For our very first episode of 2020, we kick things off with some quick updates before sharing Cameron’s ten best financial planning strategies for the new year. After laying out some statistics about the great asset class returns that 2019 saw, we get into the wonderful listener questions we have been receiving over the break. Our first topic is about buying versus leasing cars, and Ben shares his thoughts on some of the reasons he recently converted to leasing. Our second question is about using credit to invest in a TFSA and acts as a great segue into our main topic for today’s show: implementing leverage in an investment portfolio. We discover some fascinating outputs given by a Monte Carlo simulation that compares the reliability of expected returns between diversified and concentrated investment portfolios. Surprisingly, the concentrated portfolio, while unpredictable, actually produces higher returns, even in its worst iterations. We start to think of concentrated portfolios as just another form of leveraging after comparing IUSV to VLUE ETFs, and then move on to the idea of time diversification as it relates to implementing leveraging in Lifecycle investing. As always, we end off with our bad advice of the week, with the 60/40 stocks and bonds model taking centre stage, so hop on and join us for the ride!

Key Points From This Episode:

• Different corporate cultures and the value of instilling one in your workplace. [0:05:55.0]

• A top ten list of strategies for financial planning in 2020. [0:08:48.0]

• Asset class returns from 2019 which were very high across the board. [0:15:34.0]

• Market unpredictability and why to buy a second-hand car but lease a new one. [0:19:18.0]

• When to use your unsecured line of credit to invest in a tax-free savings account. [0:22:49.0]

• Three things that structure a belief: values, biases, and models. [0:24:51.0]

• Ben’s model and expected returns of diversified vs concentrated portfolios. [0:27:49.0]

• When concentrated portfolios work well: if high performing stocks are chosen. [0:34:01.0]

• Ways to achieve higher factor exposure with IUSV vs VLUE ETFs. [0:35:47.0]

• How unexplained portions of returns are the costs of leveraging via concentration. [0:40:40.0]

• Why investing using leverage creates ‘time diversification’ and higher yields. [0:42:47.0]

• Ways for young people to leverage their savings: concentration, derivatives, etc. [0:42:47.0]

• Time decay on leveraged ETFs and other reasons for leveraging not being a joke. [0:50:52.0]

• Why ditching a 60/40 portfolio denies market efficiency by increasing risk. [0:55:36.0]

Read the Transcript:

Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore.

Cameron Passmore: So, what's new in your world?

Ben Felix: Well, I had some time to relax over the holidays, hanging out with the kids.

Cameron Passmore: You checked out pretty good.

Ben Felix: Yeah. I still came in a couple times, but I took quite a few days off. Grew a beard. Shaved it.

Cameron Passmore: Yeah. I thought you were going to keep it for the videos. I was just waiting for the comments from like-

Ben Felix: I couldn't handle it, I didn't like the feeling.

Cameron Passmore: Any news on the 3D printer?

Ben Felix: Oh, good question. No, we haven't bought one yet. What I did do is our kids have a playroom upstairs in the house and I cleared out a wall and put a work bench and a big metal like garage drawer type thing, put all my tools in there. So everything's ready for the 3D printer. We've got a workshop set up.

Cameron Passmore: That'd be so cool.

Ben Felix: It'll be cool.

Cameron Passmore: Especially the kids are into the-

Ben Felix: Robots.

Cameron Passmore: ... robots. And like the-

Ben Felix: BattleBots.

Cameron Passmore: ... BattleBots and the cars and stuff. It's a lot of engineering, a little bit of fun. It's a pretty good combo.

Ben Felix: Yep. That'll be a fun project once we get it.

Cameron Passmore: Awesome. Well, as you know, everybody knows here, I got engaged over the holidays.

Ben Felix: Congratulations. Pretty cool.

Cameron Passmore: Kind of weird to share that, but people seem to like when they hear stuff about us, so I'm super happy. Lisa's incredible. And I know she's listening now and possibly dying behind her earphones, but anyways, it was phenomenal.

Ben Felix: That's good news.

Cameron Passmore: So, what are your plans for this year? Any big plans?

Ben Felix: No, I mean, I'll make some at some point, but I haven't yet. We have a baby coming sometime early in the year, April, I think. So, I'm not making any plans until after that.

Cameron Passmore: Cool. We're going to the Masters. Can't wait.

Ben Felix: That's cool.

Cameron Passmore: Told you we won... Been entering the lottery for years. Finally got tickets to the first day of practice, the Monday practice round. So that's our super cool plans for travel.

Ben Felix: Oh, we decided, you and I decided, we're going to the Dimensional advanced conference in October, right?

Cameron Passmore: Yep. Which are always very we're worthwhile and amazing presenters as people have heard us talk about.

Ben Felix: So, there, I've got some plans.

Cameron Passmore: So what are the plans for the podcast?

Ben Felix: Well, we've been doing the same thing, maybe that's not a good thing, but we've been recording an episode every week for, well, 80 weeks now. We're going to keep doing that. The audience continues to grow and we've got some really cool feedback from somebody in South Africa. And they were just a bunch of nice comments about why they think the podcast is doing well.

But one of the points that was interesting is that it appeals to an international audience just by nature of not being a US-based podcast. So a lot of the issues that we talk about as Canadian investors, they apply to anywhere outside the US. The US market is so big. Of course, you're going to invest in US-listed ETFs in the US, but in other countries that are not the US, the whole issues of tax efficiency, and do you use a Canadian or an Australian, whatever listed ETF or a US-listed ETF, all of those start to matter. But they matter the same, maybe the details aren't the same, but the issues are the same in any non-US market. So anyway, I thought that was interesting. And of course we welcome all of our international listeners.

Cameron Passmore: But don't you find we've got so many ideas of what we want to do with this community that's been developing, that things from having a dedicated portal, like a better portal to do-

Ben Felix: A website.

Cameron Passmore: ... more chats. I know there's a Rational Reminder website now, we want to beef that up, make finding episodes and topics easier to search out, finding guests easier.

Ben Felix: I think the thing that I really want to get right, and I don't know exactly how we're going to execute on, but a thing that I really want to get right is to have a place where people, the listeners, can discuss stuff, like stuff in an episode or just stuff in general, because I get, and I know you do too, tons of emails, Twitter messages, YouTube comments, whatever, all sorts of different mediums, comments on the Rational Reminder website. And it would just be amazing if we had a place where all of that could be deposited, so people can just, if they want to talk about a thing, they can talk about it there.

Cameron Passmore: And share like in a Reddit style would be super-

Ben Felix: Yeah, yeah, yeah, yeah.

Cameron Passmore: ... super amazing.

Ben Felix: So, I'd love to get there, but that's definitely on the horizon, is improving the ability of our Rational Reminder website to facilitate community discussions like that. I don't know what it's going to look like yet, but that's-

Cameron Passmore: That's one of the goals.

Ben Felix: ... yeah. So, hopefully all the listeners will appreciate that. And I think they will.

Cameron Passmore: Remember, as always, send us your audio questions, try to keep it to 15 seconds or less, get right to the point. We've got two in today's show and check out the Rational Reminder website.

Ben Felix: Yeah. People have been pretty good about commenting on the Rational Reminder site. And around that same line of thinking, like it's just in terms of a central place to put stuff for the podcast, that's as good as we have right now. People will often comment on the... We post the audio episodes on YouTube as well. And we get a ton of comments there. More than on the website. It'd be really nice to just have like, this is the place where you comment.

Cameron Passmore: That's our other plan too. We want to build a studio and get the video online.

Ben Felix: It's crazy that... So, the platform that we use to host the podcast, it automatically sends the audio file to YouTube and upload it as a video. So, people can go listen to it there. And we do nothing. And we've been doing that... For maybe a year, we've been posting them on there. And it's already up over a thousand subscribers on the YouTube channel. Which is crazy. I remember when I started my YouTube channel, getting to a thousand subscribers was a huge deal.

Cameron Passmore: Right.

Ben Felix: Anyway. So, the most popular things that we've posted on that channel are the three times that we actually tried to record video footage of us.

Cameron Passmore: Right. We're going to try to do it properly, proper cameras. I know we made an attempt last year in this closet we're in, but we're going to try to do it properly with a modest set.

Ben Felix: Yeah.

Cameron Passmore: Anyways, today's episode is a little long.

Ben Felix: So, we'll get to it.

Cameron Passmore: We'll get to it, with a lot of great content. And thanks again for listening.

Ben Felix: Welcome to episode 80 of the Rational Reminder Podcast.

Cameron Passmore: So, I want to kick it off talking about a book that I've been reading or I just actually finished reading.

Ben Felix: Yeah, let's do it.

Cameron Passmore: It's a super cool book. I heard Barry Ritholtz talk about it on Masters in Business, an interview with Ben Horowitz, who's written a new book called What You Do Is Who You Are. So, you know who Ben Horowitz is? He's co-founder of Andreessen Horowitz, who I think their big claim to fame was one of the initial investors in Twitter, I believe, and number of other companies. He's a pretty big deal in Silicon Valley. Anyways, the interview's amazing.

So, I picked up the book and the book is about culture in an office and something I'm always fascinated with. And since you spend so much time in an office culture, a lot of people think it's just the cool things in an office, like whatever happy hour, beer keg, or snacks, or whatever, but it's a lot more than that. It's a lot more than just hiring people.

And he's a pretty straightforward, lot of experience, especially on the last half of the book, creates a lot of cool takeaways into how to hire, how to train, how to interact with people, how to deal with issues in an office, and how he puts it, to quote him, he says, "Culture is a strategic investment in the company doing things the right way when you're not looking."

He also talked about how it's super important to make sure you line up the culture with who you are as a leader, as to how the company, kind of the mission the company is, one of the examples he gave is, at Amazon, frugality is everything, into what their value proposition is to the end user, but also it's the environment they work in. So, apparently desks are quite value conscious. And as a contrast to that, he talked about Apple, and Apple is everything about great design, not about frugality. So, those cultures are so totally different. And I thought it was a great example to highlight that.

Ben Felix: Thank you to mention this, we focus a ton on culture in our office and in our team.

Cameron Passmore: I think it'd be a cool topic for us to talk about on a future podcast, because we do spend a lot of time on that. And some of the things that are important to us in our office is teamwork, obviously. Continued learning, it's one of the reasons why we do the podcast. We try to be excellent in everything we do. Transparency, absolute customer obsession, respect, decency, trust. So, those are kind of the values that lead to the culture in our office.

Ben Felix: You can think about that as a client of a wealth management firm, it would be presumably important, to the end client, what the culture of the firm is like. It's an interesting thing to think about it. If you are an investor looking for someone to manage your assets, and you're interviewing different firms, getting a feel for the culture of that firm seems like it'd be important.

Cameron Passmore: Well, the title of the book, You Are What You Do. So, if what you do is hunt down new clients and that's your job is just to go find new clients in a sales type role. That's going to be the orientation.

Ben Felix: And how are you... Even compensation.

Cameron Passmore: For sure.

Ben Felix: Because that's something that, from a culture perspective, we've been very deliberate about the way that we pay people on the team, and what we reward with incentives.

Cameron Passmore: Anyways, I thought it was... It's a great book. It's getting great reviews all over the place. So worth checking out for sure.

Ben Felix: Good tip.

Cameron Passmore: Onto the next topic. So, we thought we'd run through a quick top 10 list of 2020 financial planning items.

Ben Felix: You put this list together and I thought it was really good.

Cameron Passmore: So, I can't take total credit. It came from my own thoughts, but also poking around a lot of different top 10 lists. So, I don't want to misrepresent myself, but-

Ben Felix: Well, I was still impressed.

Cameron Passmore: It's a good list. So, you want to kick it off?

Ben Felix: Sure. So, the first one that you have on there is to clarify your financial values. As was highlighted in the movie, Playing With Fire, articulate your financial goals, quantify the plan to achieve those goals. And I think this ties in quotes on our last episode, the episode that we had with all of our guests together for the end of the year. This was one of the main themes of that, is making sure that your actions are aligning with your goals financially.

Cameron Passmore: Yeah. Great movie if you haven't seen it yet. Number two, automate the savings needed to achieve the goal. And the objective there is to increase your adherence to your plan. Just make it easy, automate as much as you possibly can.

Ben Felix: Yeah. That's a good one. That's something that I haven't been great at. I end up trying to save lump sums and then dump it all in beginning of the year, the end of the year.

Cameron Passmore: Wow. I thought you'd have that adhered to.

Ben Felix: I used to and I can't remember why I stopped for a period of time and, anyway, I haven't started again, but I'm going to follow your number two tip.

Cameron Passmore: Number three.

Ben Felix: Ensure you have an evidence-based investment philosophy and you're getting advice if needed and you're getting the advice you deserve for what you are paying. If you are paying for advice.

Cameron Passmore: Yeah. Like I said so many times, fees aren't the problem. The problem, if you're not getting the service you deserve for the fees you're paying.

Ben Felix: Or if you're paying fees for service you don't need.

Cameron Passmore: Correct.

Ben Felix: Same idea, I guess.

Cameron Passmore: Exactly. And obviously people know how we feel about that evidence-based philosophy. Number four is seek opportunities to optimize. So, for example, are espouse a loan sensible in your situation? Is there a way to restructure your debts to make them tax deductible with your investment account? Registered disability savings plans, over-funding registered education savings plans, or even consolidating your debt. Maybe get a secure line of credit to reduce if you have credit card debt, for example.

Ben Felix: Yeah, those are all good ones. Super-funding the RESP is such an easy one that a lot of people don't, not that they don't know about it, because the... I think people have the pieces of information that are required to make that decision. But most people aren't doing it.

Cameron Passmore: I think a lot of people don't know about that.

Ben Felix: But they know what the max is. They know what the max grants are. They have all the pieces. They just haven't put it together.

Cameron Passmore: Right.

Ben Felix: But people may not know what we're talking about. So maybe we should explain it quickly.

Cameron Passmore: Yeah. So, lifetime limit for RESP contribution is $50,000 per beneficiary. But the most that will attract the grant is 36,000, leaving 14,000 excess, that can be put into there-

Ben Felix: Anytime.

Cameron Passmore: ... anytime.

Ben Felix: Because the limitation otherwise is that there's a maximum annual amount of grant that you can get. And if you contribute more than that, then you're not going to get additional grant. But like Cameron just said, a portion of the total lifetime contribution limit is never going to attract a grant anyway. So you put in your 2,500 to get the years grant matching and you can dump the other 14,000 in today. And you're good to go. And then you continue after that making your regular $2,500 per year contributions.

Cameron Passmore: But again, all these items are worth looking into. There's always a little bit of complexities to stuff. There are so many other things that could have gone on the list.

Ben Felix: Can we go back to number three for a second, ensure you have an evidence-based investment philosophy?

Cameron Passmore: Sure.

Ben Felix: So, say someone that's working with a financial advisor, they've purchased investments through their bank. If they don't know if they have an evidence-based philosophy, what should they do? Ask? How do they know?

Cameron Passmore: Ask for the theoretical underpinnings for the portfolio they're into.

Ben Felix: Like, "Mr. Advisor, can you explain to me the theory behind why this portfolio structured like this?"

Cameron Passmore: Right, "Show me an academic paper that suggests this makes sense."

Ben Felix: There's an academic paper for everything though.

Cameron Passmore: Is there one peer-reviewed academic paper for picking an active mutual fund?

Ben Felix: For sure there is. I was talking to Wes Gray about that paper, it exists. That's what I mean. Anyway, this is turning into a much deeper conversation than a financial planning checklist. We should move along.

Cameron Passmore: Okay. Number five, know your numbers such as your credit score, super easy on Credit Karma.

Ben Felix: Yeah.

Cameron Passmore: Know your RRSP and TFSA room. Again, super easy in your CRA website or your notices of assessment, and also know your marginal tax rates.

Ben Felix: Yep. All important for financial planning decision making.

Cameron Passmore: Number six.

Ben Felix: Go through past spending, eliminate what isn't necessary, negotiate others. That's an interesting one. Negotiating things. I saw, it might have been Ellen Roseman saying that you should call your cell phone provider once a year.

Cameron Passmore: Every year. So, my provider last year told me to call every first week of January. I tried to call before this, so I have a real example, and the wait was too long. Every year I call now and it always saves me money. And I actually just cut one of my movie subscriptions at home. I just don't watch it.

Ben Felix: That's going to be a problem. I was talking to somebody today that has-

Cameron Passmore: 23 bucks a month.

Ben Felix: I was talking to somebody today that has Netflix, Prime, Disney. I can't remember what the other one was. Another subscription. And also regular cable TV.

Cameron Passmore: Yeah. You can't watch that much. Another one was my daughter. I said, "Are you going to the gym regularly?" She says, "No, I stopped going. I'm going to my private trainer." "Well, stop paying the $22 every two weeks to the gym."

Ben Felix: Yeah. Ensure subscriptions are valued is another piece of that list item, which is what you were just talking about.

Cameron Passmore: Renegotiate your internet. Like I've had a number of people, a few people in the office here, have switched to Costco internet.

Ben Felix: I didn't know Costco has internet.

You can get Costco internet, and it's apparently a lot cheaper, and it's the same thing.

Cameron Passmore: Ben Felix: This podcast recording just paid for itself.

Cameron Passmore: Yep. Okay, number seven. Review your living benefits, including disability, insurance and life insurance and review your employee benefits. And employee benefits, if your income is high enough, you may not have the maximum available disability covers, because you may have to apply.

Ben Felix: And you may not want it.

Cameron Passmore: You may not want it, but at least be aware of if you have it or not.

Ben Felix: Yeah. Yeah.

Cameron Passmore: Worth checking out.

Ben Felix: Ensure your will and power of attorney are current. That's a big one that I find that that's something that we've been following up with all of our clients about. And that's probably got the highest hit rate in terms of financial planning questions that we ask that the answer to is no, it's not up to date or it's not done at all.

Cameron Passmore: Yeah. And that's the topic of next week's guest is talking all about that. That's a great interview coming up. Number nine, assemble your team, your planner, your investment advisor, your lawyer and your tax specialist, make sure you've got a great team and you're happy with everyone and they all work together.

Ben Felix: Yeah. It's another interesting one where you'll ask someone, "Do you have a lawyer? Do you have an accountant?" And it's often pretty piecemeal like, "Yeah, they've got this guy that I, whatever, met through this thing. And he does taxes part-time." Yeah. Having a thoughtfully put together team of professionals if you need them is probably a useful thing to do.

Cameron Passmore: And number 10, improve your financial literacy, such as read a book or, may we suggest, subscribe to a financial podcast.

Ben Felix: Oh, good suggestion.

Cameron Passmore: Yes. Apparently you're already doing that if you're hearing this.

Ben Felix: Oh yeah. It's true.

Cameron Passmore: Okay. So, kick off the next one.

Ben Felix: Well, I thought it'd be interesting to just look at asset class returns for last year.

Cameron Passmore: What a year.

Ben Felix: And there's no, I mean, what's the benefit of doing this? Nothing.

Cameron Passmore: Hey, a lot of people don't know. A lot of people, I get emails saying, "Geez, I hope last the year was okay." They don't look, they don't know lots of bad news.

Ben Felix: They shouldn't inform any decisions though. Like returns were great, you're not going to invest more. Although, some people might do that, but that's not a good decision. But anyway, it's like-

Cameron Passmore: So, what jumped out at you?

Ben Felix: Well, I mean, across the board returns were very high. Canadian equity returns were very high. I talked to a good chunk of people last year who were saying, "I want to get out of Canadian stocks," or, "Do you really think it makes sense to have the overweight to Canadian stocks?" Which is a whole other discussion, but anyway.

Which we've had here.

Ben Felix: Yeah, which we've had in the podcast. Exactly. But then you look at the numbers this year and the Canadian market in Canadian dollars was up almost 23%-

Cameron Passmore: Amazing.

Ben Felix: ... last year, just shy of what US market was up, which was 24.7%. That's the MSCI US investment market index.

Cameron Passmore: And even the five-year numbers respectable at six and a quarter, 6.28.

Ben Felix: Yes. But over five years, Canada has trailed.

Cameron Passmore: Yeah. I'm talking absolute. I'm not talking relative.

Ben Felix: Yeah, for sure.

Cameron Passmore: Of course, this is nowhere close to the US.

Ben Felix: But that five-year number, so Canada's trailed both US and international pretty substantially over the last five years. That's why that conversation about, does that overweight to Canada make sense? That's why it's been happening.

Cameron Passmore: Well, it's less than half the return of the US market over the past five years.

Ben Felix: Right.

But look at the tracking error. If you look at the small value in Canada over five years versus the broad Canadian market.

Ben Felix: That's crazy tracking.

Cameron Passmore: 3.75% per year less in small value.

Ben Felix: Annualized. That's ugly stuff. In terms of growth of wealth, that's hard to swallow.

Cameron Passmore: Yeah. Well, same thing in the US. US small value underperformance is 4.29% for five years. But still, the small value in the US over five years was 9.49, and the overall US market was 13.78, is both incredible numbers.

Ben Felix: Then you look at again, Canadian value. So Canadian market-wide value has outperformed Canadian market over the past five years.

Cameron Passmore: Whereas, US value underperformed.

Ben Felix: Right. It's like that. I'm sure people have seen that. It looks like a quilt of the different asset class returns year-by-year. And just shows that the pattern very rarely persists where the-

Cameron Passmore: Well, look at the small value internationally, outperformed, over five years, the international broad market by 1.74%. Anyways, good numbers all across the board.

Ben Felix: I thought one of the most interesting pieces of these return figures that we're looking at here is the fixed income, which people, again, so chirping about not wanting to be in Canadian equities, that's been present for sure. But there's also been this ongoing undertone of bonds being just the worst investment ever, because of where interest rates are.

Cameron Passmore: Right.

Ben Felix: Look at bond returns last year, global aggregate hedge to Canadian dollars plus 7.43%.

Cameron Passmore: Yeah. And we'll talk about that in the bad advice of the weak part. But who would've guessed that a year ago, you could make 7.43% in global bonds.

Ben Felix: Yeah. And that outperformed, this is just one year of data. So, it doesn't really matter, but it's still interesting to observe. But global bonds hedge to Canadian dollars beat Canada Universe bonds by a reasonably large margin for fixed income. And we've talked in the past in the podcast about globally-diversified currency hedge fixed income, which Vanguard has products for, and Dimensional Fund Advisors also has products for, but, I mean, that is what can happen, it can outperform.

And the reason that matters is that, on average, over the long term, it has tended to deliver slightly better risk adjusted performance, that's globally diversified fixed income has. Then you look at short-term bonds versus aggregate bonds. Short-term bonds last year were up just over 3%, half of what aggregate bonds were.

Cameron Passmore: Interesting. Anything else to add?

Ben Felix: No, just like I said, interesting to look at, but doesn't actually inform any decisions.

Okay. So, we'll go into our listener comments and questions. So, we have a couple of audio questions for the first time.

Ben Felix: Yeah. So, we'll play those clips. And I guess we hadn't thought too much about how this is going to work, but we can play the-

Cameron Passmore: We'll play the leased car question. We'll come back with our answer after that.

Sean: Hi, Ben and Cameron, Sean from Toronto. A quick question really about leasing versus buying vehicles. And Ben, you had mentioned that you had changed your mind about leasing versus buying and you had recently leased a vehicle as opposed to buying old, a used vehicle, and then extracting as much value out of it as possible. And once again, awesome job guys.

Ben Felix: I don't know if I changed my mind. Well, I guess I did. So, originally, my first car was a used Subaru that I bought. Following that, generally accepted philosophy of buying a two-year-old, really good quality vehicle and driving it until all of the value's been extracted from it. There's no question that that is the optimal or superior financial decision.

Cameron Passmore: Right. But the question really comes down, if you've decided to buy a new car.

Ben Felix: So, this is where I changed my mind.

Cameron Passmore: Yeah. If that is the decision, because certainly buying a new car all the time is not the most financially wise decision.

Ben Felix: Right.

Cameron Passmore: I mean, that's well agreed upon.

Ben Felix: Right.

Cameron Passmore: But if you're going to get a new car, to me, whether you lease or you buy, it's just a function of the math. The nice thing that I like about a lease is that you've got the option after the term of the lease, so three years or four years, normally, if you want to buy it out or not. So, what is the interest rate in between?

Ben Felix: Right. That's where I changed my mind. I changed my mind from a lifestyle perspective. I was willing to pay for the consumption good of a new vehicle every few years. And once you've made that decision, I think that leasing becomes, like you said, Cameron, very sensible. It's predictable from an economic perspective, you could say that you're taking some risk, but the residual has been determined for you at the beginning of the lease contract. If you buy a new vehicle and then resell it three years later, you have no idea what the market value's going to be.

Cameron Passmore: The big risk is if you hate the car and you're way under mileage, therefore it's worth more than what the buyout residual is, and you get the keys back, then the dealership or the manufacturers made that margin. That's the biggest risk. But if you hated it, you want it to go away anyways, that may not be a bad thing.

Ben Felix: Huh. Interesting.

Cameron Passmore: Right. The other risk I see is behaviorally, you kind of get used to a new car, like I've leased now a number of cars in a row, and as it comes up, you just kind of get used to it. And I know at the end, well, my lease, for example, this car is up in June. I might want a new car in April. So you might kind of throw in the last two payments and it might get buried, who knows where that money really goes. So, I'm sure I don't come out on the winning end of those negotiations. I mean, this is what these companies do, but there is great peace of mind. You show up, you give it back and you move on to the next one. As long as your mileage, your consumption, matches up to what you're paying for.

Ben Felix: Well, yeah, if you're driving a ton, you're going to get dinged for sure. But you're also going to depreciate a vehicle that you own more quickly if you're driving a ton.

Cameron Passmore: True.

Ben Felix: But they're probably taking a pretty hefty margin on the penalties.

Cameron Passmore: Yeah.

Ben Felix: That you wouldn't pay if you owned it.

Cameron Passmore: You just look at your equity on maturity of the lease and be smart about that. So, if you're under mileage, you have some equity in there that you can usually roll into the next car if you lease it from the same place.

Ben Felix: I've talked to two different potential sources to come on to talk about the data around leasing in Canada, which I've found pretty hard to get good figures for. But I have found two people that have access to that type of data. And we're just trying to figure out if they'd be willing to come on for a podcast episode. But I think that would be really neat, just to get the actual numbers around it.

Cameron Passmore: Okay. So up next, we have a question and from Paul in Calgary.

Paul: Hey, guys, Paul from Calgary, Alberta. Can you guys talk a little bit about when's useful to use your unsecured line of credit to invest in your tax-free savings account? Thank you.

Ben Felix: So, we're going to talk more about leverage for our financial planning topic, but the question from Paul, it's going to tie it really nicely into that. It ends up coming down to the cost of debt. So, should you use leverage in your portfolio in the first place? That's a bigger picture financial planning question that we'll talk about. But one of the easy heuristics to make that decision is, does your expected return exceed your cost of debt?

Now, where you have the investments associated with the debt is important in terms of the cost of the debt. Because if you borrow to invest in your TFSA, the interest is not deductible. So, your cost of interest is your cost of interest.

Cameron Passmore: Makes the math pretty easy.

Ben Felix: Right. If your unsecured line of credit is at 6.5%. Well, that's it. If your expected returns are not higher than that, I mean, say, expected equity of returns are 6.5%, I wouldn't lever up to get the extra 50 basis points of uncertain future returns in return for paying the 6% interest, but in a taxable account at the highest tax rate, you might roughly cut that interest cost in half. So, that can start to become more interesting.

Cameron Passmore: Then you also have to think about how you would behave if your equity portfolio that you borrowed, say, $50,000 to put into your TFSA. If that gets cut in half, your debt's still 50,000, but your TFSA might be half that. How would you react? Pretty sure you could live through that?

Ben Felix: And that wasn't the only listener question that we got about leverage. We had the one audio question from Paul there, and then we got another one just by email and asked the same question. But in their case, the cost of debt was 3.95% on a line of credit. So, anyway, it seems like... I did a YouTube video on leverage and I was surprised, I guess, at how much interest there is around doing that, but levering up a portfolio.

So, like I mentioned, we're going to talk more about that as we move along in the episode, but we had one more listener comment this time, less of a question, but they just, from listening to the podcast and hearing the way that we're thinking about different things, they said that the use of the word belief is pretty common in our discussions and how you form a belief, and they broke-

Cameron Passmore: We get that a lot, you know?

Ben Felix: Yeah. I guess-

Cameron Passmore: I mean, we do have beliefs, obviously, and if we didn't, we wouldn't do this, but I hear that comment a lot.

Ben Felix: So, I found this listener, they broke down what is a belief into three different pieces. And they just sent me this email saying, "Was listening to the last episode and I had these thoughts and I wanted to share them." And I thought the thoughts were cool enough that we should share them with everyone. The question is, what is a belief? And they broke it down into values, which is how someone makes a decision about the best use of their resources, like their time and money. So, that's values. And then the second piece of a belief is your intuitive understanding of why the world works the way that it does. So, that's almost biases, intuitive beliefs.

Cameron Passmore: Everyone views the world the way they view it. And everyone's view is a little bit different.

Ben Felix: That's a bias, right? Your biased view of the world, is that your-

Cameron Passmore: I guess, by definition, it's biased.

Ben Felix: Right.

Cameron Passmore: Doesn't mean it's wrong. It's just your view.

Ben Felix: Yeah. Right. And then the last piece. So, we have values, intuitive understanding of why the world works the way that it does. And then the last piece of a belief is models. And I thought that was interesting because I wouldn't think about models as a component of a belief, but they are.

Cameron Passmore: So, how did he frame it as a model?

Ben Felix: I guess, it comes down to the ability to apply a hypothesis testing to your beliefs.

Cameron Passmore: Because a lot of our beliefs do come from models. A model is just a representation of what reality is. It's not reality.

Ben Felix: But you can test your intuitive understanding of the world if you have a model to do so.

Cameron Passmore: Precisely.

Ben Felix: If you don't have a model, then, well, that's it.

Cameron Passmore: It's a haphazard way of doing things, I guess, especially in our world, in the investment world.

Ben Felix: Yeah. One of the sentences in this email was, I thought, just fantastic. It was, "If we are actually committed to living our values, however, we need models to be able to test the outcomes of acting on our beliefs in order to see if these outcomes align with our values."

Cameron Passmore: Wow.

Ben Felix: Yeah. So, it's like you can have values and you can believe that you're acting in a way that aligns with your values, but if you're just acting out your values based on the preconceived beliefs that you have, without able to test how accurate those beliefs are relative to what a model would suggest the real world is, then you may not truly be aligning your values with your actions.

Cameron Passmore: And it goes on to say, "We need to also be able to accurately understand the evidentiary basis of our models."

Ben Felix: Right, of course, if there's no evidence behind the model, then you're not really verifying anything.

Cameron Passmore: Great feedback.

Ben Felix: I thought that was just a... It was a fascinating collection of thoughts that I thought was worth relaying to everybody.

Cameron Passmore: Okay. So, now to the portfolio topic, this is a super cool topic that I know has been rolling around in your head for quite a while now, we're going to go through this carefully, because I think it's worth learning about and understanding about, so fire away.

Ben Felix: So ever since we had Wes Gray on, do you remember what episode that was? I don't, we can put it in the show notes.

Cameron Passmore: Yeah, six weeks or so ago, I think.

Ben Felix: Yeah. So, Wes Gray from Alpha Architect, which is a firm in the US that builds concentrated factor portfolios. So, everyone's that listens to the podcast is familiar with the idea of factors. These characteristics that explain differences in returns, and the Alpha Architect philosophy is to take a super concentrated portfolio of those factors and turn that into a product.

Cameron Passmore: Episode 69.

Ben Felix: Okay. So, Wes was on episode 69. Anyway. So, ever since we had that conversation and I've talked to Wes a couple of times after that, that idea of concentration versus diversification has been, like you said, rolling around in my head. And including recently we had a conversation where we looked at a bunch of factor products. And one of the criteria that we were using was how diversified is it? And if it's too concentrated, we said, "No, that's garbage. We don't want that."

Thinking more about this, we've been quick to dismiss concentrated portfolios. And the reason is diversification increases the reliability of the outcome. Like if you take a distribution of outcomes, a more diversified portfolio should have a more reliable outcome than a less diversified portfolio. That's just math. It's like law of large numbers.

Cameron Passmore: Yeah. Because the weight of any one particular stock movement's not going to swing the portfolio in a highly diversified portfolio as much.

Ben Felix: Right. So, you're more likely to get a higher frequency of more extreme outcomes. So, that would be, I guess, fatter and longer tails.

Cameron Passmore: But not a different expected return.

Ben Felix: Right.

Cameron Passmore: That's the key. Right?

Ben Felix: Right. Right. So, given two portfolios with the same expected return, the more diversified one is going to have a more reliable outcome around that expected return, whereas less diversified is... Well, I modeled this, so we'll talk about the model instead of just saying words. So, I made this universe, I invented it, a universe of a thousand securities.

Cameron Passmore: The world, according to Ben.

Ben Felix: Yeah. Equally weighted.

Cameron Passmore: The Ben 1000.

Ben Felix: Yeah. The Ben 1000. So an equally-weighted portfolio of a thousand securities, each security with a different expected return. And made it so that they increased incrementally. I can't remember what the increment was. But they increased incrementally and the standard deviation increased incrementally at a slightly lower rate. So, the securities are increasing in their expected risk adjusted returns as we progress through the universe.

So then, I ranked them from lowest to highest expected return. I have the numbers here, so the lowest expected returning stock had an expected return of 3%, and then a standard deviation of 9%. And the highest expected returning stock had an expected return of 13% with a standard deviation of 14%. So, the average return to this portfolio is 8% with a standard deviation of 11.5.

So, then I took this universe and... So, I've got a thousand-security universe and then I recreated a 500-security portfolio, a 100-security portfolio, and a 50-security portfolio, but with the exact same expected return and stand deviation as the universe.

Cameron Passmore: So, that is the key, the thousand and the 50, the two extremes, have the exact same expected return.

Ben Felix: Right. So, on average-

Cameron Passmore: Just the way you've sampled it to get the same expected return.

Ben Felix: Correct. So, I pulled from the universe so that I had a sub-portfolio of 50 securities such that it was the same expected return and standard deviation.

Cameron Passmore: And?

Ben Felix: And then I used Monte Carlo to run a thousand simulated return periods just to look at the distribution of outcomes, to check on the reliability. So, if we had a thousand samples, how reliable are each of the portfolios? And it's actually fascinating, with a thousand security portfolio, all of the observations were very, very close to the mean, which you'd expect.

Cameron Passmore: It's very close to what the expected return was.

Ben Felix: Correct. And then with the 50-security portfolio, there was huge dispersion.

Cameron Passmore: Wow.

Ben Felix: Around the-

Cameron Passmore: Even with 50, because 50 still is a lot of stocks.

Ben Felix: For sure, it's a lot of stocks. That whole question of how many securities is enough to be properly diversified? We'll touch on that again in a sec. So, in this example, and this has always been... Dimensional did a paper framing it this way a while ago. And that helped to form my thinking like yeah, of course diversification is better. How could it not be? And this just proves it that that wider dispersion is a bad thing from a financial planning perspective. If you're an investor saving for retirement, you don't want that wide dispersion.

Cameron Passmore: Yes. Dear listeners, there is a but coming.

Ben Felix: So, the question that we hadn't thought about, and this is what chatting with Wes got me thinking more about, is that nobody in their right mind would make a 50-security portfolio with the same expected return as the market.

Cameron Passmore: Bingo.

Ben Felix: Why would you do that? You wouldn't. Because you're taking on additional idiosyncratic risk, you're taking all that dispersion risk on, if that's a thing, with no expected benefit.

Cameron Passmore: So, why wouldn't you just take the 50 stocks with the highest expected return?

Ben Felix: Which is what Alpha Architect is doing. So, I did that in my little modeling exercise. I took the 50 highest expected returning securities from the thousand stock universe and ran that through the Monte Carlo.

Cameron Passmore: This is pretty cool. It was pretty cool thinking.

Ben Felix: It was ...

Cameron Passmore: I know we're kind of nerding out here, but face it, this is pretty cool.

Ben Felix: I thought it was pretty cool. I thought so too. So, in that case now, keep in mind that these 50 securities with the highest expected returns, they also have the highest expected standard deviation of the universe, which is, in the Monte Carlo, is going to increase that dispersion.

Cameron Passmore: Higher volatility is the cost of higher expected returns.

Ben Felix: Right. So, when we run this distribution of outcomes even wider, with even fatter tails. So, way less reliable outcome, way less. From a financial planning perspective, now, of course, expected returns, who knows what future realized returns are going to be anyway? And who knows how good we are predicting or generating expected returns that are accurate? But that aside, assuming your expected return is accurate, and you're using this super concentrated portfolio. The chances of you actually getting the return you expect are, in my sample, super low, like half the time or something, you're getting something way above or way below what you expect.

Cameron Passmore: But that expected return is much higher than the expected return of the-

Ben Felix: Correct. So, this was the-

Cameron Passmore: ... the prior portfolios.

Ben Felix: This was the crazy part about my little experiment is that the worst outcomes in the Monte Carlo were still higher than the average outcome of the universe of a thousand securities.

Cameron Passmore: The tail, the left-hand tail, must go beyond or does it not even go beyond?

Ben Felix: No, that's what I'm saying. That was the crazy part.

Cameron Passmore: The whole curve is to the right of the expected return of those initial thousand-

Ben Felix: Yes.

Cameron Passmore: ... 550 portfolios?

Ben Felix: Yes.

Cameron Passmore: Wow.

Ben Felix: Yeah. I know. That starts to form other thinking around like, Hey, maybe that concentrated portfolio of much cheaper stocks, maybe that's not so bad in the context of an Ben Felix: overall portfolio. It's just a different way of approaching it. But it has some downsides too, which we're going to talk about. I think, just at the surface, before we even get into some of the other statistics that are interesting, the behavioral risk of taking that super concentrated portfolio, I didn't map that out, but it would've been interesting to see like the year-to-year outcomes. But just based on the way the portfolio is structured with the highest expected standard deviation securities, it's going to be crazy volatile.

Cameron Passmore: Right, because your initial standard deviation table is over what period of time? Those returns?

Ben Felix: I was just using an average over a given period of time.

Cameron Passmore: Okay.

Ben Felix: So, it could be anything.

Cameron Passmore: Right. But there'll be some pretty rough periods in that, the chapter live through.

Ben Felix: Oh, for sure. I mean, what was that in the standard deviation... The 14% standard deviation was the highest expected returning stock. 13% expected return, 14% expected standard deviation. I mean, that could be pretty aggressive. Three standard deviations away from that is pretty scary.

Cameron Passmore: Oblivion, not oblivion, but-

Ben Felix: Not quite oblivion.

Cameron Passmore: ... maybe behavioral oblivion.

Ben Felix: Yeah. Well, that's the thing. So, that concept though, it's like when we're thinking about building a factor portfolio, so with the Rational Reminder ETF factor loaded portfolios, we had taken the approach that we were always talking about in the past, which was use a diversified factor fund to get your factor exposure, which makes sense to me, and it still does.

Cameron Passmore: It still does. I mean, that's another takeaway here.

Ben Felix: Well, and we're going to talk more about why it still makes sense too. But the interesting thing about... So, I'll use actual ETF examples. We have, IUSV, which is large and mid-cap value for US stocks. We have that in our Rational Reminder Model Portfolio, and one of the ETFs that we snubbed the other week and said it was no good, because it was too concentrated, was VLUE. Now, the price-to-book for VLUE, it's way more value E, so it's got a much lower price-to-book, much lower than IUSV.

Cameron Passmore: Yeah. I think it's like about a third cheaper.

Ben Felix: Right. So it's cheaper. So, and then that's characteristics. So, there are two different ways to look at how you expect securities to behave. Well, I'm sure there are more than two, but two ways are factor characteristics. So, factor regression loadings, then the other one is characteristics.

Cameron Passmore: So, it's more concentrated 148 holdings versus 693.

Ben Felix: More concentrated in cheaper stocks.

Cameron Passmore: In cheaper stocks. And the value ratios are cheaper.

Ben Felix: Right. And when you run a regression, like you run a five-factor regression on these two ETFs, IUSV and VLUE, and VLUE has, again, I should have written the numbers down, but its loading to the value factor was quite a bit higher, like substantially higher than IUSV. So, from a portfolio construction perspective, to get the same amount of factor exposure, you could use less of VLUE.

So, you can have your total market, like in our model portfolio, we have a third market, a third market-wide value and a third small cap value. But if we were going to take this concentrated approach, we might have a higher proportion in super low cost, total market, and lower proportion in much more concentrated value stocks. And now in this case, in terms of cost, that doesn't really matter, because IUSV is four base points to own anyway.

Cameron Passmore: It's nuts.

Ben Felix: Right. So yeah, the argument could be if getting value exposure is more expensive, then just use a smaller proportion of a more value ETF. In this case, that doesn't apply, because IUSV is so cheap.

Cameron Passmore: But you can still get tracking error. Like I looked up the returns, the VLUE underperformed the broad one by 5.77% for the 12 months ending November 30th.

Ben Felix: For sure. I mean, you'd expect that, and you'd expect it because it's more value. If value underperforms, you've got more value exposure in this security. But you might have had less of it in your portfolio to get the same amount of factor exposure.

Cameron Passmore: Correct.

Ben Felix: So, where it gets really interesting though, is that we can use less VLUE to get the same amount of factor exposure as we could get with IUSV, that's easy. But now think about a portfolio that's already 100% IUSV, if you want to get more value exposure using that security, what do you have to do? Use leverage.

Cameron Passmore: Or to get more exposure.

Ben Felix: Right. Now, the alternative is, okay, we're using IUSV, we're using market-wide value, but I want more value exposure. Okay, I can go borrow money to invest more in value stocks, that gives me more exposure to the value premium, or I can use the more concentrated security. So, from that perspective, it's like, you can almost start to think about concentration as a way to access a type of leverage. It's like an implied leverage.

Cameron Passmore: And this is the conversation you had with Wes, right?

Ben Felix: It was part of it.

Cameron Passmore: You could also borrow for the VLUE, really torque it up.

Ben Felix: Sure. That's kind of the interesting part is that like, in our Rational Reminder portfolio, we're not 100% value, so you probably wouldn't be doing this anyway. But the interesting argument is, if you were already all the way torqued up as you could possibly get with market-wide value, your alternatives from there, if you want more value exposure, are to use leverage or to go more concentrated.

Cameron Passmore: Right.

Ben Felix: Now, going more concentrated has pretty large implicit cost, which is idiosyncratic risk. So if you borrow to invest, as we were talking about a minute ago, and we're going to talk more about it, if you borrow to invest, you can still have that reliable outcome from the premiums, from, say, the value premium, like we've been talking about. If you're using IUSV, it's going to be more reliable. So, lever that up, you've got a reliable outcome minus the cost of interest.

Or you say, "Okay, I'm going to go highly concentrated." You're not paying for a cost of interest to lever up. You're using concentration to lever up, but you end up with sort of an implied cost of interest through idiosyncratic risk, which could work for or against you.

Cameron Passmore: Applied cost of interest in idiosyncratic risk.

Ben Felix: I mean, it's true, right?

Cameron Passmore: No, it's true, absolutely true.

Ben Felix: Like concentration is a form of leverage. And the cost of that form of leverage is idiosyncratic risk.

Cameron Passmore: Yep.

Ben Felix: And I was playing with this and I don't mean to pick on Alpha Architect, but the data is... It's just so easy to use this data. And Wes asked Portfolio Visualizer to put their data on there. So, this is his own fault. If you take the Alpha Architect factors, which are now in Portfolio Visualizer. And if anyone... I love that website. I don't know if people know about it.

Cameron Passmore: I think they're picking up on your love.

Ben Felix: So, it's portfoliovisualizer.com. It's free. You don't even need to make an account. Although, if you do, you get a couple more features, but it's still free. But you can do factor regressions on any US ETF or mutual fund, and you can upload your own data sets. So, I play with this tool all the... Like literally every day, anyway. So, Alpha Architect has the factors that they use in portfolio construction in that database now. So, it's like a dropdown menu, which factors do you want to use for the regression? You can just pick Alpha Architect.

Cameron Passmore: Oh wow.

Ben Felix: So, what I was playing with is, what if we use the Alpha Architect factors to run a regression on the alpha architect products? Because you'd expect them to align, like you'd expect high factor loadings for their own product using their own factors. And you get that. But when you look at the residuals, which is the unexplained portion of the return in the regression, they're much larger than if we look at, say, Dimensional using the Fama-French factors. With Dimensional using the Fama-French factors, the residuals are close to zero, like pretty much all of the return of a Dimensional fund is explained by factors.

But then if you go to Alpha Architect, and this is just the cost of that concentration/leverage, you get this much bigger unexplained portion of the return.

Cameron Passmore: Fascinating.

Ben Felix: So, yes, you're still getting factor exposure. And this is exactly what we're talking about with this concentration discussion. Yes, you're still getting factor exposure, and it's more extreme, and it's an alternative to using leverage. But the cost is that unexplained portion of the return, which is inevitable, because of reliability, when you have less securities. But the main takeaway is concentration isn't bad. It's just a sort of form of leverage. So, if you really want to torque up your expected returns, you can use leverage or you can use concentration.

Cameron Passmore: So, that's probably a good segue into our planning topic, which is also on leverage.

Ben Felix: I'll just throw in one more, the theoretically sound approach would be using leverage, building the optimal portfolio with a reliable expected outcome and levering it up. Now, leverage has a bunch of practical limitations, which, like you said, we'll segue in and start talking about.

Cameron Passmore: Okay. So, the question is, should you invest with leverage?

Ben Felix: Yeah. It kind of blurs the lines between portfolio management and... Well, I guess everything does. But it's very much related to financial planning and it's very much related to portfolio management. Anyway, so we'll try and do this topic justice.

There is a paper and they've written a book about it too, from a couple of Yale professors named Ian Ayres and Barry Nalebuff. And they did this whole study on why it makes sense for young investors to use leverage. And it basically hinges on the concept of time diversification, which is an interesting concept if you haven't thought much about it.

So, they're basically saying that people get asset class diversification, but people don't get time diversification. And what that means is, if you are young now, and you're saving whatever, whatever, even if you're 100% equity in your investments, so you're an aggressive young investor. If you've only got $10,000 invested, relative to your lifetime earnings, your exposure to stocks is meaningless.

Cameron Passmore: It's like doing your asset allocation in 3D. The stock bonds are your current asset allocation, but your third dimension is really how much time between now and retirement. So, if you're 40 years away, you've got all this time. So, basically you're saying you should have a... Take how much wealth you should have in the future of this age and do a present value of it. Right?

Ben Felix: So, that's what the Ayres and Nalebuff paper hinges on the Samuelson-Merton lifecycle investing concept, which they suggest putting a constant proportion of the present value of your future earnings in stocks.

Cameron Passmore: Future earnings or future wealth?

Ben Felix: You're right, future wealth.

Cameron Passmore: So, basically your net worth in retirement -

Ben Felix: Future savings, I guess.

Cameron Passmore: ... the net present value on that. So, if at this point in your life, you should have 100,000 saved up, but you only have 20, you'd go and borrow the 80, take advantage of that third dimension of time.

Ben Felix: Correct. Ideally, you'd go and borrow the 80 and get the 100,000 now.

Cameron Passmore: It's all kind of theoretical.

Ben Felix: It's worth noting that when Ayres and Nalebuff came out with this paper, Samuelson denounced it, he said, "Hey, I never said you should use leverage. This is ridiculous." Anyway, just an interesting side note. And there was a whole bunch of debate online with Ayres and Nalebuff defending the paper and Samuelson saying, "Don't do this."

Cameron Passmore: But just, conceptually, it makes sense though, if you have time-

Ben Felix: Right. I mean, the challenge is-

Cameron Passmore: ... and that offsets the liability, the ability to withstand the liability through market cycles.

Ben Felix: That's the key. If you start it with very little capital in good markets and end up with a ton of capital and the market's bad in the future, you're toast, because you got stuck in a bad time period. But if you lever up now and you end up with that good time period now, and a bad time period later, so it's exactly right, it's diversifying across market cycles. That the basis of this.

So, they proposed a maximum leverage of two to one, and that was for practical reasons. Like I think it had to do with margin limits in the US, Reg T in the US limits margin to two to one. So, they just said, "Go with that." There wasn't a ton of analysis behind it, behind that piece. But then they did a ton of analysis to show what the outcomes are like with two-to-one leverage.

And it was a four-phase asset allocation model. And to be honest, the phases in the paper were not super, super clear. At least, when I read through them. The book might be more clear. But they say, "Start with two-to-one leverage." So, lever up two to one now, and then once you have enough in total investments, then you start to deleverage until you get to the point where you have that present value of future wealth number.

And then, from there, you eventually start adding in fixed income to get to your desired overall asset allocation. So, it's like if your lifetime allocation, once you've hit total wealth number, is 80-20, you don't start to tend toward that until you've hit that total-

Cameron Passmore: Until that third dimension is melted away, the time is melted away or enough assets are there.

Ben Felix: I think it's the assets.

Cameron Passmore: Paid-for assets without debt, to where you should be based on your values-based planning we talked about upfront. It's really interesting. We do a cool graphic on that, a 3D graphic, really helps me think about this.

Ben Felix: Yeah, the asset allocation in 3D, you can write a book.

Cameron Passmore: There we go.

Ben Felix: Now, doing this, and they acknowledged this in the paper, and they did stochastic modeling and found this, you may lose everything. There's a reasonable chance, based on market returns or expected market returns, that you lose everything. So, that kind of sucks. But they say that even with that possibility, the minimum return under the strategy with the leverage, so with their four-phase asset allocation, even with losing everything in that instance, you still end up substantially better off than being in a traditional investment strategy.

Now, this is an interesting point. Their estimates in the paper suggested if people had followed this advice historically, they would've retired with portfolios with 21% more wealth on average compared to all stock. So, if you've been 100% equity, this leverage strategy would've left you with 21% more wealth.

Cameron Passmore: Wow.

Ben Felix: But this is even more interesting, when you follow a traditional lifecycle investing strategy, like a Vanguard, we don't have them in Canada, but like a Vanguard target-date portfolio they've got in the US, that start more aggressive and then get more conservative over the course of life, they found that this leverage strategy resulted in 93% more wealth. And those target-date funds have been, even Graham Westmacott here at PWL, he's written papers on why target-date investing is suboptimal. I thought that was stunning, 93% more compared to traditional. Start off more aggressive and gradually get more conservative.

Compared to 100% equity, it wasn't that... Well, 21% is, I guess, meaningful. One of my main takeaways from this, and we're not quite done talking about it yet, but one of my main takeaways from this was that young people, they shouldn't own bonds. These guys are saying even 100% equity is suboptimal, because it's too conservative. Like, okay, if you don't want to use leverage, fine, but if you're young, you shouldn't own bonds. If you're young and need to accumulate wealth.

Cameron Passmore: But you better own equities that are reliable.

Ben Felix: And you better be able to withstand the volatility, but... Man.

Cameron Passmore: There's a lot of ways you could screw this up pretty badly. Bad behavior, bad portfolios, suboptimal diversification, lots of things can go wrong, active trading.

Ben Felix: Yeah. For sure. Yeah, reliability is key. So, anyway, one of the things that I pulled from their paper that I thought was stunning, I guess, they said, "This suggests a simple rule that will lead to better outcomes, whatever savings young people have, they should leverage them up." They said that in the paper.

Cameron Passmore: Well, that's your key point here. So, what's the best way to do that? What do you think is the best way to get leverage for people? I mean, you talked about already, you could do it with effectively go into a more concentrated factor portfolio.

Ben Felix: Yeah. So, you can implicitly-

Cameron Passmore: We covered that.

Ben Felix: ... lever up through concentration. You can use derivatives, you can use long data in the money options, and you can use futures. Using futures, particularly, you can get some pretty loose margin requirements or light margin requirements. I think you can lever up 20 to one or something with index futures. Now, should you do that? I mean, I don't know. It gets more complicated. You've got to keep renewing the contracts, because they usually mature quarterly.

Cameron Passmore: But practically speaking, in easier ways to borrow.

Ben Felix: Totally. And that's one of the other things with futures do, actually, is that you can only get them on major indexes, like TSX 60 or whatever. If you borrow, then you can have that optimally reliable portfolio that you want to have. You have more control over the securities if you use traditional, just like a loan.

Cameron Passmore: So, a line of credit, take a mortgage.

Ben Felix: Yeah. So, you can use a home equity line of credit, you can use a traditional mortgage.

Cameron Passmore: If you have investments, you can convert it to a margin account.

Ben Felix: Use a margin loan. I wouldn't use, and this pertains to the listener question that we had from Paul. I wouldn't use an unsecured line of credit, because the interest rate's generally going to be too high. Generally like-

Cameron Passmore: Depending on your rate prime plus two or more probably.

Ben Felix: Yeah. Margin is a little scary, because obviously you can get margin calls, which can be a pretty ugly downward spiral if you don't have the cash available to fund the account if markets drop. I mean, leverage is no joke. This is one of the things that Wes told me when we were talking about concentration versus leverage, is that leverage sucks. And it doesn't just suck because of the volatility and the behavior and stuff like that, it actually sucks to implement, because you have stuff like margin calls and home equity lines of credit are callable.

Cameron Passmore: And interest rates can go up.

Ben Felix: Right. But this is why there's compensation for taking the additional risk.

Cameron Passmore: What about leverage ETFs?

Ben Felix: Yeah. So, you can get implied leverage through a leveraged ETF. So, instead of borrowing money yourself, there are ETFs that use derivatives, kind of like what we were just talking about with... Well, they probably use swaps, but anyway. So, there are ETFs that give you multiple exposure to an index.

So, you can buy a 2X leveraged ETF, so that you get S&P 500 times two. But one of the keys for these things is that they're daily. So, they aim to give you the daily return of the index, which is fine. But if you're using it as a long-term holding, you start into this issue called time decay that a leverage ETF suffer from. And that's like, if the index does well, and the ETF was two-to-one leveraged on day one. If it does well on day one, on day two, its assets have increased, but its debt has not increased, so therefore it's no longer two-to-one leveraged, which means it's got to lever up more. It's got to buy more stocks on days that stocks do well. And on the flip side, it's got to sell stocks when stocks do poorly. So, that results in this thing called time decay, which has been mathematically, theoretically-

Cameron Passmore: Interesting.

Ben Felix: ... and empirically studied. So, it ends up being related to volatility. If markets are volatile and flat, you'll lose money in leveraged ETFs. If markets are volatile, period, you're going to do worse than the underlying index. So, yes, you can use leveraged ETFs to get leveraged returns, but it's not perfect, because they're designed for daily use, not for long-term holding.

Cameron Passmore: They're typically on broad markets.

Ben Felix: Yeah. So, I looked at building an ETF portfolio of leveraged ETFs and ProShares had EAFE, Emerging Markets and S&P 500. And then Horizons in Canada has S&P/TSX 60, all 2X leveraged. So, I ran just a model portfolio, simulated historical return. And I found for this the same allocation, so the same geographic allocation, over the last 10 years, my leveraged ETF portfolio of 2X leveraged gave me 14.2%.

Cameron Passmore: Compounded?

Ben Felix: Compounded. Well, the index, the underlying index portfolio. And this is just index, not ETF. So, this is before any fees from an ETF. But it delivered 10.35. So, you're not getting the 2X return, which is what you would expect. Now, if you just want higher returns and you're not worried about optimizing risk-adjusted returns, then you can still use leveraged ETFs. But there's a good chance, if markets are volatile, your risk-adjusted returns from leveraged ETF are going to be pretty crummy. Still, probably higher than the index, but on a risk-adjusted basis. They're not so pretty.

Cameron Passmore: So, you're better off getting just to use your own debt. It depends what's easier to access, because this has no margin call.

Ben Felix: There's no margin call and-

Cameron Passmore: It's easy to do, easy to execute.

Ben Felix: And it limits your losses.

Cameron Passmore: True.

Ben Felix: Because if you go and borrow a money, you can end up in a net negative position, owing money to your broker or your bank or whatever.

Cameron Passmore: Portfolio implodes and yeah.

Ben Felix: But you put 100 grand on leveraged ETFs, and they implode to zero-

Cameron Passmore: Never goes sub-zero.

Ben Felix: You're capped to zero. And that's because of the daily rebalancing happening inside the ETFs.

Cameron Passmore: Yeah, true.

Ben Felix: I think if I were to lever up, which maybe I'll do it, I don't know. But I have been thinking about a lot since I've been working on this topic. If I were to do it, I think I would use margin in taxable accounts only. And the reason is, it would allow me to... I use the Dimensional Global Equity Portfolio and I could continue using that. If I decided to go do futures or leveraged ETFs, by definition of the product availability means that I'd have to go switch to large cap only. Now... Yeah, we can keep going on this topic, but we should cut it off.

Cameron Passmore: Right. Bring it in for landing soon.

Ben Felix: I'll just say it real quick. Even with futures, there's an implied cost of leverage built in. So, with futures, you end up paying probably less than what you would pay in a margin account, but on the future's role, there is an effective interest cost built in. So, you're always paying for the leverage, it's just, how are you paying for it are some ways cheaper or some ways more tax-efficient, to some ways limit your losses, like leveraged ETFs, anyway.

So, I think this is a fascinating topic. And again, when I did the video on this, I was surprised at how much listener correspondence I got by email and in the comments, just saying like, "This is interesting. I'm surprised there's academic research supporting the use of leverage. Do you think I should do it?" And of course, I never say yes or no.

Cameron Passmore: So, move on to bad advice of the week.

Ben Felix: Yeah.

Cameron Passmore: So, have you noticed how many times you've heard people talk about 60-40 is dead?

Ben Felix: Yeah. Yeah. It's come up a lot.

Cameron Passmore: It comes up a lot. And we hear lot in our industry and a lot of advisors and firms. The basic punchline that I keep hearing is equities are way overvalued and bonds have very low expected returns. So, you're getting killed on both sides of that 60-40 portfolio, 60 stock, 40 bond. Therefore, we need a new solution. So, we hear that all the time.

So, this came up again. I was reading the December 9th edition of the newsletter called Known Unknowns. This is a newsletter put out by Allison Schrager, and she's going to be a guest coming up in a couple of months. I saw her speak recently. She's a fabulous speaker and a very interesting person. She wrote a book called An Economist Walks into a Brothel, which great book, I just finished that as well over Christmas.

Anyways, so she talked about this in her December 9th newsletter. And she's a fan of building a portfolio of index fund and select the portfolio that's right for you. She doesn't feel that 60-40 is necessarily right for everyone. She's not saying that. But she talked about how she's bothered at how many people are just ditching this 60-40 altogether. And basically, she agrees with what I just said, which is, if the 40% of the portfolio is your risk cushion, your safe part of the portfolio, she talks here about so many people are being recommended to seek out higher-income assets like real estate, dividend stocks, short-term junk bonds for the 40% part.

Ben Felix: I'm shaking my head.

Cameron Passmore: No kidding. And basically she says, no matter how you slice it, these people are telling their clients to take on more risk. That's exactly what's happening. And by ditching your belief in a 60-40 portfolio, you're basically ditching any belief that the market is efficient in pricing expectations and risk. You're basically saying the market doesn't work. Equities are overpriced, bonds are too cheap, I can't make any money. There's something else I'm going to be able to go find, that other people haven't been able to find, that has higher expected returns. And these, in my experience, usually come at a higher cost.

Ben Felix: For sure. Higher fees, probably less tax-efficient.

Cameron Passmore: I think it becomes part of the advisors value proposition, pay us to find the solutions in a world where 60-40 is dead.

Ben Felix: Oh, that's, I mean, explicitly, you talked about this. I think it was in bad advice a few weeks ago, where an advisor had written an article saying exactly that, 60-40 is dead, but I have the solution.

Cameron Passmore: Right. Anyways, there it is. Good newsletter. Totally agree with her.

Ben Felix: We're not going to stop using stocks and bonds in portfolios. I think, Larry Swedroe has done some interesting work on other asset classes, like reinsurance was one. Maybe there are some other risk premiums that exist out there, but they're diversifying risk premiums. That doesn't mean that the equity risk premium is dead.

Cameron Passmore: That's the key. This is in addition to a 60-40, not instead of a 60-40.

Ben Felix: Yeah. You don't ditch stocks.

Cameron Passmore: Anything else?

Ben Felix: No, I think we went on for a while. So-

Cameron Passmore: All right.

Ben Felix: ... we're good.

Cameron Passmore: We had a lot to get out. So, thanks for listening.

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