Are index funds a menace to the market? Are pension funds still a wise way to secure your financial future? In this episode, we discuss index funds, the state-sponsored pension plan in Canada, and much more. First, we unpack the nuances of index funds and take a look at the impact that active and passive investors have on the market. We discuss current index fund trends, when to switch from a passive to an active investor, and the dreaded index fund tipping point. To help us understand pension funds, we also chat with Jordan Tarasoff, a financial planner at PWL Capital, about the recent controversy regarding state pension schemes in Canada, and he provides us with some valuable insights into the government’s upcoming plan. We switch up our usual book review to celebrate Financial Literacy Month and share five recommended books that will help you improve your understanding of finance. We also try something new by giving listeners a condensed overview of a previous episode with one of our favourite guests, Scott Rieckens. Finally, we go through some of the feedback and comments we’ve received from the growing Rational Reminder community about the show and our recent financial goals survey.
Key Points From This Episode:
What to look forward to in next week’s episode. (0:05:08)
Hear about a special promotion to celebrate Financial Literacy Month. (0:05:43)
Introducing today’s topic and what to expect in the episode. (0:05:56)
Worries and biggest critiques of index funds. (0:08:23)
Current trends regarding index funds in relation to the market. (0:09:40)
When investors should switch from passive to active. (0:12:45)
Some good news about the index fund tipping point. (0:15:46)
What investors should be aware of when actively investing. (0:16:32)
How informed and misinformed managers contribute to the index fund tipping point. (0:19:38)
Who the investors and managers are that change to passive investment. (0:20:52)
How switching from active to passive investing affects the value of the market. (0:25:38)
Unpacking the concept of markets being ‘inelastic’ as a result of index funds. (0:28:52)
Whether passive investing undermines price efficiency concerning index funds. (0:30:03)
What would cause the index tipping point to occur. (0:31:40)
A brief background on today’s guest, Jordan Tarasoff. (0:35:00)
Details about the Canada Pension Plan (CPP) and how it works. (0:35:28)
Jordan outlines the benefits of deferring a pension plan claim. (0:36:28)
Recent changes that make deferring your pension plan non-beneficial. (0:38:20)
What age group the recent pension plan changes impact the most. (0:42:14)
Why the Consumer Price Index (CPI) can’t be used to predict wage growth. (0:43:53)
How Jordan is approaching his clients’ pensions regarding the new changes. (0:45:10)
Review of our top five books for increasing financial literacy. (0:48:57)
Our new segment: summarizing a past episode in sixty seconds. (0:56:57)
We ‘talk cents’ about financial values and spending. (0:58:49)
Recent reviews and feedback received about the podcast and goals survey. (1:02:40)
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 225. I'm smiling, if you're watching on YouTube, because Ben just told me a story of Mike. Ben, you got to share this story.
Ben Felix: Okay, so our neighbors down the street had a trampoline outside. It's probably 16 feet. It's the biggest trampoline I've ever seen. It's massive.
Cameron Passmore: People know where this is going.
Ben Felix: They asked if we want it, because their kids have aged out of it and they didn't need it anymore, so they were going to give it away, donate it or whatever. Before they did that, they asked if I would come take it apart, if we wanted it and bring it over to our house. I said, sure. Brought it over. It sat in our garage for a couple of weeks. The kids were asking me about it every day, because they knew we had it. Finally last night, I got around to setting it up. Instead of setting it up outside like the neighbors had had, and like I think most people probably have –
Cameron Passmore: Do you think.
Ben Felix: We set it up in the living room of our house. Now the living room is mostly a gigantic trampoline.
Cameron Passmore: And what did you do at lunch today?
Ben Felix: Yeah. When I went downstairs for lunch today, I spent five or so minutes bouncing on the trampoline.
Cameron Passmore: How high are your ceilings?
Ben Felix: They’re high. Our house is the way it's – yeah, it's good probably 25-foot ceiling in the main part of the house.
Cameron Passmore: There’s a loft up top or something.
Ben Felix: Yeah, it’s a big loft. Yeah, there's the loft on one side, but then the main living area’s just right up the the high ceiling.
Cameron Passmore: I love it. Completely non-traditional at what makes you happy. I think it's fantastic.
Ben Felix: Yup. We currently have a climbing wall, a slide, a swing, and an enormous trampoline in our whatever – It's the equivalent of a living room, but it doesn't quite conform to what a living room would look like.
Cameron Passmore: I got a story for you. You know I was at a conference last week in the States. A bunch of us hopped in Uber to go to a restaurant for dinner. As we pull up at the restaurant and there's this great big blue bus in front of the restaurant. It's like, okay, it's a big blue bus. You look around as you get out of the Uber, there's all these black SUVs. I haven't told you the story, have I?
Ben Felix: No.
Cameron Passmore: These black SUVs, so I’m like, “Okay, something's going on here.” But we didn't really think much about it. Then all of a sudden, we looked to our right getting into the Uber and there is Douglas Emhoff, who is Vice President Kamala Harris's husband was right beside us as we got out of the Uber. That was pretty cool. I've never come anywhere near a political figure like that, certainly not in the US. Lots of people around him, of course, we got pretty close. A couple of people in our group actually got selfies with him, which was cool.
Ben Felix: Did I ever tell you with the time with the time that I had dinner across from Justin Trudeau?
Cameron Passmore: No.
Ben Felix: I never told you about that? It was a couple of years ago when he was Prime Minister, Susan and I went for sushi randomly. I guess, this was pre-COVID. Yeah, it was definitely pre-COVID. We sat down to have some sushi and then these security guard type, Secret Service looking people, I don't know what we call our equivalent in Canada, they come in and sit down. I’m like, “What is it going on? These people don't look like they're coming to sit down for dinner.” Then five minutes later, Trudeau walks in. I was like, “Whoa.” That's my political figure close encounter.
Cameron Passmore: It's funny. I met people at this conference and they said, “It's really strange to talk to you at one times speed.” Which is pretty funny.
Ben Felix: Because they're used to listening to the podcast on 10X or whatever.
Cameron Passmore: Some listen to it at 2X. I don't know. I can't do it.
Ben Felix: That's funny.
Cameron Passmore: Yeah.
Ben Felix: Your setup looks different.
Cameron Passmore: Oh, yeah. Behind me, I'm trying to improve my home office now that I moved upstairs to my son's former bedroom. I get some acoustic paneling up there. Going to fill it all in eventually, but we're getting there.
Ben Felix: It looks great.
Cameron Passmore: Slowly. Yeah.
Ben Felix: It looks like you actually have a podcast, or something.
Cameron Passmore: Which is always a reaction, right? When we talk to people. Often when I talk to advisors that reached out, this is, “Oh, my gosh. It feels like I'm on the podcast.”
Ben Felix: Yeah. Drives me crazy. I want to have a non-podcast office, so that people won’t say that anymore. That's the equivalent now, when I used to see people in person, and they would comment on my height.
Cameron Passmore: Hey, you don't get that anymore. Do you?
Ben Felix: No. Now I just get the podcast studio comment.
Cameron Passmore: That’s interesting. It was always so funny when people meet you. I know you hear this all the time, but do you play basketball?
Ben Felix: Yeah. We passed 4 million audio downloads all time, so since we launched the podcast whenever that was, to now, or yesterday, I guess, we've passed 4 million. What did we passed? Do you remember?
Cameron Passmore: That was one day last week. Maybe last Thursday.
Ben Felix: That's just audio downloads. Then on the Rational Reminder YouTube channel, we’re just about at 1 million total views. I think, probably by the end of November, we'll have passed a million views. Cool.
Next week, our guest is from the perspective of decision making and success and living a good life and all that stuff. I think, he's a really cool person to speak with. It was Commander Chris Hadfield, who's a Canadian astronaut. He's been to space. He's lived on the International Space Station. He's got really nice perspectives on success and living a good life and achieving big goals, but not letting them run your life and not being disappointed if you don't achieve them. Really good perspective.
Cameron Passmore: It was a great interview. Happy we could have him on. This being Financial Literacy Month, the sale is continuing. Spend $30 in the store and get 50% off the Talking Sense cards. You also get a free pair of socks and a cozy and that goes all month of November. Your topic today, I think is super interesting about the tipping point of index funds. That's what you dive into this week.
Ben Felix: I'll talk about this when we go into the topic too. One of the coolest things about that – I don't know where the idea came from exactly. You know what? Someone sent me an email. That's what it was. Someone sent me an email saying, “Can you do a video on inflation and a video on index funds, like breaking the market?” Because I guess, that's – I think people are talking about again. I say, sure. Working on this one. I wrote it. Then realised when I was done writing it that all except for one of the papers that I referenced in the video are papers that we've discussed with the author on Rational Reminder. It's cool.
Cameron Passmore: That's very cool.
Ben Felix: In one of the segments in today's show, we had Jordan Tarasoff, who is a financial planner on our team at PWL. He talks about this funny thing that's happened with Canada Pension Plan, CPP in Canada, the government pension scheme. I won't go into the details, but there's typical financial planning advice that makes sense with respect to Canada Pension Plan. Based on a few factors this year being different from typical, the best practices thinking for that have changed. He gives us some pretty cool insights.
Cameron Passmore: We got a lot going on this week's episode. We're also going to try something new, which we have so many great conversations with so many cool guests over the past four years. I find myself often going back and re-listening to past episodes. I thought as a refresher, what we try to do is a 62nd condensed summary of that interview. I had to take the first crack at it today and see if I can boil down our conversation with Scott Rieckens down to 60 seconds. We'll see how that goes. Bit of experiment.
Then also, for Financial Literacy Month, instead of doing a traditional book review, we're going to give five recommended books that we think will help people improve their financial literacy. These are all easily accessible, affordable, easy reading and enjoyable books. We're going to review five this week, and then we'll do five more in two weeks. With that, Ben, anything else to add to the intro?
Ben Felix: Nope. All good. Let's go to the episode.
Cameron Passmore: All right, welcome to the main part of episode 225. Ben, take it away.
Ben Felix: All right. As we said in the intro, main topic today is the index fund tipping point, which is just the concept that too much money is going into index funds and price discovery is going to stop working and the markets can become inefficient.
Cameron Passmore: This has to be the most popular critique of index funds. Can't prove it, but –
Ben Felix: I made a video on this and we covered on the podcast, too, a while ago, because it was everywhere. Everyone was worrying about it. I don't think that it's – I don't know how you'd measure this. Maybe Google Trends or something. I didn't try doing that. Just from the general buzz that I hear about it, this concern is resurfacing. It has resurfaced in the last few months. I don't think it's as prevalent as it was last time we covered the topic, but I thought it was worth addressing. I've also got a different angle than the last – last time we talked about it, we basically said – we said a few different things, but the big punch line was that even if index funds are a large part of the market, they're responsible for only a tiny amount of the trading. I think that still shows up in the data that we're going to talk about, but we're covering it from a different angle using different research. I think that’s another interesting perspective.
Okay, so I think it's safe to say at this point in time that index funds and index investing more generally are mainstream. I don't think anybody would dispute that, and neither do the data. At year end 2021, and this is a fairly recent report that came out from the Investment Company Institute, more of the US stock market was owned by index funds and actively managed funds for the first time as of year-end 2021. That's a big deal.
Now, that doesn't mean more than half of the US market is owned by index funds, because funds only own about 30% of the US market. We have a chart that we will have showed in the YouTube version of this that shows that. Funds are this tiny little piece in the bottom, and then the remaining assets. There's this massive 70% that's owned by other institutions and stuff like that. Even looking at other institutions, and not looking at just funds, but looking at institutions more generally, and there's a paper from Ralph Koijen that does this, which is what I referenced for this part.
If you look at that bigger institutional pool, assets there have also been shifting toward more passive institutions. Funds, it's a majority at this point that are in index funds. Then also, on the institutional side, there's been a big shift. I don't have as clean of a number, like it's 50%, or whatever. But there's been a significant shift. The active share of institutions has decreased significantly over the last 40 years. We'll talk more about that data in a minute. Now, this is important. It's a valid concern that there is a tipping point. It's not like, “Oh, this is stupid. You shouldn't worry about it.” It's a valid concern. We'll talk about a few different angles on that.
Index investing as a theoretically optimal investment strategy works in an efficient market. Of course, the concern is, if everybody turns passive, then the market can't be efficient. That's the whole Grossman Stiglitz paradox thing that we've talked about before. That's what has some people raising the alarm and being concerned right now.
In an efficient market, the market portfolio, and we've talked about this with Fama, we talked about John Cochran. We've had lots of interesting conversations about the market portfolio, which the market portfolio is theoretically everything, literally all ownable assets. As we talked about with Fama, we can proxy it with stock and bond index funds. Theoretically, at least in CAPM theory, that is the optimal portfolio for all investors. In multifactor asset pricing theory, it's still the optimal portfolio for the average investor.
Now that that, of course, makes investing very easy. In the CAPM world, there’s a single optimal portfolio for everyone. In the ICAPM world with multifactor asset pricing, you can at least say whether you're different from average, or you can just decide that you want to invest like the average investor. In that case, index funds are theoretically optimal. All of that makes investing super easy and low cost, which is I think, some of the reasons why index investing has gained popularity, because they're super easy to own, super easy to invest through. You can buy one, or two, or three maybe ETFs and have the market portfolio, or a proxy for the market portfolio.
Now, that all changes if markets are inefficient. If we had some measurable way to say, okay, the market’s changed now, the market’s no longer efficient. In that case, the market portfolio is no longer theoretically optimal as an investment in the theory, and investors should shift from passive to active. We talked about this with Lubos Pastor. He's got a paper on the size of the active management industry. We talked about this in the older Rational Reminder episode. Pastor and Stamba in that paper, they argued that the active management industry faces decreasing returns to scale. We talked about this with Berk and van Binsbergen, too. The ability of fund managers to outperform a passive benchmark declines as the active management industries size increases. I think that's fairly intuitive.
When there's more money chasing opportunities for alpha, prices are impacted. Those opportunities become elusive. In their model, and this is the same as Berk and van Binsbergen. I don't know if it's the same model, but it's the same effect. Negative alpha for the active management industry as a whole is a sign that too much capital has been allocated to active, not that active managers are unskilled. That's important. The corollary there is that if the active management industry gets too small, that negative alpha turns positive. Again, that's not necessarily a sign that active managers are skilled. It's a sign that they're being under allocated to, and investors should shift to active, to mop up that alpha.
Cameron Passmore: What about the other argument, where if there's too few active managers, or fewer active managers, that the ones that are remaining are the most skilled. Therefore, you have more competition. Tougher competition.
Ben Felix: Oh, I'll get there. It's coming. You're right, that is one of the main points here that I'm going to make in a second. Good observation. Now, the concept though, that there is this equilibrium and that the negative alpha means investors are over-allocated to active management and should index, cool, but also is a potential for alpha to become positive and therefore, investors should switch from index to active. That creates uncertainty for index investors. We talked about this with Lubos Pastor. I asked him outright, like does that mean investors should switch to active? He said, yes. He said, me Lubos, “I index now, but I'm waiting for that point where I should switch to active.”
It's like, man, that sounds exhausting. That's the whole reason that I think a lot of people index is that you don't have to do that thing. How do you know? How do you know when the tipping point has been reached? We got into the weeds on that with Lubos and discussed like, okay, then when do you go back to index? How do you know? It’s a interesting little conversation there. I don't think it's super obvious. Then are we already there? I don't think we are. We'll talk more about that.
Then of course, when do you switch back to passive if you do switch to active? All that, just having the existence of those questions, that indexing isn't necessarily a perpetual optimal strategy, I think that takes some of the shine, or has the potential to take some of the shine off of indexing. Now, the good news that I want to share, at least in my opinion, is that we're nowhere near any concept of an index investing tipping point, if there is a tipping point. I guess, theoretically, there must be. Realistically, whether it would ever be reached, I think it's not super obvious.
I also think that the people talking about this, saying that we are reaching a tipping point, that index funds are going to break the market or whatever, I think they're probably trying to sell you something, in most cases, at least from the views that I've heard. Hopefully, people think that's good news when we say that, but I also want to go through the reasoning. Touching on some of the stuff that you brought up, Cameron, and a few other things, so that people don't just take our word for it. They can understand why this maybe isn't such a concerning thing.
It starts with, of course, a Fama and French paper, Disagreements, Tastes and Asset Prices, which is a great paper that we've talked about many times, including with Ken French, who is very excited that we asked about it. They have this paper that shows that if misinformed and uninformed active investors who will make prices less efficient by trading, switch to market cap indexing, market efficiency actually improves. That's the comment that you made earlier, Cameron. It gets harder to be an active manager, because there's more competition. That's the relative level of competition as opposed to the absolute level is what matters.
If informed active investors, so the ones that are doing a good job, setting prices that the skilled active managers, if they switch to indexing, then in that case, prices do become less efficient. This is the concern, I guess. If everybody, including the skilled managers go to indexing, then there is a concern about ongoing marketing efficiency. As long as there are some remaining informed active investors, even if there are a few, a small few, as long as they're skilled, and they command a lot of wealth, which they would, and we'll talk more about the empirical side of that in a second. As long as there's a few left and they're competing with each other, theoretically, prices remain efficient, and arguably, even more efficient than they were in the case where there were still some unskilled managers.
In that paper, they explained that in equilibrium, investors combine what they deemed to be the tangency portfolio with risk-free borrowing, or lending. It's the CAPM theory, that the market portfolio is the one optimal portfolio. In this paper, they talk a bit about ICAPM too, but just thinking about it from a CAPM perspective gives you a simple model to walk through the logic.
Informed investors in their model choose the true tangency portfolio, which is called portfolio T. While the misinformed investors in aggregate hold a portfolio that they call in the paper, portfolio D. We've got the true tangency portfolio, the truly optimal portfolio that an informed investor would hold, portfolio T and the misinformed portfolio, portfolio D. The evaluated market is the wealth weighted aggregate portfolio, portfolio M they call, which is the combination of both portfolio T and portfolio D. The true tangency portfolio and the missing part form portfolio. Together, of course, they make up the market.
Now in the CAPM, the market portfolio is only the tangency portfolio. They're the same, portfolios T and D are the same portfolio if misinformed investors as a group also hold the market portfolio. They walk out through in the paper, a few instances where that would be true. Of course, also if the misinformed investors just go away, then the market portfolio is the tangency portfolio. The tangency portfolio is the portfolio that theoretically, all investors wants to own. It's the optimal mean variance portfolio which must be the market if prices are efficient. We've covered that in a bunch of previous episodes, if people want a refresher.
It's funny that people listen to our podcast. Back to this topic of the index fund tipping point idea. This idea of informed misinformed investors and portfolio D, the misinformed form portfolio and portfolio T, the tangency portfolio is very important because, as I mentioned, if the misinformed investors are the ones that switch to indexing, the market portfolio actually moves closer to being the true tangency portfolio. You actually want that. You want the bad active managers to leave, and then you have more confidence that the market portfolio is the truly mean variance optimal portfolio. If you've got a bunch of misinformed active managers, there's a pretty good chance the market portfolio is actually sub-optimal.
Cameron Passmore: Isn't that interesting to think about?
Ben Felix: Yeah, I know. I love this part. I find it very interesting, too. I don't know how I would describe the visual, but my brain has a nice picture of how it works. The portfolio is shifting toward like, I don't know, I wish I had an actual visual to describe, but it feels right.
Cameron Passmore: A visual of inside your brain.
Ben Felix: It feels right when I think about it, that the misinformed investors go away and this portfolio, the market portfolio converges with a true tangency portfolio and they overlap and it's all nice and perfect. In that case, index, investors aren't owning the truly optimal portfolio. Now, this clearly makes it important to ask that question of who is turning passive. We know all these dollars are shifting from active to passive. We know that's happening at the fund level and at the institutional level, but who's turning passive? Because if it's the misinformed, then great, that's good news. If it's the informed, that's bad news, and we should maybe be looking toward allocating to some skilled managers.
Okay. I guess, another piece of that is what you said earlier and then what I also alluded to is it could be two remaining active managers competing with each other, if they had a huge amount of wealth they were in control of and were very skilled. That could be it. If it's just those two active managers, then other than that, the capacity of index investing is huge, infinite. I don't know. As long as those two active managers have enough. I guess, we don't know exactly what enough is in that case.
Anyway, on the fun side, there is research from Berk and van Binsbergen that we did speak with them about, asking that question of where does the capital flow in the active management industry? They've got their 2015 paper, Measuring Skill in the Mutual Fund Industry. They find empirically that there is evidence of persistently skilled mutual fund managers and that fund investors are proficient at rewarding skilled managers with flows into their funds. In their sample, based on their measure of skill, they find that most active funds destroy value. But most of the capital is controlled by skilled managers who are adding value to their funds.
Now, if you listen to that episode, or our discussion afterwards, you'll remember that that doesn't mean that investors are getting positive net alphas, because that's not how they measure skill. They measure skill with value added, which is gross alpha times the size of the fund. Anyway, so different measure of scale that's not necessarily relevant to the end investor, because you can't go and benefit from that. You just get the risk adjusted returns of the fund in equilibrium, but it is a way to measure skill. From that measure, they find that capital flows to the skilled managers.
There’s other data. I don't think it was in their paper, but just data on persistence, or survivorship, I guess, in funds; funds that don't perform well and don't gather assets, they tend to be the ones that they close. Anyway, I think based on their stuff, it's reasonable to say that at least in the mutual fund world, it is the unskilled managers that are leaving, or the assets are flowing away from. On the institutional aside more broadly speaking, and this does include mutual funds, but also a whole bunch of other assets.
Koijen, Richmond and Yogo have a paper, Which Investors Matter for Equity Valuations and Expected Returns. They find in their sample of institutional investors that overall active share, which is how different institutions are from the market portfolio, has declined over the last 40 years. That decline was mostly due to capital moving from more active institutions to more passive ones. Now that so far doesn't tell us anything about whether it's the skilled, or the unskilled active institutions the capital is leaving. Their sample does have mutual funds, but also investment advisors, hedge funds, pension funds, life insurance, companies, private banking and brokers. It's a pretty broad sample. They find that the aggregate active share dropped from 45% in the 1980s, to a little over 25% at the end of their sample in 2019. A big drop in active share.
Again, it's not perfectly comparable to 50% of the market, of the fund market as an index funds, but whatever. At least we have a measure to compare. Big drop in active share over that time period. Now, they find that the capital going passive, this is the important part, the capital going passive was leaving both informed and uninformed active institutions roughly equally. They don't find any change in price efficiency using their measure over their sample period.
Now to test how the shift toward passive may have affected asset prices, because this is another part of that whole index investing is bad narrative, they model the counterfactual, and this is if anybody remembers our episode with Ralph Koijen, they use their demand system asset pricing approach. That's hard to think about. Going back though, to look at this topic again and prepare this discussion, going back to that episode with Ralph and reading the transcript, it was like, “Oh, this makes a lot more sense now, the second time reading it after a few months taking a break.” If anyone wants to go back to the Koijen transcript, it was easier to grasp the second time around.
Okay, so to test how the shift may have affected asset prices. They model the counterfactual where the shift never happened. That's maybe hard to think about, but I'll just keep going and hopefully, it makes sense. They find that the move from active to passive has resulted in a substantial change in valuations, especially among smaller firms. That means that particularly small firms, which are previously held by active institutions, and if you think about it, active managers, basically by definition, to be different from the market, active managers on average are going to overweight small caps relative to the market. They find that those small firms which were previously held by active institutions saw their valuations fall as capital shifted from more active institutions to more passive ones. Valuations decline.
Now, will they see the valuation effect, they also find that the informativeness of prices is affected very little. Small companies mostly see their valuations affected as funds flow from active to passive, but the informational content of prices, they don't find to be affected in any meaningful way. Now, one thing that I think is important is, and we alluded to this with Ralph in the episode with him, is that this is basically the opposite of the index fund bubble narrative, which suggests that the largest stocks in the index are getting their prices pushed up, relative to fundamental values.
What actually seems to be happening based on the Koijen paper, is that the assets that were previously held above market weights by active managers, which will tend to be smaller companies are falling in price as capital flows away from them, but the informational content is not being distorted. As opposed to price distortion, there's a change in valuations, but the informational content of prices is not really affected. I mean, when you think about it, when a dollar is added to a market cap weighted Vanguard fund, the flow into the fund proportionally affects all stocks in the market. Proportionally, because it's being allocated proportionally.
There's no cross-sectional impact when funds flow into a total market fund. If somebody switches to indexing, the securities that were overweight, or underweight in the active fund, their valuations will be affected.
Cameron Passmore: That makes sense.
Ben Felix: Right.
Cameron Passmore: That migration from a non-total market portfolio to a total market portfolio.
Ben Felix: Right. That's where the cross-sectional impact happens on prices, from the money leaving active going into passive, not from the money. The effect isn't on the side of the largest holdings in an index fund having their prices pushed up, because the cross-sectional impact is roughly zero as funds flow into an index fund, because the flow is proportional, because the portfolio is proportional. They also find in their paper that the most impactful groups of investors per dollar of assets are hedge funds and small active investment advisors, and a huge passive from Vanguard. They look at this in the paper, is not at all influential in the cross-section of prices, because they’re mostly on the market. On their paper, I think they're looking at all of Vanguard, not just the indexing business. But even still, the active share of Vanguard is extremely low.
Cameron Passmore: Isn't that fascinating for some company as huge as that?
Ben Felix: Yeah. I mean, they’re largely index. I don't know. I haven't looked too closely at their active funds. I don't know if they're super high conviction small cap value active, I don't know. Either way, in aggregate, the active share of Vanguard is not super high in the Koijen paper. Okay, now the other thing we got from Koijen was the inelasticity stuff, markets being inelastic. Funds going index potentially, and this is another thing that I've seen on this index investing is bad stuff is that this is the problem, that markets are becoming inelastic, and that's somehow bad for investors.
In an elastic market, it’s not necessarily less efficient. We talked to Ralph about that, too. The other thing is that it's not clear that the growth of index funds has made markets more inelastic. To say that, we would need to know in aggregate where the assets that went passive came from. If it came from individual households who were previously buying and holding individual stocks forever, never selling, going into index funds, which are periodically reconstituted would actually make markets more elastic, in that case. Anyway, so based on the Koijen, Richmond and Yogo stuff, the shift toward passive seems to have affected valuations particularly amongst smaller firms downward, but it's not affected the efficiency of market pricing. Maybe it affects market inelasticity, or elasticity. But even that, we don't know for sure.
Then the last one that I want to touch on is Coles, Heath and Ringgenberg, they find in their paper on index investing, that passive investing does not undermine price efficiency. They use a Grossman Stiglitz framework. They predict that the rise in indexing will have no effect on price efficiency. Their intuition for that prediction is that in equilibrium, a decrease in the cost of index investing leads to more index investors and less active investors. Because investors will always choose to gather information when it's profitable to do so, the proportion of investors willing to pay an additional cost to uncover new information adjusts, such that the returns to active remain unchanged, even as indexing increases.
In that model, price efficiency remains unchanged. To test their predictions, they examine the effect of index investing on information, production and price efficiency using variation in Russell Index Membership as an exogenous shock to stock ownership. Pretty interesting way to approach it. They find that shocked a mix of passive and active investors cause big changes in trading behaviour and information production, but the shocks do not alter the information content of prices. This ultimately suggests that index investing does have effects on investment and information production, but as the theory would predict, in the Grossman Stiglitz framework, the fraction and effort of informed investors adjusts, so that the relation between price and fundamental value is unchanged, which is in-line with the Koijen stuff that we just talked about, I think. No effect, ultimately, on price efficiency.
To finish on this topic, the tipping point for indexing depends on the level of competition, like you said earlier, Cameron. Among the remaining active investors, if uninformed active investors turned passive, the market gets less efficient, and investors should switch to active, like the Lubos Pastor paper that we talked about at the beginning. On the other hand, if it's the misinformed active managers that are turning passive, the market actually gets more efficient, and investors should index and be happy that the market portfolio is converging on the tangency portfolio. Some evidence suggests that capital flows to informed managers on the mutual fund side from Berk and van Binsbergen.
The Koijen evidence suggests that on the institutional side in aggregate, it's both informed and uninformed that are giving up capital to passive. In either case, and in-line with the Grossman Stiglitz paradox thinking, as assets shift into indexing, the remaining active managers choose to gather information when it's profitable to do so, and the proportion of investors willing to pay an additional cost uncovered new information adjusts, such that the returns to active investors remain unchanged, even as index investing increases, which again, leaves price efficiency, and the effectiveness of index investing strategy unchanged.
We’re going to do a video on my YouTube channel as well, hopefully, in the next couple of weeks. We're going to do something cool, I think, with that to pair with that, where we're going to make a companion video on the Rational Reminder channel. There'd be a video on my channel doing this topic, like normal. Then on the Rational Reminder channel, we're going to take the clips of all of the papers that we referenced just now in that video, because again, we have these perfect outtake clips of each of these people describing the findings of their paper that are relevant to what we just talked about. We're going to make this companion compilation of those clips. I think, it’d be cool.
Once you have the CSI video on one hand, that you can watch for all the information. Then on the other hand, you have a Rational Reminder – it'll probably be a 10, or 12-minute compilation of all of the academics referenced in that video describing their relevant findings.
Cameron Passmore: It's really cool, because I've been working on the year-end show lately. There's so much good content, that if we start to pull these pieces that explain, as you dig into a certain topic, it's a great idea, clearly.
Ben Felix: It’s happening more and more though. When I go and try to write something on a topic or whatever, I realised I can go and listen to this person. Instead of reading their paper and suffering through all the formulas and stuff, I can go and listen to them describe their findings. It’s like the Koijen one. I go back to his paper, the one that I talked about for this, and it's pretty dense, it's pretty hard to read, but then you go and read the transcript of him describing the paper, and then you flip back to that paper and it all just makes a lot more sense.
Cameron Passmore: Great content. All right, so let's go to our conversation now with our colleague, Jordan Tarasoff, and talk about the Canada Pension Plan and the decision-making that’s coming up.
All right, so this week, we need to cover off a financial planning topic that applies to Canadians who are considering starting their Canada Pension Plan benefit. There's a really unique situation now where traditional advice may not be the best advice. While this is a very Canadian specific topic, some that likely generalises to other state pension plans. To dig into this further, welcome back to the Rational Reminder, our colleague, Jordan Tarasoff. Jordan, great to see you.
Jordan Tarasoff: Hey. Nice to be here.
Cameron Passmore: Jordan is a certified financial planner, and an associate portfolio manager and recently, congratulations, Jordan, you were awarded the Designation of Chartered Financial Analyst.
Jordan Tarasoff: Yeah. Thank you. It's a tough couple of years, but I'm glad to have it behind me.
Cameron Passmore: Excellent. Very briefly, what is the Canada Pension Plan?
Jordan Tarasoff: Canada Pension Plan, it's usually called CPP. Today, while I'm talking through this, I’m going to have CPP and CPI, going back and forth. I'll try to keep them straight. It's a contributory earnings-based social program. What that means is that while you're working between the ages of 18 and 65, if you have a salary, you need to put money into CPP. If you are self-employed, you need to put in both halves of the contribution. If you're working for an employer, they put in half, you put in half. The purpose of this program is to replace a portion of your income when you're retired.
The benefit is indexed, so it goes up each year while you're collecting, and it's taxable as income. While you're putting money towards it, it's actually deducted off your income. When you start taking the money out, it gets added to your income, just like a withdrawal from a RSP, or a non-social pension plan would be.
Ben Felix: Okay, now people don't always take the benefit. As soon as they can, what are the benefits of deferring, or taking it later than when it's possible to take it?
Jordan Tarasoff: Yeah, so there's an option when you actually start taking it. The normal age is defined as age 65. You can actually take it sooner. You can take it at age 60, but they reduce the benefit you receive by 0.6% per month that you take it earlier. If you take it later, you can actually defer it all the way out to age 70. You get 0.7% per month for deferring. If you defer the full five years to age 70, you get 42% more for deferring that time, but you give up that five years of collecting.
Rather than having money coming in into your pocket, you can invest it, spend it, do whatever, you're waiting five years. Most of the time, that's the only benefits that's talked about. It isn't just the point 7% that needs to be included in the decision. There's also a little bit of a difference on how it's indexed before and after you start collecting it. When you're collecting Canada Pension Plan, it's indexed to CPI, so the Consumer Price Index, which is supposed to be a proxy for how much things retirees are buying actually costs.
While you're contributing, and before you start collecting it, it’s indexed to wage growth. How much are wages increasing? They're not necessarily the same thing. Historically, wage growth has been about 1% higher than a CPI. There's an article that just came out in the global mail by Fred Vettese, that's titled, Thanks to a Rare Event, Deferring CPP Until Age 70 May No Longer Be the Best Option. In that article, he shows that because wage growth is typically higher than the cost of goods getting more expensive over time, he has a great example of someone who retired in 2009, but chose to start collecting in 2014. They didn't get 42% more. They actually got 54.9% more. The standard advice with financial planners is if you don't need the money, defer it, because you get that big 42-plus percent bonus, but this year is a little bit different.
Cameron Passmore: Dive into that. What's going on this year to make the decision a bit different?
Jordan Tarasoff: This last year, everyone's seen it, that things are getting a lot more expensive, typically faster than wages are growing up. The increase in Canada Pension Plan is based on October's year-over-year CPI numbers. We don't quite have October numbers out yet. If we look at September's numbers, it’s expected to be around 6.9%. Whereas wage growth, if YMP, the years maximum pensionable earnings is what we expect, will only be 3.5.
What that means is if you start collecting before 2023, you get close to 7% of indexing. If you defer into the next year, you do get that 0.7% bonus each month, but it's only going to be indexed the total benefit at 3.5%. You almost double the indexing by collecting earlier rather than later.
Cameron Passmore: You're jumping your pension ahead notionally?
Jordan Tarasoff: Yeah, sort of. You get a higher benefit amount. It's like, you get an extra, about five months of deferral, even though you'll actually have to defer the five months. You can start collecting it. We look back and we compared wage growth versus inflation CPI increase. Wage growth is usually higher. You'd always expect it to be higher, but you can't use the increase in CPI to predict wage growth. Just because it's high this year, things are getting more expensive, doesn't necessarily mean that next year, wage growth is going to increase. Makes a big difference.
We looked at the comparison. Once you factor in the fact there's two different indexing numbers, if you were to defer to the end of December 2023, you would expect to get an 8.4% bigger benefit, but it's actually 5% once you factor in the spread between the two different indexing rates. With the old numbers, if it's same, it'll take you about 13 years data crossover point where the amount you've received at the higher benefit equals a higher amount than the amount you would have gotten had you collected a year earlier. The crossover point is about 13 years for you to be better off deferring CPP.
Ben Felix: Oh, this is important. If you start collecting later to get the deferral bonus, so you get a higher benefit amount, but you forego some years of collecting, because you're deferring, for that to be a creative, for it to be net beneficial to you, you have to live and collect for at least 13 years under normal circumstances.
Jordan Tarasoff: Yeah. That's assuming no rate of return. Just straight dollars in. How much have I received? Total it up. It's about 13 years for that crossover point to happen. Once you change that to 5%, the bonus, that can stretch up to 21 years. Rather than the crossover point being in your mid-80s, it's in your early 90s for you to be better off.
Ben Felix: Oh, because you're deferring until 70, and then you have to collect for 20 years, 21 years for the breakeven to happen.
Jordan Tarasoff: Yeah. Your benefit is not 8.4% higher. It's only 5% higher, because you got the different indexing amounts. This is all just assuming that it's just dollars and dollars out. If we assume that you're pulling money from an RSP, so our registered plan to fund the difference while you're not collecting CPP, then if you don't take that money out, because you're collecting a benefit, you can assume a rate of return on the funds. We did an analysis with a 3% real return on the CPP benefit. It jumps from – so it started at 13 years under the normal numbers, It was 21 years with the new only 5% spread. If you add in a 3% rate of return, it jumps out to 33 years. In order for you to be better off deferring for a full year, you would have to live to be a 102 under these assumptions.
Cameron Passmore: Wow.
Jordan Tarasoff: Yeah. Even once you get past one or two, they don't really diverge very quickly. I looked out 50 years, and you're only about 3% better off after 50 years. I don't have to be one of the longest people around, it's not likely that you'll be better off this way. We've talked before too about the benefit of having more money when you're younger, healthier to do more things.
Ben Felix: Right. What age group, I guess, is most affected by this thinking?
Cameron Passmore: This is biggest for people who are 69 now, turning 70 in 2023. Because anyone who's 67, 68, they have multiple years to contend with. The wage growth and CPI might switch around in future years. This is actually really a big deal for people who turned 70 before May, because they don't get the benefit of a full year of deferral. They only get a couple of months. If you turn 70 in March say, you're only getting a couple of months, you have that 0.7. But you would have gotten about 3.5% more on the indexing had you just started collecting, plus you get the three months of actually getting paid out.
Anyone who's turning 70 before May, you basically get more the same benefit, if not more, plus that whole start of the year, you get paid out. For people who are in their age 67, 68, that age, it's important remember that for wage growth, they're not just taking last year's wage growth, they're taking a five-year average of the last five years. Even if wage growth is really high this next year, so things get more expensive 2022, 2023, all the wages catch up, the index is still going to be anchored down by the last four years.
I looked at this and wage growth would have to be 9.4% higher than CPI next year, in order for the math to go back to the way it was before. For someone who's 68 is still not really clear they should keep deferring. The high spread I ever saw was 5.3 between wage growth and CPI, and that was only for a single year.
Ben Felix: Interesting. We'd have to see a huge spread. Can you talk more about that – you said, there's not a relationship between CPI and future wage growth. Can you talk more about that?
Jordan Tarasoff: Yeah. We did a regression where we tried to use CPI to predict future wage growth and see if there's a relationship there. There's basically nothing. There's no correlation between the two. It is statistically significant that wage growth is about 1% higher than CPI. If you're going to guess what the spread would be in the future, you would guess 1%. There's no reason to assume that because CPI is high now that wage growth would be high in the future, or vice versa. Because of that five-year average calculation, we know for a fact it's going to be dragged down by the last four years, regardless of what it happens to be next year.
Ben Felix: Yeah, that's super interesting. You can't look at currently high CPI and assume that that big wage growth that you would need for the breakeven to go back to what it was is going to happen.
Jordan Tarasoff: Exactly. Someone who's 67 can't say, “Oh, well. I'm going to make it up with higher wage growth in the future.” You would expect wage growth to be higher, but you wouldn't expect it to be higher because CPI was higher. It's just going to be whatever it is over the next couple of years.
Ben Felix: Like you'd expect a positive spread over CPI on average, but we have no idea what it's actually going to be.
Jordan Tarasoff: Even if it's a little bit positive next year, it doesn't matter that much, because this last year, there was such a big spread the other way.
Ben Felix: Right. Yeah, that's very interesting.
Cameron Passmore: How are we addressing this with clients?
Jordan Tarasoff: Yeah. We're doing a full audit of everyone who could be collecting CPP right now, but is choosing not to. That's people between the ages of 65 to 70. We're looking through to see if it makes sense for them to start collecting, because it's not exactly cut and dry if you're 69, you should start collecting. We need to factor in things like, if someone's still working, and they're 69, they might be dropping off really low-income years from their calculation in the past. Even though they're getting a smaller deferral benefit, they’re making a contribution, which will knock off at zero in the past for calculating their benefit.
Ben Felix: You got to explain what that means.
Jordan Tarasoff: Okay, for sure.
Cameron Passmore: Nothing is cut and dry with CPP. That's one thing we've learned.
Jordan Tarasoff: Yeah, it's tough. Yeah. I guess, I can dive into how CPP is calculated. It’s based on your average earnings over a 40-year period, from the time that you're 18 to 65, they take all your earnings over that time, they drop out the lowest 17%. They drop out years where you're disabled and years where you have kids under the age of seven. If you have, say, 20 good years and 10 bad years, and you're still working, you're still contributing CPP, there's a chance that you might be putting money in at a high rate and knocking off one of the bad years, which would increase the amount you collect, because your average is higher over the years that are keeping in the calculation. Yeah, it's not super clear how you figure these things out.
What we have to do is look at the client's situation and see, could they start collecting right now? What's their benefit if they defer? What's their benefit if they collect? Then we'll get their statement of contributions and see, are we knocking off low-income years? Then beyond that, actually, we can look at and see, does it make sense for them start collecting and still contributing? Because in Canada, you can do something called occurring post-retirement benefits, where you both collect and get bigger benefits in the future. Plus, when you look at their tax situation, too. Because if they're working contributing to CPP, they could collect, but what if they're in the highest tax bracket? Does it make sense to get a higher benefit now, but half goes to taxes, versus deferring into the future at a lower tax rate? For people who are doing it themselves and are 69, it's worth taking a look. For us, we have to go through and do a comparison of all these different variables for people.
Ben Felix: Yeah, that's wild. Somebody could, if they're earning the yearly maximum pensionable earnings now, that could give them a max contribution year, which knocks off, say they have a low contribution year, or zero contribution year in the past, and that could increase their benefit more than all the other stuff that we're talking about.
Jordan Tarasoff: Exactly. Yeah. Losing a year, losing a bad year and adding a good year could make up for that spread of CPI being much higher than wage growth this year. It depends on the person, too. If they had disability, if they have kids under the age of seven, they have multiple kids under the age of seven, it all depends on each person's statement of contributions.
Cameron Passmore: It's incredibly complicated.
Jordan Tarasoff: Yeah, it's super interesting. Super fun to dig into. Yeah, it's pretty complicated.
Ben Felix: Yeah, that was crazy, though, because it's like, there's this really cool planning thing. Oh, but it's not that easy. We can't just say everyone that's of a certain age should be taking the benefit, or deferring, or not deferring, or whatever it is. You have to take all that other stuff into account.
Jordan Tarasoff: The traditional advice, where we ignore that other stuff, they're already retired, they're not working, they’re choosing to defer purely for that 0.7% per month. In that situation, it makes sense to start collecting it sooner. A lot of clients I've brought this up with have said, well, what does this mean for old age security, which is another benefit in Canada. For old age security, that's just based on CPI. Just the change in prices while you're collecting and while you're deferring. This wouldn't change the math around that at all. It's just Canada Pension Plan, because that's based on your employment income, and wages while you're working and then the cost of goods once you start collecting.
Ben Felix: Super interesting. That was awesome.
Cameron Passmore: Indeed. Jordan, thanks.
Jordan Tarasoff: Yeah, thanks. Thanks for having me.
Ben Felix: All right, so instead of a book review, like we would often do, because it's Financial Literacy Month, where we're actually going to do five book reviews, shorter than usual book reviews of books that we think are important, or useful to financial literacy.
Cameron Passmore: All right, so let's jump in. Number one, a book by our two-time guest Andrew Hallam, who joined us back in episode 99 and 186. The book is called Balance: How to Invest and Spend for Happiness, Health and Wealth. This is actually Andrew’s third book. He sees success through four different lenses. Number one, having enough money. Number two, maintaining strong relationships. Number three, maximising physical and mental health and number four, living with a sense of purpose. Obviously, four very important topics. Very enjoyable book. Very easy to read.
Andrew weaves in a collection of stories, along with research. Plus, I think some great tips to help you with decision-making that will affect your happiness. He also talks a bit about how to decide whether or not you should work with an advisor and also, the portfolio that makes sense for you. Ben, you actually contributed to this book in the, I don’t know if you call it credits or not, but you're in the front part of the book.
Ben Felix: Yeah. What's that? The blurb. I wrote a blurb for a blurb for him.
Cameron Passmore: A blurb. You wrote, “Low-cost index funds may be the smartest investment for most people, but they won't tell you how to live a good life. This book will.”
Ben Felix: I was pretty happy with that.
Cameron Passmore: I think that's a pretty good bit of support for Andrew’s book. Number two, and this is a book I came across in doing research for this. The book is called If You Can: How Millennials Can Get Rich Slowly. This is by Dr. William Bernstein, who is a financial theorist and also a neurologist. Arguably, one of the greatest financial writers of our time and has other very popular books, such as The Four Pillars of Investing, The Intelligent Asset Allocator, and The Investor's Manifesto, which are all excellent.
The book, If You Can, was released in 2014. Is 48 pages long and is available for free as a PDF on his website, theefficientfrontier.com. The book starts, “Would you believe me if I told you there's an investment strategy that a seven-year-old could understand, will take you 15 minutes of work per year, outperform 90% of finance professionals in the long run and make you a millionaire over time?” That's pretty good, too. Pretty catchy.
Anyways, his site describes the investment savings solutions for millennials is simply to put away 15% of their salaries and low-cost target, date funds or a three-fund index portfolio for 30 to 40 years. Obviously, it sounds easy, but it's no small feat. He then outlines the five big hurdles we'll need to overcome. Spending too much, having an adequate understanding of what finance is, understanding some financial history. Of course, the biggest enemy, yourself, and the monster enemy, as he puts it is the industry.
48 pages. It's more like a booklet as he calls it, to help people go in the right direction. I truly think this is a gift from William. There's no reason that everyone can't go and just grab it, read it. It's an easy read. Great little piece.
Ben Felix: He was a podcast guest a while ago.
Cameron Passmore: He sure was. I don't know that number down here, but he certainly was a great guest. Number three, book by our good friend, Bill Schultheis, called The Coffee House Investor’s Ground Rules. Bill is a financial advisor in Seattle. As I mentioned in the podcast when he was on in episode 159, I talked about the influence that Bill's first book and his blog writings had influence me back as I transitioned from commission to index funds and fee-based back in the mid to late 90s.
This book is a 153-page guide to a life of wealth and happiness. It covers what he calls all the ground rules for success, like saving enough, investing wisely and having a plan. Very straightforward. Very pleasant read. Accessible by everyone. I highly recommend it.
Number four, no surprise to anybody. It's Morgan Housel’s book, The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness. Morgan was our guest back in episode 128 and was also a special guest for the Reading Challenge in episode 191. He writes a phenomenal blog pretty regularly at The Collaborative Fund. The Psychology of Money, this book is an absolute must read for everyone. It’s one of those books where I think it's worth rereading annually.
Morgan's got incredible gift to weave stories to make interesting points and he gets these stories. We talked about this with him about his interview with Tim Ferriss, how he gets these stories from just random readings and walking. He does a lot of walking as you think. One of the stories was how to illustrate luck and how luck can have a huge impact on your outcome in life. Example he gives is Bill Gates was lucky enough to have gone to a school that had computers way back when. A friend of his and Paul Allen, the three of them in high school were setting out to become computer entrepreneurs. We know how the story goes. But unfortunately, their third friend was killed in a very fluke accident in the mountains.
This shows that he was lucky enough to get exposed to computers. His friend was unlucky enough to have this one in a million-type freak accident, so luck will have a huge impact. Another line I always remember from that book is save like a pessimist, invest like an optimist. Anyways, Morgan doesn't need us to promote his book. He's had wild success with this. The accolades for it are endless. There's many excellent podcast interviews with Morgan. Check that one out if you haven't already. The last book is from Larry Swedroe. I mean, we could have picked one of many from Larry.
Ben Felix: This is a good one, though. These are all good books on this list. I'm just flipping through them. If someone were to read one of them, and we had been not yet exposed to anything, to anything about index investing, or – It's tough, because a lot of the ones that you just went through have a lot on happiness. Hallam’s got a big slug of happiness. The Bernstein one, I haven't read that one, but it looks like it's more focused on the investment stuff.
Anyway, this Larry book is like, to convert someone to this way of thinking about investing and financial planning –
Cameron Passmore: That’s a good point.
Ben Felix: - is very powerful.
Cameron Passmore: I dropped Larry a note last week and said, “What books should we focus on?” He said, “Yeah, you could mention that one.” He also suggested Investment Mistakes Even Smart People Make and also, The Incredible Shrinking Alpha.
Ben Felix: The Incredible Shrinking Alpha was a very good book, too. But, think I can invest like Warren Buffett is just so accessible.
Cameron Passmore: That's what I was trying to think of when choosing these books. Accessible, easy read, broad, good starting point.
Ben Felix: Like I said, if someone has – if they're at a bank, investing in actively managed funds, or whatever, this book is like, read this. Just please read this. It can be transformational.
Cameron Passmore: The title is a bit misleading. It's not teaching you really how to invest like Warren Buffett. It’s more piggybacking on Warren Buffett saying, people should invest in the S&P 500 index.
Ben Felix: Yeah. It takes a bunch of stuff, a bunch of famous Buffett quotes and says, how that applies to investing and how – Yeah, anyway.
Cameron Passmore: There you go. There's five books for today. We'll do five more in a couple of weeks.
Ben Felix: Is that one still, you can buy that book?
Cameron Passmore: Yup.
Ben Felix: Because that was a while ago that it came out.
Cameron Passmore: Yup. Still available.
Ben Felix: Yeah. It's a good book. It's tough to pick one of these. But to give to someone as a stocking stuff or whatever. It's tough to beat that one.
Cameron Passmore: Yeah. I love them all. Love them all. Okay, so ready to see if I can summarise one episode in 60 seconds?
Ben Felix: I am ready.
Cameron Passmore: Okay. This is an experiment, so we'll see how this goes. I don't know if Angelica, or the team are going to put in an alarm clock or something, but we'll see. My choice this week was from Episode 95 with Scott Rieckens. We both considered it, Ben at the time, a must listen episode. It's an amazing story of change and transformation. It's about how, after accidentally, accidentally discovering the FIRE movement, Scott and his wife were inspired to discover their money values. That's the key. They did and, wow, unreal what they did.
They realised, they're working hard to pay for things they did not values, so they changed their lives a lot. They sold their luxury cars and their house in Southern California. Moved to Oregon, and they aligned their lives with their values. This change comes to life in a phenomenal documentary they made called Playing with FIRE. They're happier now. They have a better relationship. They're less stressed. Their financial decision making is much more purposeful and in-line with their values. I asked everyone out there, have you shared your money values with your loved ones? Is your spending in-line with your values? Scott and his wife, Taylor's journey is a great example of the power of thinking about and sharing your money values.
Ben Felix: Seemed like a pretty good 60-second summary. I guess, what's not captured in there is that that episode helped us understand the FIRE movement, because we used to be critical of it, I guess, in the early days of our podcast, and lots of people whined about that. I shouldn't have said that, but I said it anyway. People used to whine about it a lot. Ben and Cameron don't understand the FIRE movement. To be fair, we didn't. This helped us understand it.
Cameron Passmore: Money values.
Ben Felix: Yeah. Aligning your life with your spending with your values.
Cameron Passmore: All right, so this is a perfect segue, Ben, to we're going to do a couple of Talking Sense cards. I'll go first, because I know in the past, I would ask you to go first. Here's the question. How do you feel when you spend money? This links directly back to Episode 95 with Scott. This has shifted for me. I used to enjoy buying stuff a lot more than I do now. I know what I enjoy doing. So much of what I enjoy doing doesn't cost a whole lot of money. I do enjoy spending things that I – on things that are experiences, that I have no regret about whatsoever. Stuff just doesn't do it for me anymore.
It's been interesting, because we're doing work to prepare for an upcoming interview to talk about financial relativism. This is where you compare spending, or incomes, or stuff to what other people have. If you have more than others, that can make you feel happier short-term. Doesn't last though. I just don't think of it that way at all anymore. I don't think I'm not aware of doing comparisons like that anymore, which has been an interesting change for me.
Ben Felix: Yeah. I don't like spending money. Never feels good. Never.
Cameron Passmore: Some things, it doesn't?
Ben Felix: No. I mean, stuff that I use a lot, that I can recognise that it is nice to have it. But at the time of spending the money to get it, never feels good.
Cameron Passmore: That’s interesting. You're more about it feels bad to spend. I just don't get the pleasure out of spending. I don't feel bad, I just don't do it.
Ben Felix: I had minimised it as much as possible. I mean, that's one of the toughest things about buying a house is all of the expenses that have come with that.
Cameron Passmore: Out of your control.
Ben Felix: Yeah. Yeah. Well, a lot of it was stuff that we knew we would have to do when we bought the house, but still hurts to actually spend the money.
Cameron Passmore: You have to look at your discussion on the trampoline. You could have decked out your living room with $50,000 worth of beautiful furniture, right? If you're in the relativism, perhaps. That just, I don't think would give you guys a whole lot of pleasure.
Ben Felix: No. It would give us stress, because our kids would destroy it. Yeah, I'm sure not entertaining any – if somebody values nice things and being fancy, I wouldn't invite them to my house.
Cameron Passmore: Your trampoline reflects your values.
Ben Felix: Yeah, I guess.
Cameron Passmore: All right. Here's the next one.
Ben Felix: It’s free, too. Didn't have to spend a penny on that.
Cameron Passmore: You can go over this next one. What does the phrase “good with money” mean? Can someone become good with money?
Ben Felix: Well, maybe it means aligning your objective financial situation with your values, like we were just talking about. I think that's probably a good definition of being good with money, but there's probably other stuff, like not having high interest debt. Following money steps that are good. I guess, that it still comes back to – if someone really values consumption, then maybe having a high interest debt is actually a good thing for that person. Maybe being good with money is different for every person, depending on what their values are, which I think comes back to my original answer.
Can someone learn to be good with money? Yeah, I think so. I think we see that transformation happening with people who listen to our podcast and tell us, like we talked about in our last episode, all the people who say that listening to us talk to each other and talk to other people has changed their lives for sure. I think, if you get information and change habits based on information, then you can become good with anything, not just money.
Cameron Passmore: Absolutely, you can become good with money. No doubt about it. I mean, Scott and Taylor did, right? We have endless examples.
Ben Felix: Yeah. They aligned their financial situation with their values. There's lots of people who might look at Scott and Taylor’s life and say, “Oh, it looks terrible. I don't want that. I like my fancy car.” That doesn't make them bad with money.
Cameron Passmore: No. All right. That's great. Want to hop to some reviews?
Ben Felix: Yup. We got a whole bunch of reviews. We got a really interesting YouTube comment that's aligned with what we're just talking about. Some interesting stuff in the community. For those three people that are still going to listen to the end here, lots of fun stuff.
Cameron Passmore: All right, fire away.
Ben Felix: Caleb Peters from the US says, that the podcast has smart, informed discussions on topics in financial economics and personal finance. That we line up experts for the show's guests and ask thoughtful questions during interviews. They appreciate the insights from the book reviews, and that Cameron contextualises them with themes from previous books. It is good. I like when you do that, too.
Cameron Passmore: All right, Officer 1BD1 from Australia said, “Most informative podcast. Thank you so much for doing the podcast. It's so informative and always provides a rational view. I love that you even pick yourselves up when you identify that you're being biased and know that best educational podcast out there.”
Ben Felix: That's good. We're always trying to learn stuff, too. VJR3612 from the US said, “That both of these guys are just amazing.” I don't know about that. “The amount of detail they pack in an episode is truly great. It is a great learning experience listening to this podcast and the interviews they do with their guests and the detailed questions they ask is awesome.” That's good. We do pride ourselves in the quality of the questions that we send to. I think, we've probably talked to this in the podcast before. It's often hours. Depending on the episode, like for John Cochran on the fiscal theory, or the price level, that was more than – I need to quantify that in probably weeks or months, instead of hours. We do spend a lot of time on questions.
Cameron Passmore: Yeah. I met a lot of amazing advisors at this conference I mentioned last week. Somebody said, “How much time do you guys put into this?” It's significant.
Ben Felix: We've talked this before, because I remember. But it's not a matter of time commitment. It's a lifestyle choice. Right? It's true.
Cameron Passmore: It's true. Yeah.
Ben Felix: It’s not like, how much time do you spend on this? It's yeah, how did you change your life to adapt to your circumstances?
Cameron Passmore: All right. You want to get a YouTube comment?
Ben Felix: Yeah. We don't usually read out YouTube comments, because YouTube comments are usually 30% vitriol, 30% scams, and the remainder are actual comments, so we don't usually talk about them. But this one is really nice, so I want to read it. This is on the investing in your financial literacy video that we did. They said that their wife then began investing last March, during the peak of the Gamestop meme stock craze. They both went into it completely ignorant. Speculated on a few stocks. Before any damage could be done, they found the Rational Reminder Podcast and Common-Sense Investing YouTube channel. They learned about the benefits of globally diversified index funds and the perils of active speculation.
Then they since read many books and listened to podcasts to further their education. Ultimately, us on the podcast here are the greatest influences on their family's financial future. They're in South Korea. They're thanking us for that. I just thought that was cool to see. It's another example of where somebody can – I guess, that's actually interesting, because that's not a matter of aligning their objective, financial situation with their subjective values. That was different. That was a case of just not having the information to know what a good financial decision is. Because you could say, well, I'm aligning my values, or my financial picture with my values. But if you don't know how to express that, that could be very messy.
If you end up picking individual meme stocks, because you think that's the good way to be putting money away for the future, and that aligns with your values, maybe there's a more objective way to measure being bad with money. Are you buying individual meme stocks? In the Rational Reminder community, there's a small movement that's been started. It's been fun to watch it develop, called No Net Worth November, where people are committing to not checking their investment accounts for the month of November. This never would have occurred to me, because I never checked my investment accounts, except for when it's tax time or whatever. Even then, I'm not checking the balances necessarily.
Cameron Passmore: Neither do I.
Ben Felix: Apparently, this is a big thing. A lot of people are concerned, they won't be able to make it for the month without checking their investment accounts. In some cases, people are making valid arguments like, “Well, I need to rebalance, or I need to invest my contributions, or whatever.” Anyway, it's just interesting to see this whole discussion about the psychological benefits people think that they would get from not looking at their investment accounts, but the practical difficulties of avoiding looking at the practical – In some of the examples I just mentioned, maybe that's more practical. But in a lot of cases, people are just saying that they won't be able to resist the urge to check. It's interesting to watch that. If people want to join the No Net Worth November challenge, they can, I don't know. There's no formal way to join it. You can comment in the community post, I guess.
Cameron Passmore: Do you think it's harder to not check in a rising or falling market? Because we're coming up with the best Dow returns since 1976, I saw a headline this morning.
Ben Felix: I've never had the urge to check. I don't know. I don't know. I'm not the guy to ask. I also wanted to mention that – we had Scott Cederburg on our podcast last week. We've had this happen with a few guests and it's always amazing when it does, but Scott joined the community and was very active in the thread discussing his episode. That was super cool. Because people had questions about the data, they had questions about the implications and the insights that you can draw from his findings. He was right in there giving feedback and answering questions and thanking people for their comments. It was very cool to see.
I saw that happening, it's like, where else does that happen, in a place that anybody can join? It's not a special club or anything. It's like, you sign up for free and you can join these conversations with people like that.
Cameron Passmore: You guys were thinking, we might be up to 10,000 members by Christmas?
Ben Felix: Yeah. Well, we'll be at 8,000 maybe in the next couple of weeks. Yeah, it could happen. By the end of the year, there were 10,000. I don't know. Two more months. Yeah. No, it's very possible. I think it's growing at around that pace. There's another arbitrary target that we have is 10,000 members in the community. What happens then? Nothing. What do we win? Nothing. But it'd be cool to see.
A couple weeks ago, when we talked about our goals survey findings, I gave multiple disclaimers about how we're not experts and basically, I have no idea what we're talking about, but maybe this is still interesting research. Justin in the community, who I understand, he is actually qualified to conduct and review this the type of qualitative research that we were doing, they said that when they listened to the episode, they thought that we actually undersold how well the research was carried out and how valid the result is. The primary contributions of the study and their perception was to create a financial goals master list, which fills the gap in the literature calling for the creation of a general master list of this kind, and to describe the methodology of eliciting and analysing the list.
They said that insofar, as those are the goals, the analysis approach was completely appropriate. They said that it was, in their opinion, extremely well-done qualitative research, and that they commended PWL for the effort and sharing the result. They hope that, this is cool. So they hope that future work – this part of the comment isn't cool, but the thing that I'll follow up with is. They hope the future work with this list and research includes researchers with expertise in conducting and disseminating qualitative research.
Yes, so I agree. I'm not going to say who the firm is, and it's not Dimensional if that's where people's minds go. We did share a data with a friendly organization, who does have a behavioural science research team. I don't want to say who it is, because I don't know where this is going to go. Hopefully, it's something that we can share in the future. They have said that they're putting a few people from their behavioural science research team on this project of looking at the data that we gave them and they're going to get back to us in the next couple of months, basically, before the end of the year. Maybe nothing happens. Maybe they say the data is garbage. Maybe they come up with some cool insights, or suggestions, or whatever. Anyway, hopefully, it's something that we can talk more about in the future. If not, oh, well, but hopefully.
Then the other cool thing that I wanted to mention on that is that I sent our summary paper of the goals survey and the master list and all that stuff to professors Bond, Carlson and Keaney, who wrote the 2008 and 2010 papers that were basically the basis of that whole exercise. I heard back from Ralph Keaney, who said that he carefully read the goal survey summary and thinks we did an excellent job and helped many people. I was like, “All right, maybe I didn't give us enough credit for the quality of the work, because that's about the best validation that we could possibly get on that.”
Cameron Passmore: Yeah, that's pretty sweet. Well, you got more feedback on the goal survey from James on LinkedIn, reached out to me saying, “Hi, Cameron. Massa, thank you for the work that you and Ben did in collecting people's financial goals and summarising it in the master list. I have listened to the RR episode and read through the PWL white paper. It was a hugely beneficial exercise for me and my wife to think about our goals together. Thank you. Bear it against the list. I know that Ben finds this scary, but you truly are making a huge difference to people's lives.”
Ben Felix: I'm just going to have to embrace that at some point.
Cameron Passmore: Just embrace it. James, thank you. We appreciate it. Another one I received on LinkedIn. “I want to say thank you for the free education and keep up the good work. I work for a wealth management firm in London, England. I joined the finance industry out of university in January 2021. Had been a listener of the podcast for a year. I found the podcast through Ben's YouTube videos. It's been a great source of learning for me. Over the last year, I went back to the first episode.” Yes, people do go back in the first episode. “Listen to them all in my commute each morning. I'm currently completing my financial planning exams as the podcast helped inspire me to pursue a career in financial planning. If you end up in London, would be great to meet up with you and others that listen to the podcast.” Yes, even though there’s not a lot of time left, we are having a meet up on November 14th. If you're interested in joining us, and I think, Ben, you'll be joining by FaceTime, so you'll be there live.
Ben Felix: I think that's so funny. Yeah, I'll be there.
Cameron Passmore: You can reach out to Angelica and the team at info@rationalreminder.ca.
Ben Felix: Where did you say? How many people are going to are going to be there?
Cameron Passmore: I think we're up to 15 to 20 people.
Ben Felix: 15 to 20 people. You meeting at a pub?
Cameron Passmore: Yup.
Ben Felix: What are you going to talk about?
Cameron Passmore: I don't know. Enjoy company. Nice to see people.
Ben Felix: Rational stuff?
Cameron Passmore: Rational stuff. Yeah. Also, got another Ireland story. Chris from BC reached out before he and his girlfriend traveled to Ireland, and ended up staying in a few of the places that we stayed at when we went, which is cool. Sounds like an amazing trip like we had and shared some amazing pictures. It's like, yeah, we were right in that spot. Cool to share that. Any final thoughts?
Ben Felix: No, I think that's good. We have gotten a fair amount of feedback on the new format. It seems to be very positive. People seem to like the fact that we're just hanging out for the second, whatever it is. Two-thirds of the podcast, we're just hanging out here. Maybe it's the three people that only want to listen to the beginning that leave, and everybody else stays. Maybe we had it backwards the whole time.
Cameron Passmore: I don't know.
Ben Felix: I don't know. I don't know either.
Cameron Passmore: Okay. As always, thanks, everybody, for listening.
Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.
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Participate in our Community Discussion about this Episode:
Books From Today’s Episode:
Balance: How to Invest and Spend for Happiness, Health, and Wealth — https://amzn.to/35tiNPC
If You Can: How Millennials Can Get Rich Slowly — https://amzn.to/3UiPmnr
The Coffeehouse Investor's Ground Rules — https://amzn.to/3hqJsyQ
The Psychology of Money — https://amzn.to/3npH7G6
Think, Act, and Invest Like Warren Buffett — https://amzn.to/3WqgvXD
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
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Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron on Twitter — https://twitter.com/CameronPassmore
'On the Size of the Active Management Industry' — https://www.jstor.org/stable/10.1086/667987
'Disagreement, tastes, and asset prices' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X06001954
'Measuring skill in the mutual fund industry' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X15000628
'Which Investors Matter for Equity Valuations and Expected Returns?' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3378340
'On index investing' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X22001143