It’s hard to believe, but today’s episode marks our fifth annual year-in-review episode — where we look back at some of our favourite conversations and takeaways from the past year! If there’s one overarching theme that stood out amongst our guests in 2023 it would be the power of purposeful decision-making to impact our future selves. Tuning in, you’ll hear our guests' remarkable views on the topic, from the power of regret when it comes to long-term decisions to the ‘hidden partner’ that accompanies us in all our decision-making. Another key theme that emerged is how the role of financial advisors is evolving. Key insights include why your financial advisor should collaborate with other advisors, why trust is essential, and how to prepare your children for wealth. We wrap things up with reflective tips on how to identify what your true goals are with a profound lesson on why setting your own scoreboard is essential. Tune in as we share some of our favourite moments from the past year and look back at the incredible guests we’ve had on the show in 2023!
Key Points From This Episode:
(0:00:19) Our year with the Rational Reminder community: 23 in 23 reading challenge, memorable meetups, live recordings, a shoutout to our community moderators, and more.
(0:08:42) Looking back at our conversation with Charles Ellis and Burton Malkiel on why money management is a loser’s game and navigating market efficiency.
(0:16:19) Pim Van Vliet’s insights on the evidence supporting higher expected returns related to certain stock characteristics.
(0:19:42) Discussing the relevance (and irrelevance) of dividends and why people tend to view dividends as particularly special, with Professor Samuel Hartzmark.
(0:24:58) Our conversation with Will Goetzmann on the value of very long-term data and why historical data is still relevant today.
(0:32:35) Nobel laureate, Robert Merton’s insights on putting together a long-term asset mix and taking into account your time horizon.
(0:39:14) Highlights from our conversation with Professor Francisco Gomes on how asset allocation should (and should not) change over the lifecycle.
(0:43:58) Our second interview with David Blanchett on how regret informs our long-term decisions and Daniel Pink’s insights on optimizing for future regret.
(0:50:50) Hear from Charles Ellis on the most under-appreciated action that every investor should take to be more successful.
(0:51:53) Making decisions on personal finance and John Cambell’s insights on how household beliefs tend to differ.
(0:54:54) Professor Ralph Keeney on why decision-making is the only purposeful way you can influence anything in your life.
(0:59:25) Input from Cass Sunstein on the extensive research he’s done on decision-making and how acquiring more information can help your decisions.
(01:03:09) We hear from Professor Eric Johnson about the ‘hidden partner’ that accompanies us when we make decisions and Cass Sunstein explains when we should update our beliefs.
(01:10:26) Professor James Choi shares his profound insights on why financial decisions are not always explained by economic theory.
(01:12:53) Unpacking the effect of overconfidence on our decision-making with Itzhak Ben-David, along with his key ideas on miscalibration.
(01:17:20) Answering the question “How good are we at understanding our future selves?” with Hal Hershfield.
(01:21:13) Our conversation with Meir Statman on the third generation of behavioural finance and what that means for decision-making and advice.
(01:23:48) Dr. Preet Banerjee’s research and insight on the value of having a financial plan.
(01:25:02) Talking with YouTuber, Darin Soat, about the struggle to find high-quality financial information online and understanding YouTube as an entertainment-first platform.
(01:28:27) Harold Geller on how to determine whether your advisor is properly understanding you and Robert Merton’s thoughts on how he views the role of financial advisors.
(01:35:02) We hear from Dr. Preet Banerjee on the business of financial advice and how it has changed over time.
(01:39:21) Victor Haghani and James White on the topic of intergenerational billionaires and why there are fewer than you might expect.
(01:44:09) An update from Rob Carrick on the state of financial planning for the average Canadian in 2023.
(01:48:48) Juhani Linnainmaa unpacks the impact of financial advisors on decision-making and the challenges of choosing a financial advisor.
(01:51:21) Dr. James Grubman on identifying a financial advisor who understands the importance of Wealth 3.0, why collaboration is key, and how to prepare children for wealth.
(02:02:28) A final takeaway from Shane Parrish on taking stock of your year and how to determine what your true goals are.
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're hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital.
Cameron Passmore: Welcome to episode 285. And this is our fifth. Can you believe it, Ben? Our fifth year-end review episode. And it's incredible that we've come to the end of another year.
Ben Felix: Yes.
Cameron Passmore: You're getting over a bit of a sickness. I was under the weather a couple weeks ago, but I'm fully back. You're what, 65% back or so?
Ben Felix: Approximately there. Yes.
Cameron Passmore: And people on YouTube will see that we spare no budget. I'm wearing, once again, my Grinch hoodie from last year and this very high-end Santa hat. That's my little bit of effort.
Anyways. Once again, we've got a retrospective show where we take a look at some of our favorite guests from this past year and try to weave together a story that highlights some of what we've learned. And I think it's safe to say it's been an incredible year. And we learned so much from our incredible guest.
And looking back, I was thinking about this on the weekend, my main takeaway from this past year is that we learned a lot about decision-making being the main driver leading to our future self. That's my overarching theme that I took out of this year. Now you can weave many stories, of course. What was your main takeaway if you look back over the year?
Ben Felix: Like you said, the guests this year have been just incredible. We're grateful to everyone, all the guests that have agreed to come on the show. It's a ton of fun for us to identify potential guests and reach out to people, which is always a bit of a thrill even though we've done it however many times now.
Cameron Passmore: Well, it's still a thrill because we get rejected so many times too, right? It keeps it real.
Ben Felix: That's true. That's true. Yes. Less and less though, I don't know.
Cameron Passmore: Yes.
Ben Felix: Not so many rejections that I can remember from this past year anyway. Yes. And then booking people. It's just a ton of fun. Most cases, I mean. I guess it makes sense. When guests are agreeing to come on, they're also excited that we're reaching out and to come on the show. And in a lot of cases, they are familiar with the podcast because they've listened to past episodes. Or in some cases, they're even regular listeners. That's always a ton of fun.
Cameron Passmore: And that never ceases to shock us. And it's so cool to hear from academics that aware of the work that we've done.
Ben Felix: Yes, yes. That, it always continues to be surprising to me. Now, by the numbers, just in terms of the podcast statistics, 2023 was a pretty significant year. We had in total 1.5 million. A little bit more than that 1.5 million approximately downloads. We had 57,000 YouTube views. Quite a few. That's a lot. I don't know.
Cameron Passmore: Seems like a lot.
Ben Felix: Yes. And our YouTube channel for the podcast is up to 26,000 subscribers. And the online community that we host has 8,339 members and continues to be very, very active every day.
Cameron Passmore: Incredible. The 23 in 23 Reading Challenge was also popular this year. And we are going to continue with 24 in 24. This year we had 528 signups to the challenge. 290 active readers. These are people that read and log their reading. But I know anecdotally, a lot of people were part of the challenge just didn't log with they were reading. 34 people completed the challenge of the 23 in 23. 3,032 books were read. 3,200 badges earned. And 155 book reviews.
We also had this year four live meetups. We were in Ottawa, Montreal, Toronto and, of course, Huntington Beach at the Future Proof Conference. That was pretty cool to meet. People that came from all over for that event.
Ben Felix: The meetups were cool. Cool to talk to the actual people that listen to us every week.
Cameron Passmore: And remarkably consistent in the profile. Really good people listening.
Ben Felix: Yes, yes, yes. Definitely. We also this year welcomed Mark McGrath onto the podcast with his new – well, not so new anymore, I guess. Still relatively new. Relative to the podcast, I guess. New segment Mark to Market, which we've been doing every other week in the ask episodes. And we had two live recordings. That was a new experience for us. We did the CFA Society Toronto Annual Wealth Management Day. That was episode 274. We aired that conversation. And then we also did Future Proof in Southern California with Hal Hershfield as a guest. And that we released as episode 275. Those were both recordings in front of audiences, which was – I mean, one of them was a regular-ish podcast episode in front of an audience. The other one was us being interviewed, which was a new experience on two different fronts.
Cameron Passmore: Yes. And a little strange for us, I think.
Ben Felix: To be interviewed? It was all right.
Cameron Passmore: Yes, it was fun.
Ben Felix: I thought it was good. Scott did a really good job with the interview.
Cameron Passmore: Yes.
Ben Felix: We did love as always hearing from a ton of listeners. In the YouTube comments, we always get good comments and questions. The podcast reviews on Apple Podcasts. We also got lots of emails. We heard from tons of people on Twitter, LinkedIn. Phone calls. We had phone calls.
Cameron Passmore: We had phone calls.
Ben Felix: I don't have –
Cameron Passmore: Let go with it.
Ben Felix: I don't talk on the phone very much. Call my wife. That's about it. I don't answer the phone.
Cameron Passmore: It's funny, we were talking about that the other day. We used to live – at least I used to live on the phone.
Ben Felix: Yes, yes, yes.
Cameron Passmore: Now I had a voicemail this morning. Oh, my gosh. A voicemail. I haven't had a voicemail in, I'm sure, months.
Ben Felix: Oh, yes. When I was a kid growing up, talking on the phone was still a thing. You talk to your friends on the phone, the landline phone all the time. Yes, I don't spend a whole lot of time with the phone anymore.
Cameron Passmore: We used to have endless debates here. How many phone lines we needed so people wouldn't get bumped when they try to call in? And I'm not even sure, do we even have different lines with the digital system? Anyways, I digress.
Ben Felix: Yes, yes. I think we do. Yes. Okay. We try to read those – a lot of those interactions. When we get good comments or when we get reviews on the podcast, when we have emails from people, we try and relay those back to the podcast audience, which I don't think we've ever gotten direct feedback on us doing that. But enough people tell us that they like to listen to the end of the episodes that I figure that some people like hearing that stuff.
I do also want to say a quick thank you to our community moderators. We got a great mod team in the Rational Reminder community. They really keep that place running. Because it's a fairly highly moderated community, I think the level of discussion there is just not something that you can match with less moderation. Those guys do an incredible job.
Cameron Passmore: Speaking of a lot of work, we have to thank and highlight the incredible team that puts on the podcast each week from behind the scenes. People have heard us talk about Angelica. Angelica Montagano leads our marketing team. And then Matt Gambino is our multimedia specialist. And he's the man behind the creation of the YouTube videos. And for those who watch on YouTube, you've seen an improvement through the year as he continues to tweak with the design and layout. We appreciate that.
I also want to give a shout out to our compliance team, our Chief Compliance Officer, Karine Deslandes and Cheryl Gilles, our senior compliance officers. Of course, before anything goes out, they have to review and improve any of our content. We also want to thank the amazing production team at the podcast consultant, and especially our main person there, Easton Duran.
Also, a special shoutout once again this year to our friend, Sachin, and his great sock company Eversocks. Every order in the store gets a free pair of custom design RR socks. They're very cool. Also, this year we want to thank our friend and musician, Trevor May, for the theme music you hear at the beginning and the end of the podcast. Trevor, thanks to the original music.
And of course, we want to thank our unreal audience that continues to listen each week. It's been an amazing experience for the past five years and hopefully continues long into the future.
2024 already, Ben, we've got incredible guests lined up. We've highlighted some of them in recent episodes. We're going to keep lining up great guests. But boy, they just keep on coming. With that, we want to wish you a terrific celebration for the end of 2023 and all the best for 2024. Ben, anything to add?
Ben Felix: You teed up the end of the introduction perfectly. I think we can go ahead to the episode.
Cameron Passmore: All right. Let's go.
***
Cameron Passmore: Welcome to episode 285, our year-end compilation show. Pulling together favourite segments from all of our guests this year, that's not easy to do. But kicking off this year's episode for the year-end episode actually was pretty easy. Because we had two legends join us who've had a profound impact on us for many years, Charley Ellis and Burt Malkiel. I thought what better place to start than with them.
Charley is the author of the classic book Winning the Loser's Game. And Burt is the author of the classic A Random Walk Down Wall Street. Charley is going to go first. And then Burt. But these two giants I think are the absolute perfect way to kick off this episode.
Ben Felix: You talked about golf and tennis. Can you explain why money management is a loser's game?
Charley Ellis: If you look at what you have done as an investment manager and compared to what would have been done if you were indexing instead, you will see that you've come out with a lower rate of return almost all the time. And it's because of the things you were doing, trying to win, trying to be better that actually didn't pay off.
Cameron Passmore: You wrote about the loser's game in 1975 in the Financial Analyst Journal. How has the perception of active management changed since then?
Charley Ellis: Well, at the time of the original article, most people thought, “Oh, that's a cute idea. Of course, it doesn't apply to me. I can beat the market anytime I want to.” If they look back over their shoulder at the prior 20 years, that was a wonderful time for active investment management. But the world changed, the world changed, the world changed, the world changed in many, many, many different ways. It was just at the time when, in my view, active management was losing its moxie and was causing more trouble than was doing good.
Since then, it's gotten harder and harder and harder to be an active manager, and successful at the same time. More and more people have accepted indexing is a perfectly rational way of taking advantage of the realities of the market, then not getting suckered into doing things that actually do you harm. It does take a sense of humour, and it does take an appreciation for history to realize, "I know you're wonderful. I know you're terrifically talented. I know you work very, very hard, but you're actually not helping yourself, or your clients.
Cameron Passmore: Wow.
Charley Ellis: Let me just drop, what to me is an absolute bombshell. If you look at the investment results of active managers, mutual funds being the only really good source of information. But take all actively managed mutual funds in a 20-year time period, 85% to 90% of them will fall short of the index that they chose as their index to beat. You’re a large cap value manager. I'm a small-cap growth manager. Whatever type of manager we want to be. We design how we're going to be really good at that. We choose the source of information that will be most helpful to us. We develop the trading skills that would be most effective. Then we go out there in the world free to do anything that we really want to do to advance our cause. And 85% to 90% of us will fall short.
At the end of 20 years, if you said, “Oh, gee. All we have to do is find the really good guys, then we'll be in great shape.” Sorry. Of those that happen to do well, about 85%, or 90% of them will fail in the next 20 years.
Cameron Passmore: It's very exciting for us to get a chance to meet you. We've been a big fan of your work for a long time. So we're very grateful. How do you describe what the term efficient markets means?
Burt Malkiel: Basically, there are two ideas behind the so-called efficient market hypothesis. The first one is that information gets recorded into stock prices without delay. If you say you have a drug company that announces that their phase three results from a new cancer drug have been absolutely wonderful, people have gone into remission. There are few if any, side effects. And that that information is sufficient to have a big effect on the stock price. Suppose the stock was selling at 20. And with this new cancer drug, it should be selling at 40. That it will go to 40 right away. It won't go slowly over time. It'll go right away because people will know that the stock now is worth 40. And anytime you buy it below 40, you're going to make a profit.
Now, obviously, one can never be sure that the FDA is going to approve the drug even though the phase 3 results were great. You never know exactly what the sales are going to be. You never know whether side effects are going to pop up later. Whether there's going to be a competing drug. No one is ever absolutely sure that the stock is going to be worth 40.
And some people may overreact and push it above. Some people may underreact and it will go below. But the point is – and this is the second idea of the efficient market hypothesis, and that is that there are no arbitrage opportunities. There is no obvious opportunity for excess risk-adjusted profits that the market gives you.
The way this is often described in academia is the efficient market professor is walking along the street with one of his graduate students. They notice a $100 bill on the ground. And the student bends down to pick it up. And the professor says, "Don't bend down to pick it up. If it were really a $100 bill, it wouldn't be there."
Well, I'm not quite that extreme. I would tell my graduate student, "Pick it up right away because it certainly isn't going to be there long." In an efficient market, these wonderful arbitrage opportunities, opportunities for these fantastic profits without risk. If they did exist, someone is going to pick them up right away. If you see it, do it immediately because it certainly isn't going to remain there as this wonderful profit-making opportunity.
Ben Felix: All right. It is great to hear why investing is a loser's game and market efficiency from Charley and Burt. The best people you can hear about those concepts from. And a lot of that would suggest you can't really do much to beat the market, which is kind of true. But as many of our listeners know, we think factor investing can make sense taking a little bit more priced risk. Assuming that there are multiple price risks out there.
Cameron Passmore: Yup.
Ben Felix: Then that maybe can allow you to have a little bit of a higher expected return if that's compensation for taking a little bit more risk. But the important part of that though is the strength of the evidence is support of differences and expected returns.
We did ask Pim van Vliet about the strength of the evidence supporting higher expected returns related to certain stock characteristics.
You've got a paper. And this one did land in a big journal, in the Journal of Financial Economics, that looked at global factor premiums from 1800 to 2016. Can you talk about the difference between a global factor premium and the cross-sectional premiums that we were just discussing?
Pim van Vliet: Good to make that distinction. So when we talk about factor investing, usually, we mean US stocks, but you can apply factor investing in international equity markets. You're still selecting stocks. You couldn't do this in Europe and Japan, emerging markets.
In this paper, Global Factor Premiums, we did it across markets. So we didn't look at individual securities. We looked at markets’ indices being stock market indices and then comparing, for example, the US stock markets with the UK stock market, with a German stock market index, and then applying factors to that.
So you can then test time-series momentum and cross-sectional momentum. So what we did is we took the big factors which were documented in the top A journals in the past five years before we started our study. That is then time-series momentum carry low-risk seasonal and value. We tested them across markets. By doing that, you can then also move outside equities. You can also look at international bull markets commodities and currencies. So that gives you a whole matrix of six factors for markets. So then you get 24 factors. Or alternative risk premia, they're called.
Again, risk premia, I'm a bit – that's not my words because I would call them factor premiums, which is a bit more agnostic. So 24. And then, yes, going back to 18 on there. We basically out-historied ourselves. Because with the broad markets, you can go even further. And there we found positive results. So factor premiums seem to be a feature, a market feature.
Also, interesting that, individually, they are not extreme. Usually, they are basically all below one. That's also good to be aware. It’s gross, so you have implementation costs. That means they're not very visible. So you need to know what you're doing. And then, for some investors, this could mean that you can reap profits from these cross-factor premiums, which are probably a feature of markets.
Cameron Passmore: This is such fascinating information. Between these two papers, how confident do you think investors should be that factors are actually a real thing?
Pim van Vliet: How confident? Yes, it's good to always have some doubt. You can be wrong. Predicting markets is one of the most difficult things. So it's all putting the odds in your favor. I think you can be pretty confident that the factors which are pretty easy and not complex, which have a solid economic rationale, that they will probably be around for the next decade. So if you have your whole investment portfolio, so you have your saving, you have insurance, you start investing, then I would certainly allocate some money to these factors.
It's the same with the equity. The biggest one is the equity premium. It's also a factor. We understand it. It has a Sharpe of .4 or .3, and we allocate to it. I have some doubts on this factor, like I have with all other factors because they can disappear for decades. I hardly meet any investor who doubts the equity premium, which makes me very doubtful
Cameron Passmore: One debate, Ben, that seems to have endless energy is around the relevance or irrelevance of dividends. I'm not sure that there's any topic in finance that causes so much heated passion debate all over Twitter. Professor Sam Hartzmark joined us on episode 274 and I thought he gave a great response in this debate that never ends and how people come to think that it's so special to filter based on dividends. I don't know if you have any to that or not, Ben.
Ben Felix: Sam didn't mince his words at all. He had pretty strong views on the topic, which I think made it a really interesting segment of that interview. I think this is the same conversation that I did a clip of and posted on Twitter. And a lot of people liked that a lot. This is a good clip. Yes, Sam wasn't messing around when he answered this question.
All right, I want to move on to another topic that people also get very emotionally invested in, which is dividends. Can you talk about how investors treat price returns and dividend returns differently?
Sam Hartzmark: Absolutely. Dividend investors are very emotional investors. I actually had another finance professor who I was presenting one of these papers and he went home to Christmas. His father-in-law was a big dividend investor. He was convinced that our arguments would convince him. I mean, he reported back afterwards that they agreed to disagree, that it was too passionate, the love for dividends. Emotions run high.
But, how do people actually treat prices and returns differently? The first thing to note is that before we bring in important real-world things, they shouldn't be treated differently at all. This is a classic finding from the 60s, whose rough intuition is correct. You've got some sort of a dividend payout. Let's say, stocks at $10 is going to pay a dividend tomorrow. Well, tomorrow, that stock will be worth $9. You've got a dollar in payment. You're not richer, or poorer. You still have $10. If it wasn't paying a dividend, you could have sold a dollar of the stocks, so it should be irrelevant. Then you bring in real-world things, like taxes and trading costs. For most US investors, most of the time, dividends will have a little bit of a tax penalty. If anything, you should probably not necessarily love them.
How do people actually treat them? Well, they view them as different and not together. That leads to a big mistake because think about what I just told you, right? The thing was $10, now it's $9, you've got a dollar in cash, you're better or worse off. If you view say dividends as separate, well, you've got a dollar. This is awesome. This is free money. This is income. This is something you can live on. Firms kind of play this up. They pay dividends in nominal amounts. They try to keep them at levels where they can always pay that amount, maybe slowly increase it. It seems like a safe, stable, nominal income stream. There's the price changes. That's what we think of as in terms of stocks. It can go up, that's awesome. It can go down, that's sad and risky.
You've got this one thing you're holding. It's a stock. You view it almost as two distinct assets. This risky price change component and the dividend component is kind of a safe, stable income stream.
Cameron Passmore: Between us, Sam, what causes people to believe dividends are so special?
Sam Hartzmark: I think that some of it is that if you aren't paying particular attention, it's not very easy to directly identify this theoretical idea. First off, empirically, it's totally the case that when the dividend gets paid, the price drops by roughly the amount of the dividend. There's a big literature in the 70s looking like, it's almost the whole amount related to taxable stuff, things like that. It's like, intuitively the price drops by the amount of the dividends. This is just true. But that's true when I've got a data set of 10,000 dividend payments and I run a regression and you get this coefficient close to one with the T stat of 30.
I'm some investor who's just looking at the five stocks in my portfolio. Well, stocks are really volatile. In practice, what happens? Well, you get a couple of basis point dividend payment. On a day the market moves 2%, you have no idea. How should you think of it as a rational person? Well, you should think of in the counterfactual world, market’s down 2%, but it would be down 2% minus those basis point dividends if I hadn't received the dividends, but you don't really see it. There's not really an effort to make you see it.
If you think about your brokerage statement, what happens with every brokerage I've ever seen is you get a dividend payment and it just shows up in cash. It's not very salient which stock it came from. It's not salient that the price of that stock should be higher. If you aren't thinking about it, it looks like free money. This volatile price has moved around. You don't notice where it came from. That's why we call this the free dividends fallacy. You kind of view dividends as this free bit of money that's distinct from the price level, as opposed to the price dropping by the amount of the dividend, which in practice is exactly what happens.
Ben Felix: All right. That's great stuff from Sam on dividend relevance or not-so-relevance. Another really important topic that we talked about with a guest this year with Will Goetzmann was the value of very, very long-term data, which is something that if people have listened to the podcast for a while, they know that we find that to be very interesting and we use it in practice. We use very long-term data in practice to think about expected returns. We asked Will Goetzmann why long-term data in his view are important. And how relevant data from hundreds of years ago are if we're thinking about expected returns today, which is an interestingly common question that comes up whenever – not whenever, but in a lot of cases. If someone hears that we're using data from 1900 to now or even earlier in some cases, it's common to hear, "Well, how is that data still relevant today?" And Will had some really good insight on that.
Cameron Passmore: Will, why is it important to collect and examine very long-term historical returns data?
Will Goetzmann: A lot of what we read about in the press, when we're thinking about the economy, or the stock market is really pretty short-term, but if you want to understand the deep rhythms of markets and society, you really have to take a long-term historical view. In particular, when you have big shocks, crashes, technological innovations that happen only occasionally through time, and you want to study them and see what their effects might be, you have to take that long trajectory, even over centuries sometimes, in order to get a sense of how things change, how does the world respond to big events.
Ben Felix: Okay. We are going to get into bubbles and innovations later. But before we progress on this, how informative do you think data from hundreds of years ago are about expected returns today?
Will Goetzmann: Well, you're asking a real financial question, expected returns, which means what kind of growth or benefits do I expect from owning a share of stock or a part of the stock index today, on average, over months and years? So, that is a puzzle for many people, and the reason for that is that the returns you get from investing are not stable. They vary quite a bit. With that volatility, that volatility creates uncertainty. And it could take you 20, 30, or 40 years to really understand what the expected return or what the average historical return is. But we'd like to think that once you've discovered something that makes money, it's going to keep on going before you can really put any kind of boundary on it at all.
So, as financial historians and financial economists, were plagued by that uncertainty about what the expected return is. But history helps you. Because what I found in my research is that, over very long stretches of time, the stock market returns some amount in a relatively narrow band once you can control for things like inflation.
Ben Felix: So, speaking of uncertainty, Will, if you were in our receipts, so we help households make financial decisions. How would you estimate the expected long-term returns of both stocks and bonds?
Will Goetzmann: You're right to differentiate the two, although they do share some characteristics. For stocks, the starting place, for me has always been the historical performance of the markets, both looking at the US market, but also comparing it to a world equity portfolio, which would take into account the failures as well as the successes.
People often ask me, “Don't you think that the expected return has really changed, because technology has changed?” Strangely enough, it doesn't seem to have really ramped up the expected return particularly or changed it that much. So, I think, at least the basics are that you look at returns, but you really have to adjust for inflation, because inflation has been a great shock since the First World War. So, 100 years, we've experienced the kind of inflation that was only episodic in the world before that.
So, you have to adjust your perspective and you have to think about why are you investing. You're investing because you want to take the fruits of that investment sometime in the future and be able to live off of it or buy stuff and buy real things. And so, those things are going to be affected by inflation. That's one big important issue. I would look at inflation-adjusted returns as my metric.
On the bonds side, bonds are theoretically less risky than stocks, although sometimes they can be very volatile themselves. But you have to realize with bonds you're not getting an upside. Occasionally, something will happen where interest rates suddenly go down and bond prices go up. But that's not why you're investing in bonds unless you're a short-term speculator. You're investing in bonds because they basically take your money from today, and ship it into the future. And unless it's an inflation-protected security, you're getting future dollars, which are going to be affected adversely by big inflation shock. So, bonds are sensitive to the potential for future inflation in the long term. And in the short term, they respond to variations in the interest rate.
Now, that's easy to say in one word. It's impossible to really explain all the complexities of what goes into causing variation in the interest rate. Today, more so than almost any time I can think of in the past, everybody's watching the Federal Reserve and the Treasury Department and trying to figure out what branches of the government or even something's, Federal Reserve is not exactly a government institution, it’s independent. What are those decisions that the Fed will make? And how are they going to affect my bond portfolio?
And those are human beings making decisions and thinking about what effect on the economy those decisions will have. So, there's a lot of speculation about what's driving them to do this, that, and the other thing. And that, in turn, makes it difficult to really forecast bond returns, at least in the short term very well.
So, those are the two different ways you think about stocks and bonds. However, one of the things that stocks and bonds both share, is their promises of future cash flows. That means both stocks and bonds are affected when the interest rate goes up or down. We've seen this recently because when the stock market went down after the Federal Reserve decided to start raising interest rates, a lot of that is probably due to the discounting of the future cash flows from the stocks in the same way you discount the value of the future coupons that you get from the bonds. So, the present value suddenly changes when the discount rate is raised.
Cameron Passmore: 2023 kicked off with an incredible conversation with Nobel laureate Robert Merton. Just an incredible incredible guest. He was so kind. And as we shift in this year-end episode into thinking about how investors should think about their long-term decision-making, I think hearing Professor Merton's perspective on our long-term asset mix and why that is important is a great way to keep going here.
Ignoring human capital, what influence do you think time horizon should have on the mix between stocks and bonds in an investor's portfolio?
Robert Merton: That's a very good question. It's a complicated question. I'll try to break it down the way I think about it. Obviously, if you have to pay your taxes in a day, or a week, or a month, with big penalties, if you don't, then you don't put that money in stocks for the week, okay? I mean, that's just simply common sense. If you're looking at long horizons, such as, as often said, that in the long run, stocks really aren't risky because is an argument, which is both mathematically and empirically incorrect, which is that if I have a very long horizon, then I'm going to earn by the law of large numbers, or some argument, or just looking at the data, I'm going to earn the expected return without taking risk.
If I can wait 200 years, I'm going to get by the law of large numbers. That's a fallacious argument mathematically. Empirically, it's refutable. What I first want to say is, what's not true is that in long run, stocks are not risky. They are. In fact, how much money you will have at some future date gets larger if you're taking risks, the range, the farther out you go. I just wanted to, first of all, be very clear about that.
By the way, I wish it were otherwise because then we could solve all our problems in the United States. We could just tell Congress, borrow a billion dollars, which they do all the time in the United States. Put it in whatever portfolio that some pension advisor say we'll earn in the long run 6%, 8%, your choice. Okay? Then you'll put it in there and you're eventually going to surely got to have a very big payoff far enough in the future.
I mean, let me just use, I don't know, 8%, or something. Some number like that, that they sometimes use for portfolios. If you could get 8%, what's the time horizon for a country? Let's say, the United States or Canada. I hope, at least a couple of 100 years. What is a billion dollars? If I borrow a billion dollars at 3% and I invest it at 8%. I borrowed the government rate and I invested in this magic portfolio, how much will I have at the end of 200 years? That's a math problem. I can give you a hint. 4.3 quadrillion dollars. You've heard of trillions, now we throw those around. A quadrillion is 1,000 times bigger than a trillion. 4.3 quadrillion dollars from borrowing 1 billion dollars today and investing it in that magic portfolio. That's a long horizon for a person. We hope it's not a long horizon for the country.
If I have 4 point something quadrillion in the bank, the government bank, like anyone who has a lot of assets, safe assets, you can go and borrow against it. You see where I'm going. We've got quadrillions for sure. Therefore, we don't have to have any taxes. We'll just borrow for it and then pay it off at the end. We can spend as much more or less we want. By the way, if you're worried about 4.3 quadrillion not being enough, borrow 2 billion. Now, you're up to 8.6. You see my point?
The very argument used, you've all heard it, particularly pension funds that in the long run, it's really not risky. It'll all work out through some argument. If that were really true, the country has a much longer horizon than any pension fund. It can really do the job. I’m taking you through this example because I hope it will make people say, “That doesn't make any sense. It can't be such a free lunch,” and there isn't. Whatever you think is there is that way.
Time horizon is important. Obviously, you're planning a horizon and so forth. That factors into it when you solve the problem optimization. The idea that somehow, if you have a long horizon, you don't have to think about it that in the long run, you're going to get what the expected return or some other simplifying argument is fallacious. It's dangerously fallacious in that if people really behave that way, or we run our government that way, we have a serious problem. I tried to explain it by showing this little – what Jon Swift would call a modest proposal, that creates something that's completely ridiculous to say, if you don't see the mathematics of it, or if you don't see the wherever you can see there's something wrong with it. It gives too much of a free lunch for all of us forever.
We see that one popping up, by the way, as an aside from time to time within the political framework where they say, you can borrow forever and it'll all be – work out. I don't know if that's responsive enough. I think, I'm trying to give you a sense that what is not right. Now with horizon, it's not simple. I may have a long-planning horizon, but the horizon might not have a very big impact on what I hold my portfolio each time, other than my risk-free asset. Obviously, the risk-free asset is going to pay me for sure when I want to be paid. If I have a very long horizon, the risk-free asset is going to be a very long, some bond, whether it's inflation protected, or in dollars, or euros, or whatever, okay.
But other than that, I see the time horizon as important and there are some characteristics such as mean reversion and so forth when you get into technical stuff, where if you have a long enough horizon, that you may get more benefit from it. I just view that element as just standard portfolio optimization.
Ben Felix: All right. Great to hear from Professor Merton. We also got some really interesting insights from Professor Francisco Gomes on how asset allocation should – or to our surprise, when we heard this from him, should not change over the lifecycle.
Cameron Passmore: Can you expand on that a bit? How does optimal asset allocation change over the life cycle?
Francisco Gomes: Building on this, so when we're young, we still have kind of our whole trajectory of income or wages coming up for the rest of our lives, right? And so, this human capital is gigantic. It's huge. It's at its maximum. We still have all our human capital ahead of us and we haven't accumulated that much wealth.
Therefore, this ratio I was just talking about is very, very large. A lot of human capital. Very little financial wealth. We can afford to take significant risk in our financial wealth. Because if things don't go well, we have kind of this human capital fall back on.
As we get older, we start having less and less years remaining in which we're going to earn our wages. At the same time, if we're being prudent, we're saving for retirement. So our wealth is growing and growing. This ratio is actually falling significantly because the numerator is falling and the denominator is increasing. The ratio is just falling, falling very rapidly, which means we're now should be converted to a more and more conservative portfolio.
This kind of gives rise to sort of this standard target date fund predictions or recommendations, right? If you invest in a target date fund, which these days is default option many retirement, DC retirement plans. They have this decreasing profile. And it's kind of based on this intuition that you kind of – early in life, you can afford take more risks. As you approach retirement, you can afford to take less risk because you depleted more and more of your human capital. So you have sort of this guide path until retirement.
Now this is a good rule of thumb for retirement allocation. But, of course, when you think about our whole portfolio, it has to be a bit more complicated than that because now we have to think about the expenditures side. We have to think about those income shocks.
Early in life, since I don't have much wealth, if I have an unemployment spell. I have some major expenditure, or my car breaks down, or some major house repair, or medical bills. Those can happen even early in life. If I haven't saved enough in liquid safe assets, then I might not have enough to cover those bills.
First, we want to make sure we build what is called a buffer stock of wealth. We have like a pot of wealth we can fall back on if things go bad in terms of the income side or in terms of the expenditure side. First, we want to build that buffer stock. And that buffer stock, since it has to be available, there's sort of an emergency fund, it has to be invested in relatively safe asset and relatively liquid assets. And this should be about six months to a year and a half of our wealth. Basically, depending on how large these risks are.
And as we accumulate more and more wealth, then we should just start putting more and more in stocks because we can afford to take risk. And also, at some point, we have enough wealth, this buffer stock becomes less relevant. Because if I have significant amount of wealth, even if I lose 10%, 15% on the stock market, I still have enough. And if I invest in that low-cost broad index fund, losing more than 15% in a year in the stock market is very, very rare. If I kind of follow in that trajectory, then I'm just going to be investing a lot in stocks.
If you want to think about a simple rule is if you have like a graph where you plot sort of on your horizontal axis your age and on the vertical axis you have your allocation to stocks or risk assets in general, it should be kind of like a hump shape. Start more less moderate early in life because you want to have that buffer stock in a relatively safe asset to a large extent. Then you increase sort of towards 35, 40 years old, you kind of max out over there. And then it kind of sort of gradually decrease towards retirement. That's kind of the standard profile or standard prediction that most of these early models predict.
More recently I've kind of deviated a little bit from that, I must say, to the extent that we're on the last part. Last difficult path towards retirement. There's a bit of dispute among academics about how much more comfortable people are in taking risks as they get richer or not. Some academics think that there's not much evidence that people become more risk lovers as they get richer.
I think that by now, especially in this context, the evidence is around that they do. That people feel more comfortable taking more risks as they have more wealth. And so, that kind of counteracts this idea to decrease significantly your allocation as you get older because you're becoming richer and richer.
Now my recommendation is more kind of a mild decreasing path or even a flat one. For example, myself, I'm following a flat one. I'm not increasing my allocation. And I have no plans to increase it as I approach retirement. That's kind of in a broad sense the wide path of the allocation of our life.
Cameron Passmore: It's super interesting how regret forms part of how we make long-term decisions. And David Blanchett joined us for a second time in 2023 and talked about regret. And then he compared regret aversion to risk aversion. We have two clips of David's. Let's go to those.
What is driving that regret in investing?
David Blanchett: This is going to shock your listeners, but people aren't utility-maximizing robots across all time periods at all times. We’re people, right? I mean, we go back to the tulip mania, you look at real estate bubbles, you look at – people are prone to greed, right? When things start doing well, I think investors respond differently to having missed out. Could this have changed my life? Oh, my gosh, I could have bought Bitcoin at a dollar, and now, it's worth, I don't know, 25,000, whatever it is.
I think that the emotional response that's triggered when we see other things do well that we don't know, it's very personal, very emotional. But I even make the point in the research that I would say even institutional asset managers, to some extent, could suffer from regret. Right? You could see this, for example, in the performance of the US Stock Market, if you’re a hunter. You might hate large-cap stocks as a tactical asset manager. Okay. But if you don't own them, and they do really well, that can be really bad for you from a benchmarking perspective.
Even if it's little bit less efficient, based upon your expectations, it could actually make sense to still own it, to the extent it allows your clients to realize the value of your process, do a full cycle, right? So, to me, the key here is not just saying, “Okay, you could have less wealth.” You have to acknowledge that individuals bail out over certain time periods, and that's where they really get burned. So, trying to do things to keep them engaged over a longer timeframe, acknowledging regret, and acknowledging FOMO, could actually help them create more wealth over the long term.
Ben Felix: I want to start with your new paper on regret, which is just a fascinating way to think about portfolio optimization. Can you talk about the difference between risk aversion and regret aversion?
David Blanchett: So, risk in a traditional portfolio optimization routine, just standard deviation or downside risk. It's volatility or losing money. I think we can all kind of agree that that's pretty uniform. People don't like losing money. Now, people have different perspectives on what losing money would do to them. You might be really conservative and I might be really aggressive. I'm okay with having a more aggressive portfolio.
What that totally ignores though is how you might feel about certain assets doing really well. Risk is focused on losing money. Regret or FOMO would be a fun word to use is focused on the notion that how you experience an outcome could really affect you. Maybe you didn't lose money, but maybe not making money really negatively affects you and it creates all this emotional pain. It's obviously a different type of pain than losing money. But the thing about risk as a continuum, maybe I would have been willing to have a little bit more risk in my portfolio if it would reduce regret at some point down the line. So, there are behavioral things here too, like we've seen these investors abandon diversified portfolios during speculative bubbles because they're missing out on this next wave. Could allocating into assets, even in small portions, actually increase their wealth because it keeps them diversified over longer time periods because you're less prone to investing speculatively?
Ben Felix: Continuing on with the idea of regret, one of our most popular guests in 2023 was Daniel Pink who wrote the book The Power of Regret. Let's hear what Daniel had to say about optimizing for future regret.
Okay, so that's regrets that you have. The other thing that I liked in your book is you don't talk about avoiding future regret, which of course makes sense because we've talked about how it's important. Can you talk about how to optimize future regret?
Daniel Pink: Yes. This is a tough one, because there's a little bit of nuance here. So theoretically, what we would want to do is just minimize future regrets, right? That makes perfect sense. Totally makes sense. It's harder than it looks. The reason for that is that we make a huge number of decisions. If you're putting that kind of analysis on all your decisions, it will grind you to bits. What we want to do is, this is like social psychology 101. There's a – and you guys are probably talking about this too. There's a difference in the research on decision-making between what I call maximizers and what I call satisficers. Maximizers want to make the best decision in every case. "I want the very best ETF. I want the best roofer in Washington DC to fix my slate. I want the juiciest hamburger in the Delmarva area for lunch. I'm going to get the best of everything."
What we know is that maximizers and satisficers say, "It's good enough. I just have a hamburger, it's good enough, whatever the hamburger is. Most of these ETFs are the same. I don't really care about one basis point lower in fees, I'll deal. There are plenty of good roofers, I'll just take whatever roofer there is." Here's what we know, maximizers are often slightly more successful, they are also miserable. They're miserable, because you can't maximize on everything. Again, going to, Ben, one of your earlier questions here. I think this is the thing that's so exciting about this emotion of regret, is that you pop the lid on it, and inside are like these pretty fundamental questions about how to live your life.
So one of them that you brought out was the difference between where do you have agency and where do you not? What's in your control and what's not? If something's not in your control, don't stress out about it, because it's futile. Right now, in this case, the difference is this. There are some decisions on which you should maximize. There's no question about that. But most decisions you should satisfice on. And that's hard for a lot of us to do. My view is that the optimal way of doing this is that you maximize on avoiding these four core regrets. You maximize on avoiding the regret of not building a stable foundation. You maximize on your regret of not wasting your time on this planet in trying stuff. You maximize on being good. You maximize on building connections of love, and everything else you satisfice on. Because, again, let's go to housework.
If you were to have a conversation with yourself 10 years from now, the you of 10 years from now, really doesn't care what hamburger you chose. The you of 10 years from now doesn't care whether you got the best roofer in Washington or the third best roofer in Washington. The you of 10 years from now doesn't care whether you bought a blue car or a gray car. The you of 10 years from now does not care about those other things a lot. So, if we maximize on those important things, and satisfice on everything else, I think that that at least gives us a map, a route to a life well-lived.
Cameron Passmore: Okay. Let's now go back to Charley Ellis, episode 244. And he had pretty clear thoughts on what the most under-appreciated action that every individual investor should be doing to be more successful.
Ben Felix: You've been doing this for a long time, Charley, and you've talked to a lot of people. What do you think is the most underappreciated action that individual investors can take to be more successful?
Charley Ellis: Oh, defining who they really are. Figuring out what the real problem is. I'm an art history major, but I had friends who were engineers. They all told me the same thing. Most of engineering is learning how to figure out and define the problem. Solving the problem is not very hard. Most of us candidly, with regard to investing, have not figured out what is the problem. If we just didn't realize, “Oh, yes. That's really important.” Then if you could get everybody to sit down and spend even a day, trying to figure out what is the problem, they'd probably be well-advantaged.
Cameron Passmore: All right. Continuing on this idea of decision-making, one of the challenges in personal finance is that every person is going to have different beliefs, which is ultimately going to impact their decisions. John Campbell told us how household beliefs tend to differ.
You mentioned households are differing in their beliefs as being one of the challenges of household finance. Do you have a sense of how much households differ in their beliefs and preferences?
John Campbell: The evidence on beliefs is just beginning to come in now as people – really, the Holy Grail in the field is can you link self-reported beliefs to what people actually do? And you're always going to have a small sample where people report their beliefs. And it's hard to link to what people do. But we're beginning to learn about that.
I would say there are some persistent differences in belief. Some people are just always more optimistic than others. It's sort of like temperament. Some people are more up. Some people are more down. And then when people say their beliefs are changing, they do seem to change what they do but only a little bit. Not nearly as much as the sort of portfolio choice formulas that we discussed earlier would imply. It's as if the beliefs are a very noisy measure or sort of amplified measure of what they truly act upon.
Now with regard to preferences, that's another great question. And I have a working paper that studies this in Scandinavia where we can measure quite accurately both how much households save and also how they allocate their assets. This paper, which is written with Laurent Calvet, Francisco Gomes and Paolo Sodini, a kind of very European author team. It's called The Cross-Section of Household Preferences.
And we study Swedish households that are middle-aged and have sort of accumulated some retirement wealth. And we use a life cycle model, which sort of fits that part of life pretty well. And what we find is a great deal of variation in the rate of time preference how impatient people are.
Some people are very patient. They save early in life. They do their retirement saving. And then other people are impatient and put it off and have a great scramble as retirement approaches. We also find a lot of variation in the responsiveness of saving to interest rates, what economists call the elasticity of inter-temporal substitution. And we find a bit of variation in risk aversion, but actually less in that. And the reason is that almost all of these households in Sweden do take some risk through home ownership and equity mutual fund ownership also by leveraging using mortgages.
Most people have a sort of moderate coefficient of risk aversion somewhere between four and seven. There's some variation there. But you don't see too many people with risk aversion of one, or less, or 50, or more. It's not that kind of range.
It's interesting that we find so much difference even when we're looking at these middle-aged Swedish households that have some stock market ownership. Because if you looked at the full population, including the very young, the very old, people who don't have any stocks, you'd probably find even more variation. But that's for us to look at in future research.
Ben Felix: This might have been the quote of the year. This really struck me when we heard it the first time. And it stuck with me since. Decision-making is the only purposeful way you can influence anything in your life. That's something that's pretty obvious when you think about it. It's obviously true. But it's not something that I've heard said so, I don't know, explicitly before. We got that from Professor Ralph Keeney back in episode 238.
Cameron Passmore: Such a great conversation. And I remember we talk about this in the clip coming up. But I remember texting you when I read that in the book. It's just like, wow. So clear. So good.
Ben Felix: Yes, yes.
Ralph, how do you describe the focus of your career’s research and your consulting work?
Ralph Keeney: Well, my emphasis has always been in decision-making, but my undergraduate degree was in engineering. There were certainly no degrees in decision-making, and very few courses. Then I went to grad school at MIT and met one of the founders of decision analysis and negotiation analysis, Howard Raiffa, who was at Harvard, and I worked with him and worked with him for his whole next 50 years and mine too. The thing is, I realized the power of decision-making in the sense that it's the only purposeful way you can influence anything in your life, in your business, in your family, or in your country. You make the decisions and then the consequences occur.
It was very interesting to me. I like working on personal decisions. The style is exactly the same. It’s what's business decisions when I've worked on. The elements are the same. You can learn a lot from the personal decisions to help make the bigger business decisions, or governmental decisions, etc.
Cameron Passmore: I must say, Ralph, that quote is a quote that I read in your book. When I read it, I shared it to Ben online. That quote that is the only way that you can purposely influence anything in your life is by your decisions. It hit me like a ton of bricks. I just want to thank you for that. It was a great, clarifying sentence about your book.
Ralph Keeney: Well, and about decision-making, per se.
Cameron Passmore: Which brings me to my next question, which is how do you articulate the importance of thoughtful decision-making?
Ralph Keeney: Well, partly, it's important because that's the only way to influence your life, and we would all like to have a better life. That doesn't mean selfishly. A better life for an awful lot of people means contributions to the lives of others as well and to their community, certainly, their family, their country. That's what I think is so crucial there and why it is. Just because of that fact, which I didn't realize when I first started working out on decisions, I figured there's many ways to influence your life, but the word purposefully is key there. You can certainly influence your life greatly by acting without thinking, and particularly, if you do really stupid things once in a while.
Ben Felix: I agree with Cameron. That quote also hit me like a ton of bricks. You read it and that's like, that’s a big, bold statement, but it's true. There's no way around it. It's the truth.
You mentioned that you've got a background in engineering. I also did my undergraduate degree in engineering, and many of our listeners are computer scientists and engineers. I think that they'll be interested in the answer to this question. Do you view good decision-making, or good decisions as objective, or subjective?
Ralph Keeney: Well, they certainly have subjective aspects, I think. I don't view them as objective. The sense is, why bother to make a decision? It's because you care about something. Now, many of those cares could be based on all kinds of subjective things. There's not an objective. That would be, I'm trying to figure out the right thing from externally for my decision. In fact, the right thing for me to consider in my decision, like the right objectives is what I feel is important. I think, the subjectivity is there. It doesn't mean you can't be systematic about doing it. You want to be thoughtful and organized and set up, so you can do a better job. That's what gives yourself nudges in a sense about, trying to help people with that process. I think, subjectivity would be the answer there, if I have to choose one of those two.
Cameron Passmore: Continuing with the theme of decision-making, in episode 266, Professor Cass Sunstein joined us and he's done an enormous amount of research into decision-making. We asked him about deciding to acquire more information that would help in your decisions. And here's how he explained it.
Ben Felix: I think this next question continues off of that topic. How do people decide whether or not to obtain information that could help them make better decisions?
Cass Sunstein: This is maybe the most fundamental of all. I had for a number of years, I'm still in it, a kind of reckless research project. It's reckless in the sense that any research project, you should have a hypothesis that you're testing. I've asked people in many nations now, nationally representative surveys, whether they want to know, for example, the number of calories in their food, what the stock market's going to be at the end of the calendar year. A lot of people don't want to know that, by the way, which is a startling thing. Whether people want to know when they're going to die. Whether people want to know whether they are going to get Alzheimer's. Whether people want to know what their friends and family really think of them. Whether they want to know that. Whether they want to know if their partner is having an affair.
I've asked a zillion questions. And here's what seems to come from the sometimes startling results, that people care about three things. First, they care about whether the information is useful. Can they do anything with it? A number of people don't want to know whether there's calories in their food, the number of calories. There's likely to be some calories in there, and they don't want to know the number. I think they think, I'm going to eat when I'm going to eat, and I don't want to know that. A lot of people don't want to know the side effects of medicines. I think they think the food, the medicine, if my doctor wants me to do it, or if I want to do it, it's probably fine. Side effects aren't going to tell me anything I need to know. Of course, they want to know, is it valuable?
People don't want to know the year they're going to die? Because they think, "Oh, what can I do with that? Nothing, most people think. Second thing people think about is, does it make them feel sad or happy? Do they think it's going to make them have a better day or worse day? People don't want to know things that are upsetting to hear. That's why a significant percentage of people don't want to know what their friends and family really think of them. That's pretty useful. But if you learn that your best friend thinks you're kind of annoying, they love you, but they think you're kind of annoying, that it's not good. People don't want to know things that make them sad or scared.
Third, people have an interest in just learning things, because it satisfies something like curiosity. People want to know whether Shakespeare really wrote Shakespeare's plays, even though that's not very useful. The answer might not make them happy or sad. I really want to know whether dogs are descended from wolves, and in what sense? I'm really interested in that question, but it's not particularly useful for me, and the answer won't make me jump for joy or break out in tears.
I think the most interesting thing about information seeking and information avoidance is the power of people's rapid assessment of whether knowing X, or Y, or Z is going to make their day better or worse. There's an ostrich effect where with respect to health and economic things, people don't want news that will be bad. That can create all sorts of problems in trying to avoid the bad. You don't know about the risk you might run into it.
Ben Felix: One of the decision inputs that people may not realize they are affected by is the design of the decision itself, which is often been architected by someone else. There's this hidden partner in a lot of the decisions that people make. We asked Professor Eric Johnson about this in episode 240.
Cameron Passmore: First off, how do you describe the hidden partner that accompanies us when we make decisions?
Eric Johnson: Every time we make a decision, we don't realize it, but someone has been there before us. And that person, who I’ll call the designer because that's a simple word, has actually made a bunch of decisions about how to present that decision to us. They've decided how many options. So this range is from maybe a parent talking to a kid about going to bed, or a CEO giving direct reports, possible strategies. Somebody has already thought about how many options do I give somebody. What happens if they don't make a choice? What are the descriptions, the attributes of the options?
There's a whole set of things that have already been chosen, decided by the designer. In some way, the thing that's really important to realize is that, well, determine, at least in part, what gets chosen. So for example, if I decide not to present an option to you, you're not likely to choose it. It's as simple as that. The designer has a lot more influence than we as people make decisions and they as designers appreciate.
Ben Felix: How significant is the effect of those design choices on the decisions that we ultimately make?
Eric Johnson: In some cases, particularly when the decision is infrequent and one we're not sure of, it can be huge. I think one of the world's records is held by a study done in Switzerland with real utility customers. They were told you can either choose the green electricity as the one that's generated by, in their case hydro and solar, but mostly hydro, or grey, or black electricity, which is made by coal. The green’s a little bit more expensive. It turns out, all they did was pre-check one box, so you can make either choice, but you just had to move that check.
They found about a 90% difference in what people chose. What's interesting is you think, well, maybe the first time it works, but they fool people, something like 85% of people stick with that initial choice. There are lots of examples, but that's the sense of pretty good things. You don't think about your electricity choices that often. It's going to have a bigger effect than it would be if you're talking about do I want to eat liver or not.
Cameron Passmore: Okay. You can have a silent partner when you make decisions. And you can decide if you're going to get more information before making a decision. But what about how to decide what information you will believe and whether you should update your beliefs. Here's Cass Sunstein again from episode 266.
Ben Felix: Okay. We talked about how people decide whether to seek information. How do people decide what information to believe, and when to update their beliefs?
Cass Sunstein: To get it this, this is a frontiers issue where we know so much more than we did even 10 years ago. We need to have three concepts, one of which will be familiar. One is confirmation bias. If people hear something that confirms their prior beliefs, like I believe my dog is healthy and barks occasionally, that I'm finding that very credible. The noise [inaudible 1:06:34] in the background. Confirmation bias means, we tend to believe things that fit with our pre-existing views, and people just do that. There are two ways to think about confirmation bias. I think the popular way is to think it's kind of crazy. That why wouldn't we find disconfirming information as credible as confirming information feels a little bit self-interested. That's part of that. But it has a little more of a foundation than that.
If people told me that dropped objects don't fall, which I don't believe to be true. I won't believe that if they told me [inaudible 1:07:15], I'd feel that confirms what I believe, and confirmation bias would kick in. It's rational given your pre-existing beliefs to update or not depending on how it fits with what you think. There's the motivated part, and then there's the rational updating part. Take that as confirmation bias.
Then there's a kind of subset called motivated reasoning, which is the emotional part, where people believe things that they want to believe. That means that if you tell me something about politics or something about a politician, that I really am saddened by. I might think you’re biased and you don't study very hard, so you don't know that the politician I love is actually God's gift and couldn't possibly have done or said that bad thing. So motivated reasoning is a second thing.
The third, the newer is desirability bias, which suggests that we believe things that we find it desirable to believe. So if you tell me that actually, the hair loss that I thought I had, I actually don't have. That it's an artifact of Zoom and some unflattering photographs, but I have a completely full head of hair. That's desirable to hear. Thank you for that. I will find that particularly credible. If you tell me something like my male Labrador Retriever is not so beautiful. He's okay looking, but he's not so beautiful, I find that highly undesirable, and I not want to believe it. There's desirability bias.
Now, what's really fun, I think, is confirmation bias and desirability bias, if you're with me, we'll often go in exactly the same direction. That what confirms my beliefs, I'll find agreeable, and credible, and that will be desirable, but you can pull them apart. If you think, for example, that you aren't very good at sports, but you're given information suggesting you actually are good at sports. That is disconfirming information, but it's highly desirable information. We have some data suggesting, and a horse race between desirability bias, and confirmation bias. Desirability bias is secretariat. It's the better horse. That is people will believe information that they want to believe, even if it is disconfirming of what they started out believing.
That's a very long-winded way of saying that what people believe fits with what they find it pleasing to believe, motivated reasoning, and was what they start out believing. That can mean, one last bet that good news will be more credible than bad news, with respect to almost everything, which can lead to unrealistic optimism with respect to, let's say, investments, and it can also lead to terrible mistakes in updating.
Ben Felix: Professor James Choi joined us on episode 260. That was an incredible episode. We asked Professor Choi why financial decisions are not always explained by economic theory. People do all sorts of stuff that economic theory would not predict that they would do. Why?
Cameron Passmore: They sure do.
Ben Felix: James, in general, why do you think economic theory often fails to describe how real people make personal finance decisions?
John Campbell: That's a big question. I think that every theory, every set of theories is wrong. The statistician George Fox famously said that every theory is wrong, but some are useful. Anything that's going to have some explanatory power that has some ability to offer – insight is going to simplify the world, and so it's going to necessarily not get everything right. The question is, how wrong, or what kinds of wrong are you willing to tolerate because you'd think that the insight that's provided is reasonable for that cost.
Economic theory, just like every other theory has its blind spots, its oversimplifications, and its particular kinds of oversimplifications that had traditionally been made over many decades in economics, that at some point we decided that the wrongness was too much to be tolerated. This notion that everybody is perfectly rational and is able to do these complex calculations on the fly or not necessarily on the fly, but at least eventually get there. That was a pretty useful paradigm to maintain the research for a very long time.
Then you had people like Danny Kahneman, Amos Tversky, Richard Thaler having a lot of fun and showing ways in which we systematically make mistakes that seem to deviate from that rational paradigm. That birthed the field of behavioural economics, behavioural finance. I think the people are not rational, calculating supercomputers. They have limited amount of cognitive ability. Then there is cognitive illusion that we all suffer from to a certain extent. Then there's failures of self-control and motivation. All these things were swept under the rug and ignored really for many decades. We're still in the process of figuring out what is the right balance of these other forces to allow into our theories and into our models, again, recognizing that we need to oversimplify and get some things wrong in order to get greater insight into what might actually be going on in people's heads and complex economic systems.
Ben Felix: Another reason that people might make errors in thinking about the future is overconfidence. And one form of overconfidence is miscalibration, where people overestimate their ability, they overestimate the precision of their predictions about the future, which can lead to all sorts of problems in future-oriented decision-making.
We asked Professor Zahi Ben-David about this in episode 268. He's done some incredible papers on miscalibration specific to CFOs in American companies.
We've got one more topic to cover to finish up our conversation here, Zahi. You've got a couple of just phenomenal papers on this idea of miscalibration. I love these papers. Can you talk about what miscalibration is?
Zahi Ben-David: Yes. These papers are part of a broader literature of behavioural biases, behavioural economics. In behavioural economics, we think about biases from rational thinking. There are many different biases. But the two that we're thinking about often in either household finance, or financial markets, or behaviour of managers, executives, as we have in this case, are optimism and overconfidence.
One way to think about these is basically, these are first and second moments in predicting future outcomes. Optimism is going to be being overly optimistic about the outcome. The outcome might be sales of my firm next year. Overconfidence is about the distribution of outcomes. Obviously, sales next year could have a distribution that could be good, bad, or maybe in the middle. Overconfidence, I'm just too sure of my forecast.
In the literature of psychology, people think about three types of overconfidence. One is called better than the average. This matches to this survey question, are you better than the average driver? The answer is, of course, and others are morons. It turns out that 80% of people think that they are better than the average. This is one type of overconfidence. The second type of overconfidence is called illusion of control. Things happen in the world. Oftentimes, we attribute these things that happen outside to our own decisions. This was a great decision for me to invest in the stock market. See? The stock market went up 10% last year. Obviously, if I lost money, it's somebody else's fault, not mine.
The third one is miscalibration. Miscalibration is really an overestimation of my own ability to make forecasts. Oftentimes, people ask in the context, not in the financial context, in order to measure overconfidence, people ask a series of questions. The goal in these questions is going to get 80% of them correct, let's say. Thre's going to be an 80% confidence interval. These type of questions might be, for example, what is the distribution of the New York Times? When was the Black Plague? For each question, you would give me some range. It happened between these years and these years, say, the distribution of the New York Times, between this number and this number. The goal of this game is to get 80% of the answers within the range.
Now, as it turns out, most people are miscalibrated. They give you a too narrow interval. They're too confident in their own estimate. This is the background. Now, you could see how this type of bias is so important in the corporate world, right? I mean, in order to advance in the ranks, you'd better be a good manager. Good manager, meaning taking good decisions, deciding on the right advertising campaign and closing sales. By being bold and being confident in your estimates, you're more likely to succeed.
Now, oftentimes, I mean, other people have shown in the research, past successes are attributed to people who have been advanced. I don't know whether you noticed, I have a slight accent. Not everybody can notice it. I'm originally from Israel, and there is this saying of who becomes the chief of staff in the military, although they took risks and we're lucky not to be killed in the battlefield. It's the same thing. You’re a risk taker, you don't realize that you're taking risks and you happen to survive, you climb the ranks.
Cameron Passmore: Hal Hershfield was a guest twice in 2023. First time was for the launch of his new book Your Future Self. He was also a guest at our live episode from Future Proof. The book Your Future Self was one of my favourite books of this year. I thought it was an incredible book. And ultimately, when we make financial decisions, it will have an economic impact on our future self. But how good are we at understanding our future selves? Let's feature some segments from Hal's visit on episode 265.
How connected do people tend to feel to their, I guess, potentially changed future selves?
Hal Hershfield: There's a continuum. I would say we all have a tendency to think of our future selves, as if they are different people. This is an analogy, but I think, to some extent, we sort of think of those future selves, as if they're sort of another person. But where we differ when you asked, how connected are people? I think the way to answer is that, some people will experience a great degree of connection with their future selves, the sort of connection that we feel to our kids if we love them, our spouses if we love them. Other people experience, not necessarily like a dislike, but they lack that strong connection.
The analogy that I like to use is, it's the co-worker of yours who's in the break room. You know they're there. It's not like you're surprised at their existence, but you're not that emotionally invested in them, you're not that close to them. That's another way of describing the relationship that some people have with their future selves.
Cameron Passmore: Which emotion drives decisions that favour our current self or our future self?
Hal Hershfield: I would almost answer it a different way. And to say it's not which emotion, it's just that emotions, behaviours, or current self. In other words, everything that's happening right now feels more intense than the stuff that we think is going to happen in the future. It's not that it's just like greed, or laziness, or pleasure or any of those things. It's also on the negative side I dread doing something right now and I don't want to experience that, so I pushed off to later. It's not that I would say that there's one emotion that necessarily colours their tendency to do things now versus later. It's just that, we're feeling so much emotion in the present, and it can lead us a bit astray. I want to be careful there, because there are a lot of times where it really makes sense to prioritize the present is what's happening. If we're thinking about what's certain and what's not certain, I'd rather do the thing that's certain. The problem becomes when I sort of excessively prioritize the present at the disservice of my future self.
Ben Felix: What do you think it is about our future selves that makes them feel like a stranger?
Hal Hershfield: It's such a deep question. There's so many things involved there. One of which is that they don't yet exist, and you can think about it. There are strangers in our lives, again, I said, the co-worker but it can also talk about the people all the way around the other side of the globe. They currently exist and we don't know them. Our future selves, they don't exist yet. It's incredibly hard, it's a tap into their emotions. We're really not that great at forecasting our feelings into the future. If you think about it, that's probably one of the core aspects of being able to relate to somebody if I can feel what they're feeling and see the world through their eyes. That is just a really difficult thing to do, which I think can increasingly make it likely that our future selves are seen as strangers. Then, another component that needs to be mentioned here is that it's really easy to get wrapped up in the present. That's where everything's happening, and can make it really hard to think beyond that.
Ben Felix: Meir Statman is someone we had wanted to have the podcast for a long time. And this year, we finally accomplished that. Meir is very well-known and well-respected in the study of behavioural finance. And we actually got to meet him, which is pretty cool, at Future Proof in California, which was really cool. We got a nice picture of him too.
Cameron Passmore: Yes.
Ben Felix: When he was on, one of the things that he talked about that was really impactful to us was his description of the third generation of behavioural finance and what that means for decision-making and advice.
What's the third generation of behavioural finance?
Meir Statman: The second-generation kind of expands the domain or expands the range of behavioural finance, beyond making mistakes, that no longer assumes that all people want is to maximize wealth. People want to maximize wealth, but they also want to stay true to their values. The third generation of behavioural finance really broadens the lens of finance, even broader. It says, eventually, what finance is all about is maximizing people's well-being, which is sometimes called happiness, although happiness is too narrow. The question is, what is money for? Money is for well-being, and well-being has many domains. It is family, it is friends, it is work, it is health, it is religion and values, it’s the society.
I wrote a book that is called Finding Well-Being that looks at these domains. The important thing is that finances, money enhances well-being. But more than that, money underlies well-being in all the other domains. You cannot support a family without money, you cannot see a doctor without money, you cannot enrol at a university without money, and so on. Some people who write about those issues of well-being and happiness say things like what is really important, this friendship. Well, that is nice, but friendship is not enough and you need money even for friendship. Because if you're going to go on the subway to visit a friend, you have to pay.
Ben Felix: That’s a great explanation.
Cameron Passmore: A great friend of the podcast, Dr. Preet Banerjee, joined us on episode 269. Again, another great episode, and he’s done some amazing research into the value of having a financial plan. So, here, Preet shares with us his thoughts on that.
Ben Felix: That seems like one of the big findings from the paper is that regardless of channel and regardless of whether how valuable we think advice is, having a financial plan is huge on every metric that you looked at.
Preet Banerjee: Yes, because portfolio management is commoditized now. The value-add is in everything outside of the portfolios. Now, I know there are some people who are still stuck in the portfolio-centric view of the universe of financial advice. Not to say it's unimportant. It's just that the relative importance of adding value on that aspect, that's a much tougher game now than it was before. Now, we have all-in-one portfolio ETFs. What are they, 20 basis points now? Man, that's tough. That's tough to beat. Wouldn't you rather focus your time and energy on areas where you can make a much more significant difference with probably a higher level of reliability as well? I mean, that seems to be the trend moving forward, but it's a slow-turning ship as you know.
Cameron Passmore: We really do try hard. We put a lot of time and effort into providing high-quality personal finance information on the Internet through our podcast and through my YouTube channel, free to the world. That’s something that we’re passionate about, but it’s also something that if you look around personal finance channels on YouTube, high-quality information is not so easy to find, and low-quality information tends to get a lot more views and a lot more clicks. So we asked Darin Soat, who is a YouTuber, a successful YouTuber with a huge channel, but also a very thoughtful guy. We asked him why that is. Why is it hard to find high-quality personal finance information on the Internet?
Why is it harder for high-quality personal finance information to be seen on YouTube?
Darin Soat: It's because YouTube is an entertainment-first platform. It really is the house of Mr. Beast. One example I like to use is someone who is a good friend of mine and it's Patrick Boyle. If you look at his old lectures where he might explain something like the Fama-French Five-Factor model, that probably doesn't get a lot of views. But it's something that's really important, maybe not for somebody to understand about their own personal finance. But if you're trying to learn something about finance, you should probably watch that video, instead of watching a day trading video. The issue with that is it's boring. While it might be interesting to somebody like yourself or me, to a general audience, it's not.
Basically, for his more current videos, he has to be more news-related. He adds a little bit of comedy, dry humour to it. You have to do that because if you think about how Mr. Beast operates his videos, every second is trying to keep the viewer watching for a little longer. If you're watching for a little longer, and that's more people that the video is pushed to. If the video is being pushed to more people, that's more people that watch the video, which is ultimately more revenue for Mr. Beast, which is more views, which leads to more revenue and more growth for his brand and more growth to his channel.
For example, he'll do something at the beginning where he says, “I'm about to throw these Lamborghinis into this grinder and crunch them up.” But you'll see that at the end of the video. Then in between, he'll do a bunch of other different things. The whole idea there is to keep people to watch the video for a long period of time. With that comes the fact that you have to basically compete with clickbait. I try not to use the word clickbait, but you really have to be competitive for clicks.
What I try and do is I try my best to balance, making sure that what I say is with the video title, thumbnail is relevant to the video. Because if I'm not competing for clicks, then I'm not going to be seen over some of these more nefarious actors on YouTube. I have to in a way find ways to be creative with my title that encourages people to click through. It's an incredibly hard thing, especially if you're a channel like mine that brings people in and says things that they don't want to hear. Like it'll be harder for you to retire compared to prior generations. You won't get rich quick. Then still get views. It's incredibly hard to do that.
Ultimately, you have to figure out how you can be competitive with others in YouTube. It really just comes down to being entertaining because, again, YouTube is really an entertainment-first platform. If you're not entertaining, then you will not make it on YouTube.
Cameron Passmore: In working with an advisor to help you make your long-term financial decisions, it’s really important to be aware if your advisor is properly understanding you and your situation. We welcomed Harold Geller, a lawyer who helps consumers sue financial advisors, and that was the actual title of that episode and episode 236. So we dug into that question about whether or not your advisor is properly understanding you.
Ben Felix: I want to come back to Cameron's question, but I want to ask it slightly differently. Cameron asked about product, product due diligence, KYP. I want to ask a similar question on KYC. So we were talking about risk profiling, and you illustrated an education opportunity for an advisor to give to their client through that process. How should a client know whether their advisor is properly performing the KYC process, properly understanding them as a client?
Harold Geller: Well, it's also difficult. How much are they asking about your past investments? It's not just what was your experience, although that's important, right? Because that's a subjective evaluation and might inform things about your objectives and your risk tolerance. But, also, what did you do? When did you do it? Did you make money? Did you lose money? How did the experience of making money impact on you? How does the experience of losing money impact on you? If I made you 10% over two years, how would that impact you? If you lost 10%? Now, let's try 20%. These are the types of discussions with know your client that really should go on. Not just good news about how successful a financial advisor is.
Also, if the financial advisor is using a whole lot of industry jargon, then you really got to question their skills because one of the skills is communication. I think this is true, whether you're a lawyer or a financial advisor. Pick someone who can explain the concepts to you, that will help you to learn more about the industry term, so you can understand the forms. So you can understand the reporting. If your financial advisor is not sitting down with you when you get your first statement and asking you what you understood and what you didn't understand, what more information you could use, then they're not reporting to you meaningfully. That's another indicator that this whole KYC process, which should be ongoing is not occurring. If it only occurs at the beginning or once every couple of years, when they have to fill in a mandatory form, they're not really keeping up on you because we all forget. That's about KYC.
Well, KYC changes over time. Most of us forget to tell people about KYC changes. Know your client circumstances to change. Well, I mean, there were obvious ones. I'm planning to retire. Well, I'll probably going to tell my financial advisor about that. But if I'm worried about getting my bonus, or I'm worried that I'm taking on another expense because my child got into the university, and it's going to cost me more than I planned, those are material changes. If the financial advisor is not seeking to update themselves regularly about these changes by sitting down and inquiring, then you're not likely to report them, and it's a garbage in, garbage out scenario. They can't give you good advice because they don't know you.
Cameron Passmore: All right, continuing on thinking about the role of financial advisors, we did also ask Professor Robert Merton, where he sees a role for financial advisors.
Ben Felix: You mentioned financial advisors. What role do you see for financial advisors?
Robert Merton: I see – well, obviously, it depends on what. They can have multiple roles. First of all, that financial products are complicated, and they're not transparent to the holders. Like a doctor, they can give them advice on those products and explain it to them and tell them that things that are there. I mean, that's pretty basic. They can put together plans. They can talk to people. We can get much better at it. Some are doing that by looking at the lifecycle of the person and extracting from that what they need to do, rather than just mechanically saying 60-40, 70-30, whatever, all right?
The advisor themselves can do a huge job. The reason is that you're not going to hire an advisor if you don't trust them, I don't think. If you trust them, they're in a position to, therefore, help you get to a good solution you can't get to yourself, all right? Trust is an absolute essential. That's what I see the advisor providing. As I already said, mathematical models by themselves are not trusted. Despite what they say, technology by itself is not trusted. I don't think you would take your cell phone and put it in and ask, “What should I do about my sore leg?” If it came back and told you, cut it off, that you would do it, all right? You don't trust your technology by itself.
Technology combined with things, yes. That's the role of the advisor. I say that however they do it is providing that trust, the same kind of trust that you need for your medical. At some point, they're going to explain things to you. At the end of the day, you're going to have to trust the person that’s in the operating room, or you're going to have to trust the person that's prescribing because you have no other choice. I'm sorry to run on about this. I view that the issue of trust is absolutely essential. You cannot verify most performance, okay? We know that. If you could, there will only be one provider. You only have two choices, three choices. Verification, then you don't need trust because you could just do it. Transparency, which means you really understand what you're saying. That's limited, okay? If you don't have transparency and you don't have verification, then you have to have trust.
I think the role of the advisor is trust. If advisor is your advisor, they have that asset. Maybe they shouldn't, but they do. They have your trust. Therefore, that's the important role I see for the advisor in the mechanisms. I don't see it being replaced directly by someone who just claims that they have a mathematical model that does it, unless the provider’s a very trusted entity, and probably that doesn't work.
Cameron Passmore: Okay. Let’s go back to Preet Banerjee again to get his perspective on the business of financial advice and how that is changed over time.
Ben Felix: Can you talk about some of the main problems with past research that's attempted to demonstrate the value of financial advice?
Preet Banerjee: There's a couple. I cover quite a few aspects in terms of the challenges of studying this problem. I'll just highlight, I think, a couple of them that come to mind right now. The first one is moving goalposts. Financial advice has evolved continuously and continues to evolve and will into the future. It's in response to competition, consumer preferences, availability of information. If you use it as an example, May 1st, 1975, pretty auspicious day in our industry. It was May Day. That's when commissions for securities trades were deregulated. Up until that point, it was a fixed commissions schedule no matter where you went on the street.
At that time, a lot of people thought, this is going to be the death of financial advice. That didn't end up happening. The industry responded. Consumers said, “Oh, great. We'll go do these discount brokerages.” The industry, in attempt to respond to changing consumer preferences, changed from just providing advice on individual stock trades to, at the time, portfolio management, and trying to look more holistically at all the different parts of people's portfolios. Now, that was a slow process. That did not happen overnight. You could argue that that's still happening in the industry. Not everyone is evidence-based like you guys. Changing goalposts is one thing. Over the time, you look at the history of research in this area. That's one part.
The second, the framing of the value of financial advice has always been made in the context of the portfolio. It's very portfolio-centric, where the measures of success, the outcome measures, the dependent variables have been what's the size of the portfolio? Are people getting more diversification if they use a financial advisor versus doing it themselves? Things of that nature, all rooted in the portfolio. Contemporary industry practices, the market for financial advice has, again, shifted. It's, again, a very slow gradual shift towards non-portfolio-centric advice model. Looking at being more holistic, including things like insurance coverage, estate plans, tax planning, cash flow management, debt management, and other things other than the portfolio.
The other problems that thinking about the value of advice has been a very binary thing. A lot of the research says here's a study looking at people who use advisors and people who don't use advisors. Now, there's a couple of problems with that. One is not all financial advisors are created equal. There's a huge variation in the quality of financial advice. Some of that is even set at the firm level. It was interesting. There's early on in the days of financial planning, when it was still been delineated, there are some firms that borrowed the use of the word financial planning. Because if you said that, that might put the firm at risk of having to fulfill a fiduciary duty, and they didn't want to go down that road.
Portfolio management at the same time has become a little bit commoditized. The value propositions have changed. There's also different channels of advice. It's not just financial advisor or not. There's many different types of financial advice available. Then within those channels, there's different quality of advice as well. I would categorize a lot of the prior research as being very undifferentiated. What I set out to do was take a much more differentiated look at the market for financial advice and take into account that there are some channels that might be better than other channels. Within each of those channels, there might be better models of those channels, again, in those silos, so previously quite undifferentiated.
Then the flip side of that coin is households are also not all the same. Just as not all financial advisors or channels are the same, not every individual is the same. You probably have great stories to tell about different types of clients. Some that are probably can't wait to have this meeting. It's going to be I enjoy talking. They get it. We're on the same page. Other where maybe you end up firing down the road, because you know what, it’s just not a good fit. We're giving you all the advice, and you're just not taking it. Households are not all the same as well.
Ben Felix: We had Victor Haghani and James White on in episode 270. They’ve got this book where the premise is that there aren’t as many intergenerational billionaire families as you would expect based on the wealth of people, whatever, a couple generations ago. Their explanation is kind of the whole premise of their book. I won’t spoil it, but we did ask them what explains the puzzle of the missing billionaires.
Okay. I mean, we've talked about in sort of general terms, financial decision-making is hard, especially over the long term and people make investing mistakes. More specifically, what do you think explains the puzzle of the missing billionaires?
Victor Haghani: Well, we face all kinds of headwinds in terms of trying to grow and maintain our wealth. I mean, there's taxes. There's the fact that we're spending our money. But we think that those sort of obvious problems don't really fully explain the puzzle at all. So what we think is happening, and as we've taken a closer look at some particular families, we really see this, is that, over time, people make poor risk decisions.
As James was saying, this has been a really – the last 120 years has been a super positive investment environment. It's not that returns have been really low. It's that people take either too much risk or too little risk at different times with their investment portfolio and also with their consumption or spending decisions. These two things go together. We're going to talk more about risk and volatility in your spending decisions and how that could help or hurt your outcomes over time.
But on both the investing and the spending side, we think that people weren't making good decisions under uncertainty. That's really what our book is primarily about is these how much decisions, these risk decisions. It's much more that than the choosing of your investments.
Cameron Passmore: Can you talk about the features of the common but important financial decision-making problems that most people face?
Victor Haghani: Sure. I think that the most important common feature is uncertainty, that we just don't know what the future holds. Building uncertainty into our decisions is really important, and it's kind of subtle. That you don't want to just think about what's the most likely thing to happen, and then make your decision based on that. Or make your decision based on a probability of a certain outcome. You want to take account of all the outcomes, and you want to have an objective function. You want to have a benchmark that you're using to translate all these financial outcomes into what's important for you to come up with the best decisions under uncertainty. We'll expand on that more.
Ben Felix: What do you think are the most consequential financial errors that people commonly make?
Victor Haghani: Our belief is that their decisions around risk. As I was saying earlier, you could be taking too much risk or too little risk over time. Also, I think that sometimes people kind of believe that you can get return without much risk. I think that that leads people down some very bad paths that at the centre of thinking about investing and your decisions that you have to really build in that there shouldn't be a way to get more return without taking more risk. So I think sometimes people will take risk thinking that they're not taking risk, and they're just getting kind of returned for free.
Another really big error that I think people have a tendency to make is to extrapolate the future from too little past data. What we call return chasing, thinking that the future is going to be very much like the immediate past and that this extrapolation error that we are prone to make, I think, is another really harmful one over time.
James White: I would add, and this is something we see and work with clients a lot in our investment management practice, is people failing to connect their investment policies with their spending policies. That lack of connection, especially not being able to withstand a lot of spending volatility but having a lot of investment volatility, is what leads to not just once but sometimes many times for people having to de-risk. When markets are on their lows, then they re-risk when they're on their highs, and they ride that several times. That can be really wealth-destroying for people. I think the ultimate, ultimate cause of that is people not recognizing that their spending and investing policies need to be determined jointly rather than separately.
Cameron Passmore: [inaudible] personal finance, right? Rob Carrick joined us again in 2023. Rob’s such a, first of all, great guy. We get along great, and the episodes are super fun to do. Rob’s got the position of having his ear to the ground for what Canadians were thinking about when it comes to personal finance by virtue of getting so much correspondence from readers of his articles. So he’s on the front lines. Here’s a great deal from readers. So we asked Rob about the current state of financial planning for the average Canadian on episode 272.
So you mentioned value from advisors. What proportion of Canadians do you think are getting comprehensive advice from their financial advisor?
Rob Carrick: So I had a JD Power survey on advisors and customer satisfaction with it. I think I'm going on memory here, but I think it says something like six percent are getting what JD Powers set out as comprehensive financial planning and services that go beyond just managing investments. What I take from that is that very few people are getting comprehensive. I think a lot of people were probably a little fuzzy on all this and when they answer these surveys. I find these financial services give out results that I just don't believe a lot of times. Like half the people can't afford $200 for a financial emergency.
I mean, come on. I think the way they're worded, I think the way they're put out there, I think the way they catch people at dinner, and they're not really thinking they'll say anything to make the surveyor go away. I don't believe half the data, and the six percent sounds a bit low. But I don't think it's very low. I think most investors are just getting their portfolios managed, and they may get a little chat about taxes, and they may get urged to open up FHSA for their kids or that sort of thing. Maybe the advisor has systematized their contributions to all their accounts. Like it's going to come out of your account, go in every month. But a financial plan, a conversation about goals, I mean, a look at estates and wills and taxes and all that stuff. I think a minority are getting that, probably a very small minority.
Cameron Passmore: Where do you think the resistance, if there is resistance? Is it on the consumer side not really necessarily wanting it, or is it up to the industry to compel people to seek out planning advice?
Rob Carrick: It's a little bit of both. I think people want it. If you said, "Cameron, would you like us to do a big financial plan on you before we get to your investments?" You'd say, "Yes, please." But the process of doing it is laborious, and I'll have to find out numbers, and I don't know where to find them. Eventually, I'm going to lose interest in things. Maybe this could all just go away. I mean, I've been through it myself, and I was surprised at how many factoids I had to go find for the planner. It was a bit annoying, but I was very curious about the results, so I was quite motivated.
I don't understand why people aren't more motivated. You got to tough it out and do this. I would put a little bit of onus on the individuals, but it's also the industry. It's all about selling. It's a selling business. It's not an advice business, and it likes to pretend otherwise. It likes to pretend it's an expertise business. But, really, it's about selling. It's about pulling revenue out of client portfolios. The planning is kind of like that's like your eye on. You're sitting in neutral. You're not driving forward during that. I think it's partly the industry.
Now, the industry is making moves. I'm hearing the term planning used a lot more by people in the industry, but I'm not sure what the net effect is on people. Like is there a financial plan? Have you had a conversation with the person? What's driving the investment choice? Did you just do a quick risk questionnaire and then off to the races? I think that's what's happening most of the time.
I think there's a big disconnect between what people want, need, and what they're getting from the advice industry. I mean, my email in-basket is full of questions, questions, questions, questions all the time. I would say about 4 or 5 times out of 10, I'm sending people lists of investment advisors. These are advisor questions, planner questions, and a lot of them say, "Oh, thank you. I'm really open to doing that." Why are these people not already working with planners and advisors? Well, I suspect some don't have the assets, or some can't find the right person.
I think there's like two solitudes out there. There's the planners and advisors, and then there's the clients. Half the clients or some percentage of them are finding you, and you've got good relationships, and it's going well. Then there's a whole chunk of people who aren't matched up with advisors or planners who probably should be. I challenged the industry to find a way to serve these people at whatever asset level they have. I mean, there's all this talk about how AI is going to change the advice business. Well, I can think of a great way. How about you figure out a way to serve people with small portfolios?
Cameron Passmore: To the extent that someone decides that it makes sense for them to seek out financial advice, it’s not necessarily easy to pick a good one.
Ben Felix: No.
Cameron Passmore: Yes. So we asked Professor Juhani Linnainmaa who has looked at the role of financial advisors and the impact of financial advisors on investors’ decisions-making, how he thinks investors can assess the quality of the advisors’ beliefs. That’s one of the things that his research has suggested is that many financial advisors have misinformed beliefs, which if you’re an investor, it’s not ideal for obvious reasons. So I think Juhani had some really good points and tips. But, ultimately, I think his answer speaks to the challenges of picking a financial advisor, which is not an easy task, unfortunately.
Ben Felix: At the client level, how do you think investors can assess the quality of a potential advisor's beliefs?
Juhani Linnainmaa: The problem is going to be that if you – as a client, you know that's the right questions. That's already going to imply that you probably wouldn't even need a financial advisor. Of course, we want to advise people that when you look at an advisor, pay attention to fees that you're going to be paying. Don't try to invest in funds that are going to be churning around too much and things like that.
Again, if they can be asking those questions, that already implies that maybe they will know how to do it on their own. Somehow, it would have to be about education, not just about how you approach the advisors, but how you tell people about the financial markets. The issue that people have found, and this is not about our study, is that educating people about financial matters is really, really tricky.
I think there was a study by Bruce Carlin from UCLA. In a lab, they had people do experiment where they gave people different types of credit cards, different types of fees, and then they asked people to choose the best card. What would be the cheapest option for them? Of course, people made many mistakes with the choices. Then they educated people like what would be the right choice. When they tested the people again, after the education session, they found that people make many fewer mistakes, that it's easy to teach people to do the right thing.
Then they did a follow-up where they asked the same people back to the lab a few weeks later and gave exactly the same test. They found that none of the advice had stuck, that people had made the same mistakes. We can always tell people that in terms of advisors, don't pay too much for mutual funds. Don't chase returns. Probably they're going to be nodding and saying that that makes perfect sense.
Then when you meet with an advisor, they're going to be very convincing when they say that, well, this can be high-fee fund, but the returns are going to be even higher. All the education that you have given is going to go out the window. Again, the main question of, well, how do you educate people how to make good choices. That's the big question. We don't have an answer to it.
Ben Felix: Through the end of the year, we had a spectacular guest in Dr. James Grubman, who authored two of our favorite books. Number one, Strangers in Paradise, a phenomenal book, and then the most recent one, Wealth 3.0. The episode with Dr. Grubman is fantastic. You’re going to have to go back and listen to it if you’ve not listened to it yet. Anyways, we had a chance to ask James about if you’re looking for an advisor, how to identify an advisor that gets the importance of Wealth 3.0.
Cameron Passmore: Would you have any pragmatic advice for someone in terms of how can they identify advisors who really get the importance of Wealth 3.0?
James Grubman: That's a good one. That's really important because if you're a client who is ready for Wealth 3.0, you need an advisor who's thinking in 3.0, a capable advisor. I've talked with various firms and advisors and families, and they raise exactly this point. If you're a 3.0 family with 2.0 advisors, that's not a good fit. How do you make a change? If you're a 3.0 firm with 2.0 clients, who still think wealth is toxic and it's going to fail and they want you to do certain things about that, that's not a good fit.
But if you're a 3.0 client, how do you identify a 3.0 advisor? Number one, listen. What do they ask about? What do they lead with? Do they focus on fears, negative outcomes, likely difficulties, they lead with challenges, the challenges of wealth? Or do they seem to have –remember, we talked about openness. Advisors vary from closed to open. I've had advisors who say, “Hey, I've seen shirt sleeves to shirt sleeves. It's real. Why are we not talking about that?”
The idea that actually, we have no evidence whatsoever, no statistics that are any good of exactly what does happen with families. Families do struggle. But don't tell me you actually know how much or how often. Listen to how an advisor approaches things. Are they open to talking about communication techniques? Are they interested? Do they push products or services aimed at controlling the money for the family? Or do they show an openness to family communication? Family meetings are probably one of the best things that can be done for a family. But a lot of advisors don't know how to do family meetings or are really nervous about them. They’re encouraging communication within the family, giving resources that help parents talk to the next generation in ways that are useful.
A 3.0 advisor emphasizes strengths more than challenges, asks what have you already done to begin working on this, asks what do you think I can do to help you with it. It's a very collaborative relationship. If you will allow me, that leads into a related area, which is collaboration among advisors. I'm going to pause here for a second in case you want to pursue some of the other things first.
Ben Felix: Oh, please keep going on advisor collaboration.
James Grubman: Well, I think one of the biggest new movements that's part of Wealth 3.0 is a rethinking of the nature of wealth management and the fact that it really needs to be collaborative and integrated among the advisors serving a family. In 2.0, and you know this better than I do, a big phrase or label that came up was the advent of the trusted advisor and that desire to be that first phone call. That's a precious position to be the centre one. We talked about the quarterback, the general contractor, whatever you want to say. That wonderful position of the primary advisor for the family that directs everything else, particularly at the ultra-high-net-worth level, that just doesn't cut it anymore.
The complexity of wealth and families and the desire of families to have all of their advisors play well with each other, like in kindergarten. It's a different world. Demographics are changing. The movement is shifting from the trusted advisor to the trusted team. For a lot of advisors, they see danger in that. It's a threat to their position. They want to be the trusted advisor. They're not really very good at collaborating with others. Protecting the client relationship is more important.
For families and clients that are ready for 3.0 approaches, one of the things to watch for is not just how does your advisor talk to you? How do they talk to your other advisors? Are they open, collaborative, willing to function as a team with accountability? Or do they want to own the relationship and they are mistrustful or wary or standoffish when you ask them to work with other advisors? That's one of the most important changes that's going on.
Cameron Passmore: We also have to share Dr. Grubman’s thoughts on what is one of the most frequent questions that we get, which is how to prepare children for wealth. Dr. Grubman’s answer to this question was, as you would expect, incredible. This is from, again, episode 282.
Cameron Passmore: What should parents be thinking about as they prepare their children to receive wealth?
James Grubman: That's a big question.
Cameron Passmore: And often asked. I know many listeners have that question.
James Grubman: Well, here, we could probably spend 2,000 or 3,000 hours talking about age-appropriate education and skills training and other stuff. That's the long answer for that. The short answer is actually, and it's funny because, again, it goes back to adapting parenting. Parenting of a seven-year-old or a nine-year-old needs to be very specific when the family has wealth, compared to when you're talking about parenting a 17-year-old or a 27-year-old.
One of the things that I often talk about is the idea that when you become wealthy, when the family becomes wealthy, money disappears, especially in the modern world. It becomes in the background. When a middle-class family uses a credit card, and then the credit card bill comes in the mail, and you have to pay bills at the end of the month or periodically and stuff, the child watches their parents having to, well, what used to be write a check. Now, maybe it's online or whatever. But money is present. People more often now have cash, although it is, again, transitioning to more electronic. Kids see money.
In wealthy families, a debit card that's linked to a brokerage account that gets automatically paid from a money market account that you manage using plastic for a purchase, the kid never ever sees the money get changed hands. You have to explicitly reinsert cash transactions, money transactions into life, remember what I said before, so the kids can see decision-making.
One of the things, I often tell a story about how I took one of my wonderful grandchildren to the Lego store. If you've ever been to a Lego store, you’ll know what a monumental amount of wonderfulness is in that store. You also know what the prices are on Legos. I did something that I've written about and others talked about. We went in and, basically, I was going to do a treasure hunt first. I said you have a budget of around a $100. I'm going to go around, and why don't we talk about what you might want to select? I'll buy you the gift. It's not your money. I will pay for it. But we're going to first look around, and you're going to decide how you want to – I basically gave her a budget. She said, “Okay.” We went around and she tried this. She looked at that. Sometimes, she said, “Well, this and this add up to a 100, don't they?” I would say, “Yes, you can have both if you want.” Then she might do some other stuff. Well, no, that's over the limit.
First of all, I was trying to teach her how to evaluate and make decisions of what's a good value for the money that we have, that we're going to spend. Eventually, she picked out something. Then I did something different because we could have gone up. I could have given the credit card transaction. She would have taken her hand, give me a kiss on the cheek for grandpa, and that would be it. But we didn't do that. I was prepared. I had a bunch of $20 bills. Before we went up to the counter, I gave her. I asked her. There's going to be tax. It's going to be a little bit more. So I gave her $120 in 20s. I put it in her hand. We go to the counter. The person behind the counter takes the toy and says it's $112.50 or whatever it was. She says, “Okay.” She takes the 20s in her hands, and she counts out 20, 40, 60, 80, 100, and the next one. They take the money in, give her the change back, and they give her the thing.
She turns to me, and she said the thing that was the biggest payoff for the entire exercise. She looked at me with big eyes, and she said, “Grandpa, that was a lot of money.” I said, “Yes, it was. But it's okay. You're worth it.” I kissed her, and everything was fine. She never would have said, “That's a lot of money if I had paid for it with plastic.”
Ben Felix: That's really interesting.
James Grubman: JG: Kids need to touch it. It's concrete. It's tangible. They need the contact with money as transaction in order to learn some of those skills.
Cameron Passmore: Of course, we have to include a segment from our episode with our good friend, Shane Parrish, who joined us to talk about his new book, Clear Thinking, a perfect final segment to this episode and really something to consider as you think about your goals for 2024.
Ben Felix: How do you think people should approach determining what their true goals are?
Shane Parrish: I think it should be like an annual sort of exercise, to be honest with you. You don't set it at 19 and be like, "Here's my goal in life. It's never changing. Here's the destination I'm going to get to." I think you just have to take stock every year with yourself and have a hard conversation. I do this. I go away. I usually go away for a night just to a different city. I want to get out either into nature or into a different city, different environment that I'm in. I really just go for a big walk, and I start thinking about like, "What are the things that I like doing this year? What are the things I didn't like doing this year? How can I do more of the things I like, less of the things I didn't? Am I moving in the right direction? Am I growing at the right pace? Can I sustain this? If I get to where I'm going? Do I want to be there? Is it worth it? Because we only get one shot at this thing we call life.”
If we spend all of our time on things that aren't important to us or things that are important to somebody else, then all of a sudden, we get to the destination, and we're like, "Oh. Why am I here?” Dr. Karl Pillemer wrote this book called 30 Lessons for Living. What he did, I thought this was a genius idea. He went to a whole bunch of people who are close to death, and he asked them, "What would you teach us about life?" The number one regret was they didn't live a life true to themselves. In Warren Buffett's words, “They played by somebody else's scoreboard.” We have to set our own scoreboard and make sure that we're aware of where we're going, and we're getting the things that we want, and those things are worth wanting.
Cameron Passmore: That’s our look at 2023. It’s really hard to pick the segments to make our storyboard [inaudible 2:04:25] of the year. But that’s our attempt this year. Once again, we’re super grateful for all of our listeners and viewers, of course, and everyone who reached out by email or letter review or said hi to us in public, which happened a couple times. Not that [inaudible 2:04:39] a couple times, which is kind of neat. So, of course, we wish everyone a great holiday season and hope you kick off 2024 in fantastic fashion.
Ben Felix: Yes, well said.
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Books From Today’s Episode:
Winning the Loser's Game: Timeless Strategies for Successful Investing — https://www.amazon.com/Winning-Losers-Game-Strategies-Successful/dp/1264258461
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing — https://www.amazon.com/Random-Walk-Down-Wall-Street/dp/0393358380
Your Future Self: How to Make Tomorrow Better Today — https://www.halhershfield.com/yourfutureself
A Wealth of Well-Being: A Holistic Approach to Behavioral Finance — https://www.amazon.com/Wealth-Well-Being-Holistic-Approach-Behavioral/dp/1394249675
Strangers in Paradise: How Families Adapt to Wealth Across Generations — https://www.amazon.com/Strangers-Paradise-Families-Wealth-Generations/dp/0615894356
Wealth 3.0: The Future of Family Wealth Advising — https://www.amazon.com/Wealth-3-0-Future-Family-Advising/dp/B0C9SHFSGM
Clear Thinking: Turning Ordinary Moments into Extraordinary Results — https://www.amazon.com/Clear-Thinking-Turning-Ordinary-Extraordinary/dp/0593086112
30 Lessons for Living — https://www.karlpillemer.com/books/30-lessons-for-living/
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/
Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/
Rational Reminder on X — https://twitter.com/RationalRemind
Rational Reminder on YouTube — https://www.youtube.com/channel/
Rational Reminder Email — info@rationalreminder.ca
Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/
Benjamin on X — https://twitter.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/
Cameron on X — https://twitter.com/CameronPassmore
Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/
Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/
Mark McGrath on X — https://twitter.com/MarkMcGrathCFP