investing for idiots

Welcome to investing for idiots yes you've come to the right place this is a video for the Libra bag holder option day trader the Wall Street bets afficianado I'm making this video for the people for the victims who find the scams they're in featured on my videos and today we're doing something a bit different this is a series where we have real experts on the show and a perennial topic of this series is investing given That so much of my work is investing gone wrong we've had Patrick Boo the playing bagel and today we're joined

by Ben Felix the whole point of this series is to point people toward channels which give a sound theoretical understanding to finance and moving them away from gambling and financial nihilism and towards basic Common Sense investing welcome to the show Ben I appreciate you coming on if you don't mind I want to start at the end in mind for those who Just watch you know the first minute what is the optimal strategy for most people not considering individual circumstance for most people to put their to allocate their money and then we'll back up to why

that is the case I think you've said that inv investing is a solved issue what do you mean by that yeah I I call it a solved problem because we have these tools called index funds which is what you're I think referring to in the question which are Funds that give you really lowcost tax efficient exposure to an entire stock market so the S&P 500 is an index that a lot of people have heard of that's I'm not saying that's the index people should be investing in we can talk more about that later but an

index is a representation of a stock market so the S&P 500 it the way that they describe it that S&P describes it is that it represents 500 leading companies in the US Stock Market and it's a Capitalization weighted index which means that larger companies measured by their size by their market capitalization have more weight in the index and smaller companies have less weight so we have these things called indexes we have these things called index funds that all they do when you invest your money in the index fund is they invest your money in the

stocks in the index and that's a really efficient way to get exposure to the stock market And so I mentioned not just the S&P 500 there are indexes representing stock markets all all over the world and so you can use these tools to build a portfolio that's going to give you exposure to Global stock markets which is kind of all most people need uh in terms of building a really high quality portfolio yeah so there's this so now I want to thank you for that I think that is the answer that basically I was like

looking for and I've heard so many People say so many experts say but now I want to back up to sort of the beginning let's just start with a bit about you and then I want to talk about why it is kind of counterintuitive that in experts would tell you sort of not to go with experts there are active financial advisors things like that and we'll get into why you and I think I also think that that is not the most prudent strategy for you know uh most people not to get into individual situations but

um Start with a bit about yourself what is your back I think your engineering to start right like just like me I did chemical engineering I did nothing with it and uh I think you are the same mechanical right yeah that's right you you know yeah mechanical engineering at at nor Eastern I'm I'm Canadian I live in Canada but I went to North Eastern University in Boston did mechanical engineer engineering there and then I came back to Canada and did an MBA in Finance after that and that's how I got into into finance and like

you I never used my engineering degree went straight to the NBA yeah why did you what made you interested in finance why why were you you kind of taken by the idea of investing and I wasn't at all I I was I was not taken by the by the idea of engineering I I knew I I probably didn't want to work as a mechanical engineer but uh I I was playing basketball that's why I was at nor Eastern I'm I'm 6 foot1 People don't often realize that because they see me sitting down on my YouTube

channel uh so that's re really are you joking no I'm dead serious like actually 610 I'm listed at 611 for like if you go on the North Eastern website you can see it from when I played uh oh man yeah wow yeah so I played basketball that's why I was at nor Eastern and then I came back to Canada primarily for basketball I came to play at a Carlton University which is like I don't know what to Compare it to um the best basketball school in Canada by far uh so I came back to play

there and I had to choose a program an academic program so I went there for basketball but it's like okay I probably don't want to do a masters in engineering uh maybe I'll do an NBA because you know that's pretty flexible with what I can do with it afterwards and then I picked Finance for the same a concentration of Finance for the same reason that I picked an engineering Degree in the first place was that it was kind of the hardest program I was told mechanical engineering is the hardest thing you can do and I

was like all right I kind of like mechanical stuff I'll just I'll do that and then same thing for finance like of all the streams you can pick in the NBA Finance is the hardest one so all right let's do it and that's that's it but I was never like I love investing or I love finance that no I do now yeah no no I was going To say that really bleeds through a lot of your videos that actually you are very interested in the research side of Finance that's how I found your videos is

I was looking for somebody who talked about not just like their opinion about stocks but what the research actually said and you'll often cite you know journals and articles in your videos which I really appreciate but it's interesting so the counterintuitive thing that I want to get at in this Video why I'm calling it investing for idiots be besides the Prov of title is that I think it is interesting and deeply counterintuitive that in most Industries expertise is how you get the superior advantage in the field so if you would want you know something done

right you hire an expert to do it for you that is the intuition that is at the heart of almost everything we do in the world and there's like a saying you get what you pay for right um there's a Reverse saying in Finance now which is popularized by I think Jack Bogle which the the founder of Vanguard where he says in finance you get what you don't pay for meaning that it's the reverse and that often times hiring the best wealth manag manager in the world will lead to worse outcomes than doing the very

at this point now simple and dumb thing and the idio like it almost feels too dumb which is hold a very Broad Diversified Index Fund not choose stocks Not choose timing not choose any of the things that you would think you would have to do if you want to achieve a kind of a above average is a bit misleading because actually you're getting the average but the getting the average is in finance weirdly above average can you break down why this is the case that that that is deeply counterintuitive so I think the average return

piece there that you just Mentioned is actually really important that with with index funds I've heard people say like well why would just settle for the average return why wouldn't I try and do better by by picking stocks or timing the market but I think if you look at what are average returns like what are what are the average returns of investors or what are the average returns of actively managed mutual funds they're way below index fund returns so I think what you said is Not incorrect that you're getting relative to other investors you're getting

above ad average returns using index funds you're getting the market return which is the average but if you compare yourselves to yourself to other investors uh or or other types of funds I think you're getting an above average return with index funds why is that the case expertise is weird in financial markets I think it's because financial markets are competitive they're a Competition now if you have one skilled person and nobody else is doing anything to price stocks St stocks are priced based on trading so if I think a stock is worth more and you

think it's worth uh and you think it's worth less we might have a transaction and and every time that that happens it puts information into stock prices now everybody wants to make a profit if there's one person pricing assets and nobody else is there they they could Make a lot of money because there'd be a bunch of mispriced assets and they could go decide what to pay for them and and they' they'd be become very wealthy very quickly but that's obviously not the reality there's a bunch of people competing to be the one putting their

information into the price to try and make a profit and that competition is what sets stock prices but it also results in a situation where you've got if you've got two extremely skilled Traders to and like you know we talk about active manager underperformance and I think a lot of the times it almost becomes pejorative where active managers are dumb and I don't think that's the case I think they're some of the smartest people in the world like finances become this brain drain for all the other smart Fields so it's really smart people and but

they're competing with each other to be the ones to to make a profit and when you get that you You get this thing called the Paradox of skill where when the the players playing against each other in a game are increasingly skilled the outcome is increasingly determined by luck rather than skill take like NBA games for example uh you take two NBA players that are equally skilled and make them play oneon-one against each other and they play 100 games like the winners is going to be determined by luck assuming they're equally matched right uh yeah

so I think that's it there's there's a paradox of skill and it creates a situation where being skilled does not lead to better outcomes and then for investors the the you get what you don't pay for comment is because for the service of hiring someone to try and do that for you you're going to pay a high fee you're also going to have high transaction costs because every time they trade a there's a cost implicit or explicit or or usually both and so net Of fees and costs trying to beat the market on average is

going to be a losing game so you got those two pieces one the outcomes are determined by luck because all the players are so highly skilled and two you're paying a cost to participate in that game to try and beat the market and so net of costs on average you're going to lose it's a it's a losing game when you say it it it sounds simple but it it is uh hard to get your head Around and I have you know I have a bunch of uh you know family members for example who will tell

me like yeah I've got this active manager he's charging me you know sort of 1% and uh and I want to like I want to shake them I want to just tell them like this is gonna be horrible for you but they just always tell me like no no no this guy's a smart guy he's a smart you know he's a smart guy and um and I've I've said something in the Past and and my wife has told me like hey you got to stop this you got to stop it's not you're not you don't

need to evangelize about this because for some people they need this get they wouldn't save the money if not for the fact that somebody's holding on like if they if they were in charge of these decisions they wouldn't act as rationally as you think they would act which is they would just put it in you know an index fund and just hold it can you there also is This piece which I think is hard to expl understand and wrap your head around when you think about it in terms of like textbook Math versus there's a

behavioral side of this too um how do you think about Behavior behaviors as they impact returns and how do people work against themselves so to speak I think there's like a saying like we've met the enemy and the enemy is us um that I think is true of most people who are Investing yeah for sure I mean you look at the data on how do investors perform relative to the assets that they invest in so you can look at that for indexes you can look at for mutual funds investors pretty much always underperform so you

take the a stock index fund for example or a stock index and and the index returns whatever 8% a year or something like that investors typically would earn uh less 7% or 6% or something like that depending on what Asset class we're talking about explain by what that's the the difference what's the explanation for the behavior no no what what is causing that underperformance are they just trading it because they trade at the bottom and they buy at the top it's it's bad timeing decisions yeah so that's it's it's really comparing money weighted and time

weighted returns I mean Finance terms I guess but there's this Gap if uh If people are investing at the top and selling uh at the bottom there's going to be a difference between the money weighted and the time waited return the mechanics that don't really matter but that's why we see those those gaps it's poor poor timing decisions and that's really it's it's really everywhere and it's been around for a long time but I I think your your comment about the person needing handholding is important because there's a separation between The investment strategy and the

fact that somebody may need investment advice I'm I'm biased here because I'm the chief investment officer of a wealth management firm we use lowcost funds to build portfolios like we believe all the stuff that I'm saying on the investment management side but I still do think that there's room for handholding as you called it but also other things like Financial Planning and tax advice that people need so I don't think those two Things have to be combined someone who's giving Financial advice doesn't have to be selling you crappy High fee investment funds unfortunately that has

been the synonym for a while where Financial advice has become synonymous with like this self-dealing that is happening where they're selling often tools that they are getting kickbacks from selling um so that is just an unfortunate like you know I think well-deserved reputation of the Financial it is well deserved yeah I industry industry but um you touched on something thing which I think is worth talking about which is uh market efficiency where you said you know as the players get better then the outcome is increasingly determined by luck which brings me to a question which

H are markets getting more efficient as information gets faster and the players become more sophisticated market efficiency is a Really really hard question to answer uh whenever I ask academics about this on my podcast they kind of laugh and like how how are you defining market efficiency how do you want me toine market to Define market efficiency market efficiency is is technically is kind of the plain English definition it means that prices reflect all available information stock prices reflect all available information now how do you actually test for that to check like our Market's getting

more efficient there are a lot of different ways none of them are completely conclusive uh but if you look at something like information production so is is there is information about individual stocks uh being produced at at a higher rate or or a lower rate than than the past uh I think from measures like that markets are at least as efficient as they've been in the past possibly getting more efficient but that's not the only thing That that uh that matters like another big one is active manager performance so we talked about can active managers

beat the market and that's been pretty stable for a very long time very few active managers are able to beat the market if markets were getting less efficient we might see we might expect to see that reverse the other thing so yes information is more available yes technolog is getting better the other thing that we're seeing though as a big Trend is that a lot of people are moving to index funds which means there are fewer dollars invested with active managers and the way that prices got right in the first place is because the active

managers were trading on information trying to make a profit so this is a thing called the Grossman stiglets Paradox it's basically the Paradox is basically that markets can never be perfectly efficient because if they were there would be no more Information production it's kind of like an equilibrium though in reality where if if the pendulum ever swings too far toward passive there will be opportunities for active managers then at least in theory they'll come back make a profit for a bit and then markets will be efficient again yeah because fundamentally Index Fund investors are sort

of getting a free lunch of the work of pass of active managers to determine the price of stock the fair price of Stocks uh talk to me about about diversification and what a type of risk is that you can diversify away and things that you can't diversify away because I I think this is also something that's counterintuitive where you go why would I buy a basket of stocks when that basket of stocks is for sure going to have a bunch of losers like stocks that are going to be terrible why would I not just pick

the stocks that I know are going to be good you know I know hey I Believe in Tesla right I believe paler Alex C whatever his name is uh that that guy you know he's got he's got Big Ideas Ben why don't I just invest in that instead of your dumb idea where I you know invest in these losers what is what is the answer to that yeah it's really easy to identify past winners like we can say hey that guy's really smart or hey this company's doing really really well that's reflected in the price

and so I think that's a bit of A trap that people get can get caught in where people can end up paying a really high price to invest in an objectively good company but because you paid a high price for it your investment returns are going to suck we've seen that happen uh throughout the course of financial Market history again and again like it's it's a again back to investor Behavior it's something that people kind of love to do they love to overpay for exciting companies more generally Though the problem is most stocks perform poorly

they perform poorly relative to treasury bills they perform poorly relative to the market a few stocks perform really really well so I mean to your question can we identify those winners ahead of time that's really really hard to do and because most stocks perform poorly you're much more likely to pick losers than to pick uh winners so if you look at people building concentrated portfolios there's A study that looks at this if you build concentrated portfolios of stocks you're much more likely to underperform the market than to uh to outperform it so that that's concentration

uh the risks that you can diversify away are company specific risks or industry specific risks so that's like take two companies that are otherwise identical they're exposed to the same uh the same big picture risks but one Company CEO starts doing some crazy stuff that the market Really doesn't like that company is going to do relatively poorly its returns are going to be relatively poor compared to the other company uh because of what the COO is doing not because of anything that's going on in the overall market so that that's company specific risk that can

be Diversified Away by owning all of the companies in that industry or or uh or sector okay right and then when you diversify all the risks away like company specific risk You've got industry risk which you can diversify Away by investing in other Industries you've got country specific risk which to an extent you can diversify a way by investing in other countries and then you roll all that up you're left with what's called Market risk the reason this matters is that market risk is priced that means you expect compensation for taking on Market risk you

do not expect compensation for taking on individual company risk or Industry risk is this that is this why they say like diversification is the free lunch in finance or like there there's some saying about that because you're actually getting above average or you're getting extra expected return for not having uh for not taking on more risk where most of the time taking on getting more return means taking on more risk yeah yeah so if if you diversify with a bunch of risky assets those stocks are Risky if you have a whole bunch of them you're

reducing your risk without decreasing your expected return whereas typically in finance if you want to take less risk you have to expect lower returns so why do all these people pick stocks I think it's exciting I think people think they're smart I think there's a lot of overom confidence in investing uh whenever I make a video smart I I'm no that's why this video is investing for that that is like the Whole premise is that kind of the most genius thing to do as an investor is to know what you don't know and sort of

and kind of take the counterintuitive position of of realizing that average returns are really easy to get and above average return slightly above average returns are incredibly hard to get and almost no one gets them that is like the very odd thing at play here yeah and you're introducing a whole bunch of risk that You're going to get below average returns by trying to get above average returns and you're much more likely to get below average returns I think it's the overconfidence uh people want to believe that that there's a smart person out there or

that they're the smart person that can give them a out performance but yeah it's uh not not very well supported okay so I got another another question for you which is I hear about AI Hot Topic robots Hot Topic I want to screw you know Screw the total market index I want to put my money in the uh roll the dice in the AI funds in the you know whatever uh why is that a bad idea or a good idea is it a good idea so I got a lot of questions about this when Arc

Kathy Woods fund or funds were doing really really well like there were a couple years or a few years where they were just crazy rocket ships crushing and so I started getting questions like Why would we invest because her narrative was the index has all these old boring companies that really suck and they're not Innovative and we're going to pick the Innovative ones they going to do really well so I started getting questions from clients like why why wouldn't we why would we want to invest in these old companies why wouldn't we want to invest

in the new economy so I did a lot of work digging into that I made a couple videos on it On investing in technological revolutions I did one on uh Superstar fund managers or something like that too uh which those two things of go hand inand so what tends to happen why is investing in Revolutionary Technologies or or or new economy stocks historically a losing a losing game it comes back to asset pricing so when something's really exciting so AI for example I think crypto went through this too marijuana stocks went through it too electric

Vehicles I mean it's just recent history but this is a this is something that happens throughout history Railway stocks went through this too so what happens is people people realize this thing is exciting they realize it's going to be impactful and ass prices start to reflect that and so the asset prices shoot up and what happens when asset prices shoot up more people hear about this thing oh AI it's going to be really big and the stock prices just Went up a bunch so more people invest in it and the price keeps going up and

that cycle carries on for a while and you see asset prices go up up up investors tend to buy after they've gone up and then they tend to come back down because nothing nothing tends to be as as revolutionary as quickly as I think people expect and you have a dilutive factor don't you like the companies also are issuing a bunch of new shares They're also you're not capturing the full um profits of that sector that you think you are yeah that's one of my favorite pieces of this whole thing so you get high asset

prices and one of the reasons that they're high I've heard someone called this the big Market delusion which is basically that every stock is priced as if they're going to capture all of the market share of that new industry but that's never what happened so even if there is a massive Amount of new earnings that are going to be available for an industry to capture when it's a new exciting industry like you said a lot of companies are going to issue new stock a lot of new companies are going to be created and so there's

this huge earnings pie but it's not one company capturing it and the more companies that go after that huge earnings pie the lower the earnings per share which is what matters to investors which is what matters for stock prices Is going to be and so you can end up with massive earnings growth for a new industry and really bad earnings per share growth for all the companies that are issuing stock to try and try and capture that that new opportunity and so investors end up just kind of getting getting hosed and this is like you

go back through history this happens again and again and again High stock prices exciting technology investors buy at the peak and they get Smoked this this is what is so interesting to me about um finances there are all these traps for otherwise smart people to make catastrophic mistakes with their finances because of things that seem intuitive until you like know a bit more of the picture like um you're not I have a guy I won't say his name but a very you know popular Finance guy on YouTube and he was he's telling me behind the

scenes oh you got to invest you know This smart you know industry and da d d d da and he was making the case so strongly to me that I was like what is the like research on emerging market like like some of these like really you know interesting Industries and that's when I found your video on I was like oh this is not the easy buy that I thought it was where it's like yeah just buy a few of these you know hot AI stocks or hot robot look it's going to be the future

it's not as simple as I Identified as if not as if everyone can't see that Ai and robots are going to be an important part of the the future anyway to say nothing of that um I want to touch on an interesting piece which is that even though we all know past performance is no indicator of future you know results we all kind of behave a little bit differently than that everyone sort of behaves as if the opposite is true and I want to talk about us versus International right this Is a big conversation um

where the US has sort of especially in the past decade or so has sort of crushed um and so there is a narrative that crops up every time something like this happens which is well I just want to abandon this loser which is everybody else but the US US number one we're the Kings sorry Canada you guys are you know you guys are sorry I'm just it's you're not performing I'm dumping the loser for my Portfolio in theory intuitively like if you just didn't know anything else it kind of there's some tendenc to believe that

idea can you explain why this might be a problem and explain the trend of us assets that have become higher priced PE wise relative to other International assets AKA is investing in international stocks a dumb idea yeah so the the US market has been wild for for the last 15 years it's been just I mean incredible insane like Anyone that was not investing in the US over that period like you you you you missed out on a lot of returns and you don't get those back like that's it uh which which is one of the

reasons that you know even though we're about to talk about us expected returns maybe being a little lower than the past I don't think that means anybody should get out of the US market because I could have sent I could have said the same thing five years ago and here we are the US market Has been incredible uh so what has happened over the last 15 years but really over the last 30 or so years years is that us stock prices have gotten higher relative to their fundamentals and that the fundamentals have been they' been

good um like there's no question there the US market is objectively strong economically uh but but the other thing that's happened is the valuations of US Stocks have Gotten Higher and Higher and Higher and right now if you look at the the the Schiller price earnings ratio which is one way to measure stock market valuations it's you know it's not as high as it was in the year 2000 but it's really high Ben it's really high it's about as close as it's been since since then since the 20 year 2000 and you know it's not

conclusive by any means but typically when stock prices are high expected future returns are low and Realized future returns are are low like if you go and sort historical US market returns by their starting Cape they're starting cyclically adjusted price earnings ratio higher starting capes are ass explain what you just said what's a what's a cape I'm sorry sorry sorry cyclically adjusted price earnings ratio so it's a way of measuring stock market valuations it's the 10year smoothed real earnings of companies yeah so you're measuring the prices relative to that Smooth earnings figure and that just

helps to balance out big changes in earnings from year to year and so that that measures really high right now meaning meaning buying a dollar of earnings of us company earnings is really expensive right now compared to history and historically that has led had been associated with lower future returns now what does this mean for for does international investing make sense if you look back to 1980 or so up until Now a huge portion us has completely obliterated International stocks over that period and a huge portion of that difference has come from rising valuations and

so if we think about is the same thing going to happen for the next 20 years for the next 30 years it's it's really hard to say that valuations us valuations are going to keep going up the way that they have over the last 15 or so years to deliver the type of returns that people might expect when They say oh I'm only going to invest in US Stocks so I think that's a little bit of a trap uh currently expected returns are low uh they're low partially because past returns have been high which has

led to increasing valuations and so people see the past returns and they project that into the future but in reality they should probably probably if anything be expecting the opposite lower returns now if we look at uh US versus International stocks throughout history I looked at this a while ago I looked at 10year rolling periods from I think 1900 to 2023 or something like that and it was about 60% of the time that us beat International which is like it it won most of the time but it wasn't all the time by any means it

wasn't what you'd expect if you were only alive from 2010 or something that's right that's right so yeah like I I I think International divers diversification makes sense I made a video on it I I diversify Internationally the US is only one part of the world it currently makes makes up about 65% of the global stock market which is a lot uh it's increased each year partially because valuations have been going up and up uh but there's a huge portion of the global stock market that is not the US and the US I don't think

will perform the way it has in recent history forever and historically when the US has faltered when it's had lower returns International returns have Been better relatively speaking and that's diversification it's like basic this is another way to diversify it's just interesting because people who talk about diversification especially in the US are usually talking about us Equity diversification they're not actually they don't want to diversify to the rest of the world they're like they actually want to bet on their country there's a bit of a country preference of you know and and and we have

uh historical Returns we look back and we go see look we proved it we're we're the best we want to but it is interesting like the same I I I find this because I follow some of these um there's this community called the bogleheads have you heard of these guys oh I've heard of them yep these bogleheads uh they're they're like people who kind more or less subscribe to the the theories of Jack Bogle the Vanguard kind of father of uh index investing they and to some I don't want To treat them all as a

monolith but some of them have issues with this idea of international like most of them are like look even people who in theory completely subscribe to the idea of diversification sort of half subscribed to it cuz they go look I don't want to really hold that much you know I back tested this and I'm a little smart I backed and I found out that you know International is not worth holding so I'm fully us and then Jack Bogle even Himself is like I don't hold any International I I hold like and Max 20% something like

that so do if we are looking at this from what I wanted to give my audience is no advice just a theoretic understanding a framework for how to think about this in my mind this is an irrational side of both Jack bogle's philosophy and in the philosophy of a lot of people who even subscribe to Diversification if you really subscribe to it you kind of have to subscribe full send unless you're making arguments about like tax efficiency of international like I guess I guess but uh what what is your thought about that do you think

that the the most sound theoretical framework is just buy everything and if that's true do you buy more than just equities do you buy every like Commodities you buy oil yeah yeah yeah What what is your answer yeah so I I think on the international diversification piece if someone wanted to be only us Equity it's it's probably not the end of the world I don't think it's a good decision but there are worse countries to invest 100% of your wealth in like the US is 6 it's 65% of the global market and it it it

has companies that do have exposure to markets all around the world right it's not it's not quite Globally Diversified because us companies that sell overseas are going to perform differently than companies overseas so it's not perfect but again if if you wanted to invest in one country the US is probably the way the way to do it I do also think for us investors like you mentioned tax there's also currency issues costs there are reasons to have Home Country bias if you're in the US or elsewhere like in Canada many people have a home country

Bias and I think to an extent that can make sense just because of of the frictions of owning foreign stocks there's other weird stuff too that you can start thinking about like the risk of expropriation by Foreign governments in times of conflict like those are real things that are worth considering and thinking about diversification uh so I you know I don't think it's the end of the world if a Us-based investor said I'm going to invest everything in US Stocks I'm not recommending that or suggesting it and I've argued against that including with the bogleheads

community many times every time I make a video on International diversification they lose their minds yeah by the way I like this guy I like that I'm not I'm not hating I I I think uh they're one of the more sound you Know um Financial groups out there actually but and and they have you know interesting discussions but it is something that's cropped up that I think is interesting because I'm like wow this uh knowing the theoretical underpinnings and actually believing in it when you have all this data that that kind of pushes you towards

well the US seems so good um is is hard to it's kind of hard to argue against the past performance of a guy who's like I invested in the US in the last 40 years and I you know everyone who invested in Fe you know International is an idiot compared to me and like the yeah you know in theory no yeah not not in theory but I guess in practice he's right in those 40 years he was right you know correct just like if you invested in Nvidia for the last 10 years and I'm going

to come to you and say hey you shouldn't have shouldn't have done that and they would say well in theory you're Right in practice you know you're wrong yeah I think be there there's a little bit of rear viw mirror bi bias because the US market has done so well on recent history but you go back like from 2000 to 2010 US Stocks returned zero for 10 years it's like those those those periods happen and over that period uh other other St elsewhere did did better I mean even in the US I don't know if

we're going to talk about this but even in the US the US market which Is what everybody sees the past performance of right now was flat us small cap value stocks over that 20120 period did incredibly well that's not quite diversification that's not like an appropriate term for it um but investing in something other than the US market capitalization weighted index can make a lot of sense in some cases the theory piece of that is is pretty simple if markets are efficient uh the global portfolio of assets is the theoretically Optimal portfolio and that like

that's the it's pretty simple that's the basic argument for why you should be globally Diversified okay question on top of that because you say that Ben you say that but you don't do that you don't do that in your own life you do a little thing called the slice and the factor tilt yeah what are the uh you know see I've done my research I've done my homework what are the factors uh in the F French model what is The F let's back up what's who's fam and does he know French and what are these

things I think we have to back up even further actually I think we have to go back one step further to this is for idiots B yeah we're going for going for idiots yeah I'm G to I'm going to do my best here so we talked about Market risk earlier you can diversify everything away uh and you end up with Market risk and that's the one priced risk that's the risk you expect compensation for for Taking okay uh that's you get that by owning a an index fund a total market index fund so that idea

really comes from a 1964 paper in the Journal of Finance by a guy named Bill Sharp who he won the Nobel Memorial prize in economic Sciences for this this work he came up with this thing called the capital asset pricing model the capm and this model basically predicts I hope this is not too nerdy but it basically predict predicts that uh expected returns are Explained by exposure to Market risk so you you take on Market risk you get you get an expected return if you take on more Market Risk by taking by owning stocks that

have a higher Market beta that's pretty Nery what talk but riskier stocks should have higher expected returns in his in his model uh but it's a single Factor model meaning Market risk is the only risk that explains expected returns so that's 1964 from then until the '90s there were a Whole bunch of things that were violating that that model so there were a whole bunch of types of stocks where if you looked at their capm if if you analyze them through the lens of the capm it looked like they had higher returns that were too

high for the amount of Market risk that they were exposed to so that could mean two things it could mean markets are inefficient and that there are all these profit opportunities these risk-free profit Opportunities for people to take or it could mean that the capital asset pricing model was not the best model to to to explain how assets are priced to explain what risks are incorporated into stock prices so this is where F and French f is the guy who came up with the idea of market efficiency in the 1960s and 70s and his co-author

Ken French uh they came up with the idea that maybe there are more than the one market risk maybe there's more than one risk that Investors care about when they price assets because the the capam was empirically wrong meaning you could find lots of way lots of places where it was not not working yeah so they they came up with this uh a three Factor model where they said it looks like investors probably care about Market risk but also the specific risk of small stocks and the specific risk of of value stocks and those were

two of those empirical irregularities is this dumb enough I Don't know like we be no yeah this is fine no you want to explain value versus growth real quick yeah yeah okay so value the way that F and French measure it they they measure price relative to book value so the book value is like the just the value of a company's assets and then its price is the value of its assets plus the discounted value of future cash flows so basically if if people think a company's going to do really badly in the future it

might Trade at its Book value like this company's going to generate no profits it really sucks right if a company's going to do really well it's going to have a really high price relative to its Book value so a growth stock would be a high price relative to book value stock a value stock is a cheap stock it's got a low price relative to its Book value so they had observed that value stocks tended to beat grow stocks over time likewise they'd observed that Small companies measured by their market capitalization had tended to outperform big

companies so they added these two independent factors to the asset pricing model and all of a sudden a lot of those empirical irregularities that the capm was failing to explain they kind of went away so from that paper this whole field of of financial economics was born called uh multiactor asset pricing which is really the study of like how are assets priced like what what information Goes into the price of a stock what do investors car about uh so they had that three Factor model and they later in 2015 came out with a five Factor

model let's not talk about the five let's just let's just do let's stick with the okay for now for now yeah that's that the three Factor model is really the it explains the the the capm explained like two-thirds of the differences in returns between Diversified portfolios the three Factor model brought that up to about 90% that means like if you take two actively managed portfolios for example and ask why are their returns different the capm is going to explain about 2/3 of it the the three Factor model is going to explain about 90% of it

the five Factor model explains about 95% so there's definitely some diminishing returns that is to say their returns are explainable as a function of the amount of risk they're taking on that is fundamentally their The whole idea is exactly that yeah so because this is something that was con that was confusing me when I first learned about this is I was like oh are the factors like another way like diversification to get sort of this uh free lunch like I just buy more small cap index funds and I buy more value stocks and I just

get better returns as opposed to people who buy the whole market index is that what you're saying well theoretically there are Independent risks that a lot of investors probably should not be taking and that is why they're compensated so the market portfolio in theory the the market capitalization weighted like you go and buy the market index fund that's the optimal portfolio for the average investor now if you're not the average investor if you're in a position to take more risk than than the average investor and take more risks that show up at really bad times

than the average Investor like risks that will show up at the same time that you might lose your job somebody who has a job that's exposed to those types of risks they maybe shouldn't be investing in value stocks someone who's retired for example and doesn't depend on their income at all Maybe they can take a little bit more Risk by tilting toward toward value stocks but they're they're not for everybody and they are risk at least in in the F French thinking they're risk Premiums which means like no it's not a free lunch it's an

additional risk that you're taking and doing it can suck like if you were investing in value or small cap value stocks over this recent period where the US Market's been going nuts it hurt like I I have a value tilt in my portfolio and it sucks yeah because growth actually has been value doesn't always beat growth and growth has been killing yeah um so anyway I wanted to kind of uh bring that up because it's an Interesting you know um Deep dive on the specifics of you know diversification people talk about these Factor tilts they're

not talking about the same thing as diversification where you get sort of an increase in expect expected returns for no additional risk you are getting an increase in expected returns for taking more risk just like if you were to have you know 100% equities versus having 80 20 bonds or something like that you would get an expect more return But you're taking on more total risk um I think probably we should touch on bonds a little bit everyone kind of is bored to death by bonds but for the first time ever they've become a little

bit interesting well at least the first time in sort of my investing lifetime um where they're actually paying something how do you think about Bonds in somebody's portfolio so far we've just been talking about equities but that is not sort of the uh the commonly Understood way to invest because if you want to diversify you should also be thinking about diversifying away from just pure Market risk as well depending on how much risk you want to take what is the kind of theory behind why someone should consider Bonds in their portfolio what are they maybe

just jump into that sure so stocks pieces of equity ownership in a company you're participating in in the expected future earnings of a business and because of That earnings are they can fluctuate a lot businesses can have bad times and so stock investors are exposed to a lot of risk so that's investing in a company's stock there are also these things called bonds which is another way for companies to raise Capital if they don't want to issue stock they can issue bonds and that's they're effectively borrowing money so if you buy a bond you're kind

of lending money to a company or to a government or whatever and they're going To pay you interest they're called coupon payments and then at the end of the when it when it matures they're going to give you your principle back the the other interesting thing is that if a company goes bust stockholders usually get zero but Bond holders often have some claim on assets so there's a couple different reasons there like you've got guaranteed payments you've got principal at maturity and you've got potential claim on assets in a worst Case scenario so all of

that together suggests that bonds are a little bit safer than stocks which you know it's more complicated than that but that's kind of step one they're a little bit safer yeah want to talk about what is risk later if you have if you have time I I don't want to take too much of your time but um okay the point is a little bit lower downside in the in theory bonds have a lower uh downside risk of losing money Especially when you talk about what a lot of people are thinking of when they think of

bonds at least for their Investment Portfolio is some type of government bonds or highgrade bonds um for a while the us especially has been in an odd position I don't know the interest rate situation around the world but the US was in the interesting position of paying very little for bonds so there was you know the what's sometimes known as like the risk-free Rate for the least risky thing we can think of is like sort of what the government going bust um so the closest thing to risk-free as you can get was basically nil I

mean nearly nil um so how should people think of bonds and and there's long-term bonds there's short-term bonds there's medium-term bonds I ironically these are have different types of risk because when I first understood bonds I was like oh well the Longterm seem the safest get a 30-year Bond you're guaranteed to have that payment for like what's the risk can you explain the different types of risk of short medium long-term bonds yeah really question no it's it's a great it's great question it's it's not an investing for uh idiots question but but I love it

but I love the question okay so shorter maturity bonds are going to be really low in volatility so volatility is like the price can Change if you buy a a short or treasury bill for example like it's basically like cash like you're going to earn some interest it's not going to move around the price is not going to move around as you go longer out in maturity the price is going to move around more and more uh day-to-day based on changes and things like interest rates break that down because if I buy a 30-year Bond

today at 5% just so everyone's clear I will if I wait the full 30 years The price doesn't fluctuate and the interest rates don't fluctuate so why are you saying that the price fluctuates it if all of a sudden tomorrow so you've got a bond that's paying you 5% if all of a sudden tomorrow I can go and get a bond for 6% your bond is going to be worth relatively Less in the in the market so it'll be repriced based on what the new what the new rates are and if you went to sell

it you're not going to get your Principal back so and because because assets are priced daily you're going to see a price fluctuation the longer you go out and maturity the more extreme those price fluctuations are going to be so at like the 30-year Mark you they can be extremely volatile but now back to your question what is risk so for short maturity bonds uh you're not going to have any volatility which is one way to think about risk you're also going to have a relatively low interest rate uh And if you look in the

in the data around the world for how to bills like short very short-term government debt obligations how do they perform they're there's a pretty good chance you're going to lose money in real terms holding very short-term debt so they're not volatile but there's a good chance they won't keep up with inflation so you're not taking on volatility risk but you're taking on the risk of losing your Purchasing power if we go to the other end of the spectrum uh it's nominal bonds what we're talking about so bonds that don't adjust for inflation there are also

real bonds or tips in the in the states that do adjust for inflation it's this is an idiot's class it's hard it's hard to ignore them so I I'll talk though about long long-term bonds like you mentioned earlier if you if you have a a nominal liability and that's important it's frustratingly complicated But it's important if you have a nominal so it's $100,000 but it's a $100,000 nominal so it's not going to change in in real terms like there's no inflation on this liability that you have right and you buy a bond for that you're

going to get your interest over time and you're going to get your principal back at maturity and even the price fluctuations in the inter term are not going to matter to you because you have this 30-year liability that you need to Fund and you don't care about the end term so it's not it's going to be volatile uh but it's going to hedge your future liability the problem is most liabilities are not nominal like I don't think an individual house like you or I do not have nominal liabilities I don't think in in any anything

like there's no nothing that I'm going to want to buy in the future that's not exposed to inflation insurance companies have Nominal liabilities because someone buys a million dollar insurance policy it's going to be a million dollar insurance policy in 30 years or whatever uh but we we households people want to buy stuff food whatever those are real liabilities so a nominal Bond even if it perfectly Hedges a nominal liability can be extremely risky in real terms and so this gets to the the really interest interesting thing about now you can buy you can buy

an inflation protected bond To hedge that real liability um but bonds more generally nominal bonds how do they fit into portfolios they reduce your volatility for sure bonds to your stocks reduces your volatility but they probably decrease your ability to maintain purchasing power in the long run and so we should yeah we yeah we should first we need to we need to probably Define what volatility is even though We've been talking about it for a while because most of us myself included we I usually think of risk in just in terms of volatility like you

know the the risk that price will go up or down and the the size of those swings um but that is not all that risk is risk is actually very hard to Define anyway go ahead what's volatility uh it's the price how much the magnitude of price changes I guess is one way to think about it so a stock Is going to be volatile it's going to be worth you know $10 today but it might be worth $15 tomorrow or $5 Bitcoin is volatile you know Bitcoin one day it's worth you 10,000 one day it's

worth 100,000 um and then as compared to that we talk about bonds as being less risky what do we mean by that we mean they are going to be subject to lower price fluctuations but that as you say is not the only risk a huge risk that we you Know all are concerned with is okay in 30 50 80 years when you know when I need to fund some retirement do I have enough money at relative to uh my standard of living and infl the inflation that has happened during that period of time that is

a huge risk that and there is an argument maybe you could give it that equities having equities as part of your portfolio actually Dr risks that yeah so equities are very risky in the sense that they're volatile and they Do have an uncertain long-term outcome like there there's no sane world where I would say that investing in stocks is going to give you a guaranteed inflation adjusted return the long there's still a chance you lose money but relative to nominal bonds uh Bond stocks have historically been much safer there's a paper on this that's not

published yet it's going through like the conference uh cycle and stuff and it's it's getting interesting Comments I've been talking to the author about it the whole time but it's uh the paper's called challenging the status quo it's basically saying that the status quo is that people think they should start out investing in stocks when they younger and then add bonds as they get older because bonds are safer and that's like you know Common Sense textbook and so their paper basically shows if you go and look at the they use global data going back to

1870 and they Did something called bootstrap simulations basically they they created a whole bunch of hypothetical scenarios using actual historical data but it gave them way more potential hypothetical scenarios based on historical data than we actually have historical data right and what they found in those simulations is that the optimal portfolio for the whole life cycle is 100% stocks now this is like it's pretty controversial because while their data show that like A lot of people get really upset that anybody would possibly say that but it's at very at the very least it's a very

interesting finding and it's driven by the fact that stocks are still very risky and they emphasize this in the paper stocks are still super risky at long Horizons but bonds nominal bonds are a lot riskier you're much more likely to lose money in bonds and so adding them to your portfolio crazy right adding them to your portfolio Makes it riskier it makes it less volatile which is great if you're really worried about volatility but it makes it riskier from the perspect perspective of funding your future consumption okay that that being said one thing that always

freaks me out about things like that and maybe this is the you know the slightly risk averse volatility wise guy in me which is that every Financial investor can read all the theory till They're kind of blew in the face but they only get one shot at the financial markets and they can't predict beforehand what their ride is going to be so they have they have all this history but they're guaranteed a different ride than the historically was the case so saying historically we had all this you know evidence that you know stocks or whatever

um stocks don't always beat bonds now they beat bonds over if you take a long enough time Frame you could say that they you know they they beat them over you know this many if you take this many years but we also don't know that that's even a guarantee that that will continue to be the case so what always you know freaks me out about that is like you have to plan for what historically didn't happen to happen and that is like to me the basis of a lot of a sound framework for investing is

you have to build a portfolio Where yes you want us stocks to rip a 100 like for the rest of time but you have to plan for the event that doesn't happen because you only have one shot at the your investing time period does that make sense it does it does make sense and I mean there there are different ways that people have tried to express that I've seen some pretty crazy portfolios that take what you're saying to the extreme where it's like we're going to have 10% gold 10% stocks 10% Bitcoin like every possible

thing that's going to perform potentially differently from the other stuff so I I don't disagree with you and bonds are a pretty tame example of of diversification obviously and I I'm not advocating for 100% stock portfolios we have not very many clients that are firmed that are actually invested that way I I think it's an interesting idea um yeah I mean there there are limits to that thinking I I we don't know the distribution of All future asset returns and because of that we don't know which assets are going to be good diversifiers I think

looking at historical data is one interesting lens but I agree with you like if you look at just the theory and forget about that empirical paper yeah of course bonds makes sense but then you look at the empirical paper and it's like well yeah okay this gets me to actually where I want to um where I want to sort of try to start wrapping things Up which is through listening to the boggles to the Ben Felix's of the world to all you smart guys who are reading all these papers I've sort of come to an

interesting um place where the fundamentals are sort of Undisputed in a lot of these circles where it's like okay passive investing you get what you don't pay for most Active investors will lose so the average makes sense and then it's almost like when you get into like the basics of fitness and then you get into advanced Fitness where there's all the these new papers that come out and people excitedly rush into these like new theories about like how to optimize the you know the little tidbits of this or that but they are sort of making

tiny little I would say like a like uh you know Theoretical I don't know bets is the right word I guess in finance it's a little bit more of bets uh because you don't know the outcome But ultimately when you do think about people who are not plugged in what do you think about this is I guess where we're going to end where we started which is what should most investors okay that they're not reading journals they don't want to pay attention to any of this stuff they Don't want to be worried about um you

know sort of what the latest paper says about allocation what are their what is like the basics and then we can't tell them what portfolio to build because obviously they need to make their own decision based on that but let's get back to ignoring like the daily trends of or I get it's not I know it's not daily but like the year-to-year decade to deade trends of you know we think this is interesting this is you know a Slightly better way to do it what is the ad not advice but framework for most people to

think about investing going back to for idiots so let me give you an interesting example we talked about factors we talked about the F French three Factor model we didn't get to the five Factor model and that's okay but there's a there's this term that's that's uh been created in acad Finance called the factor zoo and that term was created because there were so many Documented factors there were so many they're called pricing anomal anomalies like so many observations that this type of stock or that type of stock did better than other models would predict

and for the exact reason that you're saying that is that is a problem for someone who's trying to optimize down to the most recent paper so I I I don't think that anybody should be doing that the problem that creates for people who want to pursue Factor investing is that There's always competing models so the F and F and French have a model but there's a ton of other models out there and a lot of people say now that while the F French model is no longer relevant because of this this and this so if

you're a f French value investor it's really hard to stick with your value portfolio when it's underperforming and people are saying well no F and French are wrong now because of this this and this you should be using this Factor Model so for most people who don't want to get into the details of why they think F and French are still right uh they should probably not that type of investing now some some people can do it like I have we have an online community for our podcast called the rational reminder Community named after our

podcast and there's a bunch of people in there that like it it blows my mind honestly I I love that community and I interact in there often but there are People in there that literally nerd out all day spend hours in there talking about you know value should be defined this way no it should be this way or like momentum is a good Factor no it's not uh so some people love that and I mean I think that those people probably treat it like a hobby that is not most people the rational minor Community is

not most people so I think for someone who's listening for the uh Investing For idiotes listener the intended consumer Of this podcast they should probably be using lowcost index funds that just track the market now whether that's us or globally Diversified I don't know man like there there's funds like VT that's a that's not a recommendation but that's an all stock Global portfolio that's a that's a pretty nice security as a starting point at least on the equity side of a portfolio one thing you don't have to think about it you have to worry about

it in Canada we have similar Products called asset allocation ETFs they're not quite like V VT because they're not they give an overweight to Canadian stocks they're not market cap weight but same same idea one thing and you buy that and that's your portfolio I think that level of Simplicity like we talked about investor Behavior earlier too uh when you look at the data on that funds that are self-contained that rebalance themselves they tend to have much lower Behavior gaps investors tend To behave much better in those products so for for the typical person that's

listening to this podcast that's like trying to learn about investing and they want to just make good decisions uh total market index funds market capitalization weights are a great starting point and the more simple you can make it the better you're going to be in the long run and if I could humbly add one tiny thing to your great wrapup there low Fees we didn't really Touch Too Much on like because ETFs and and mutual funds have their own set of fees involved you need to pay attention of that and keep it as low as

low as possible um Ben Felix you have been a uh fascinating character for me to to learn from and I really appreciate you coming on the show where can people find you obviously you have the rational reminder podcast and you have the YouTube channel is that your main two outlets where people can Discover your work yeah those are I release videos every two weeks on my YouTube channel and then I just search Ben Felix I guess on YouTube and you'll you'll find my channel and then rational reminder we post an episode every week those are

like they're pretty nerdy I mean if people want to be like really get into the weeds I guess that they can listen but I mean yeah investing for idiots is not is not rational reminders intended Audience yeah that's not a bad that's that's fine these are our meme coin investors our our our Wall Street bets guys uh okay thank you for watching we'll see you next time