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Excess Returns
Most Portfolios Are Built Backwards | Cullen Roche on Building Your Perfect Portfolio
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- [00:00]
Stassi Schroeder
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Podcast Host 1
This is your fix.
- [00:33]
Stassi Schroeder
I am your host, Stassi Schroeder. Welcome to Tell Me Lies, the official podcast. What's the most unhinged thing of season three?
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Podcast Host 1
Steven because he's so evil, I do
- [00:44]
Colin (Author and ETF Strategist)
think he is misunderstood.
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Stassi Schroeder
You see everyone face consequences. It's intoxicating. The writers just know how to trick. Yeah, there's always a twist in this show. Tell Me Lies, the official podcast January 6th. And stream the new season of Tell Me Lies January 13th on Hulu and Hulu on Disney.
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Colin (Author and ETF Strategist)
When you think about this, about the risk being the uncertainty of lifetime consumption, it's sort of all encompassing. It takes all of these things and builds them down into one definition. Asset liability matching, just for me is so much more applicable to financial planning and the way that people can actually build a portfolio because people can then begin to understand how are certain pockets of my portfolio actually serving very specific goal. I think 2022 exposed the problem in that, especially if you're not thinking across this in very specific time horizons because the, the 40% bond piece is actually, it's a relatively long time horizon for most people. I've come kind of come to love thinking about factors not in the the sort of alpha generating sense necessarily, but in the sense of how are they going to perform across different time horizons. People are really critical of investment management fees. But man, the two biggies are the other ones. It's inflation and taxes. Inflation and taxes just they slaughter you in the long run.
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Podcast Host 1
Colin, welcome back to Excess Returns. How are you?
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Colin (Author and ETF Strategist)
I'm doing great. It's great to be back, guys.
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Podcast Host 1
We usually have you on to talk about things like the Fed inflation, the dollar macro, related concepts and topics that we've talked a lot about with you in the past. But today we want to go in a different direction, one that I'm excited about and that's to talk to you about the new book that you published, your perfect portfolio. I think what's great about this book is it doesn't start out with like, you know, what is your optimal, you know, asset allocation mix. It really tries to start with a Deeper question about, you know, what are you trying to sort of accomplish with your money. And from the back of the book, I love this. You wrote, finding the right investment portfolio is a lot like finding true love. What works for someone else might not work for you. And that's okay. And I think like today we wanted to really just use the book as like an outline for what I think is going to be a great discussion, sort of talk about the core principles that you wrote about in terms of how you start to think about building and constructing a portfolio and then get into many of the strategies that you outlined. I think there's 20 different, over 20 different strategies in the book that you researched and you wrote about and you talk through and you look at the performance of. And so we'll get at maybe to as many of those as we can today. And then, and then just sort of lastly here in closing, sort of trying to connect this and what you wrote about in the book and some of these strategies to actually how you're applying and how you're building portfolios at discipline funds. So people can go to disciplinefunds.com obviously you can learn more about Cullen, his ETFs that he runs and, and the overall sort of strategy that he deploys. So anyways, sorry to be so long winded up front, but I want to make sure you got that nice intro so people know what we're talking about here.
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Colin (Author and ETF Strategist)
Yeah, thanks. It was a fun book to write A. You know, a lot of people know me for the macro sort of wonky stuff. And you know, my first book, Pragmatic Capitalism was more along the lines of that it was very sort of textbooky. And it was funny because I actually I went back and I read a lot of that book and as I was going through it I was like, man, this book is so bad or just so, just so boring. And so this one was fun to write. It's written in like a totally different tone, much more approachable and I tried to very intentionally make it very actionable. So I not only like, I kind of, I wrote the book from like the third party perspective, sort of where I was sort of operating as like an independent analyst of the different portfolios. And so, and so for people who don't know, the, the book covers 20 plus different strategies and some of them are, most of them are relatively famous or they have some person that, you know, developed them or an origin story that's really interesting. So. And it ranges from very boring strategies to relatively complex strategies. So it runs kind of the full gamut of, like Boglehead 3Fun Portfolio, where I interviewed Taylor Larimore, who's kind of the what, who John Bogle crowned the. The king of the Bogleheads. He said up to like 60, 40 stock bonds. Where did that portfolio come from? That's probably the, you know, arguably the most famous portfolio that exists. I covered factor investing and risk parody and all weather investing and a few of my own original strategies. And then things that are much more complex where you get into like, almost like team investing, like endowment strategies, and very, very complex strategies that probably shouldn't be used by most individual investors. But I tried to cover the full gamut and give people a really actionable way to actually implement these portfolios. I go through and literally show people, hey, this is. These are the funds you could use. And this is how you could actually allocate to this strategy to build this on your own so that you can kind of build your own perfect portfolio. Because that's ultimately the whole goal is, you know, like you mentioned, I kind of frame it as like trying to find a spouse a little bit, that everybody has to find somebody that works for them. And portfolio construction is very much the same way that you have to find something that works for you and not just buy into whatever somebody else is selling or whatever, you know, you've read about on the Internet that you think might sound really good and in theory may not actually be compatible with you and your financial life.
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Podcast Host 1
Yeah, and I love the fact that, you know, you, like you said, you have concrete examples of how investors can, you know, replicate these types of strategies on their own, which is great. But before we get into the strategies, let's just talk about some of the foundational principles along the lines of portfolio construction. So you had a number of these, but let me just, you know, I'll work through a few of them or you can work through a few of them. But your first one was your. You're a saver, not an investor. And why do you. Why is it important to differentiate those two things?
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Colin (Author and ETF Strategist)
Well, it was funny when I actually, when I was writing Pragmatic Capitalism 12 years ago, I. That book is a. Both an E. Com book and a finance book. And the. The word investing doesn't mean the same in these two fields, which is really strange when you think about it. The whole world that we call the investment world is based on, in some ways, a misnomer, because in the field of economics, investing, investment means to spend for future production. So when a firm, for instance, goes out and builds a factory, they're spending for future production, and that will generate a return on investment in the future that then will accrue to the value of things like stocks and bonds and be reflected in the value of those things. Whereas when somebody goes out and buys stocks and bonds, they're not literally doing the same thing. They're not, they're spending for. They're not. They're spending or, sorry, they're reallocating some of their savings. And the value of that savings is actually impacted and influenced primarily by the way that the firm spends for investment. And so I try to differentiate between the two things. That investment is what actually creates or accrues to the value of savings. And when we buy stocks and bonds on a secondary market, for instance, we're literally not spending for future production, we are reallocating some of our savings. And so for me, this is a really useful concept because I think some people get into the, the practice of investing thinking that this is some sort of get rich quick scheme or something that is sort of sexy and will make them, you know, fabulously wealthy. And sure, you can make a lot of money allocating your savings, but the process of allocating savings is a process that is much more methodical. It is process based and you need to have a plan for all of this when you're allocating your savings. And that sort of a process, I think, is. It's different, it's a different mentality going into that than, you know, something that you see a lot of these days where a lot of people are sort of treating their portfolios like they're, you know, they call it the degenerate economy now because the, there's so much widespread sort of gambling. And these, you see these new instruments every day of like, you know, triple and quadruple and quintuple leveraged ETFs. And it's all kind of trying to take advantage of this gambling mentality, which is exactly what I'm trying to deter people from having the mentality of when they get into this.
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Podcast Host 1
What did you mean on this principle that risk is uncertainty of lifetime consumption?
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Colin (Author and ETF Strategist)
Yeah, so this is a famous Ken French quote. So Ken French from Fama, French for people who are familiar with like Fama, Fama and French factor investing and whatnot. And I love this because it's sort of all encompassing in terms of what is risk. There are lots of different, you know, so many different different definitions of risk in the finance world where, you know, risk could be standard deviation, risk could be, you know, Morgan Housel calls risk what we don't know. And there's lots of different ways to parse and analyze and define risk. And for me, I love this definition because when you think about this, about the risk being the uncertainty of lifetime consumption, it's sort of all encompassing. It takes all of these things and builds them down into one definition where sure risk could be volatility or standard deviation. Risk could also be not taking enough risk. Risk in your portfolio risk could be sure it's maybe it's what we don't know. And when you think of it in this more of a consumption based aspect, I think you get into the understanding that really what we all want in life is the ability to allocate assets where those assets will give us the ability to predict and understand with some high degree of certainty how much are we going to be able to consume at future points in our lives? Are we going to have enough money to retire at a certain age? Are we going to have enough money to pay for a kid's college tuition? A house down payment? Do we have enough money allocated for like an emergency fund? And when you think about things across a temporal consumption timeline, you think about risk in a little bit of a different way. The world moves fast. Your workday even faster. Pitching products, drafting reports, analyzing data. Microsoft 365 Copilot is your AI assistant for work built into Word, Excel, PowerPoint, and other Microsoft 365 apps you use, helping you quickly write, analyze, create and summarize so you can cut through clutter and clear a path to your best work. Learn more@Microsoft.com N365Copilot this episode is brought
- [11:46]
Stassi Schroeder
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Podcast Host 1
Yeah, so talk about that. You actually talked about temporal conundrum. And in that essential principle, you kind of led with this Warren Buffett quote. Buffett said the biggest thing about making money is time. You don't have to be particularly smart, you just have to be patient. So how does that relate to this temporal conundrum concept?
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Colin (Author and ETF Strategist)
Yeah, so I talk about how portfolio construction is really a temporal conundrum. And what I mean by that is that time is the thing that we're all trying to navigate, ultimately, it's the thing that constrains all of our ability to do all of this because time is the one thing that we're all running out of, essentially. And so we're trying to have this predictability of consumption across very specific time horizons. And so when I speak about the temporal conundrum, I talk about how, especially, you know, in the, in the way that Buffett is explaining it there, that he's referring primarily to, to the stock market and whatnot, and how the stock market in my framework is this very long duration instrument. It's an instrument that you have to be patient with because corporations are long term in nature. They generate their cash flows and returns over very long periods of time. So if you get into the stock market and you're, you're allocating your savings in a way where you expect the returns to accrue to stocks very, very quickly and you're impatient, you're exposing yourself to huge amounts of behavioral bias because these instruments are literally not designed to generate huge returns in the short term. They're designed to generate their returns over very long periods of time. And so I try to structure the whole book and the, the discussion around asset allocation in large part around understanding how different instruments can function across different time horizons for your portfolio and help you solve that uncertainty of consumption.
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Podcast Host 1
So just in this last one, then we'll move on to some of these investment strategies. But, and this is as a ETF strategist, Cullen as an ria, Jack, as someone for myself that, you know, consults to different investment companies, this, you know, past performance is not indicative of future returns. We've all seen it big and bold and bright in all the performance disclaimers we've put out there. But I guess what I want to ask you, Colin, is how do you think, you know, past performance is best used when sort of thinking about portfolio construction, looking at investment strategies like these?
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Colin (Author and ETF Strategist)
I think that, so, you know, there's a lot of, there's a lot of criticism of both forecasting and also back testing. And, you know, I think that both of these things are useful in certain sense. I mean, I do a lot of back testing in the book, but I also am very clear with people that, hey, the future is not going to look like the past. And so you have to to some degree make forecasts about certain things. I mean, good financial planning involves a required level of forecasting where you're requiring yourself to try to forecast future expenses, for instance, and future inflation and what Will the stock and bond markets might. And I think you can look at these things and you can, you can look at past performance of the stock market and give yourself a general framework for understanding, okay, what are a reasonable set of outcomes. And so you can apply a back testing methodology or understanding past performance in a way where it gives you a framework for understanding that, okay, I know that stocks are very likely to beat bonds in the long run and that the bond market is likely to beat the T bill market over time. And you can get a, a better understanding for, you know, I go into things like managed futures and trend following and I look at, I rip apart a lot of the past performance of lots of these different instruments and so you can, you can look at the, the back tested performance of a lot of these things to get better perspective about what these things might do. But there's also a necessary amount of guesswork in all this. And it's the part that I try to communicate that is really the main emphasis around not only temporal diversification, but just diversification in general. That diversification is understanding that the future is unknowable. And you need to diversify to reduce the amount of risks that you're exposed to. Because nobody really knows how all this stuff is ultimately going to play out. Even though we can make pretty, you know, educated guesses about how it might play out based on, you know, not only some forecasting of the future, but also understanding the past.
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Podcast Host 2
Just one more before we get to the actual portfolios, I want to ask you about human capital because I think that's something a lot of people don't consider when they build a portfolio. And I'm just wondering, like, how do you think people should think about that? I mean, all of us have money we expect to make, at least if we're still employed, we have money we expect to make for the rest of our careers. And the duration of that career could be very different. So like, how do you think people should think about that or do you think they should be think about that when they think about actually building a portfolio?
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Colin (Author and ETF Strategist)
Human capital is arguably the most important asset that any of us have. And so I try to emphasize in the book that, you know, again, along the lines of like this time horizon based thinking, that someone who's very young, who's building a skill set or has developed a decent amount of human capital already, let's say somebody has a high income. I actually frame this in the book as being sort of equivalent to like a bond allocation in your portfolio where you can think of someone who, let's say you make $100,000 a year. You know, you could kind of frame this as someone who maybe they've got. You can think of it as someone who basically has like a $2 million bond portfolio that generates 5% per year. Because this is a literal fixed income inside of the way that you're, you're balance sheet and your income is income statement is ultimately going to function in the future. And so human capital is the thing that, you know, when I say going back to the, the concept of saving versus investing, this is the place where you should really be investing is in your own human capital. Because it's the thing that when you spend for future production to try to generate your own skill set or understanding, like right now I'm a big advocate of like, you know, using AI to try to leverage these tools to better build your skill set and, and give yourself some advantages and things like that. When you spend for future production like that, you are, you're generating an ROI in the future that will help you generate higher income, that then allows you to save more. Reallocate some of your savings into a portfolio that then helps you insulate and protect, you know, your overall financial picture. And so I love thinking of human capital as its own sort of fixed income allocation in large part because that's the thing that allows you to have a huge risk capacity. It's the thing that allows you, if you're 25 years old and you make 100 grand and you've got that sort of synthetic big bond allocation, this is the thing that gives you the capacity to take maybe 100% stock market risk and be really aggressive with your savings in a way because you've got this sort of synthetic fixed income allocation that makes you actually much more diversified than you might think you are. Technically.
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Podcast Host 2
You mentioned 100% stock allocation and that's one of the first portfolios you deal with in the book. And you could argue to the point you just made that people who are very young, very early in their career, saving for retirement for 30 years, that might be an optimal portfolio. So how did you think about the idea of 100% stock allocation and the pros and cons of it?
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Colin (Author and ETF Strategist)
Yeah, this is, it's one that I think is perfect for somebody who has that huge amount of human capital, is very young, has a very long time horizon. And I. But it could also be really applicable to somebody that, you know, the, it's, it's hard because different people have different time horizons in different pockets of their Portfolios too, where another thing I try to emphasize in the book is that, you know, if you're, if you're 55 years old and you're 10 years out from retirement, but you've got a Roth IRA that you've got, let's just say, you know, $100,000 in your Roth IRA might have a completely different time horizon than your taxable investment account. Where your, your taxable investment account maybe is something that it needs to be a little more insulated from risks because you're, you're kind of nearing that danger zone. You're entering a period where you're getting closer to retirement. Your glide path is kind of reducing into a lower, more, more sort of conservative risk capacity. And so, but your Roth IRA might be completely different. Your Roth IRA for that person, it probably is a portfolio that if you're 55, you might not touch that thing for 25, 30, 40, who knows, it might be a multigenerational portfolio. Your children's risk profile might matter more in that portfolio than in the taxable one. So you've got to sort of, this is all very personalized and that's one of the main messages of the book is that you've got to look at this at a very personalized level. But in general, I would argue that the, the 100% stock portfolio is something that it should be, it should be matched to very long time horizons, the ability to be very patient, to have a very high risk capacity. And that's generally most appropriate for people who are either very young or maybe older people who have pockets of money that they can afford to have a very long time horizon with.
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Podcast Host 2
Yeah, it's funny, this next portfolio I'm going to ask you about, we've asked you about before, but probably in a completely different context. Like we probably asked you in 2022 about the 6040 portfolio from the context of inflation's back. You know, is it, does this portfolio have massive holes in it? But in this book you're kind of thinking about it in a different context. So like, how do you think about it? And it's not just 6040, it's sort of a stock and bond allocation at various percentages. But how do you think about that? I mean, it seems like for most people that is a pretty solid portfolio for the long term.
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Colin (Author and ETF Strategist)
Yeah, it's kind of the, it's the in betweener portfolio. So at the other end of the spectrum was a portfolio that I called T, Bill and Chill, which is basically just your, your cash management account and that's on the very other end of the spectrum where I think of T bills are basically very, very short term instruments. So that's, these are things that if you were, you know, planning like an emergency fund, this would be where your T bill and chill portfolio is basically and the, the stock market's on the other end of the spectrum. But when you blend these two things, you create kind of an in between or. And so I like to think of a 6040 portfolio as, I mean I actually incite a, my own methodology that I call defined duration. In one of the chapters. I think of a 6040 portfolio as basically being like a, it's like a 10 to 15 year instrument because when you blend really long duration stocks basically with really short duration or shorter duration bonds and cash and whatnot, you create this in betweener. And that's part of why it works really well is because you've created something that's really broadly diversified where you're, you're not just diversified across different asset classes, but you're very intentionally inside of that portfolio, diversified across different time horizons where the, the portfolio is insulating you across a very balanced sort of set of time horizons.
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Podcast Host 2
How about this idea that maybe the 6040 portfolio sort of tricked us over the last 40 years in terms of we had a very certain type of environment and maybe like it made it seem like it's a better long term portfolio than for investors than it really is and it has this hole of inflation that needs to be plugged and so you need other things. How do you think about that idea?
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Colin (Author and ETF Strategist)
I think that's a, a really reasonable way to think about. I mean I think that 2022 especially it exposed some of the potential flaws in a 6040. Where a, a 6040 portfolio, especially one that's just comprised of, I mean take the simplest version of 6040 where you just have a, an all stock index and then something like a bond aggregate. I think 2022 exposed the problem in that especially if you're not thinking across this in very specific time horizons because the, the 40% bond piece is actually, it's a relatively long time horizon for most people. A bond aggregate fund is, it's a five year, five, six year instrument basically on average. And that's if you go through a year like 2022, you realize that, oh, I've got a lot more temporal exposure here. I've got a lot more timeline risk in my portfolio than I expected. Because that thing's actually, that bond aggregate actually has a decent amount of interest rate sensitivity because of its not a, not a long duration bond portfolio, but it's long enough to, to expose you to a lot of behavioral biases because a lot of people who build a diversified portfolio, they, they might not have the patience to wait five years. They may not have the financial capability to wait five years for something to break even. And that, that's the crazy thing. A bond aggregate in real terms, it still hasn't broken even since 2022. And so, you know, we're four years out from there. So I think people woke up and realized like, hey, bonds can be a lot riskier than I thought. And that's the, that's the kind of, the trickery of the last 40 years where bonds just perpetually, for 40 years interest rates were falling and bonds seem to be sort of impervious to, to any sort of risk in 2022 kind of lopped us over the head. And so I think it's, I think it's good that people are kind of moving a little bit beyond 6040 in that sense. I, I think that, you know, it's interesting because you could look at T bills, I think, and you could say, oh well, you could reduce a lot of the temporal risk in an environment where T bills are yielding, you know, pretty decent interest rates. But I think it's smart for, especially for people who are really behaviorally sensitive to, to short term gyrations in the bond market, in, in the stock market in general, to be thinking beyond the traditional 6040 in a way where they're looking at other types of asset classes and diversifiers.
- [25:45]
Podcast Host 2
And so for the rest of the interview, what we're going to do is we're going to go brick by brick and we're going to talk about the different things you could potentially add to a US6040 portfolio and maybe the pros and cons of each. And I guess the simplest one is thinking about still having stocks and bonds but bringing in that international component. And I've been saying to clients for forever, you need international stocks. And I was wrong. And I was wrong and I was wrong, at least in the short term because it just wasn't working. But I think there is a pretty good long term argument for having, at least as a US Investor for having some degree of international diversification in your portfolio.
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Colin (Author and ETF Strategist)
Oh, and I totally agree. I mean, I've been saying the same thing for, I mean, most of my career. And yeah, it, it's funny because in the last, you know, sort of two and a half Years. All of a sudden this concept looks really massively right. And in certain pockets of international, it hasn't just been right, it's been, it's been hugely, hugely right relative to domestic. I mean, even so far this year, I think, you know what most international. What is it? International's up, you know, nine, nine and a half percent this year and the US market is flat again. So you had 32% performance last year in international and you know what 17 in domestic. And so you've had huge, huge outperformance. You've had even better performance in, you know, some, some people run emerging market funds that have done really, really, really well in the last few years. We won't, we won't name any names for compliance reasons, but you probably know the names. So you know, there I think that the, the argument for international I think is, is more sensible than ever in an environment like this. Because the way that I like to look at this is especially from a valuation perspective, we have never had a divergence like this where I mean 10 year CAPE ratios are 40 in the United States and in the mid 20s for international. And so for me in my framework, the way I like to think about this is that international in this sort of an environment, it has what a financial planner would call lower sequence risk because the, the probability of a, a NASDAQ like bust in the United States is much higher than it is in something like the international markets or even like domestic value stocks because the, they just haven't boomed as much. The expectations aren't as high. That's the way I really like to think about valuations, is that valuations are expectations. And when expectations are really high, you create an environment where the potential for underperformance is higher on average. Because when expectations are high, if for instance, the AI trade doesn't pan out the way that everybody expects it to, you've just, you created such a high bar, such a high bar of expectations there that any level of underperformance results in huge amounts of volatility. And it, it doesn't even mean necessarily that you need to get like a NASDAQ style crash. It just means that the, the level of volatility that comes with those instruments is likely to be much higher on average. And so your, your risk adjusted returns over time horizons is likely to be lower than it has been in the past because the embedded expectations are just so high.
- [28:52]
Podcast Host 2
Do you think there's any value in attempting to time that international exposure? Like you could argue right now, the valuation case has been strong for a long time. But you could argue right now maybe some of the things that have made the US a little bit better than other countries are going the other direction. The dollar's weak, but, but we also know timing that's really, really hard. I mean, do you think there's any value at looking at a time like now and saying it's a better time for international exposure? Do you think that should be pretty consistent over time?
- [29:15]
Colin (Author and ETF Strategist)
I do, because I think that most people should think about their portfolio across very specific time horizons. So like, I would argue that if you're someone who is building a portfolio that, you know, let's say you're that 55 year old that you're, you're kind of gliding into retirement in some point in the next five to 10 years and you're loaded to the gills with AI stocks and things like that. I think that your sequence risk is vastly, vastly different than someone who owns a 60, 40 portfolio, for instance, or someone who even just owns a portfolio of domestic value stocks or international value stocks or something like that. So I do think that, you know, we talk a lot about how, you know, it's, it's not smart to time the market. But I think that when you, when you think about your portfolio across different time horizons, you have to think of the way that you're going to apply certain assets to very specific time horizons where, I mean, if you need money in a year, you can't go out and allocate that pocket of money to the stock market, for instance, because the stock market, who knows what it's going to do in the next year. And so, you know, that's a, that's a timeline that, that has to be matched to something like T bills or you know, maybe even short term bonds at the most, something like that. It can't be super aggressive though. So if you're that sort of like retiree who is sensitive to volatility and sequence risk and the way that you're going to be able to plan for the future, I think that it makes a lot of sense to look at pockets of the stock market where you can start to decipher the relative risks. Where you know, is, is there a risk of this pocket of the stock market Falling, you know, 50, 60, 70% in the next five to 10 years and exposing me to a huge amount of risks inside of a time horizon where I can't afford to have that exposure.
- [31:04]
Podcast Host 2
So we're going to start to build some more things on top of the portfolio. But it was interesting we had Rick Ferry on, we did this exact same thing and we got to this stage of the discussion. Then anything after this, it was like, you don't need any of that. So for everything I'm going to ask you about for the next half hour was. And he's actually got a pretty good case. Yeah, we've talked about something that's a pretty simple, sensible portfolio and it actually makes sense for a lot of people. But, but now I'm going to talk about adding some layers. So one layer you could potentially add that you talked about. The book was factor investing. And I'm a big fan of factor investing. It's what I do. But I also understand the drawbacks of it. It cannot work for long periods of time. It makes you look different in the market. It's challenging, challenging behaviorally. So, like how do you think about factor investing and how did you deal with it in the book?
- [31:42]
Colin (Author and ETF Strategist)
Yeah, I, you know, I, my confession over the course of the last five to 10 years is that I, I used to be sort of probably more like Rick that I was a little bit of a critic of factor investing and I think the. Mainly because I'm, I'm not a huge advocate of, of necessarily trying to allocate assets to try to outperform the market. So I don't go into the mentality of all of this thinking that I'm trying to generate, you know, what a practitioner might call alpha necessarily. But I've backpedaled on this a little bit because when I developed the defined duration methodology I realized that you can actually think of factors across different time horizons. And to me that's actually, it makes factor investing a really useful way to think of all of this where I'm not applying it in sort of the traditional, you know, fama French factor investing perspective where you might buy a factor because you're necessarily trying to outperform the market. For me it's again, it's going back to that time horizon based thinking where like I think you could look at something like domestic value or international value inside of this environment and you can say these instruments probably have lower sequence risk. They have a, they expose you to less volatility over certain time horizons which gives you more certainty of returns, potential in the portfolio. Whereas something like if you're buying like domestic growth or a momentum fund or you know, even, even like a quality factor, something like that, these things are loaded to the gills with the AI trade, the MAG7 trade these things that the, the valuations are very, very high, the expectations are very, very high. And so for me, I actually, I love now thinking about factors across different time horizons where, you know, if you're. And, and this is not to be critical of even the, the more growthy sort of AI trades necessarily, or saying that people shouldn't own any of those things, but it's framing them in very specific time horizons where, for instance, if you're a young person who, you know, you've got a Roth IRA that you're funding, well, the growth stuff, maybe it aligns with that long time horizon. Right? Really, really well, you shouldn't care what happens in the next 10 years. Whereas if you're that retiree who's 55 and you're navigating a more uncertain time horizon, maybe your portfolio should be a lot more tilted towards value and things that are, you know, a little lower volatility, a little less aggressive in large part because I think those instruments have the potential to give you a lot more certainty navigating those time horizons. So, yeah, I've come kind of come to love thinking about factors not in the sort of alpha generating sense necessarily, but in the sense of how are they going to perform across different time horizons. Pausar rapida esto mesorprendio Los consejos masuti les que recibo ahora no bien and de expertos sino de gente comun and TikTok lo que funciona lo que no.
- [34:45]
Stassi Schroeder
How old were you when you realized
- [34:46]
Colin (Author and ETF Strategist)
you were the son of a president? I don't think anyone's ever asked me that before. FX's love story John F. Kennedy Jr. And Carolyn Bessette. I didn't think I could love someone like this until you. From executive producer Ryan Murphy. It's not a question of if I want to spend the rest of my life with you, it's if I'm cut out to be Mrs. JFK Jr. FX's love story John F. Kennedy Jr. And Carolyn Bessette. Watch now on FX, Hulu and Hulu on Disney plus for bundle subscribers.
- [35:15]
Podcast Host 2
Yeah, it's interesting. We had Kai Wu on recently and he was talking about this idea that it's something like 50% of the S&P 500 right now is exposed in some way to the AI capex trade. And if you think about it from that perspective, like something like value is actually, it's like a risk management tool to some degree. I have my exposure the AI Capex trade. I don't get rid of it, but I supplement it with something else based on fundamentals in case that goes the other way.
- [35:35]
Colin (Author and ETF Strategist)
Yeah, Kai's awesome. I, I totally agree. I think that you know, looking at these things in, in different pockets, it was actually, it was really, really interesting when I went through the process of building our own ETFs. Like, like our 20 year fund was really sort of fun to build because I, I'm. These are time weighted ETFs and so they're funds that I'm trying to build into an asset liability matching portfolio where like the 20 year fund has a 20 year target time horizon where it's kind of like a, it's almost like a constant maturity target date fund is really what I kind of structured them as. But it was funny building this fund because like I went through the historical defined duration of the stock market and on average it's rained like ranged from like 15 to 20 years. So when I built this fund I was thinking, well I'm going to pick the long end of this because I want this fund to be really aggressive. And then when we actually went to, to put the basket together, the underlying index and I built this algorithm for it, it couldn't own any basically like US tech because all the US tech was, was way, way long. It was like too long in duration the way that I quantify it. And so the portfolio ended up being like a, basically like an international and domestic value fund. It's got like low Vol in it and like it's, it had to counterbalance the super high valuation environment by basically embedding all of this really low valuation stuff inside of the portfolio. Which it shocked me the way that, that ended up being constructed because we're just in such a, we're in such an unusual environment right now where valuations especially in the US are just, they're so high, the divergence is so large that you do you have to be really sensitive about the way you build your equity portfolio on average because the valuations in the across different pockets of the equity market are so divergent Right now one of the cool things you
- [37:35]
Podcast Host 2
did in the book is you actually have I think at least three portfolios in here that you came up with yourself. So you weren't just finding portfolios other people created, you came up with some yourself. And I think maybe the most interesting one is this idea of the forward cap portfolio. So can you explain what that is?
- [37:48]
Colin (Author and ETF Strategist)
Yeah. So to the person who wrote that Amazon review saying I had no novel strategies in here. I know you didn't read the book, sir. Um, so. But no, the, the forward cap portfolio was kind Of a, it was a fun one to write because it was, it's probably the most original strategy in the book. And I kind of built off of my sort of macroeconomic understanding. And I took basically like five big mega trends in the book and I sort of tried to basically predict what the portfolio really does is it tries to predict what is the forward market capitalization of the market going to look like in say like 30 or 40 years. And so if you think of like a traditional sort of market cap weighted ETF these days, like something like the S&P 500, that portfolio, basically the way I like to think of it, it sort of skates with the puck because it is, basically it's taking what the, the market's current expectations of, of, of different weights are going to be across a different portfolio. Whereas the forward cap portfolio would look at the, the market capitalization today and it's trying to actually predict what is the market cap going to look like in say, 40 or 50 years. And so one example is that I took like the, the famous Marc Andreessen trend of, he says technology is eating the world. And, and I tried to extrapolate the technology trend out into the future, out 30, 40, 50 years to try to understand how big is the tech sector inside of the S and P likely to be in 30 or 40 years. And in doing so, we're sort of skating to where the puck is going to be. And so in this portfolio, what I basically did was I, I extrapolated out a trend of like E commerce retail sales as a percentage of overall retail sales. And you can look at this trend and you can kind of, you can see how early we still are in the tech trend. Basically where E commerce as a percentage of overall retail sales is something like 17%. It's grown from zero since basically 1999. And if you extrapolate that trend out, it basically it almost doubles over the course of the next 30, 40 years. And so if you applied that doubling of overall consumption of technology to something like the market cap weight of the S&P 500, you arrive at a, a future cap weight of something like 50, 60%. In the book, I, I, I chose 40 because we went out 30 years basically, but in 50 years it's going to be as high as 50 or 60%. And so it was interesting because when you, when you build that sort of a portfolio, if you want to skate to where the puck is going, you actually would be way, way overweight. Technology. Whereas today, what is the technology weight? It's something like 35% in the S&P 500 right now. And so, but if you were trying to skate, if you had a really long time horizon, you're trying to skate to where the puck is going, you actually way, way overweight technology inside of your portfolio. Because the expectation is that in 30, 40, 50 years, the likelihood is the vast majority of companies that exist, they're going to look like technology companies of some sort. They will have embedded technology in everything they do in a way that basically has transformed them into some form of a technology company.
- [40:58]
Podcast Host 2
Yeah, well, if you read the AI stuff recently, I mean, basically in 40 or 50 years, we're gonna have like five companies left and we're all going to report to Elon Musk in some way or another.
- [41:06]
Colin (Author and ETF Strategist)
Government. Government. Universal Basic Income or something. Right.
- [41:12]
Podcast Host 2
So, yeah, I want to ask you about going back to the inflation thing we talked about before. I want to ask you about what many people think is like a logical way to deal with that, which is something along the lines of the permanent portfolio and adding in some gold exposure. And you talked about that in the book. So how do you think people should think about that type of portfolio relative to a 60, 40?
- [41:29]
Colin (Author and ETF Strategist)
Well, gosh, there's, there's a lot of different ways to protect against inflation. Like, I, it's actually one of the, one of the reasons that I'm an advocate of international stock investing is because I think of it as a domestic currency hedge, basically, that when you get a, an environment like one of the big trends of the last few years and part of why the international trade has been working so well is because the dollar's falling. And so when you get high inflation, when you get the, you know, relative change, a relative drop in the foreign exchange rate, you get a big tailwind from the international stuff that you own. And so, you know, I would actually argue stocks are, and I try to emphasize this in the book. I, I actually wrote all the data in real terms in the book, so I, I backed out inflation in all the data sets in the book to, to give a real understanding of how the, you know, the portfolios are generating returns, that the dollars that actually go into your pocket in real terms, the. What can you actually consume? And so I tried to emphasize that the stock market's actually one of the very best places to build an inflation insulation inside of your portfolio. But, yeah, there are lots of other ways to do it. I mean, there are, and there are ways to do it inside of even the bond market where, you know, like I talk about How a, a handful of the strategies and the, the advocates behind them are big advocates of owning TIPS portfolios, Treasury inflation protected securities. And so you can, you can build a, an inflation protected portfolio even inside of your bond allocation. If you're someone who likes that. I wrote that, you know William Bernstein who I interviewed in the book was, he's a big advocate of TIPS portfolios and matching TIPS across different time horizons in a, like a bond ladder structure. Swenson, David Swenson from the Yale Endowment. He's a huge advocate of using tips. And so but yeah, then you can get more sort of fanciful where you go into other types of instruments whether it is, you know, just plain vanilla commodity funds or things like gold. Gold is obviously in the long run probably the ultimate real, a real hedge against inflation. I do think I, I liked talking about the Harry Brown portfolio because I that's the permanent portfolio which is sort of this, it's a four quadrant portfolio where what Brown basically did was this was the true all weather portfolio. And the way he framed it was to be insulation against all four sort of seasons of what you might be the risks you might experience in the, the financial markets where he's using cash as a recession insulator, he's using gold as the inflation insulator, the stock market is a expansion protection. And then the, the final component was T bonds which protect you against deflation. And I liked talking about that portfolio in large part because you can look at the way that this portfolio is in a lot of ways very sort of simplistically allocated. There's an elegance to the simplicity, but it also exposes you to really sort of potentially like huge asymmetric risks in the portfolio where the, you know, like I would argue right now is a really interesting time for the permanent portfolio because the, the gold component has just been dragging that portfolio wherever gold goes. Because the volatility in gold has been so gigantic in the last few years and it's been, it's been volatile in a good way, it's been volatile in a positive way. But if for Some reason that 25% slice of gold in the permanent portfolio was to become, you know, hugely negative in the next few years, I wonder if that portfolio will perform so well. So you've got, even though you've got a lot of diversification there, you've got a lot of concentration risk in a certain way in a portfolio like that that you have to be mindful of.
- [45:11]
Podcast Host 2
So that actually leads well into the next portfolio which is risk parity. And this idea If Gold's dragging the portfolio all over the place, could think about balancing our portfolio based on risk. So what are your thoughts on the. On risk parity?
- [45:23]
Colin (Author and ETF Strategist)
Yeah, this one's really hard to build actually. So that was the, you know, Ray Dalio is the, the, the originator of this one. And what Dalio said to apply a true risk parody, he says that you want at least 15 non correlated instruments inside of the portfolio. So I think that Dalio's risk parity portfolio is one of the more complex portfolio. If you're really building this true to its name and true to its methodology, this portfolio can get really complex. And it, it's weird because I think you can also get into a position where this portfolio ends up being way too diversified basically where you, you own so many things, you have so much non correlated return streams in the portfolio that you maybe are doing a lot of things that are sort of counterproductive where you're offsetting returns inside the portfolio so much that you actually create really low sort of expensive returns. Because that's the other thing. Getting, Getting access to 15 uncorrelated return streams probably requires you to use a lot of very expensive sort of strategies where you're, you're going into like futures markets and you're, you know, what are you buying? Are you buying like, you know, lean hog futures and soybean futures? And you're doing lots of different things that are very intricate, probably overly intricate for the average retail investor. And so it's indicative in the performance too where risk parity actually in the book is one of the, it's one of the lower performing portfolios I think in part because you've created so much diversification inside of the way the methodology works that you've, you've almost dampened the returns inside the portfolio where you have a relatively good risk adjusted return inside of something like that, but you've really dampened the returns because you've got so many return streams inside the portfolio that you could argue you're, you know, kind of, it's almost like the opposite of like the permanent portfolio in some sense where you, you've actually, you probably created too much diversification inside of a portfolio like that versus something like the, the, the simplistic forefund, a permanent portfolio.
- [47:33]
Podcast Host 1
So talk about, I think this one is original to you, the countercyclical rebalancing portfolio. What's the idea behind that?
- [47:42]
Colin (Author and ETF Strategist)
Yeah, so this one's actually from, I kind of ripped it off from John Bogle where like it's funny A lot of people think of Bogle as this like super passive investor. And the interesting thing is that Bogle at times was really, really active. Like he famously, in the year 2000, he rebalanced his 7030 portfolio to 3070. And Vanguard actually is advocating to do something really similar like this now where they're saying you should flip the script on 60 40. You should be 40 60, basically. And so I, I framed this one. Some of the portfolios are very specifically behavioral portfolios where I frame them as, hey, are you somebody who is sensitive to volatility? Are you, do you, do you struggle with behavioral biases? And this portfolio is one that is very specifically a behavioral bias hedge where you are in an environment like today, you're building something that is sort of countercyclical, not necessarily because you, you want to time the market, but because you look at things like valuations and you say, I'm uncomfortable with this. And I know that if the, if I had a 6040 today and that thing fell, if it fell 30% like it did in 2008, I'd probably feel the need to sell out of it. And so maybe you do what John Bogle did and you, you flip the script on it and you go, you know, from 7030 to 3070 or something. And in doing so, you actually adhering to sort of a Bogle like mentality where you're, you're staying fully invested, you're staying the course to a large degree, but you're doing it in a way where you're, you're not necessarily moving all in and all out like a gambler might do. Whereas somebody who gets scared oftentimes will move all in or all out. In a bear market, you might sell all of your stocks and go to cash and then you don't have a re entry plan. And you, you know, you find yourself after selling out in 2010, you, you find yourself in 2020 or 2015 or whatever, you know, after the stock market has gone up a lot without a re entry plan. And this is a way of maintaining something that helps you stay the course but is also rebalancing in sort of a more dynamic way where you're buffering yourself from some of the behavioral biases that, you know, you might be exposed to over the course of time.
- [50:01]
Podcast Host 1
One, one of the people we've had on the podcast, well, we've actually had Dan Rasmussen, who's been pretty critical of private equity and, and MEB Faber in terms of, you know, private assets and the value that investors get. And this kind of comes out of like the, you know, Yale Endowment strategy and what Dave Swenson developed there and a lot of people trying to like replicate those results by, you know, allocating to, to private assets. So what, what are your thoughts just generally on, on those types of things?
- [50:33]
Colin (Author and ETF Strategist)
Yeah, Dan's great. Dan's. Dan actually runs a, his own counter cyclical sort of strategy. I touch on it. He wrote a great book called the Humble Investor. And he talks about his own way of. He basically think a little simpler methodology where he's using basically credit spreads to try to sort of create his own sort of countercyclical approach to, to allocating assets. But. And I touch on that in that chapter, but I build on it, try to build out something a little more sophisticated, I guess, maybe not more sophisticated, but more usable for a retail investor. But I'm, I talk about private assets a lot because like in the endowment strategy, I talk about how David Swenson talked a lot about the illiquidity premium that exists in private markets where if you're, if you're someone who's patient, where you're allocating to things like venture capital funds or private equity project, these projects typically have a, they have a lead time that is very long. They, it takes. I mean, if you're investing in venture capital, for instance, you know, you're probably investing in young companies. Young companies, they take a long time to generate growth. They're high risk. You need to be very, very patient with these things. And so I think in the right type of wrapper, private assets are great. And I think that for the right type of person who's patient, private assets can be a great diversifier. I am very critical of trying to take private assets and put them in things like ETFs. Because the ETF wrapper just, it's not designed to have illiquid instruments in it really. It just doesn't function efficiently inside of a wrapper like that because you. The beauty of an etf, really, the secret sauce of an ETF is that they, the market makers are able to, to strike the net asset value because they know exactly what the underlying are worth to a large degree. So for instance, a T bill ETF works fabulously because the market makers can see exactly what the T bills are worth at every second of the trading hour, basically. And so they're able to set very tight spreads. Those instruments function really, really well because the ETF reflects the underlying instruments very, very purely, whereas private instruments, they're just, they're for the most part, they're not mark to market. You know, they might mark to market on a quarterly basis or, you know, even longer in some cases. And so when you try to put something like that inside of an ETF wrapper, you're trying to, you know, jam a square peg into a round hole, and it just, it doesn't work inside of that wrapper. And so, you know, I think that there are, there are structures that work better. I mean, there are, there are even, you know, types of mutual funds that, that have sort of lockup periods that only they're gated to, like a quarterly basis. Those things work better. They probably still don't even work as well as, like, you know, God, I'd say if you're, if you're doing private equity the right way or you're doing venture the right way, you probably should be locking up your investors for years because you're trying to very, you know, very clearly communicate to them that, hey, this, this partnership doesn't work unless you have the patience to allow us to allocate capital to our projects in a way where you allow the returns to accrue. So that's a whole different world, though, when you start getting into, like, you know, things like Angell List and, you know, private equity investing and doing this the right way through a, a private equity fund or a venture capital fund. I just don't think public markets are the right place to be allocating that. We heard you. Nine years of bring back the snack wrap and you've won. But maybe you should have asked for more. Say hello to the hot honey snack wrap. Now you've really won. Go to McDonald's and get it while you can.
- [54:23]
Stassi Schroeder
Stitch Fix Shopping is hard. Let's talk about it.
- [54:27]
Podcast Host 1
I don't have time to shop, so I buy all my clothes where I buy my seafood.
- [54:30]
Colin (Author and ETF Strategist)
I just want someone to tell me what shirt goes with what pants.
- [54:34]
Podcast Host 1
I just want jeans that fit.
- [54:35]
Stassi Schroeder
Stitch Fix makes shopping easy. Just show your size, style and budget and your stylist sends personalized looks right to your door. No subscription required, plus free shipping and returns.
- [54:45]
Colin (Author and ETF Strategist)
Man, that was easy. I look good.
- [54:48]
Stassi Schroeder
Stitch Fix online Personal styling for everyone. Take your style quiz today@stitch fix.com.
- [54:55]
Podcast Host 1
one of the chapters you have is the define duration strategy. And you've talked to that a little bit already today with us. But the other thing is you have discipline. Fund now has three ETFs with three different defined target dates. You have a five year, you have a 10 year. And as you mentioned, before you have a 20 year fund in terms of its defined duration. So just talk to those overall and like how an investor might, we're kind of stepping out of the book now into, into ETF world, but you know how an investor might utilize those within their portfolio and in their investment strategy.
- [55:33]
Colin (Author and ETF Strategist)
Yeah, it's funny because when I, I worked with banks a lot after the financial crisis, so I used to work with a lot of bank traders about the way that like things like quantitative easing would impact their portfolios and after the financial crisis trying to decipher how these bank balance sheets would be impacted because for the most part banks are, they're relatively constrained to what they can invest in and so they're very, very bond heavy. A lot of these traders are and I always found it interesting that a bank, banks and pension funds and insurance companies, these big, big complex institutions, they use what's called asset liability matching strategies very meticulously. They, they work from basically like a, a cash flow plan, trying to understand what their outflows are going to be over certain time horizons. And they're matching assets to match these cash flows basically. And I always found it kind of interesting that the, the retail investing community gets sold something completely different. We basically get sold a style investing approach. So it's like a Morningstar style box strategy approach basically. And there's not a lot of asset liability matching strategies out there, which I find really strange because the, I think the asset liability matching actually is a lot more understandable for your average retail investor because your average retail investor actually understands time. They don't understand things like, you know, a growth fund, they don't even, they don't understand what a mid cap fund is versus a large cap fund probably. They, you know, they have some vague concept of what it means, but they're not really, they don't really truly understand like how is this helping me plan for my future necessarily. And so asset liability matching just for me is so much more applicable to financial planning and the way that people can actually build a portfolio because people can then begin to understand how are certain pockets of my portfolio actually serving very specific goals. And so I built these funds basically to create what are. They're essentially time weighted funds where I tried to, I'm quantifying the potential sequence of return risk over a different time horizon. So the five year fund has much lower sequence risk than the ten year fund and the ten year fund has higher sequence risk than the five year fund but much lower sequence risk than the twenty year fund. And so what you can do with these funds is you can go in and you can start to sort of customize the way that the different funds might match different goals in your financial life. Where you know, for instance, if you're that 55 year old retiree and you're 10 years out from retirement, you might build your portfolio in a way where you've got a, say a T bill ladder that's funding an emergency fund over the course of two years, maybe you've got a kid who's getting married in the next two years, you're matching that part of your portfolio specifically to that liability in the future. And then you've got a sequence of other say time horizons where maybe you're planning to buy a house in five years, maybe that goes to the five year fund, you're retiring in 10 years, you've got a slug of assets that gets matched to that. And what you do over the course of this allocation process is you're, you're reducing the amount of sequence risk that you have across all of the different time horizons that you're navigating. Because you know that these, these temporarily diversified or time weighted instruments are very methodically matched to specific time horizons and specific goals inside the portfolio where you can create sort of a, something that looks a lot like an asset liability matched portfolio that a bank might put together, but you're doing it in a way where now a retail investor has access to this thing in a way where they can build something that is actually relatively simple looking but is sophisticated enough to actually be based on your financial plan and give you an understanding of okay, now I look at my portfolio and I understand the actual role that each of these things is playing relative to certain goals and different time horizon based needs that I have within my portfolio.
- [59:26]
Podcast Host 1
So you've looked at all of these strategies, you show the performance, the historical performance of these strategies. You know, historically going backwards. Was there any thing that really jumped out and surprised you that you were like, like whoa, this is, this is not what I expected in terms of maybe like a risk adjusted type of number or just something that really like kind of struck you as this is really interesting, impressive, or maybe, you know, maybe not what investors really know about the strategy.
- [60:01]
Colin (Author and ETF Strategist)
You know, I thought the, one of the things that I thought was the most interesting was the way that I, I built the portfolio data in this real return methodology where you're, when you back out inflation, the numbers are just so much lower than what I think. A lot of us think that, you know, when you, you read the Financial media or watch financial tv, you hear about how the stock market does like, you know, whatever, 10 or 12% a year. And people get these sort of like fantastical numbers in their minds where I think they start thinking like, ah, you know, the stock market really is a place that's going to make me fabulously rich in the long run. And then it's funny though, when you back out, taxes and fees and then inflation, the numbers are really, they're pretty small. So the, the amount of money that actually goes into your pocket after all of this is relatively small. Because the, the after me, it's, you know, we, we talk. People are really critical of investment management fees. But man, the two biggies are the other ones. It's inflation and taxes. Inflation and taxes just, they slaughter you in the long run. And so they, they'll take that 10 number and after you back out, all of these other things, you know, you might have, even in a really high stock market performance like 10, you might have 3% or something in a, in a real, real return basis. And so it, that was the thing that I sort of found the most interesting. It's probably the thing that a lot of readers will look at and say, you know, hey, none of these portfolios seem to actually do that well because when you look at the actual numbers in an after inflation, after, especially if you back out, if you, if I backed out taxes and fees from all these portfolios, the numbers would be way, way lower than they even are in the book. And so, but I found that really interesting. I found it actually really useful for perspective because I think it's, it's good to get into this with the, the understanding that, you know, kind of going back to the very beginning of the conversation that it's your human capital is the thing that's going to make you rich. Your portfolio. If you allocate it sensibly and you diversify and you treat it like a savings portfolio, it'll insulate you from a lot of different risks, but it's very unlikely to be the thing that actually makes you rich in the long run. So you want to really, you know, not put the cart before the horse there. You want to build your human capital, build that income, save that income and diversify it into a portfolio that fits, you know, your, your needs and whatnot, but have the right perspective where the, the real investing you're doing is in your own human capital. Because that's the thing that's going to drive your real wealth generation in the long run. It's great.
- [62:37]
Podcast Host 1
Colin, thank you very much for joining us. The book is excellent. We really encourage our listeners to check it out and check out Discipline funds too. Thanks.
- [62:47]
Colin (Author and ETF Strategist)
Thanks guys. Great talking with you.
- [62:49]
Podcast Host 1
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio or on YouTube. You can also follow all the podcasts in the Excess returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on this podcast
- [63:10]
Stassi Schroeder
should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.