December 26, 2019

Episode 78: 2019 Retrospective: A Review and Discussion of the Year's Guest Episodes

December 26, 2019

As we see 2019 out and enter a new decade, we thought it only fitting to do a round-up of some of our shows this year. While we had 26 guests throughout the year, we chose 14 that best captured the sensible investing and education-focused spirit of our show. Some of the guests we have included on this special episode include Rob Carrick, from The Global Mail and leading authority on Canadian personal finance, Alexandra McQueen, a teacher at York University, who offers an explanation on the difference between financial economics and financial planning and Jonathan Clements, who explains why the hardest part of investing is keeping it simple. We also share clips about nipping overconfidence in the bud with Daniel Crosby and the next grand challenge of investing with Dave Nadig. This is just a snapshot of some of the incredibly generous people who have joined us this year. We hope that this show has contributed in some way to educating and helping investors make informed decisions and we are excited for what’s on the horizon. Happy New Year from all of us here at The Rational Reminder!

Key Points From This Episode:

Rob Carrick’s insights into whether Canadians have a good relationship with money. [0:04:02.0]
Dr. Moira Somers’ tips on lifestyle changes to decrease financial stress. [0:07:51.3]
Why ‘debunking the nonsense’ of financial advice is so important to Barry Ritholz. [0:10:23.0]
The difference between financial economics and financial planning. [0:13:10.0]
Discover the importance of having a clear belief system when it comes to investing. [0:16:51.0]
Criteria other than performance to use to choose a quant fund according to Wes Gray. [0:19:47.0]
Why the most difficult part of investing is trusting in simplicity. [0:23:14.0]
Learn what has surprised David Butler the most about working with academics. [0:28:56.0]
Ben explaining discount rates and factors to his mom. [0:31:58.0]
All factors will underperform at some stage so embracing volatility is key. [0:40:14.0]
What Jill Schlesinger has found the most common investment blind spots to be. [0:42:54.0]
A look at what adverse selection means and how it applies to DIY investors. [0:44:40.0]
Find out why Daniel Crosby calls overconfidence the ‘granddaddy’ of investment biases.[0:46:17.0]
Even though investing is ‘solved,’ that does not mean people are good investors. [0:44:40.0]

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. So this is our last episode for the 2019 calendar year, episode number 78. And we thought we would do a little bit of a retrospective where we look back at some of the past discussions that we had with guests throughout the year.

Cameron Passmore: We're so grateful to all the guests that joined us. We had 26 guests, one join us every other week. We met people, and Ben and I went to New York City this past summer, which was amazing. I did an interview in Sydney, Australia. We had some guests live in our studio here in Ottawa, but most of them were done online over the internet and that turned out great.

Ben Felix: We've had a lot of guests who, our relatively small Canadian podcast, it's not risk free from the perspective of a guest to come on a smaller, maybe less established podcast. So for that, we're very grateful for the type of people that have been willing to come on the podcast and talk to us.

Cameron Passmore: Well on that, I've seen many people in their Twitter feed say, "I just say 'No' to podcasts because so many people are getting invited so many times," and we've been lucky enough to get early on some phenomenal guests, which clearly have helped increase our awareness and increase the numbers, which makes it, I'm hoping, easier to get guests going forward. Now that being said, we have guests booked right through May now, I believe. So we thought for year end we would do a compilation of thoughts from 14 different guests assembled into a story. Every guest was amazing. Every guest brought insights. So we don't mean to necessarily leave people out meaning they weren't as great, but it's just a story we decided to weave into about a 50-minute or so episode today. And as Ben says off the top every week, this is a weekly reality check on sensible investing and financial-decision making, and that was the point of this podcast.

Ben Felix: So we're going to play these clips that we found impactful, and before we play each clip, we're going to talk a little bit about why we found that particular clip to be impactful. And we'll just go through like that, and we hope the story that we weave is useful to you.

Cameron Passmore: And again, thanks for listening all year, and Happy New Year, and we will be right back.

Ben Felix: Welcome to episode 78 of the Rational Reminder Podcast. So as we described in the introduction, we're going to play a series of clips from guest interviews that we had throughout the year. And these are clips that we think really fit in with the theme of our thinking throughout the year as a whole. So we're going to try and weave them together into a bit of a story. And before each clip, we're going to describe why we thought it was impactful, and after the clip, we'll tie it into the next clip, and it'll all fit together, but you'll see how the story comes together as we go.

Cameron Passmore: So the first one is from Rob Carrick who is the personal finance writer for The Globe and Mail. And I thought to kick off, I would ask him, do you think that Canadians have a healthy relationship with money?

Ben Felix: And this is an important question. When you think about what is this podcast about? I mean, it's in the name, the Rational Reminder Podcast, that the goal of the conversations that we're having between each other and with guests is to give people the information to think more rationally about money and financial decisions in general. And so I think that asking Rob about the relationship that people have with money is for what I think are obvious reasons, an important part of being rational. If you have a terrible relationship with money, or with anything, it's really hard to make good decisions about that thing.

Cameron Passmore: What is really neat about Rob is that he hears from so many Canadians, he knows what people are thinking.

Ben Felix: His inbox gets flooded all the time.

Cameron Passmore: But for decades he's been doing this, so he can see long-term trends. So very interesting perspective.

Rob Carrick: No. I think the relationship with money is as unhealthy as it's ever been. I'll back this up by saying how much financial stress seems to be a big theme right now. I'm actually working on a project about this. I'm trying to document why economists say the economy is doing reasonably well, not spectacularly, maybe it's slowing, but it's doing okay. Unemployment at a... I've been covering economics for about 25 years. Unemployment's at a staggeringly low rate on a historical basis. Wage increases aren't great, but they're more or less in the range with inflation. Housing. Most people have made a lot in housing. Stock markets over the past five years have done pretty well, even if last year wasn't that bad. And yet polls continually show people are stressed about money. People who in the core corporate world say money stress is impacting productivity at work. You're starting to see companies introduce financial counseling and credit counseling and financial planning services for employees to get their heads out of their money and into their job. And I'm working on trying to figure out what's going on here, but that tells me people, they're spending too much and they're not saving enough, and they know it, but they don't know how to get out of it.

Ben Felix: So based on what Rob is saying as you all heard, in general, in broad terms, people have what you might call a stressful relationship with money, which is understandable and easy to believe when you see how most people think and act with their money. But the question that follows that is, what do you do about it?

Cameron Passmore: What do you do and how do you think about it? So for that, we reached out to Dr. Moira Somers, who is a wealth psychologist based in Winnipeg. And she gave us some interesting perspective on how to think about your money, how to plan for your money and for your financial future.

Ben Felix: And how can you make your lifestyle and the decisions that you make with your money, how can you make those align with the values that you've built around how you want to think about money? And when you do those things, it might decrease stress. So specifically, we asked Dr. Somers, what are some easy changes that people can make from a lifestyle perspective to improve their financial health, and here's what she said.

Dr. Moira Somers: The biggest thing that you need to do, of course, is to make sure that you are saving adequately and that you're bringing your spending in line so that you are taking care not only of your current self, but also your future self. And people often just are insufficiently in touch with where their money is going. And so it makes it hard for them to put aside the money that they need for their future selves.

So job one, I think, is to have a period every once in a while, it doesn't have to be constant, but of tracking finances and really getting clear about what's coming in and where it's all going to, and asking the questions, like that house purging guru asked about stuff in your house, does it spark joy, to ask the same of your spending. Is this really where I want my life energy in the form of money to be going?

And sometimes we find that when I have people do these exercises, we sometimes find hundreds of dollars per month. In one case, it was actually thousands of dollars per month that was going into unused subscriptions for services, online services that they no longer used, bank fees that they were incurring for accounts that were essentially sitting dormant, overdraft fees that were unnecessary because there was money sitting in other accounts. It was just remarkable just how unconscious a couple could become. And the good news was that the growing consciousness is something that often allows people to turn their ships around. So becoming conscious of where things are going and making sure that they're going in the direction you want is probably job one.

Automating things so that you don't have to decide again and again and remember again and again what it is you want to be doing is probably the next most sensible thing. I think more and more advisors just do this automatically now. There's a reason why 98% of mortgage payments are made on time every month, and that's because the bank doesn't leave it up to our motivation or our memory to get that mortgage payment from people. They make sure that it happens automatically on people's payday. They pay themselves. They make sure that that mortgage gets paid right away. And I think that if we would treat our own retirement plans or our own education savings plans or vacation goals in the same way, if we would automate those contributions, if we would automate the percentage of future pay increases that go into our savings, it just makes it that much easier to implement. Pre-commitment automation are friends, are our big friends of ours in the 21st century, and we need to do better at really harnessing that.

Cameron Passmore: So, super interesting to me to hear Dr. Somers talk about how important behavior is. And a lot of people might be able to behave well on their own, and we've talked a lot about being a DIY investor this past year, but we had a neat conversation with Barry Ritholz in New York this past summer.

Ben Felix: And this is one of the things that, and I know I say this all the time, so now I'm self-conscious about saying it too, but one of the things that I'm not crazy about talking about because it feels like it's a sales pitch is the value of working with someone who gives financial advice. Obviously, we believe from our perspective and anecdotally that there is value there in having someone to cut through all of the noise. Now, Barry Ritholz sits in the same seat as we do. He does the same thing in the States. So knowing what we know about behavior and how people like Dr. Somers and Dr. Daniel Crosby, who we had on a later episode, how important they say behavior is for investor outcomes, we wanted to ask Barry what he sees as the biggest value from financial advice.

Cameron Passmore: And as you'll hear, he doesn't mince words about adding advice.

Barry Ritholz: Oh, that's easy. That's the behavioral counseling. That's what we do. And we do it in a lot of really subtle ways. Some are overt. When we bring people on the process, we don't just take people's clients. We make sure they understand what we do, and we try and figure out what they want. We spend a lot of time debunking nonsense, getting people to think about long term and not dealing with the availability bias or the recency effect or all the overconfidence bias, or there's so many different things that people do that are just natural human responses that we really spend a lot of time trying to show them the context of this. That market drawdowns and crashes are inevitable. That recessions happen all the time. That these things are cyclical. And if we had any confidence that anybody could consistently forecast them, well, then we might swing in and out of portfolios.

But all you needed to do is be wrong once, and all the lucky calls beforehand turn out to be meaningless. We created a series of things that we think have been really helpful. And once people understand they're investing towards a goal and how the market did last week, last month, last quarter isn't relevant, and that drawdowns are inevitable, and people selling snake oil and promising you, "I will get you out in time and then I'll get you back in," once they realize the statistics and the evidence about that, it's a very different conversation. And all of that is behavioral.

Cameron Passmore: So I got a kick out of Barry talking about how much time they spend "debunking nonsense." And he was very passionate about that when we were with him, and they spend a lot of time getting people to realize the stats and be, as we say, rational with things, but that isn't always a case in the industry.

Ben Felix: Yeah, I mean. Financial services in general, I mean, finance as a whole, it's financial economics, it's a social science, which means there's a lot of room to have rules of thumb. Everything's uncertain anyway, so you can say whatever you want.

Cameron Passmore: We had Alexander McQueen on this past year, and she's a financial author, educator, editor, and an annuity expert here in Canada. She also teaches at York University.

Ben Felix: So we asked Alexandra, what is the difference between financial economics, which is at least somewhat scientific, I know I just said that it's all uncertain anyway, but there is a way to approach this scientifically. What's the difference between that and financial planning, two very different things.

Cameron Passmore: And I want to say looking back, or thinking back to all the interviews we did this past year, this line coming up is one that has stuck out to me all the way along.

Alexandra McQueen: Great. It's a great question. So think about financial economics is a branch of finance which looks at the efficient allocation of resources under conditions of uncertainty. And you think, "Oh, that sounds exactly like financial planning," but it is an academic discipline. And in Canada at any rate, the discipline of financial planning hasn't really advanced to the level of an academic discipline. So one, financial planning is sort of governed by rules of thumb and almost a folklore versus financial economics, which is governed by lots of quantitative thinking, equations, lots of rational econs.

Ben Felix: So we're operating in this world where financial economics is one thing and financial planning is this different thing. And financial planning is governed by, or at least full of folklore, just rules of thumb and then stuff. And when we have all that folklore type information, which there's tons, of and people actually use this in their decision-making, which is, I would say, a flaw, but they do. But when we have all of this stuff out there, I think that one of the most important things that people have to do if they're going to make good decisions is have their own set of beliefs. And having a belief system is something that we've talked about and how we've developed our own. But we asked Ted Seides, and maybe Cameron, you can just talk about who Ted is briefly.

Cameron Passmore: So Ted is host of the popular podcast the Capital Allocators podcast, former hedge fund manager, and possibly most famously worked with David Swensen at the Yale endowment, which is the gold standard of endowment portfolio management. Incredible pedigrees. And so we reached out to Ted last summer and he graciously agreed to come on the podcast.

Ben Felix: We asked Ted what he learned from working with David Swensen.

Cameron Passmore: The main takeaways from working with David Swensen, and to go back to your original comment, we started this podcast with the belief system, which is why we were confident starting a podcast because we did have a belief system. It was structured in theoretical thinking and tons of research, and it's a consistent approach that we use across all of our clients. So because of that, we were able to do this.

Ben Felix: Communicate the ideas.

Cameron Passmore: If we were not on the same page, you couldn't do this.

Ben Felix: Or if you didn't have a belief system at all. There's no framework to cut through what is from that framework nonsense, as Barry said, and what is worth using in making a decision.

Cameron Passmore: Or if you did have a different belief system for different clients, well, that's not our case, right? It's consistent across the board. So if you didn't have that, you couldn't do this. And I thought Ted did a great job in explaining how important it is to have A, a belief system, and B, an ability to communicate it.

Ben Felix: Which is fascinating when we think about it in the context of investors. If you think about a couple, two people who are together investing for their retirement, having a belief system is part of that. Because if you believe in a way to do things and you're going to make decisions accordingly, but being able to communicate that to all parties involved, whether that's a spouse or if it's parents that you're helping financially or siblings or whatever, other people in your life, the ability to have a belief system and communicate that to all of the stakeholders in your life becomes extremely important.

Cameron Passmore: So here's the answer that Ted gave to our question, can you talk about what you learned and what lessons you learned from David Swensen that have carried you through your career?

Ted Seides: Well, sure. I learned a lot. He wrote it all up in a book, and at the time he wrote the book, I felt like I knew what was going to be on the next page. But if you were distilling a lot of what I learned into something that's broadly applicable, I would say the core of how David approached the investment problem which is pervasive, is he developed a certain set of beliefs about investing. And then he was incredibly good at communicating those beliefs to his constituents, which is his board, his team, and then being very creative about what strategy he was going to use to tie into those beliefs. And for David, a lot of it was in the book. It's an endowment with a long time horizon. That leads to an equity orientation and diversification. And he didn't think you were truly diversified in like a 60/40 two-asset portfolio, so he diversified across other things that looked like equity-oriented assets.

And then when you really get into the weeds a little bit, what David possesses that very, very few investors of all types do is just an extreme discipline in being able to stick to the plan and being able to communicate in such a way that encourages everyone around him to stick to the plan.

Ben Felix: So Ted told us how important it is to have a belief system and be able to communicate that belief system. And I was just thinking, the ability to communicate a belief system, that's not just to other people. You've got to be able to communicate it to yourself because you can believe something, and as soon as you run up against something that doesn't fit with that belief, if you can't communicate what the impact of that thing is...

Cameron Passmore: And people can tell if you don't believe. Like if you're sitting in a client meeting, if you don't really believe it, the clients can tell. And I think people by listening to you know you're pretty passionate about this belief system, especially one based around a quant theoretical type model.

Ben Felix: For us sitting in our seats, for sure that's important. And I think for the end investor, whether they're managing their own investments or working with an advisor, I think that to some extent they also have to have that on some level a grasp of the belief system. And whether that's straight index funds, which I think are really easy to get and people understand, or if that's factor investing, just having a grasp and the ability to understand and communicate why you're doing what you're doing is so, why are you doing it that way?

Cameron Passmore: I think this does give confide of people, whether you're doing this philosophy on your own as a DIY or with an advisor or with us, if you have more confidence, you will be a better investor.

Ben Felix: That's certainly true. Now, one of the challenges with that is that there are a ton of different models out there that suggest whatever, like indexing is better or factor investing is better or stock picking is better. So we had Wes Gray, who's the CEO of Alpha Architect, which is a quant index creator and ETF manager in the States. And we asked Wes, how do you choose a good quant model? How do you choose the best quant model? There are all these different ways to say, "This is the optimal portfolio." How do you decide what you should actually do?

Cameron Passmore: And in classic Wes style, he gave a pretty colorful answer.

Wes Gray: I mean, honestly, one of the things that we've learned over time is there's really no such thing as best. It's about understanding the transparency of what the heck are these people doing and how does this fit in my process, or how does this help clients achieve a particular goal? So I think the most important thing when you're dealing with quant shops is how transparent are they, because you need to understand what they're doing, because you then need to explain to someone. And how focused on education and reality are they, because all these models that are doing anything that's going to add "excess return" in like a back test or historical sense, well, the reality is that those things earn expected excess return because they probably suck. They're either high risk or behaviorally very challenging to own. So it's not really about how awesome your quant model is. It's about how reasonable is your quant model and how much do you help us explain this to clients so they can actually sit and deal with this quant model. I think the ability to help on the behavioral side to help people stay in their seats, which is not really a pure quant but kind of pure quant with a behavioral element, is what allows people to actually be successful.

And so let me summarize. If I had a black box quant shop who doesn't tell me what the hell's going on, and they just say, "Hey, it's all proprietary. Just trust me." Even if it was free, I would probably not want to do that because presumably whatever they're doing will have a bad streak. I'd much rather go to a shop that's like, "Hey, here's what we're doing. Here's a bunch of materials that explain, outline why this works, why it stinks sometimes. When we them through bad times will help explain that to your clients so they don't blow out the exact wrong time." That actually has a lot more value than say this black box quant shop that, let's presume they had an even better quant model. Let's just assume that was true. I think you need the whole package these days.

Cameron Passmore: I really liked Wes' answer and how straightforward he is for a guy who is brilliant. He has a PhD from Chicago and intellectually brilliant and does a great job and great research into very complicated stuff, but he does make it quite understandable.

Ben Felix: He makes it understandable and he makes it explicit that no matter how good your model is and no matter how good your research is, whatever you want to call it, however you want to frame it, at the end of the day what matters is your ability to hang on to that investment through good times and bad.

Cameron Passmore: And not to overcomplicate that process. To have a process and a belief system and to stick with it. And I thought this next clip does a great job of highlighting that. We had a chance to meet Jonathan Clements, who is a former personal finance writer at the Wall Street Journal.

Ben Felix: So we know from the clips we've just played, you've got to have... Well, behavior's important. You've got to have a belief system. You've got to be able to communicate that belief system to yourself and to other parties that are involved in your financial situation. There are all these crazy quant models out there and all these different ways about thinking about portfolio management. None of them are necessarily the right one. And so we asked Jonathan Clements, understanding investing's kind of figured out as Dave Nadig told us, investing's kind of figured out, we know in general how you should do this. Whether that's index funds or factor investing or whatever you're comfortable with, I guess is the answer based on what Wes was just saying. But we asked Jonathan Clements, what is the hardest part of investing?

Jonathan Clements: The hardest part is accepting that it is indeed simple and not trying to be overly clever. We are hardwired to believe that the harder we work, the more clever we are, the better our results are going to be. And it simply isn't the case.

Cameron Passmore: So Wes talk about how you have to be able to communicate some pretty complicated quant type work and make sure what you're getting into. To listen to Jonathan Clements talk about keeping things simple is so vital. And as people know, we are fans of the market and we believe that markets are relatively efficient, and it's very tough to beat the market. And we had a chance to talk with Dr. David Blitzer who was the head of the index committee at Standard and Poor's, in New York City this past summer.

Ben Felix: And we asked Dr. Blitzer, and I mean, if you haven't listened to that episode, you've got to have the context that he's been at Standard and Poor's since pre the index investing boom. He was around when indexes were just used to sell newspapers. And he's been, he's seen through the whole growth of index investing as a thing, which it wasn't always.

Cameron Passmore: So we asked Dr. Blitzer why it's so tough to beat the S&P 500?

David Blitzer: I guess there are two or three theories and stories, and so on. First is the cost. I happened to call up a bank and asked what they charged to buy US Treasuries, and they quoted me several basis points as the fee. And when I sort of got over the shock, he said, "Wow, you know, that's not so high." And I looked at him and said, "I buy a portfolio of 500 stocks and cost me about three basis points, so anything more than that for US Treasuries is ridiculous." So the cost is definitely number one.

There's the... I don't remember exactly who the argument is, but if you look at the whole market, the whole market is indexed and so on. So there's some winners and some losers. You take only part of it, and that kind of thing. But I think the other thing is if you look at the stocks in the S&P 500, look across the whole 500 stocks, how they did in a year, and obviously some did not very well and a few did very well, but it skewed to the extreme right-hand side.

So if you were the, as an active manager, if you own the six or seven stocks in the extreme right-hand tail, the ones that probably return six times what the index overall did, you'll be in fat city. But the chances are you own those stocks, even on a random selection basis, not very good. If there are five stocks out there, you got about one of 500 chance that's in your portfolio. If you own the index, you own all of them, and so on. And over time, there's few stocks at the end, and the tail, that account for the lion's share of the performance in any given year, and so on. So I think that's what's really doing it is if you're in the index through your fund or whatever, you're going to own something of both. That also is part of the reason why the equal weighted version of the 500 seems to do much, so much better than the cap weighted version over the long term.

Ben Felix: So with all these models out there and all these difficult financial decisions that we make in investing and allocating our own money, it's easy to say as Jonathan Clements did that keeping it simple is the hardest part. And of course, that makes sense because there's so much information out there and there's so much uncertainty out there. Understanding, as Dr. Blitzer just explained, why it's so hard to beat the market makes it maybe a little bit easier to understand why keeping things simple is so important.

Cameron Passmore: And it's also, you think about market efficiency. There's so much work that goes in, just think in the S&P 500, all the work by all those companies and all those employees, plus all the work by all the analysts and all the industry participants to price those shares. There's so much information that is now available to the academics to figure out what is the best way to invest.

Ben Felix: And this is where it gets nuanced, right? As we're talking about these models and we're talking about belief systems, we're talking about why it's hard to beat the market, but, and this is a nuance, the fact that it's hard to beat the market because the market's pretty efficient, it doesn't mean that there aren't opportunities to seek higher expected returns. And the insights to do that can come from ideally a theoretical source that's backed by empirical data.

Cameron Passmore: So I had a chance when I was in Sydney last March to sit down with David Butler, who is the co-CEO of Dimensional Fund Advisors. And the question I asked him was, what is it like working with people like Fama and French who we've talked about for so long, and these kinds of academics that are heavily involved with Dimensional Fund Advisors? And I asked him, you work with them regularly. What's it like?

Ben Felix: It's really this Idea of, okay, you can't beat the market because it's efficient, but how do you draw insight from what the market is doing and how the market is pricing assets? And I thought Dave had a great answer.

David Butler: Yeah, it's incredible. They are the most inquisitive, they're obviously all smart, but they're very modest and they're very, they're funny. But I think that the modesty part is the part that strikes me the most I think about working with this group. And I think it started with Merton Miller, because people always talk about Merton as being kind of the godfather of all these economists. But the way Merton collaborated and the way he had this level of modesty that was unparalleled, I think he set a tone for these guys that there always is another answer around the corner and you've never finished finishing what you think you have. You never have the complete answer. And a model is just that, right? Model is not reality. And if it was reality, it wouldn't be a model. That's what Fama and French and these guys will always say.

So what you always try to do is you try to look at what you, the empirical data that's out there. You try to build models that explain that empirical data to the best way possible. And you continue to tweak that model to do better and to do more. And so they, the term that I heard Fama use one time is it's called the pursuit of truth. You're never going to get to truth, but you're always in pursuit. And I would say at Dimensional, that's really the culture of the business is this constant pursuit. It's a constant pursuit in trading. How do we trade a little bit better? Can we do this? Can we tweak that to get another basis point? In research, can we use this information to translate into portfolio advancements? But all of it's done with a very wary eye.

And I think that's where I, if I was a client of yours, of any advisor we work with, one of the things that I would take satisfaction is that you don't have this firm that's leveraging models and shooting for the moon and hoping for the best. It's a very sensible, methodical approach to capital markets and what we deliver. And again, going back to the 38 years of the firm, the delivery has been just that. Very consistent, very methodical, very clear, clearly thought out advancements in the capital market space. And Dimensional frankly, is number one. I mean, Dimensional is the firm that you asked the question earlier on. When we talk about multifactor and smart beta and all this stuff that's starting to bubble up in the market, Dimensional has been doing that for 38 years.

Cameron Passmore: So as Dave said, you never really get to the truth. You're always in pursuit of the truth in academia. And these are just models that they all use, but Dimensional being the first one in the factor space, I always found quite interesting. It goes back almost 40 years, 50 years or more with Fama studying this stuff.

So we often have a challenge of trying to explain what factors are to people. So we thought it'd be a neat idea to invite your mom on the show. So Andrea joined us this fall for us to attempt to explain factors to her. Now interesting, it's the second most downloaded episode.

Ben Felix: Nice work, mom. But we can talk about the academic literature. And this ties right back to the earlier clips we talked about, about communicating those ideas. An investor that doesn't understand... And this is what Wes was talking about. An investor that doesn't understand what they're invested in or why they're investing in that thing, it's going to be really hard for them to stay invested when volatility strikes as it most definitely will, or tracking airstrikes, which can be even worse than volatility, depending on how you're thinking about or how well you understand the portfolio. And we talk about the literature, like what Dave was saying and how great these researchers are, and all these different things, but something that somebody, a listener pointed out to us was like, "You guys reference these factor things all the time. What does that actually mean?" And so Cameron and I were like, "Oh yeah, I guess we need to be able to explain that."

Cameron Passmore: So we took a, I took a shot. It's a bit of a long clip, but I think you hear the discourse between the three of us.

Ben Felix: So a stock is the value of the company's book value. Book value just means the assets that the company owns basically like physical assets, a building would be an example of what would make up the book value. So the price is the book value plus the discounted value of future cash flows. And I know there are a lot of big words in there, so we'll unpack it.

Andrea Felix: Yeah, I don't know what a discounted cash flow is.

Ben Felix: Yes, that is the most important part so I'm going to explain it. So when a company earns profits, you as the investor, you want to invest in that company so that you can partake in the profits. Now, when you buy a stock, you're buying a stream of profits in the future, because the company's earning profits now, but you also expect it to earn profits in the future, which is why you're willing to pay money for it. You're buying the future profits.

Now the discount rate, the thing that you asked about, the discount rate is the rate at which you discount those future profits to decide how much you're willing to pay for them today.

Andrea Felix: So I'm taking away the projections of the future.

Ben Felix: You're projecting the cash flows into the future, but the term would be-

Andrea Felix: You're not counting them.

Ben Felix: You're counting them less. You're counting the ones in the future less, and you're counting them less and less the further that you get out. The reason the discount rate is important is because it reflects the amount of risk in the cash flows. A very low risk set of cash flows, like a very safe company, you would apply a low discount rate because you're fairly certain you're going to get all of those future profits.

Cameron Passmore: So a discount rate, that means that you're charging or expecting a lower return because it's a safer investment.

Ben Felix: Right.

Cameron Passmore: So that's why the discount rate is lower.

Andrea Felix: Lower.

Cameron Passmore: Right? So you're paying a bit more now to get more certain future cash flows. Whereas if it's a riskier stock with more uncertain future cash flows, you're going to say, "Well, for me to own this, I'm going to pay a lower price." Therefore, ensuring you have a higher expected return. The riskier the investment, the higher the expected return. Otherwise, why would you invest in it? I'm not sure we're succeeding here.

Andrea Felix: So, no. So yeah, I'm not... Can we go back to the discounted value? So if you've got a company that has high risk, you're going to project a higher discounted value?

Ben Felix: A higher discount rate.

Andrea Felix: Discount rate.

Ben Felix: Which is going to reduce the amount that you're willing to pay for the future profits. So it's like if you're buying a company that you expect to have profits of, whatever, a thousand dollars, your shares are going to have a thousand dollars per year that you're going to expect to get from them. And you're fairly certain you're going to get this year's, but less so about next year, and decreasingly certain going into the future. Because of that uncertainty, you're going to be willing to pay less for each successive year cash flow. So the cash flow five years from now, you're not going to pay a thousand dollars for it because you don't have it yet. And you're going to pay less and less depending on how risky or how uncertain it is that you're going to get that future cash flow five years from now, or whatever point in the future.

So if it's certainly that you're going to get it, you might pay $900 for it. That's a low discount rate. You're only discounting the thousand dollars cash flow to $900.

Andrea Felix: Right.

Ben Felix: But if you're really uncertain that you're actually going to get it-

Andrea Felix: I'm going to pay 700.

Ben Felix: 7, 6, 5, whatever. So the less you're willing to pay, that's a higher discount rate. You're discounting the cash flows at a higher rate.

Now, the reason that this is important is that if you actually do end up getting the cash flows that you expected, if you paid less for them, meaning a higher discount rate at the beginning. If you paid less for them, you're going to end up with more return. Because if you paid $600 for this thousand dollar expected future cash flow, if you actually end up getting the thousand dollars, yes, you took some risk, but you made a $400 profit in that example. So the way that that translates into financial speak, I guess, is when your discount rate is higher, your expected return is also higher.

Cameron Passmore: And there's millions of people like you doing this all day, every day, as they choose how much you're willing to pay for stocks on the market. There's all kinds of people doing this discounted calculation on every trade. So you're competing with other buyers, so if we're looking at two stocks that have identical future cash flows and one's riskier, so the riskier one will have a greater discount rate, therefore you're paying less, but you're going to be competing with other investors for that same stocks. That competition goes on all the time.

Andrea Felix: I have another question. How do you determine the risk?

Ben Felix: So that is the question. And so that's what the market mechanism, like what Cameron's talking about, all these people competing with each other to determine how much they should pay for assets, that is-

Andrea Felix: How risky is that stock?

Ben Felix: Correct. And no one person can say what the right value is, but the aggregation of everybody's guess regarding what the price of the stock should be, that ends up creating a price. And that consensus price has implicit in it, the discount rate. Does that make sense?

Andrea Felix: I think so.

Cameron Passmore: There's a hundred million stock trades a day that go on around the world. So what they're doing, they're pricing an enormous amount of information about those stocks and those discount rates all the time. Academic science has worked on this for 50-plus years, and that's where they've discovered that certain factors explain expected returns.

Ben Felix: Well, I think we have to back up because we're still at risk. Factors sort of decompose risk into different types of risk, but where we are now, so we're at the place where the higher discount rate indicates a lower price. You're willing to pay less for the future cash flows. And you're competing with all these other people, so even though nobody can say definitively how risky a thing is, the market's price is the best proxy that we have for how risky. We know how risky the market thinks the thing is. Even if I can't say this discount rate should be 6%, what we can do is look, what is the actual price? What are the company's actual expected cash flows? And from that, we can figure out what the market is applying as a discount rate. So we can look at market prices and use those prices to figure out which stocks the market thinks are riskier.

If we look at two different stocks with the same expected future cash flows. So you're an investor looking at these two different stocks. Both of them, you're expected to get the same amount of future cash flows, but one of them is trading at a lower price. So they're same expected future cash flows, but this stock is trading for... It's $10 and the other one is $11. The $10 stock must... The market is deciding that stock is riskier because these two companies have the exact same future cash flows, expected future cash flows, but one of them's cheaper.

Andrea Felix: And the market is determined by all of these millions of people that are investing, and they have determined that there's more risk in that one?

Ben Felix: Correct. Before we introduced that clip of explaining factors to my mom, I mentioned tracking error being a risk. And that's, it ties back to understanding so why am I investing in this thing? And the reason that understanding is important is because that thing that you're investing in, if it's not the market, will likely have performance different from the market over some periods of time.

Now, when we're talking about factors over the long term, you expect that difference to be positive, but over a given period of time, it can be negative. Now this is tricky because it leads some people to think that because a factor portfolio can trail the market, because of that it's riskier than the market. And so one of the questions that we get a lot is, how long do you need to have to make factor investing make sense? And because this is such a common question, we wanted to ask Larry Swedroe, who's one of the best factor communicators in terms of understanding and being able to communicate the underlying ideas. So we asked him that exact question.

Cameron Passmore: So Larry is the director of research at Buckingham Asset Management, which is a very large RIA based in the St. Louis area, and he's been a long time friend of ours, so much that we named a boardroom after him. So we asked him, is there any merit to avoiding factors because you can't wait for them to deliver?

Ben Felix: And I'll say this. This clip has been something that I've sent out that from the transcript, the text, I've sent it out probably 10 times since we recorded it because I get the question so often.

Cameron Passmore: Well, think back to our interview with Dave Getsch in 2017. We talked about how you have to learn to embrace variability, embrace volatility, and know what you're going to be going through. Nothing we've seen in our careers, anything statistically abnormal. It feels abnormal at the time, but it never is.

Larry Swedroe: What people fail to understand because they're unaware of the evidence is that any one factor can go through very long periods of underperformance. And that's the point we make in my book, Your Complete Guide to Factor-Based Investment. We have a table that shows the odds of each factor having negative performance. Even the US, we estimate US stocks, there's a 3% probability that it could underperform totally riskless Treasury bills over 20-year periods. And as I mentioned, we've had three 13-year periods where US stocks have underperformed T-bills. So that can happen to one factor. If that's true, why would you want to run the risk that your portfolio is totally concentrated, virtually all your eggs are in that one basket? That makes absolutely no sense to me at all. In fact, the shorter your horizon, the more likely it is you can underperform by very large amounts.

And I'll give you a one great example in from 2000 to 2002, the S&P 500 lost about 40%. Our equity portfolio which is much more tilted to small and value and international did lose money during that period, but our model portfolio like I have, you see in my books, only lost about 6%. So what if you retired and you were sitting with that period? You didn't have the ability to wait out and get the better returns in the long term, your portfolio crashes because you retire in 2000 and are now withdrawing from that portfolio and you can't recover from those losses with money that's already spent. People get this backwards. Actually, the shorter your horizon, the more important diversification becomes.

Cameron Passmore: So I like how Larry talked about you have to be able to embrace the volatility, understand that these things are normal. And from there, I wanted to link this to a conversation we had with Jill Schlesinger, who is an author and part of the CBS News team on television, personal financial reporter for CBS News. And she talks about how emotions can get the best of us. Even though we may know what Larry says is true, humans are still human.

Ben Felix: And it's interesting because we started out with sort of bigger picture in general, behavior is important. And these next couple of clips really focus on the micro level or the individual level of how behavior impacts real decision-making.

Cameron Passmore: So in Jill's book, she talked a lot about blind spots. So we asked her if she can talk about some of the common blind spots that investors face.

Jill Schlesinger: Well, I just think that most of us tend to be guided by either fear or greed when it comes to money. And I'm sure you guys have talked about this on the podcast. There's a series of underlying behavioral economics theories that really do play into why we can often make choices that are not optimal. And of course, that flies in the face of standard economics, right? You get some economists who says, "Well, where this line meets this line, that is supply meets demand. That's equilibrium. That's what happens." Except then real life takes over, and you're like, "Wait a minute. That didn't work out that way."

And so what we now know is over time, that human beings sadly, because we are human beings, tend to let emotions guide a lot of our decisions. And that's why we feel better putting money into our retirement accounts when markets are trading higher, and we feel scared and anxious and nauseous, and we don't think, "Wow, this is a great buying opportunity." No matter how many times people like you and me quote Warren Buffett, people are not going to feel happy when the market is going down and they're investing. So it's a conundrum to be a human being, isn't it? The financial world is just one expression of that.

Ben Felix: So we have blind spots. That's a known thing. Behavioral economics has been studied pretty extensively. But one of the challenges with those blind spots is that most, many people... I don't know about most. That may not be fair to say, but it probably is most. I'll go with most. Most people won't realize that they have those blind spots because they're overconfident.

Cameron Passmore: But don't you find it interesting how you can feel scared and anxious as Jill said, when things don't go the way you expect? Where did that overconfidence go in the down markets?

Ben Felix: It's a great question. It's a great question. I think that one of the things that came from one of the discussions that we had this year, and it's from the guests that we're about to play a clip from, but this isn't the clip. He talked about this adverse selection that happens with... Well, he was describing do-it-yourself investors where he threw out the number. And I don't think that he had real statistics to back this up, but say 10% of investors are really equipped, psychologically, educationally equipped to be great, successful, do-it-yourself investors. 10%. And of that 10%, the ones that actually go and become successful do-it-yourself investors is going to be much lower. Because the 10% is equipped to understand their own limitations, they're going to be the ones that are rational enough not try and do it themselves.

So you end up with adverse selection where the people that go and do it themselves are the people that are probably too overconfident to be doing it themselves.

Cameron Passmore: Fascinating. And behavioral finance is absolutely fascinating. It's a massive field. That's why we invited Daniel Crosby on. So he is an advisor and a... What do you call a wealth... He's not a wealth psychologist. He's a behavioral scientist, I guess, with Brinker Capital, well known in Twitter, great Twitter follower, great author. He's got a couple of excellent books out there and he's a fabulous guest. So we asked him about overconfidence, which is, as he puts it, the granddaddy of all behavioral biases.

Daniel Crosby: Yeah, it's the biggest deal. There's 177 different behavioral biases at my last count. But overconfidence is sort of the granddaddy of them all because overconfidence is the bias that begets all other biases. It's the bias that enables every other bias because being a good behavioral investor means telling yourself, admitting to yourself that you're just as susceptible to making poor decisions as the next person, which is a form of humility. And once you're able to do that, you diversify, you get professional help, you do all the things you ought to be doing. But overconfidence says, "Hey, yeah, I know this is a problem for humanity writ large, but I'm different or I'm special." And so in a very real sense, overconfidence, if you could root that one out, all the others begin to die off a bit. And yet overconfidence is really central to our happiness.

If we viewed the world as it actually is, we'd be much less happy than we are, I think. I'm employed now, but I was for many years an entrepreneur. Entrepreneurship is universally an exercise in overconfidence. Every single time someone starts a business, it's a bad idea. Probabilistically speaking, 90% of businesses fail. Every time you start a business, you're doing something that doesn't make much sense from a strict probability standpoint. Starting a restaurant is even dumber from a strict probability standpoint. And yet we're glad people start restaurants. We're glad people start businesses. And so in a respect, overconfidence helps us get through the day.

I think we as men in particular, evidence dramatic levels of overconfidence. And if I hadn't had the overconfidence that I have, I never would've talked to my wife because I had no business talking to her, right, if I had seen myself as I truly was. I'm glad I talked to my wife. I'm glad I started a business. I'm glad I wrote a book. I'm glad I did all these things. But my advice is sort of to be overconfident in other parts of your life, right? Hey, like you think you're better looking than the next guy. Good for you, whatever. We're going to not question the veracity of that. But you have to leave overconfidence aside when it comes to investing because it's very, very dangerous.

Ben Felix: Investors are overconfident, and when we know that, and-

Cameron Passmore: Well, I love how he said, thankfully we are overconfident. Otherwise, you wouldn't get a new restaurant. Why would you open up a restaurant? Imagine this world? He's right. If people were not overconfident...

Ben Felix: Entrepreneurship in its entirety... I mean, capitalism in its entirety requires overconfidence, so of course we should be thankful. But I think it's at the level of the individual investor investing the money that they're going to use for their long-term financial goals. Sure, go and start a restaurant over here. But when you're investing in the stock market to achieve long-term goals, you got to try and check the overconfidence.

Cameron Passmore: And it's because of all those overconfident people doing all this work, that's what makes markets work. And our next guest, Dave Nadig talks a lot about how investing is largely solved.

Ben Felix: We mentioned this earlier in this episode too before one of the clips, and yeah, and he is right. He talks about why we're working at the edges. We largely understand, and depending on the... With either framework you choose, whether it's a risk-based framework or a behavioral framework, we can explain the extent of differences in market returns through science. It's social science, but close enough to science.

Cameron Passmore: So I'd seen him at a conference last fall and he had a presentation talking about the investment world is largely solved. And I found that such a provocative question, we invited him on the podcast and we did ask him exactly that.

Ben Felix: His answer is fascinating. You'll hear it in a second, but he explains that investing is solved, but that doesn't mean that investing is solved.

Understanding how markets work, which is, I think, what he meant by investing being solved doesn't mean that people are going to be good investors. And that ties back to the overconfidence, the behavior, the understanding. And so in Dave's opinion, the next grand challenge, and he talks about grand challenges in the clip. The next grand challenge is really about helping... So investing, solved, checked, it's done. Next up is helping people make consistently good financial decisions, which requires communication, requires overcoming all these biases that we know exist. So even though we can say what the... Well, we can almost say what the perfect portfolio looks like, that doesn't solve investing at the individual level.

Cameron Passmore: Absolutely not. He was a terrific guest, and as of right now, the number one downloaded episode of all time.

Ben Felix: Yeah, that's right.

Dave Nadig: Yeah, sure. What I mean by that is that I tend to think of the world in very broad strokes. And so I think about grand challenges, right? The whole idea of grand challenges, like put a man, get a man on the moon in this decade as Kennedy said, or understanding human consciousness. That's the great challenge of neuroscience, right? Or self-driving cars. That's the grand challenge of Tesla right now. So I love these grand challenges. I think they focus the mind. And for a long time, investing was kind of this grand challenge. And starting in going all the way back to Fama French, and then all the amazing work that's been done, Jim Simons, and all sorts of people over the years have teased apart what really makes market works to move as much uncertainty from it.

And while it is not still a science in the sense that I can tell you precisely what set of inputs is going to reveal what set of results, I feel like it is incredibly well understood. And the pieces that we don't understand that get knocked down in the academic journals once a year are very, very small, right? The piece... People are now talking about scraping five basis points of alpha from better trading strategies, or timing strategies, or arbitraging sub-second price discrepancies, and information flows. That's the deep end of the pool, right? That is fundamentally a solved problem the way that building a building is a solved problem and we're just arguing about what you're putting on the roof. So from that perspective, I just don't think that there's that much interesting left in the core science of how investing works. Doesn't mean it's easy. Just means it's largely solved. There are lots of solved problems that are not easy.

And the reason I put that out there was because I think the more interesting challenge, the real grand challenge is human beings and how we interact with money and how we plan for a lifetime, right? The idea, people who are actually in the financial advice business going on a journey with their clients from 30-year-old junior executive at Nabisco or something like that, through estate planning. That journey, that is a grand challenge, and the number of variables that come into that process, the number of opportunities to screw it up and have that person on the street, the number of opportunities to get something really right and make a difference between having their kids struggle to get through college and just have a free ride through college because your parents saved enough, those are huge, meaningful, real challenges. And there's almost no good work being done about how to do that job and how to understand how human beings interact in positions of uncertainty. So I'm much more interested in the work of people like Dick Thaler who are really trying to tug at behavioral issues in investing than I am about folks that are finding factor number 27.

Cameron Passmore: So there's our attempt at a 14-clip storyboard for the year. I think it turned out okay. Pretty interesting people.

Ben Felix: And I replay them in my head all the time because they've been so impactful. Not just these ones, but all of the episodes that we've had with guests. But going through these clips, it just speaks to the quality of the people that we've been, we, you and I, Cameron, as hosts have been lucky enough to convince to come on the podcast.

Cameron Passmore: So what's your main takeaway looking back over 52 episodes in 2019?

Ben Felix: Main takeaway from what perspective?

Cameron Passmore: In general, you think about the podcast.

Ben Felix: There are so many different angles. I mean, the things that we talked about today just in learning more about what is important for investors in general, what is important for, most important for us in our capacity is helping people be better investors, I think we've learned a ton. Bigger picture, I mean, we know that the podcast has been unparalleled in terms of communicating with clients. I had someone say to me, a client, "I love the podcast. It feels like we have a meeting every week." And I mean, that's from where we sit in communication being so important as we've been talking about, from where we sit, that's exceptionally powerful.

Cameron Passmore: And what's neat is that it's making that person more confident.

Ben Felix: Which ties right back to all these things that we're talking about. What is the next grand challenge in investing? It's helping people be confident in making the financial decisions that they're making, hopefully with good basis. Like you're making those decisions for the right reasons, but having confidence in those decisions that's founded, not the overconfidence bias type confidence.

Cameron Passmore: And I think it's interesting how we fell on this recipe of a couple of current topics, planning topic, investment topic, and bad advice of the week. I think that combination with a guest is a neat recipe to give people enough flexibility and creativity and rapidity in the podcast that they can stay interested and yet learn something every single time in 45 minutes or so each week.

Ben Felix: It's true. There's been a whole evolution in the format, in the length of the podcast. And you're right. A lot of it comes from feedback that we get from listeners, which we love. And by the way, I had in my inbox before we started recording this today, our first audio... I haven't listened to it yet, but our first audio recorded listener question, so that's exciting.

Cameron Passmore: Very exciting. So thanks to everyone for listening all year. It's been an incredible experience to put together these ideas to try to communicate them. Hopefully, we get better every week. We got great guests lined up. We got lots, it's endless ideas that we have in terms of content to bring out on the podcast.

Ben Felix: But yeah, like you said, Cameron, thanks everyone for listening, and we greatly appreciate it.

Cameron Passmore: And Happy New Year, everybody.