews we've got, Ben.

Ben Felix: C. Brogven, via Apple Podcasts, wrote that the podcast is so good and they've been listening to us since inception, and it's the first thing that they listen to every Thursday when a new episode drops. Great topics, amazing guests, learn about personal finance, and how to live a fulfilling life. What more could you ask for? And we're great hosts, apparently.

Cameron Passmore: It's pretty catchy. Just speaking of LinkedIn, and Neil from India reached out on LinkedIn saying he follows the podcast religiously. It's pretty cool to hear from people all over the world. And then Mike on LinkedIn reached out, just to thank me for connecting. Wanted to say thank you to you and I for the podcast. He wanted to note that he enjoyed the book reviews and recommendations, saying he's put many on his reading list, and he looks forward to many more, and keep up the great work. He also appreciated the year end review and the behind the curtains of the stats of the podcast. That's kind of nice.

Get this one that we got. Vic on LinkedIn from Belgium reached out to thank us for the podcast. And he said, "The evidence base may not always be the easiest, especially when working as a financial advisor from one of the biggest Belgian commercial banks, but communities like the Rational Reminder has supported me immensely." And he was listening to the episode two weeks ago and heard us talk about Frederick from Belgium, who is working for an evidence based financial firm in Belgium. And he was wondering if he could reach out in any way. So, I shared their contacts. I don't know if they've connected, I assume they have, but kind of neat how we're able to match people up like that.

Ben Felix: Yeah, that is cool.

Cameron Passmore: Anything else?

Ben Felix: No, let's go ahead with the episode. Welcome to episode 193 of The Rational Reminder Podcast.

Cameron Passmore: Oh, and I've got a book review for you this week. This is a phenomenal, phenomenal book. I learned so much. The point of the book, so the book's called Stolen Focus: Why You Can't Pay Attention, and is written by Johann Hari. So, happened to catch him as a guest on Real Time with Bill Maher. I think it was in January he was on, and I thought he presented some really interesting, compelling ideas on what is causing this issue, the fact that so much of our focus is being stolen in society.

So, we ask the simple question, why is this happening? Why is it that so many people have lost their attention spans? Get this through some absolutely jaw dropping statistics. The average American, and I only say American because that's what the book said, but I presume it spans the globe, data shows that the average American spends over three hours per day on their phone. We touch our phones 2,617 times per day on average. The average American worker is distracted every three minutes. Very few workers get a solid hour of no interruptions. The average CEO only gets 28 minutes of solid time uninterrupted per day.

Get this one, 200,000 lifetimes are spent every day scrolling on a phone. Anyways, the author embarked on a multi-year project to try to find out why this is happening. So, actually started with three months of completely disconnectedness. He went off the grid for three months in Provincetown, Massachusetts, and then after that, he traveled the world to speak to as many experts as he could to learn about what is causing this. His big takeaway is that this has been going on for generations, but it has accelerated with the internet. And he concluded that there's some very deep forces that are causing this.

And this is not just a technology story. We've all heard about technology. We've all heard about the impact of Facebook, etc. There's much more to this story than that. The punchline is we're soaked in information and we love it. In 1986, get this, if you added up all the information being blasted at the average person, TV, radio, reading, it amounted to 40 newspapers worth of information every day. By 2007, that's up to 174 newspapers per day. We also love, as humans, the speed of gathering new information. Stress levels are up. Things are moving faster. For example, people in cities walk 10% faster now than they did in the '50s. They also talk significantly faster. Sleep deprivation is exploding and as a society we're taking pride in needing little sleep.

Ben Felix: Is that still a thing?

Cameron Passmore: You don't think so?

Ben Felix: I thought sleeping was cool now.

Cameron Passmore: I think it's cooler. I think a lot of people still take pride. I don't need that much sleep. It's complete nonsense.

Ben Felix: When I was in like university, whenever that was, people that drank lots of coffee and didn't sleep were ... That was impressive, but now it's ...

Cameron Passmore: Got one. When I was in university, coffee wasn't even a thing. I didn't even know about coffee till my first day of my first job. They were all drinking coffee, so I tried it. Anyways, and as a society, we're all being trained to desperately things, be they social media, likes, shares. Also, we're as a society getting addicted to sugar and fat and caffeine and alcohol. Another major point that he makes is that we've had many crises over the past two decades, such as the internet bubble, 9/11, the financial crisis, now COVID. And children who grew up in a crisis environment have many more attention issues. Six out of 10 Americans have less than $500 in case of an incoming crisis.

Ben Felix: Wait, but financial crises aren't a modern phenomenon. Anyway.

Cameron Passmore: I'm just reporting the book.

Ben Felix: Sorry. Carry on.

Cameron Passmore: I'm just saying the point is there's crises, right? Only 56% of Americas take a week vacation every year. Diets are loaded with many more foods that have energy spikes and troughs at many more foods that act like drugs, such as coffee. Air pollution is damaging our focus, so pesticides. ADHD diagnoses are soaring. 30% of boys are now diagnosed ADHD by the time they turn 18. The last I'll give you is the proportion of Americans who read books for pleasure is now at the lowest level ever recorded. Some 57% of people do not read a single book in a typical year. This all adds up to stolen focus.

Anyways, what are the cost of this? The cost is that there's very little depth of knowledge. And often our thinking is framed by commentary, but the truth is depth takes time and energy, and more information that comes out pulls us closer to the surface of the ideas and the arguments and doesn't allow for deeper thought into it. And no matter how much information there is and how fast we take it in, you can only have one or two thoughts in your brain at a time. I know I've heard this from my kids, is that it's different now. Kids can now multitask and do many more things. It's categorically impossible is what the author says.

Probably the biggest cost of this acceleration of information is what they call the creativity drain. The reality is that new thoughts come from shaping new connections and thinking about something, and the brain needs to be free from distractions in order for this to happen. This takes place at the subconscious level. And if the brain is processing stuff, be it on social media or whatever, it will not come up with the idea ideas that are needed. And this is referring to flow state. If you're so busy doing stuff, you don't actually have a chance to get into flow and get into something that's deeply fulfilling and learning that can then trigger the connections to create ideas that will solve some of the biggest problems that we're all facing.

One of the things that can to be done, he says slow down, do one thing at a time, sleep more, eat whole foods. He said, it's not simply put down your phone because putting down your phone will simply cause a void. You need to replace that fix of the phone with something else that will get you into flow. One example he gives is break deep learning. Reading a long form book is one of the greatest forms of flow that humans can experience. Also, long form interviews and conversations. Get deep into a topic. What can tech companies do?

This, I thought was really interesting. His argument, techniques to feed our focus and not fracture it. Get off the ad model and get to a subscription model. Turn off the infinite scroll. The infinite scrolls, where you just keep going, and they're so good at feeding what you want to watch. As an example, he says, Facebook could ask at regular intervals, what changes do you want to make in your life? They could help you because they're so good at this to do that. He says government could acknowledge that social media is now an essential public utility and explain that when it is run according to the wrong incentives, it causes unintended consequences.

Anyways, my biggest takeaway, the more flow you have, the better you feel. There's a direct link to satisfaction and happiness. If you don't get into flow, you become frustrated. During mind wandering, you start to make sense of the rule. You find solutions to problems. This is where it all comes together. You're able to get into flow, do some deep learning, then chill and let it kind of ruminate in your head, and you will be happier and more creative. And he says, "This is exactly what the world needs to solve some of the biggest problems we're facing." There you go. Love the book. Great book. And if you're interested, go check him out on Real Time with Bill Maher from earlier this year.

Ben Felix: Yep. Those are great ideas in that book.

Cameron Passmore: All right. Onto some recent news stories.

Ben Felix: Yep.

Cameron Passmore: This first one, kind of like some of the stats we shared a couple weeks ago. Just a tweet post from John Erlichman. In 2000, Palm ... Do you remember the PalmPilot? Did you own one?

Ben Felix: I vaguely remember it, but I never had one.

Cameron Passmore: Anyways. Palm was worth more in 2000 than Apple, Google, and Amazon combined.

Ben Felix: Wild.

Cameron Passmore: If that doesn't blow your mind. And then I came across an article in the May 3rd edition of RIA Intel called The Vanguard Paper That Financial Advisors Will Love to Read. No kidding. So, it highlights research report from Vanguard Group that basically said that robo advisors are not the threat to the human variety of advisors. This is a survey of 1500 investors done last July who use either human or robo service, or both. And no surprise, more than 90% of human advised clients would not consider switching to a robo-advisor according to the survey. Meanwhile, 88% of robo advise clients would consider using a human advisor.

Ben Felix: Well, the robo advisor platforms are a bit of a joke, right? At this point. I think we can all agree on that.

Cameron Passmore: Well, that's kind of what these upcoming stories are. So, you want to jump to the next one here? Wealthfront. It's just such a great example. I mean, go ahead.

Ben Felix: We already picked on them last time, but they've announced new investment options. And it's basically, when you look at the investment and options that they're offering, it's basically the thematic ETFs that we bashed. I think we said that they were like lighting your money on fire.

Cameron Passmore: Yeah. But Ben, it's never been easier to build a portfolio you believe in.

Ben Felix: Yeah, you believe in right. You can invest in technology, the metaverse commodities, whole bunch of funny stuff like that, but it's inevitable. I mean, they need to find margin somewhere or keep people's attention somehow. So, it's not surprising to see that happening.

Cameron Passmore: But again, even the robo advisors couldn't keep you from bad behavior.

Ben Felix: Yep.

Cameron Passmore: Incredible.

Ben Felix: It's a different incentive, right? People are poorly behaved for different reasons, but the robo advisors are ... They need to find ways to make money off of their customers, and it's not so easy to do that. But I think the other thing that's happening, like the suite of single fund ETFs in Canada are comprehensive at this point from all sorts of different companies at different fee levels, with different tweaks. I think the Fidelity all-in-one portfolios in Canada, even have some Bitcoin in there, if you're into that kind of thing. You shouldn't be, but if you are, but it's like, why would you pay 40 or 50 basis points to a robo advisor? Unless you're getting human advice attached to it, which some of them are doing, to an extent for a certain asset level. But it's like, if you're not getting that, there's just no point. I think that, that became pretty obvious.

Cameron Passmore: Exactly. Another article from Financial Planning Magazine, Is Gamification and FinTech Hurting Investors? That was in the March 16th edition. I talked about this when I met with my friend who had his Robinhood app, and I looked at it and it is credible. The platform is beautiful. So, the question was, are these online portals good or not for investors? And they found that investors were encouraged to take higher risk than they would on a non-gamified platform. I mean, real big shock there. They said the effect was even stronger with higher volatility assets such as crypto and leveraged derivatives. Again, no big surprise there.

Ben Felix: No there've been academic papers on this too. We talked about them, I don't know when that episode was, but we talked about, was day trading in 2020 better than day trading historically? And no, it's worse. People do worse and take more risks. And largely because of that gamification stuff.

Cameron Passmore: Now some like gamification though can be good, like goal setting and financial planning perhaps and some little nudges. But I think when it tempts you or teases the FOMO, that's where it can take a wrong direction.

Ben Felix: Yeah. Well, it's like what the book that you talked about, that's switching from a free ad based model to the subscription model. There's no money in goal setting unless you're collecting subscription fees.

Cameron Passmore: That's a good point. All right. Onto the beef for today.

Ben Felix: Yep. Onto the main topic. We're going to talk about modern portfolio theory, which isn't that modern. Goes back to 1952. We're going to talk a little bit about that and then talk about how it's changed since 1952. And it's changed quite a bit, which is interesting because I think people still think about portfolio theory from the 1952 perspective. The significance of 1952 is that's when Harry Markowitz had his paper Portfolio Selection come out, and he followed up in 1950 in with a book of the same title.

Markowitz developed a theory of portfolio selection on the basis that investors seek to minimize the variance in their portfolios for a given level of expected return. Or equivalently, they seek to maximize their expected return for a given level of variance. And of course, using variance as a proxy for risk. Now, theoretically, there's a combination of risky assets that maximizes this function for various levels of risk and expected return. And those are the mean variants efficient portfolios that people may have heard about.

Cameron Passmore: That's the key. I mean, I think it's really important that people understand exactly how you're kicking this off. Level of return for a certain level of risk?

Ben Felix: Yeah. Well, I got to talk more about it too, and I think there are probably some visuals that we can put in the YouTube version to show the graphical depiction of the mean variance frontier that's referred to. The idea that there is a theoretically optimal combination of risky assets, that's what reshaped the thinking around portfolio management and led to the search for the optimal mean variance efficient portfolio that people are still looking for today and talking about today.

It even still, it comes up in the Rational Reminder community sometimes too, where it's like, let's optimize the sharp ratio in this portfolio, but that's maybe not the best objective, which is one of the things we're going to talk about. It's really when you're comparing sharp ratios and trying to add other assets to a portfolio to optimize the sharp ratio, that's 1952 thinking, is what I would call it. And things have changed a lot since then, just in our understanding of how assets are priced and how financial markets function, and how portfolios are structured empirically, and how should be structured theoretically.

But there are still important lessons that we do take away from Markowitz's portfolio theory. I mean, it's still the foundation of modern asset pricing theory. One of the big lessons is that mathematically, a combined group of risky assets provides superior return variance trade-offs, relative to any one of the underlying assets in the group when the individual assets are not perfectly correlated. That's, again, one of those things that we hear people talking about, looking for uncorrelated assets. That is why, for each level of variance, the modern portfolio theory tells us that there is an optimal combination of risky assets based on their expected returns and co-variances with each other.

And that combination results in the highest possible expected return at each level of portfolio variance. And you can connect all these points and that's where you have the efficient frontier, maximizing the expected returns for each level of risk. So, we'll try and like I said, include an image of that in the YouTube version, because I think it is useful to see. On this assumption, investors are risk-averse, and using variance as a measure for risk. We know that investors want to seek minimum variance for a given level of expected return, or equivalently, seek maximum expected return for a given level of variance. I think I've said the same thing a few times, but I think it's worth repeating because it's a bit to process.

Cameron Passmore: Absolutely.

Ben Felix: When we have a set of risky assets available for portfolio construction, like the stocks that exist in the stock market, for example, it just becomes an exercise in mathematical optimization. We want to optimally combine the assets to find the efficient set of portfolios. Again, that's where the efficient frontier comes from. It's like a curved line, and hopefully people watching can see what that looks like. Now, that's when you have a bunch of risky assets to choose from, but the math changes when you include a risk free asset in your portfolio problem, when you include a risk free asset, and you can draw a line from the risk free asset. And this is the graphical representation of the mathematics.

You can draw a line from the risk free asset, tangent with the efficient frontier of risky assets. So, it's a straight line. Now that line becomes the efficient frontier when we have a risk free asset in the portfolio problem. The line connecting the risk free rate and then touching on the point of tangency with the risky efficient frontier, you get the efficient frontier. Along that line are all of your efficient portfolios. So, instead of changing your combination of risky assets to affect your risk and expected return, you're combining the tangency portfolio.

So, that's the one portfolio, the optimal mix of risky assets. You're going to combine that with either a long, so you're buying, or a short, you're borrowing, position in the risk free asset to increase your expected returns and risk if you're borrowing, or decrease if you're purchasing the risk-free asset. So, somebody could be like 60% tangency portfolio and 60% risk free asset. And for that level of risk and expected return, that would be the optimal portfolio.

Now, in this theory, everybody should invest 100% of their wealth in the tangency portfolio, whatever that is. So, we need to find that ency portfolio and then everyone will cater to their risk and expected the return preferences just by adding or borrowing at the risk free rate. So, this is known as Tobin's Separation Theorem. It's just the idea that you got to find the optimal combination of risky assets, and then you're going to tailor your portfolio, just by combining it with the risk free asset.

Again, foundational portfolio theory, important stuff. Looking for the tangency portfolio, what is the tangency portfolio? It's a big open question. And we're going to talk more about what some of the theory says about what it might be, which is pretty interesting stuff. So, the other big foundational portfolio theory principle that comes from the mean variance model is the capital asset pricing model, the CAPM. So, anybody that's studied finance or taken any kind of, even business course probably, has heard of the capital asset pricing model.

Now, how are they related? The market with mean variance model provides a mathematical condition on asset weights in mean variance efficient portfolios. That's the stuff that we were just talking about a minute ago. Now, one of the big insights from Markowitz is that the risk of an asset depends on its co-variance with other assets in a portfolio. Not its own standalone variance. With mean expected returns of variances and co-variances, we can solve, and this is what we were just talking about with the efficient portfolios, we can solve for the theoretically optimal portfolio weights of all assets.

Every asset has a theoretically optimal weight in a portfolio. The CAPM, what it does is it takes Markowitz's theory and turns it into a testable prediction about the relationship between risk and expected return. That's a lot to take, I think. I don't know. Took me a while of rereading that and writing it to understand, but hopefully the next bits will make it clear. If investors are mean variance optimizers, which theoretically they should be, they will hold the tangency portfolio of risky assets alongside a long or short position in the risk free asset.

Given that investors are mean variance optimizers, or on the assumption that they're mean variance optimizers, and that markets must clear, that's for every buyer, there's a seller, and for every seller, there's a buyer. So, markets must clear. Given those assumptions, the market portfolio is the tangency portfolio. The assets contained in the market are being optimally priced to reflect their expected means variances and co-variances, such that their weight in the market portfolio is their mean variance optimal weight.

That's the market pricing mechanism is giving you, it's giving you the key calculated tangency portfolio effectively of risky assets. And if something's expected returns are too high for its level of variance and co-variance, or if the co variance is too low or whatever, market prices will adjust such that the weight is optimal. If we believe that everybody's a mean variance optimizer would, which is of course, a question, but on that assumption.

The big insight that we get from the CAPM is that in market equilibrium, the riskiness of an asset is not measured by the standard deviation of its returns, but by its beta, which is proportional to its co-variance with the market portfolio. Prior to the CAPM, we might have looked at the volatility, standalone, or variance of an individual stock return, but what actually matters, once we understand CAPM, to asset pricing, at least in this theory, is the stock's beta. How does it move relative to the market as opposed to on its own?

Another way to think about it is an asset's riskiness does not just depend on its own volatility, but on its incremental contribution to portfolio volatility, right? And of course, that lesson's very important in evaluating asset classes and asset allocation decisions. With the CAPM, we can analyze mutual funds and other active investment strategies to see how they perform relative to the market risk that they're loading on, that they're taking.

Then excess return that's unexplained by market beta. That's what's known as alpha. So, if based on a stock's beta, we expect it to return 5% based on its riskiness, relative to the market, and return seven, the 2% additional return is alpha. The portfolio advice that stems from me and variance optimization, and like I mentioned earlier, there's still a lot of this advice out there in the world, 70 years later, is to identify the tangency portfolio and then tailor it to your needs by combining it with a long or short position in the risk free asset.

Now, even if the market portfolio is the tangency portfolio, it's not clear that the stock market is the tangency portfolio. The reason is, in the theory, the market portfolio is literally all assets, including all human capital and other like houses, whatever. The market portfolio is literally everything. Something like the stock market is a proxy for the market portfolio. There have been studies that have tried adding different stuff, like does a CAPM with real estate, or does the CAPM with long-term bonds, or whatever, does that have better explanatory power?

And those studies have found that no, the market is still the best proxy, but the reality is it is not the market portfolio. It's a proxy for the market portfolio. I think that's probably one of the reasons that there are so many funky attempts at trying to build tangency portfolio, is trying to build the mean variance optimal portfolio by adding in other stuff. Like you see people adding in gold, private equity, hedge funds, long-term bonds, and saying, "Look, look, the sharp ratio in the historical data is getting better."

I think that's probably why we see that because the stock market is not the tangency portfolio. It can't be. It's an approximation. Anyway, those attempts to find the true tangency portfolio or unlikely to improve portfolio construction, a lot of them have high costs, low expected returns, like in the case of gold, if it's got a very low beta, based on the CAPM stuff that we were just talking about, an asset with a very low beta, by definition, I guess, in the CAPM must have a low expected return. So, you start jamming other stuff in there, and you're going to affect your expected returns.

It's the same kind of thing with the risk parody idea of jamming in long-term bonds and stuff like that, same kind of problems can arise. Not the risk parody, is always bad. Like our friend, Larry Swedroe, who's joining us at the end of this episode, he talks about other asset classes that do have true independent risk premiums and are uncorrelated. That starts to get more interesting. Anyway, the other big problem with the mean variance optimization with jamming stuff in there to improve the sharp ratio is that the parameters are extremely unstable over time.

If we take something that looks really good in a back test for the last hundred years, the chances that the last a hundred years are indicative of the next a hundred years in terms of those parameters is pretty low. And why that is problematic is that what looks optimal today can end up looking extremely suboptimal in the future because these models are so sensitive to the inputs. So, you maximize your sharp ratio today. It has nothing to do with your sharp ratio in the future, because of course, you can't invest in historical returns. You can only invest in expected returns. So, I would call a lot of the mean variance optimal portfolios out there, they're just really data mining expeditions.

Now, the other way that you can build a tangency portfolio, or try to build an optimal tangency portfolio, is by expressing information beliefs. It's like what I was just saying. I mean, even using his historical data is in a way expressing an information belief that history is going to be predictive of the future. But the other way you can do it is say, prices are just wrong. Market prices are wrong. Therefore, I'm going to overweight large CAP growth stocks because they're undervalued by the market. If you're right, then sure, that would be the tangency portfolio X post if you're right. X annually, I think that's a pretty tough bet to win as we know from the empirical data on active management.

Now, alpha, I mentioned alpha earlier. So, excess risk adjusted returns from a CAPM, well, not just from a CAPM. It started from a CAPM perspective. Alpha is risk adjusted returns adjusted for whatever asset pricing model. Like, you can have a five factor alpha. But anyway, alpha comes from Michael Jensen's, 1967 application of the CAPM. He looked at 115 mutual funds from 1945 to 1964, and found that they were on average, not able to predict security prices well enough to outperform by the market and hold policy. And that there's very little evidence that any individual fund was able to do significantly better than expected from random chance. That's 1967, and we're still fighting the battle of whether or not mutual funds outperform today. That's pretty crazy, isn't it?

Cameron Passmore: I was one year old.

Ben Felix: Ah, it's wild.

Cameron Passmore: Hell, we're still debating it. It's incredible.

Ben Felix: I know. It is crazy. It really is. And the evidence continues to come out supporting that same finding.

Cameron Passmore: And think of the technology change since then. Think of all the changes since then. It's crazy.

Ben Felix: Yeah. So, it is just fascinating to think about that being true and having been documented so long ago. The other portfolio construction, theoretical portfolio construction takeaway away from Markowitz portfolio theory and the CAPM is that diversification is important in this theoretical construct. If the market portfolio is a tangency portfolio, any sub-portfolios, so again, if we have that picture of the efficient frontier, any subsets of the market lie below the efficient frontier, and they're theoretically suboptimal by construction of this model.

Now, of course, it's just a theory. It doesn't mean that's actually true. But in that theory, where the market is optimally pricing, all assets to be mean variance efficient, anything, any subset of the market is, by definition, an inefficient portfolio. Now, not everybody believes in these models, which is fine, but that's one of the big takeaways, the CAPM and the sharp ratio optimization approach to portfolio management, that kind of stems from it. They do have big empirical problems, and that shouldn't be too surprising when you look at the assumptions of the CAPM.

We're assuming complete agreement among investors on the joint distribution of asset returns, and that the distribution is the distribution from which returns we use to test the model are drawn. Big assumption. And then the other big assumption is that there's a borrowing and lending at a risk free rate. And that, that it's the same for all investors, and it does not depend on the amount borrowed or lent. Again, big assumptions, which makes you realize that any precise optimization under these obviously unrealistic assumptions is a pretty noisy proposition. Then empirically, tests of the CAPM, and this is one of the other reasons why, when people talk about sharp ratios and CAPM alphas, it's kind of silly, because tests of the CAPM fail often. This is going back to the 1970s, I think, that the CAPA was failing in documented published tests.

What that means is the CAPM does not accurately predict the relationship between risk and expected return. In the 1970s, it was observed that stocks with lower are relative prices and lower market capitalization, so that's value and small CAP stocks in current language, had returns that were higher than what could be explained by their exposure to market beta. Failure of the model right there. Couple reasons that could have happened, maybe expected returns deviate from their CAPM predictions due to erroneous investor behavior.

I mean, here we are back in familiar territory. It's either behavior or risk. So, either investors extrapolate past performance too far into the future, which causes gross stocks to get too expensive and value stocks to get too cheap, leading to eventual high returns for value stocks and low returns for gross stocks when the errors are eventually corrected. The other possible story is that, in addition to fol variance, investors also care about how their portfolio behaves relative to other states of the world.

This is where we start to get into modern portfolio theory, multifactor thinking. In other words, investors don't just care about variance. They don't just care about the ups and downs of their portfolio. They care about when the variance shows up. That's my very basic summary of multifactor thinking. Single factor is we only care about variance. Multifactor is we care about variance, but we also care about how that variance co-varies with others dates of the world that might matter to people or institutions, I guess.

This one goes back to 1973. Though the other thing, CAPM is a single period model. Martin's 1973 intertemporal CAPM, or ICAPM, it considers a multi period investor who, in addition to mean in variance, is concerned with the co variances of their portfolio returns with other things like their labor income, the prices of consumption goods, and the nature of future investment opportunities. This changes the portfolio advice, and it adds another dimension to designing an optimal portfolio. Some of the stuff in here is just ... It's a little mind blowing when you start digging into it.

If we assume that there's one additional risk factor to think about, call it a recession risk factor, investors are now concerned with maximizing their expected returns for each unit of volatility, but they're willing to accept a little more volatility, or a little less expected return if their portfolio does not do poorly in recessions. There you go. That's my multifactor model right there. In the multifactor model, you need positions to build a portfolio. You need positions in the market portfolio and the risk free asset, just like in a CAPM world, but you also need a position in a multifactor efficient portfolio.

Now investors, not only different in their expected return and volatility preferences, like they do in a CAPM world, where you've got the two-fund theorem, you're mixing your tangency portfolio with a risk free asset, but now they also differ in their ability to take on recession related risk. There's another dimension of risk that investors now care about in this multifactor world. They still use Markowitz mean variance efficient portfolios to optimize the trade-off of expected return for volatility. But they're also concerned with hedging other risks, like the recession risk, in my single additional factor example.

The ICAPM multifactor efficient portfolio combines the mean variance efficient portfolio with hedging portfolios for common risk risks, like the recession risk that tend to be protective in those times. It starts to get pretty interesting, if it's not already, or maybe people are falling asleep, I don't know. I'm excited. Like CAPM investors, the ICAPM investors, they prefer high expected return to low variance, same preference there, but ICAPM investors are also concerned with the co-variances of portfolio returns with other risks, which means they want to maximize expected returns for a given level of return variance and return co-variances with the other relevant state variables. State variables like the recession risk idea that you could have other state variables.

Now, following the same logic and assumptions as the CAPM, that market clearing prices imply that the market portfolio is multifactor efficient. That's important. It took me some thinking to understand what it meant. So, hopefully I can communicate it in a way that people understand, but in a CAPM world, the market portfolio is mean variance efficient. All the assets are optimally priced for mean variance efficiency. In an ICAPM world, the market portfolio is multifactor efficient, but it's not mean variance efficient.

If the market portfolio is multifactor efficient, it cannot be mean variance efficient because investors are combining the mean variance optimal portfolio. That's one thing. There's a mean variance optimal portfolio that exists. Investors are combining that with the state variable hedging portfolios, the combination of the mean variance portfolio and the hedge portfolios is the market portfolio, which is multi-factor efficient. But because the market portfolio is combining the mean variance efficient portfolio with the hedging portfolios, it's a combination of both of those things together. The market portfolio cannot be the mean variance efficient portfolio. Does that make sense?

Cameron Passmore: I can see people hitting the back up 15 seconds to replay that.

Ben Felix: The market portfolio is the combination of the theoretical mean variance efficient portfolio and the hedging portfolios that people are willing to sacrifice a little bit of expected return or a little bit more variance so that it doesn't co-vary with other risks that matter to them, like the recession risk example. Because the market portfolio is both of these things together, because of course, every stock has to be owned. The average investor owns the market. That means that the average investor owns a combination of the mean variance efficient portfolio and the hedging portfolios.

Therefore, the market as a whole is not mean variance efficient. Unlike in the CAPM world, where the market portfolio is the tangency portfolio. In a multifactor world, the market portfolio is not the tangency portfolio. It is a combination of the mean variance efficient portfolio and the multifactor portfolio. It's still multifactor efficient for the average investor, but of course not everybody is the average investor. And this is the stuff that we talked about a lot with John Cochran, who is the average investor.

And you can think about how you're different from average and all that kind of stuff, instead of trying to just go for me and variance optimal, which doesn't make sense when we know that there are multiple pricing factors in the market. Now the portfolio for any given individual is going to depend on their sensitivity to risk, to state variables. If you have labor income that's sensitive to recession risk, and this recession risk example that I have going here, you probably don't want to invest in the stocks that are sensitive to recessions. This becomes pretty important to portfolio theory. If you are the average investor, you're sensitive to the same economic risks and have the same risk aversion, you should still hold the market portfolio.

But if you have more or less sensitivity to economic risks, or different risk aversion, your portfolio should be different. Now, on the other hand, and this starts to get really interesting too, if you're not exposed to any common risks, so you don't depend on labor income, you don't own a business, you don't have any other sensitivity to economic at risks, other than your portfolio's performance, you are still a mean variance investor. But as a mean variance investor, you don't want to hold the market anymore because it's no longer mean variance efficient.

The mean variance efficient portfolio, because it's the combination ... The market portfolio is a combination of the mean variance efficient portfolio and the hedge portfolios, if you're the mean variance investor, or a mean variance investor, you want to hold the stocks that other investors want to avoid. You can hold the mean variance efficient portfolio if you're a mean variance investor, if you don't any of that outside income or business or whatever risk. But the mean variance efficient portfolio tilts more heavily toward the risks that other investors want to avoid.

That's a big change to portfolio theory. We can't just look at the market and say, hey, that's mean variance optimal anymore. We can say it's multifactor efficient. But if you're exposed to different factors in the average investor, you may want to think about addressing the portfolio. Now, of course there are other costs and stuff like that to think about, which I'll touch on a bit. If the market portfolio is not mean variance efficient, because the average investor is exposed to certain risks like recession risk, which some stocks are less sensitive to. So, the average investor builds hedge portfolios out of the less risk factor sensitive stocks and adds them to the mean variance efficient portfolio.

Based on this, an investor who is not exposed to the same risk as the average investor and is therefore a traditional mean variance investor needs to tilt towards the risk that the average investor wants to avoid to be mean variance efficient. But all investors are being faced with different risks, not everybody needs to hedge the same risks and not to the same extent. In a CAPM world, everyone just holds the market portfolio and adjusts risks with exposure to the risk free asset, but in a multifactor world, everybody's going to tailor their portfolios by adjusting the weights in the mean variance efficient portfolio, the risk free asset, and the hedge portfolios.

If you think about this, I don't understand the math, but if you do, like John Cochran does, the efficient frontier becomes an efficient surface. It's a rotation of the parabola that gives us the efficient frontier. And we'll include an image from one of John's papers on this. But it's crazy, like there's the third dimension. I mean, it makes sense, right? There's the allocation to the multi-factor efficient portfolio that becomes a consideration of portfolio design, which gives us a third dimension.

So, this thing becomes a three-dimensional object instead of a two-dimensional frontier. So, it's this surface that people have to think about optimizing their portfolio on, which is like, it's not practical, and I think that John Cochran, for example, recognizes that. But as a theory, it is very interesting. So, every investor has to think about how they're different from average, trying to estimate means, variances, co-variance, and state variable sensitivities is pretty hard. Mean variance optimization, as we've talked about, is not useful. And even less so when we introduce risks other than the variance that investors care about. Asking how you're different from average is a lot easier.

For a lot of people, the answer may well be that you are a lot like the average investor and you just want to own the market portfolio through low cost index funds, and that's a pretty good answer, probably for most people even. If you're different from average, because you have more or less sensitivity to economic risks or different risk aversion, then there's more thinking to do in portfolio construction. The ICAPM model does not define the state variables that affect expected returns. Of course, it'd be nice to know exactly which state variables matter, but it's unknowable, but this is where Fama and French's 1993 paper becomes important.

They took the empirical literature about the returns with small CAP and value stocks that were unexplained by CAPM, and they kind of suggest, hey, these stocks might reflect unidentified state variables that produce non-diversifiable risks. That's where we get the three factor model. Then of course, as they say, the rest is history where there's been a massive literature that's developed around this basic idea. When you think about it empirically, value stocks tend to be under distress, have high financial leverage, face substantial uncertainty in future earnings. They tend to be riskier than gross stocks in bad times, and only slightly, they're less risky in good times, and they deliver low returns when labor income and consumption fall.

Based on that, we might expect investors with high human capital and high exposure to macroeconomic risk to tilt their portfolios toward gross stocks in equilibrium, of course, to act as a hedge portfolio. In equilibrium means like you take all the people that look like that. This is how you'd expect them to behave. Now, all that theory that I just talked about, I think a lot of people would think, including me, before I read some of the other papers I'm going to talk about next.

Yeah, this is nice in theory, but yeah, right, come on. People don't think like that. But the fascinating thing about large groups of people, I mean, we know this from asset pricing in general, just when you ... Like market efficiency, market efficiency as a model. You take any average Joe off the street, or even any institutional investor and ask them why they made that investment decision, why do they pay that much for that stock? You're probably not going to get a market efficiency answer. Probably not.

But if you take everybody together, and there are however many millions of people participating in financial markets, you take everybody together, and they're actually pretty smart. I think it's kind of similar when we start talking about this, how do people behave in aggregate? Well, hey, it turns out they actually behave exactly how the theory would predict. There's a paper from Sebastien Betermier, who's, like we mentioned at the beginning of the episode, an upcoming guest. As a side note, I only touch on his papers very briefly, but in a few weeks, we have a full episode where we really dig into this with him, and it's fascinating stuff.

Cameron Passmore: Three weeks.

Ben Felix: When you look at the data, and it's hard, not easy to get this data in North America, but they used a representative random sample of approximately 70,000 Swedish households. I guess you can get more granular data for Swedish investors. And this is a paper of Professor Betermier's, that was published in the Journal of Finance. They find that households progressively shift from growth to value as they become older and their balance sheets improve. Interestingly, exactly what the theory to predict. And investors with high human capital and high exposure to macro economic risk tilt their portfolios away from value stocks.

Again, that is what the economic theory will predict. So, it's pretty interesting to see empirical support for it. It's consistent with the greater hedging demands of younger and less wealthy investors, and older wealthier investors tending to look more like the mean variance investor. This is a 2017 paper. Then I'm going to talk about a working paper that's 2019, I think. Or no, even more recent 2021 maybe, but it's supporting theory that goes back to the 1970s. So, it's just kind of neat to think about.

The more recent working paper, and again, we talked to Professor Betermier about this when he was a guest, or when he will be a guest, what do the portfolios of individual investors reveal about the cross-section of equity returns? This is a sample of all Norwegian investors from 1996 to 2017. In this sample, they find that mature and wealthy investors tend to hold stocks with large market capitalizations, low prices, high profitability, low investment, and low CAPM betas. And that's similar, interestingly, to the US institutional investors documented in another recent paper, a demand system approach to asset pricing.

Now I've got wealthy households and institutional investors that have portfolios with low value stocks, value with high profitability, low investment, and low CAPM betas. So, it's kind of interesting. Is that the mean variance portfolio? It's an interesting question. An obvious question that comes out of that, if you understand, or if you know what the factors in the five factor model are, why are the wealthy households and the institutions tilting toward larger and lower beta stocks rather than smaller and higher beta stocks if they have that risk capacity? The answer may lie in sentiment or investor behavior rather than an ICAPM based hedging demand story.

So, younger and less wealthy investors are more likely to hold volatile stocks with high share turnover and low institutional ownership. These are the stocks about which investors disagree the most, and in which arbitrage can be limited. Younger, less wealthy investors may be pushing the demand for these stocks while the wealthier and institutional investors may have a harder time charging them. So, the result is that, that sentiment or behavioral effects may be contributing to the tilts away from those stocks for the wealthier households and institutions.

When we asked Professor Betermier about this, his answer was basically, don't think about it on the long side. He built a long, short factor for wealthy and less ... Anyway, no, don't need to get into that now, but he said, "Don't think about the long side. Don't think about why the wealthier households own those portfolios. Think about what the younger people own and how that might be making the wealthy or older people not want to own those stocks." It sounds like it's a limit or arbitrage story. Another consideration, in thinking about portfolio construction, is industry portfolios.

That's kind of an easy one. If you work in the steel industry, for example, you might consider removing that industry from your portfolio, instead of removing value stocks as a whole. That's a nice way to think about it because industry portfolios are not priced factors, controlling for other factors. Industry portfolios don't have different expected returns. Theoretically, you can reduce your portfolio's co-variance with the state variable sensitivity of your industry without affecting your expected returns, kind of neat, but probably impractical, which is too bad.

Portfolio theory has come long way since 1952. Investors care more about just the mean and variance of their portfolios. And we know that to be true empirically, because there is a multifactor structure to expect the returns. That's pretty well documented at this point. The need to hedge other risks like recession risk causes most investors to move away from the mean variance optimal portfolio by adding in hedge portfolios. The mean variance optimal portfolio and the hedge portfolios together make up the market portfolio.

The market portfolio is not mean variance efficient in a multifactor world. It's multifactor efficient. Investors should be asking themselves how they're different from average. If you look like the average investor, you should hold the market portfolio. If you have lower financial wealth, higher debt relative to your income, more cyclical, employment income, or otherwise higher macroeconomic risk sensitivity than average, it might make sense to build a portfolio tilted more toward large CAP growth stocks. First time I've ever said that, I think.

Cameron Passmore: Yep.

Ben Felix: Then the market to hedge those risks. Some of the other factors they look at in those papers is level of education. People who are more educated in economics and finance will tend to look more like the mean variance investor. There's an interesting dynamic in there too. If you take everybody in aggregate, even somebody who has the characteristics that would make them average or below average in their risk capacity, if they have an understanding of the risk they're taking maybe, maybe that changes their risk aversion, decreases their risk aversion, and they can still ... A low wealth investor with lots of debt, but you can still be a value investor, just in equilibrium, you wouldn't be.

And you have to understand that you're taking more risk than somebody working in tech, somebody working in a value industry, somebody working in steel, or in oil and gas, or something like that. If they're comparing their portfolio to their cousin who works in software, and you guys have the same portfolio, the same value tilt, well, the person with the value like human capital or the exposure to the steel industry or whatever, they're taking a lot more risk than the person with the growth portfolio.

Your financial asset portfolios can look the same in terms of asset allocation, but the person with the more macroeconomic risk in the remainder of their financial situation is taking on way more risk. I think that's one of the big takeaways for people to understand. And likewise, in the Rational Reminder community, everybody's talking about their value tilt. Well, hey, how does that relate to your human capital? Because the person with the super concentrated tilts, or whatever, the person that's all small CAP value, maybe they're taking the same amount of risk as somebody who's owning market CAP weighted ETFs, once you factor in their own income risk. So, I think that's an important takeaway.

Cameron Passmore: Yep.

Ben Felix: Now, in equilibrium, if you have high financial wealth, low debt, and low exposure to macroeconomic risks, then you might be the mean variance investor, which means loading your portfolio onto the risks that most investors want to avoid. As we know, those risks can be proxied by small CAP, and value, and profitability, and investment, Fama-French five factor model. But as I was just saying, in doing this, it's important to keep in mind why these stocks have higher expected returns. It's because they're risky at times when other risks tend to show up.

If that results in you selling your value stocks, or whatever, in a recession, or in a time when value stocks do poorly, because you lost your job, or otherwise, whatever, had a personal household venture crisis that resulted in having to sell your portfolio, you don't get to keep the risk premium. So, it's fine to take risks, but you have to be able to stay in the game to rip the rewards. Maybe that means holding a bit more cash, but that's also effectively reducing your exposure to value stocks, so I don't know.

The last thing to keep in mind is that, while tilting toward or away from risk mimicking portfolios or eliminating industry portfolios may be theoretically optimal, it comes at the cost of complexity. You can buy one fund, you can buy VT, and own the market, or VEQT in Canada, to be a little more tax efficient. One fund and you're done. That's as easy as it gets. But you start adding in tilts toward growth, if you're into that kind of thing, or value, which is probably what most people would think about doing, you need more funds. If you want to remove industries, I don't know how you would do that.

You would have to build a portfolio of like industry ETFs, including all industries, but your own. Not to mention adding in value and stuff like that. Maybe you could get that by tilting toward more value industries. I don't know. But it's messy and it gets messier. I think that's another important takeaway. It's like, this is all really cool in theory, but the practical aspect is important too. So, even if somebody's the perfect candidate to be the mean variance investor and they could theoretically tilt toward value, it doesn't necessarily mean you have to do it. There's other considerations on implementation in there too. That's it.

Cameron Passmore: It's good. It's going to be worth listening to a couple times for sure.

Ben Felix: I hope so. I had to read a lot of ... I got modern portfolio theory as a concept, but not ... I don't know. I learned a lot, I guess what I'm trying to say. Even though these are like foundational principles and I conceptually understood everything that we just talked about, and how it relates to asset pricing, and all that stuff, I don't think I had a grasp of the distinction between the mean variance efficient portfolio and the multifactor efficient portfolios, and how they theoretically combine to make the market portfolio. And how the state variable sensitivities, like, what are these other risk factors? Why do they theoretically exist? I don't know. In my own head, a lot of stuff became clear putting these notes together. So, hopefully it helps other people too,

Cameron Passmore: But let's go back to the book I talked about, Stolen Focus, right? You were able to get into flow and really dig into this and get into a space where you could really let it come to be in your head, right?

Ben Felix: Oh, trust me. When you're talking about that book, I get it. If I have one meeting in a day, I have trouble doing any thinking.

Cameron Passmore: It's breaking your flow. But here's an example where someone could listen to that conversation, which was 45 minutes long or something, and benefit from you spending hours of reading, researching, thinking, noodling, working with other people to get their feedback on this. For someone to spend 45 minutes to learn about this, that's a lot of time for the average person, given what is going on in everybody's lives.

Ben Felix: True.

Cameron Passmore: It's an interesting observation that people can spend that amount of time to benefit from the amount of time that you spend behind this getting into flow, and they can get into flow in this in 45 minutes. So, it's pretty cool.

Ben Felix: Yeah, that is cool.

Cameron Passmore: That's great. All right. Let's go to our conversation now with our very good friend, Larry Swedroe.

Ben Felix: Let's go.

Cameron Passmore: Larry. Welcome back to the Rational Reminder.

Larry Swedroe: My pleasure. Always great to be with you, Cameron and Ben.

Cameron Passmore: Yeah. It's so great to have you as part of the reading challenge, because you're such an avid reader and a prolific author. So, we're super excited to have you join us.

Larry Swedroe: Yeah. Thanks.

Cameron Passmore: Tell us off the top, why do you think reading is so important?

Larry Swedroe: I'll even start by saying, I think one of the greatest gifts I gave my children was the love of reading. We would sit and read with them all hours of the day and a night, to give them that love, because I think it's so important. One, just from your profession, that's how you learn. You keep an open mind, you keep reading. And I like to read things that don't happen to agree with my preconceived notions to make sure I'm learning something new, and like all smart people, when you learn that you were wrong about something, you change your mind.

I read a lot of investment books on the business side, having run companies and been a leader of organizations. I also read a lot on leadership issues and how to work with employees and stuff. Then I read a lot of history and historical fiction because I want to learn from that and enjoy also just that. Then I'll read just for pure pleasure, mysteries, spy novels, whatever, it doesn't matter. If you give me a good book, I will read it and try to make lots of time every day to read.

Ben Felix: Larry, can you describe your reading habit?

Larry Swedroe: Yeah, sure. Whenever I don't have something to do, I'll pick up my book, but I'm pretty disciplined every day, at least sitting down for a half hour or an hour. Whenever I have to go visit a doctor, for example, I've got a book with me, so I'm not doing anything I'm using that time. When I travel for business, I've always got at least two books in case the plane is late. I've even been on Tauck tours, which is kind of upscale travel for two weeks, and I'll take like six or eight books with me, because I'll plenty of time read on the bus and the planes and the hotel rooms. I read whenever there's any spare time, even when I'm watching like the NCAA tournament, in between commercials, I'll read a few pages.

Cameron Passmore: So, I'm curious about the tactics that you use for capturing the ideas from what you read so that you can use them later. How do you do that?

Larry Swedroe: That's a really interesting question. First of all, if I'm reading anything related to what I might want to be learning or writing about, I always have a pen with me. I mark it down. I write the page number in the book, and then I'll go back to that, look through it, and then write it up immediately, so I've that information handy. I'll either write a book review from that, or I'll use that for an academic type of paper, helping investors understand the key points, but I'm also always looking for ideas to help convey what are often difficult concepts to investors.

Let me give you a good example of that. When I was writing my first book, I was very privileged. My agent was an English professor, writing professor at Columbia. He really helped me learn that in order to get people to understand something, the best way to do it is to tell a story, and use an analogy. He mentioned that, if you want somebody to learn, you tell them a fact. If you want them to believe, you tell them the truth. And if you wanted to live in their heart forever, you tell them a story. So, I was always looking for stories. My books are filled with analogies to sports, and cooking, and gardening, and history, and movies and stuff.

To do that, and so a good example is I was watching a play about Galileo. As you know, he was imprisoned under a house arrest by the Catholic Church for telling the story that the earth was not the center of the universe, but the sun was. I'm sitting there watching that, and it came to me that here was a powerful establishment that didn't want you to know what the facts were, because if you did, then maybe you would think, well, they were wrong about that, then maybe they're wrong about everything else.

And I'm sitting there observing this in the play, and it hit me. I use that story often in my books to make the point, that's what Wall Street doesn't want you to know. They don't want you to know the facts that yes, it's possible to outperform the market, but the odds of doing so are so low, you shouldn't try. I'm always looking for analogies like that. And when I pop up, I immediately get up and write them down. I'm watching a movie or something. I'll get an idea, immediately write it down.

Ben Felix: Larry, you've got a scoring system that you share each year for all the books that you read. What is that scoring process like?

Larry Swedroe: I wish I could tell you, it's really like a Fama-French pricing model, but it's really just a gut feel. To me, I put books in the distinguished categories. To me, that's a must read almost, regardless of whether you are interested in that topic. Just a great book with great writing or great facts are important. And excellent just doesn't quite make that. It may be great writing, but just is not in that distinguished category. And then I have very good, good, fair, which means I wouldn't recommend it, but if it's a topic you're interested in, and then I have the poor category, which books I think just aren't very well written, or don't contain truths.

Cameron Passmore: How do you decide what to actually start reading?

Larry Swedroe: Well, one I'm lucky there. My wife belongs to two good book clubs, so I get a lot of recommendations there. Because of my Twitter and LinkedIn accounts, and where I post books I recommend, get a lot of people, send me back, either tweets or emails, letting me know good books. Lot of friends who are avid readers, and we exchange book ideas. A group of friends we call the ROMEOs, the Retired Old Men Eating Out, and we talk. That's the first thing, we sit down and talk about once a month at our lunches, is what books are you recommending to read? Most of it is recommendations from other people who I highly regard. I know I enjoy the books they recommend and trust their judgment as well.

Ben Felix: The other thing that always amazes me about you, Larry, is the amount of academic papers that you read and then synthesize. How do you decide which academic papers to read?

Larry Swedroe: Well, one of the great benefits that we have with the internet is a website, the Social Science Research Network, and there's a whole bunch of different sub-sites they have. I check literally six of them daily to see what's being posted on there. And then, on the six sites, there maybe 12 or 15, or 20 papers. I don't obviously even read the abstracts for all of them if it's not a topic I'm particularly interested in or think our clients, as investors, would be interested in. But if there is a topic that is, I will at least read the abstract, and if I think it's worth then reading, I will try to find it on the internet where it's available publicly on SSRRN, or I'll have my firm buy a subscription for that article, and then I'll read it.

What I'm really lucky is I've developed a really good cadre of very smart people, a lot smarter than I am, who I've become friends with. After, I'll write something up, or even while I'm reading it, I'll often call them, "Hey, I don't understand this. Can you give me some insights? What am I may be missing?" Anything I write that you might find on Alpha Architect, or Advisor Perspectives, or Evidence Based Investor, the odds are pretty good. It's been reviewed by some really smart people like Wes Gray, or Andy Berkin, or Toby Moskowitz, at AQR. People like that. I've been very lucky, developed friendships with people who are so generous with their time.

Cameron Passmore: It's amazing. This reading challenge that 22 in 22 is taking place in an online community, what do you think about the benefit of making a public commitment if you are wanting to read more.

Larry Swedroe: I'm a big reader of behavioral finance. It's my favorite topic. I've even written books on it. One of the things that psychology has taught us, that if people make a commitment, they're much more likely to do it. If they put it in writing and sign it, they're even more likely to do it. And if you give them a reward for doing it, they're even more likely to do so. I think that's great that people make a commitment and hopefully then they will stick with it and find that they really enjoy reading, especially if you good books. That's why I publish my list to hopefully give people, at least books to read that I think are really worthwhile.

Larry Swedroe: That's the great thing about reading, although there are no right answers whether a book is good or not, if it's a novel in particular, just different tastes, different people. Just if I love a book, you may hate it. So, you try to find people who like books that you like to read and then share your recommendations with them and get their recommendations.

Ben Felix: You are yourself, an accomplished author. Do you think that impacts how you judge the books that you read?

Larry Swedroe: I don't think it has any impact on where I rate books in terms of quality, but I will say this. I will only write on my column, a book recommendation for books that I really love and people think are worth reading, even if I don't think it's the best book, if I think there's something worthwhile for them reading. I just posted a book that just came out on Risk Parity. I thought it was a good introduction to learn about the concepts, but if I find the book that's poor, you won't see me putting that out, say, "Don't read this book." So, maybe a little bit more kindness because I'm an author myself maybe.

Cameron Passmore: Now, you find a book that's poor, do you finish the book or do you often bail on reading books?

Larry Swedroe: I very rarely not finished the book if it's a novel, or historical fiction, things like only a couple of times, really in my whole life have I abandoned books. Because I have found often that sometimes books just get better. One of my favorite books of all time, I almost gave up at a hundred pages, I was that far into it, it's a book called the Angle of Repose, a book considered by many to be by one of the great American authors, Wallace Stegner. That book, I was about to quit, and then it just got better. And the book is a fabulous book, and I'd recommend reading anything Stegner writes.

My wife is much more likely to abandon something. She'll quit on a movie after five or 10 minutes. I'll give it a lot longer. But if it's an investment book, I will say, and it's not well written, or I don't think it's factual, I might read 20, 34, and then just give up because I don't think it's worth my time.

Ben Felix: Do you have any last words of advice, Larry, for people who are listening that want to read more this year?

Larry Swedroe: Just make the time, carry a book around with you, instead of watching some reality TV or cooking show. Nothing wrong with any of those things, but I think reading is one of the great joys in life. And the best thing about reading is you'll never get to read all the books that you probably would enjoy. I'll have one last word of advice. Just people often ask me, what's my favorite book of all time? I would judge that by the fact I've read it four times in about every 10 years or so now I go back and read it. Again, I think it's the greatest story of revenge ever told. And that's The Count of Monte Cristo by Dumas. The most important book I think was Ayn Rand's Atlas Shrugged. But I think the best book for enjoyment reading is The Count of Monte Cristo.

Ben Felix: I want to thank you, Larry, for this, but also, Cameron mentioned the community that people are making the public commitment to reading in. I just want to thank you for your continued involvement in there. I know that everybody that's in the community appreciates your contributions, and you're so generous with your time. So, wanted to take the opportunity to thank you for that.

Larry Swedroe: Yeah, my pleasure. Always happy to help. It's my way of giving back. One of the great joys for me is every week I get pretty much an email from somebody somewhere in the world who I don't know, will never know, will never meet, just thanking me for having helped them achieve their life and financial goals and prevent them from getting ripped off from Wall Street. That's the benefit. And people say it's much better to give than to receive. That's absolutely true here. It's a real pleasure to know that you're helping people and making a difference in their lives.

Cameron Passmore: Well, it's that spirit how you and I met, Larry, back in '99, I think, maybe 2000. But I think it was '99 that you and I met for the first time, so you've been that gracious all the way along, so we really appreciate it.

Larry Swedroe: Yeah. Even got you out whitewater rafting.

Cameron Passmore: Twice, you did blast. It was great.

Larry Swedroe: Twice.

Cameron Passmore: Larry, thanks so much for joining us, and thanks everyone for listening this week.

Books From Today’s Episode:

Stolen Focus: Why You Can't Pay Attention — and How to Think Deeply Again — https://amzn.to/3JCxJKw

Portfolio Selection: Efficient Diversification of Investments — https://amzn.to/3NoxzJd

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22 in 22 Reading Challenge — Join the Rational Reminder’s 22 in 22 reading challenge!

Ben’s Reading Code (22 in 22 Challenge): 7XWESMK

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