Preston Pysh  01:18

So Scott, in this episode we’re going to be talking about the crashes of 1907, 1929, 1987, 2008, and the Flash Crash of 2010. I’m sure some, if not all of those years are very familiar for a lot of people in our audience. But let’s start all the way back to 1907. And for people not familiar with this crash, JP Morgan was a key character in this crash. So talk to us a little bit about him and talk to us about the characteristics of the 1907 Crash.

Scott Nations  01:46

JP Morgan was a fascinating man. He was a fascinating man. He was a man of privilege. He was born into privilege. His father was Judas Morgan, who was, well, essentially made the family even more wealthy by selling civil war bonds in London during the American Civil War. JP Morgan was educated as you would expect somebody of his wealth. He had a peripatetic education. He was obviously educated in the United States, but also in Switzerland and in Germany. As a young man in Germany, he developed an appreciation for art; actually a love for art, which informed his private life. But JP Morgan was really raised to be a banker in the early part of the 20th century. He was by far the wealthiest man on Wall Street. Well, maybe not the wealthiest, but certainly the most powerful. He was absolutely the most powerful man on Wall Street. He was called, “the Zeus of Wall Street.” And he really was involved in every aspect of finance in the United States in the first part of the 20th century.

Stig Brodersen  02:54

Now, if we go back to October 1907, the market crashed almost 50 percent from previous ESP. The panic might have been even worse if it hadn’t been for JP Morgan, and he pledged a huge sum of his money and convinced others to do the same. Perhaps you could tell us some of the factors about what caused the crash, but also the story about Morgan’s intervention in the market. It’s a very fascinating story.

Scott Nations  03:22

Before 1907, the United States was really beginning to understand that it was going to be the American Century. It was powerful. It was probably at that point, the most powerful country on the globe. And so, frankly, the United States got carried away with itself. And we’ll talk about some of the specifics of some of these crashes and how these shared some similarities in a bit. But you asked specifically about Morgan’s intervention in the market. This was before the US Federal Reserve existed. In fact, the Panic of 1907 was the cause the Federal Reserve was created. But if you were worried about the market; you were worried about the Panic of 1907, the person you went to see was JP Morgan because, again, he was so powerful. And one example occurred in the midst of the panic. On Thursday, the 24th of October of 1907, when the Press of the New York Stock Exchange went to JP Morgan. At the time, his office was directly across the street from the New York Stock Exchange. Very simply, “Mr. Morgan, we will have to close the exchange early. There’s simply too much selling.” And JP Morgan understood what that meant.

Scott Nations  04:37

His question was: How in the world do you ever reopen a stock market that you’ve been forced to close because there’s too much selling? And so, JP Morgan asked, “When do you normally close?” “Well, sir, we normally close at three o’clock, but we can’t get there. It’s too much sign.” He said, “Then, you will not close one minute early.” And his confidence was…it was not naked. He rounded up bankers in the Wall Street area. Got them all into his office. It was a time when if JP Morgan called, you came running. And he told the assembled bankers, “You have 15 minutes to raise $25 million to save the stock market.” $25 million back then was a colossal amount of money, but JP Morgan essentially said, “You have 15 minutes to raise this money or the stock market is going to close. And who knows when it will ever reopen?” And that’s just one specific story of his involvement. That’s not the first time he did something like that. Probably the most immediate, but within 15 minutes, they had raised actually more than $25 million. The officials were able to go on the floor and say, “We have $25 million to lend to investors, who are in trouble.” People were so desperate to get this money that the clerk, who was responsible for recording borrowers and amounts had his suit coat ripped off of him in the turmoil. So JP Morgan was really the man; the single man, who managed to save the stock market in 1907.

Preston Pysh  06:11

So Scott, you briefly mentioned that the Panic in 1907 was the reason for the creation of the Federal Reserve. Talk to us a little bit more about that idea.

Scott Nations  06:19

It became obvious to everybody after things had settled down after the Panic of 1907, the United States government needed a way to inject liquidity into the system and didn’t have it. And that there needed to be a lender of last resort, if you will, for the financial market. And that didn’t exist before 1907. And so, the Federal Reserve was created in 1913 because everybody realized, if nothing else, JP Morgan is not going to live forever. And we can’t rely on one man, one person to essentially bailout the stock market in times of stress.

Stig Brodersen  06:57

Let’s turn to the next crash, the crash of 1929. And to really understand what happened, we also have to understand how crazy the market behaved in 1927 and 1928. And I think you do a fantastic job of that in your book explaining everything leading up to the crash. In 1928, the Dow closed in 300, which probably to the listeners out there seems outrageously cheap, but that was definitely not the case. And this was at the end of the second biggest two-year run ever. It was actually more than 90%. So Scott, what drove the all-time highs leading up to the crash in 1929?

Scott Nations  07:38

In the late 1920s, actually much of the entire decade, but particularly in the last half of the 1920s, there were simply a euphoria at work in the United States. It was not just financial. It was…it had to do with the United States’ place in the world. And from a military point of view, also from an industrial point of view. So as you pointed out, in 1927 and 1928, the stock market gained more than 90%. We had come out of World War I. We felt great about our place in the world, but there were also some other things that were…for example, in a situation like that; with an economy roaring like that; a stock market booming like that, you would expect the Federal Reserve, which was new at the time, you would expect them to raise rates. One Federal Reserve officer at one time described it as “taking away the punch bowl, when the party really got going.” And the Federal Reserve did not do that. In fact, they kept rates low. They kept rates too low, largely because they wanted to help England return to the gold standard after World War I. That was a tragic mistake–keeping rates that low. There was also a roster of new technologies that were unleashed following World War I. Radio would probably be the biggest, but also the automobile industry really got going; really came into its own. And then, America just felt good about itself. And so, all of those things spawn this euphoria that eventually made its way into the stock market. And the stock market got carried away with itself.

Stig Brodersen  09:13

It’s very interesting. And you mentioned that before here with the Federal Reserve. Now, could you talk more about which actions did it take? You already, again, briefly touched upon that. But if you should outline and put some years on like before, during and then, especially after the crash. It was very interesting, the type of monetary policy that the Federal Reserve decided to carry out.

Scott Nations  09:34

The Federal Reserve really started making errors in policy in 1924, when they were essentially begged by the British government to help them get back on a gold standard by lowering interest rates here in the United States. And they did that. And they continued that sort of policy, and eventually the Federal Reserve simply lost control of the monetary situation in the United States. There was so much money being made by industry and individuals that they were happy to loan that money, the stock market speculators, and that’s sometimes called, “the call money market.” Call money is money that’s available to investors to speculate with, and for a long time that money had been provided by banks. And now, outside investors were providing it, and they did it in droves because interest rates were so low, otherwise. And the bubble was undeniable. In the late 1920s, American brokerage firms paid a $100,000 to put a brokerage office on a single transatlantic liner, the Barren Garea. A $100,000 just to open up; the opportunity to open a brokerage office. Another brokerage firm opened a tent at the US Amateur Golf Open in Pebble Beach. The stock market was such a phenomenon, and the rally was such a phenomenon that people didn’t want to get away from it.

Preston Pysh  11:01

Scott, do you see any parallels between what’s happening today? And what was happening back in the 1920s?

Scott Nations  11:08

I think that’s a great question. I think that given our stock market, the American stock market is at all-time highs and that our economy is doing pretty well. Not great, but pretty well. I think it’s easy to say that interest rates here in the United States is guided by the Federal Reserve are too low. The Federal Reserve, I believe, is responsible for the crash in 1929 by keeping rates too low in the late 1920s. And I think they did the same thing in the decade of the 2000s, just before the crash in 2008; 2009. They kept rates too low for too long. So I think there’s real concern.

Stig Brodersen  11:45

Before we turn to the next crash, Scott, I just have a quick follow up question. What happened in 1929 was just so…so many interesting things happened, and we still talk about it today. We still talk about the Great Depression. Now, what is the one thing, if you can just name one thing, that all listeners should learn from that interesting period as stock investors? What is that thing that they can learn from?

Scott Nations  12:10

I think that the thing to take away from all the crashes actually is that they are all hauntingly similar. Crashes are all hauntingly similar, and that’s really the reason I wrote the book. But they’re also extremely rare. Crashes are extremely rare. It was more than 20 years from the first and the second that I write about. And more than 50 from years from the second to the third, and then, again, 20 years from the third to the fourth. I think that those are the two things that I would leave investors with. Unfortunately, they’re also inevitable. Crashes are inevitable. Why is that? It’s because our greed runs away with us, and we lose sight of fear. And every investor should have a reliable balance of those two things. So it’s unfortunate that we do have crashes because they do inflict a monetary and a psychic cost. But over time, the stock market is a great place to provide for educations or retirements. So, I guess the lesson is don’t get caught up in the hype. And if you think that there’s hype going on right now, well, don’t get caught up in it. Scott, let’s

Preston Pysh  13:22

Scott, let’s talk about the really famous 1987 Crash. But before we get into the meat of all the information surrounding it, I think it’s important for people to understand that this decade was full of activism. Call it, “the Carl Icahn style of corporate governance raiders.” Talk to our audience a little bit about this, and what was going on back during this decade?

Scott Nations  13:44

Certainly. Before the 1980s, businessmen were seen as gentlemen. JP Morgan would have thought first and foremost that he was a gentleman, and they did not believe in essentially rocking the boat, when they did business. They wanted to do business together. They wanted everybody to agree. The 1980s, things changed. And we ended up with what we ended up calling corporate raiders: people who were happy to rock the boat, who realized that corporations were holding this hidden value, and that only somebody who was willing to rock the boat could unleash that value. And the example, one of the first examples from the 1980s is an example from T. Boone Pickens.

T. Boone Pickens ran a small, smallish petroleum firm, Mesa petroleum; essentially drilling for either royal or natural gas. And obviously he paid attention to the bigger firms in the business. And one of the firm’s that he saw was a company called, Cities Service, that have been around for a long time. And T. Boone  Pickens did a little math and realized that the price at which Cities Service’s stock was trading meant that all of the crude oil reserves that they had were selling for about $5 a barrel. So if he could have bought the whole company at the current stock price, he would have bought a whole bunch of proven oil reserves accrued over about $5 a barrel. Well, T. Boone Pickens also knew that the industry finding cost; that is the cost to go out, and do the geology; drill a test well and the like was $15, 1-5 dollars. And that crude oil was actually trading on the commodity markets for $30. So crude oil as reserves for Cities Service were trading at a huge discount to what the crude oil was really worth. And so, T. Boone Pickens realized the best place to find crude oil was on Wall Street. And he drilled for it by trying to buy Cities Service because he realized that as an activist that the value of the company was grossly under stated by the stock market.

Stig Brodersen  16:02

Before we go on, I just would like to give a quick hand off talking about T. Boone Pickens. We did a thorough review of his book, The First Billion is the Hottest, and I’ll make sure to link to that in the show notes. Now, very interesting, Scott, the way that you explained activism and the role in terms of driving up the prices. Now, a new concept I would like to introduce to the audience here today, together with you, is the technique of portfolio insurance. And that was something that was pioneered by Hayne Leland and Mike Rubenstein back in 1979. Now, this is a hedging strategy developed to limit the losses an investor might face from a declining basket of stocks without having to sell the stocks themselves. Now, all of that being said because it sounds like a great product like why wouldn’t we have that? But keeping that in mind, could you please talk to us how this seemingly risk-producing product led to a 22.6% decline, the biggest one-day percentage loss in history that crucial day in 1987.

Scott Nations  17:09

I actually just started my career, when the crash of 1987 happened, and it was certainly something to live through. I talked about every crash having some sort of financial contraption. And portfolio insurance was certainly the financial contraption for 1987. So portfolio insurance was certainly the contraption for 1987. What is portfolio insurance? Because it sounds like a wonderful idea. Sounds like a wonderful concept. The math of options on stocks can get pretty rigorous. But some academics realize that if you were to trade a portfolio of stocks in small slices and in a very particular way that you could replicate the performance of an insured portfolio; hence, portfolio insurance. And these academics realized that if they used this really rigorous math that theoretically, they could limit the risk on a portfolio. And again, that sounds like a wonderful thing.

They use stock index futures to do this, eventually. But the problem is that portfolio insurance and the math at the heart of it rely on some assumptions about our market which just are not valid. It assumes that there’s essentially an unlimited amount of liquidity. And we know that in times of stress, liquidity dries up. So, portfolio insurance call for selling tiny slivers of a portfolio in the form of stock index futures as the market fell. In continuing to sell small slivers as the market continues to fall, and eventually as it…if it falls enough, you have to sell more slivers and larger slips. So that’s what happened in October of 1987. Investors were entranced by this concept of portfolio insurance. And so, they used it to a huge degree. They also invested more money in the stock market because of portfolio insurance that they would have otherwise. They felt confident that this insurance would save the day, essentially. And so, what happened is that there was just this cascade of selling from portfolio insurance as more, and more, and more had to be sold. Liquidity dries up in an environment like this. And that’s what happened. The market was essentially trying to sell billions of dollars worth of stock, and there were simply no buyers.

Preston Pysh  19:43

So Scott, you were just starting out during this period of time. So what was that like to live through?

Scott Nations  19:49

I just started as a clerk on the floor of the Chicago Board of Trade in the financial futures markets. I was a young guy, so I had the benefit of not having a lot of responsibilities. I didn’t know if I would have a job the next day. I worked for a wonderful man who was a legendary trader, and he was able to navigate it very easily. But you never know what else is going to happen. Is the market simply going to close down? Am I going to have a job? Fortunately, it worked out. It worked out well. It certainly didn’t work out well for investors. Again, there was a lot of psychic and financial damage. But it was something interesting to live through because it explained…it shows in sharp focus that markets often behave irrationally; that the market can fall farther than you believe it can. And that the worst time to try and right size your portfolio is during a panic.

Stig Brodersen  20:51

How did it change your investment approach; if it changed your investment approach to experience something like that so early in your career?

Scott Nations  21:00

That’s a great question. It really drives home the idea that markets can fall farther than we believe. And that some of these, again, financial contraptions have problems. And I didn’t really understand the idea of the financial contraption across stock market crashes at the time. But I came to realize that some of these great ideas that people have are flawed at their very core. And so, you have to be a little bit, we’ll call it dubious, you have to be a little bit dubious about some of these great ideas.

Preston Pysh  21:33

So talk to us about the rebound, Scott. How long did it take? What was the sentiment through that period of time?

Scott Nations  21:40

The interesting thing to takeaway is now that our equity market has what we would call, “circuit breakers,” so it would simply not be possible for our stock market to drop by 22%, almost 23% in a single day. The market would close down before that would happen. But…and because these are engineered in such a way that everybody knows what they are, these secret circuit breakers, what they do is they tell everybody, “Let’s just stop and think about what we’re doing. And let’s just not sell because we’re in the middle of a panic.” So that sort of a loss for a single day is simply not possible anymore. And that’s important for an investor to realize. Doesn’t mean it couldn’t happen over the course of a month or two, which would be pretty ugly. But things are a little bit different. I think we also have an understanding now that…about the interaction of some of our markets, and we didn’t understand how some of our markets interacted back in 1987. So we’re certainly a lot smarter about some of those issues than we used to be.

Stig Brodersen  22:46

Now, Scott, we can definitely talk. I mean, almost entire episode if not more about each of these crashes. But let’s jump to the next crash here in 2008. Now, that is the story of new fancy products that changed the financial markets. But what I really like in your book, you talked about Bistro that was first introduced in 1997, and it’s not as delicious as it sounds. It was the predecessor of the synthetic collateralized debt products that just grew in popularity and was contributing to causing this major, major crisis. Now, Scott, could you please explain the relationship between the various debt products and the financial crisis?

Scott Nations  23:28

A few decades ago, a mortgage on a home was a very different sort of thing. For example, the mortgage that my parents had on the home I grew up in, they got from a local savings and loan. It was down the street. That’s where they dropped off their check every month. The savings and loan kept that mortgage. They kept that loan. It was an asset for that savings and loan. My parents knew some of the people who work there. They probably knew the banker, who made them the mortgage. That relationship changed fundamentally over the last say 20, 30 years. Instead of a mortgage being an asset that a savings and loan would keep on their books, bankers realized it’s really an asset that can be sold off. And once it’s sold off, it can be combined with a bunch of other mortgages, and that makes sense. There’s no reason that an investor, let’s say, an institutional investor might not want to own a big portfolio of say, 10,000 mortgages. They’re going to take the risk, but they’re also going to reap the interest rate rewards, so that is an interesting concept. Unfortunately, we got to the point where we wanted to divide up that portfolio of mortgages in different ways to satisfy different needs. And we lost sight of the risk.

But really what happened was that there was this enormous appetite for mortgages from financial…essentially from investment banks to put into these mortgage backed securities, which could then be diced up and sold to investors. And the problem with that is that this appetite for mortgages means that everybody lets their guard down a little bit. The homeowner is able to get a bigger mortgage than they might otherwise. The mortgage broker gets paid for writing the mortgage. The bank that originally makes the mortgage gets paid, when they sell it. Everybody gets paid except the end investor. And so, again, so financial engineering got a little ahead of itself. And we ended up with these products that destroyed the link between the end investor and the person who was actually borrowing the money for a mortgage. And I think it’s that destruction of that link that really caused the problems in 2008, 2009.

Preston Pysh  25:50

So let’s talk a little bit more about the mortgage backed securities and all the key players that had their hands in this crash, and how they were incentivized. What were the key motivations and catalysts?

Scott Nations  26:03

It seems that everybody had the incentive to get paid, and it seemed like everybody was going to get paid. The homeowner was going to get a big mortgage. The rating agencies were going to get paid by the banks, who paid them to rate these deals. The investment bankers got paid, when they bought these mortgages; put them into mortgage backed securities, and then, sold them to investors. And policymakers got paid to the degree that they were able to satisfy their personal opinions about how involved government should be in these sorts of things. The best way to express that everybody was getting paid and that there was that the link of trust had been broken is one of the phrases that some of the mortgage brokers used and that some of the investment bankers used, and it was very, very simply put, “I’ll be gone. You’ll be gone.” And what they meant was that we’re going to get paid for these deals now. We’re going to get paid for writing mortgages, or buying mortgages, or packaging mortgages and selling them. We’re going to get paid now. And when the problems rise because people aren’t able to pay their mortgage, you and I’ll be gone. We will have cashed the check. We’ll be wealthy. Maybe we’ll be retired, but we’ll get paid. And I’ll be gone, and you’ll be gone.

Stig Brodersen  27:23

Very interesting the way that you phrase that. You can probably still make the argument that a lot of people want to put blame of everything that happened back then. Is that the right lens to look back at all the events back there, saying these people are to blame? How do you look at that?

Scott Nations  27:42

They all got paid. That means that they were all greedy; to the degree they were greedy for more money, or more love, or more free time. Seems that everybody wants more of something. Those people wanted more money. So to look back and say that we’re going to try and regulate greed, or legislate against greed, I think is a mistake. There were lots of problems that were made. There were lots of mistakes that were made; problems were generated. But to a certain degree, they’re human. I mean, Warren Buffett is the first one to talk about fear versus greed, and those are purely human emotions.

Preston Pysh  28:21

So, Scott, is it even possible to regulate greed? Or is there something else that can be done?

Scott Nations  28:26

No, you simply can’t. I talked about every crash being abetted by some new sort of contraption. The contraptions just change. The contraptions change. They get much more sophisticated as time goes on. The contraption for the very first crash in 1907 was a savings trust. It was called a savings trust. And what could sound better than that? Two wonderful words put together to mean something entirely different. It was really intended to be a savings and loan or a beg. Ultimately, it became essentially a savings and loan that was grafted onto a hedge fund, so the worst sort of thing. But the point is that these contraptions, they all…they evolve. They become much more sophisticated. They feed people’s greed because people are getting paid or believe that it reduces risk. And there’s simply no way to legislate against that.

Stig Brodersen  29:25

Let’s turn our attention to the crash in 2010. And this was a time where it seemed like everyone suddenly started to talk about the Greek economy, which they weren’t really seem to have been doing before. And perhaps that is a little surprising because it’s such a small economy; only around 3% of the total EU economy. How would you best describe the Greek economy leading up to 2010? And why was the Greek economy all of a sudden a problem for the entire financial system?

Scott Nations  29:54

That’s a great question. And let me preface this by saying that people often ask: Why did I write about the flash crash in 2010? Because it happened very, very quickly. And it was over almost as soon as it started. It’s certainly not as familiar to everybody as 2008, 1987, 1929. And probably more people have heard of the Panic in 1907. Then, remember the Flash Crash of 2010. But I write about the Flash Crash of 2010…I write about that because the next crash we have, and I don’t know if it’s going to be a week from now or two decades from now. But the next crash we have is going to look much more like the flash crash than it’s going to look like anything else. It’s certainly going to look more like the flash crash, and it’s going to look like 1929, so that’s why I write about the flash crash.

Scott Nations  30:48

Now, specifically, Greece and the eurozone economy. The best way to describe the Greek economy in period from say, 2000 and 2010 was a lie, which was built on a disaster. And what do I mean by that? Well, the Greek economy was a disaster. It was absolutely a disaster. It was underperforming. There were few jobs. Tax avoidance was not just something that was a problem. It was essentially an avocation for every Greek citizen. They felt like, they almost…it seemed that they almost felt like it was their job to avoid taxes. And it was tough to fund an economy or a government that way. And even though they didn’t have revenue coming in, the Greek national government spent money like it was going out of style. One example in the book, the Greek national railroad. One year had revenues of a 100 million euros. Total money they pulled in was a 100 million euros, but their expenses were seven times that. Their expenses were 700 million euros. And the Greek finance minister calculated at one point that it would be cheaper for the government to simply shut down the Greek national railroad and pay for every passenger to take a taxi cab. So that was the Greek government, but they obviously couldn’t shut down the railroad for political considerations.

When it came time for them to try and get into the eurozone, that is the community of countries that uses the common currency, the common euro currency. The Greek government was desperate to do so because of the benefits that they thought which would ensue. But they weren’t even close to being able to meet the objective standards for inclusion standard like the size of the government deficit; the amount of government debt. So they simply started lying about these things to their European brothers, and so eventually, Europe let them into the eurozone. When the problem, the size of the problem in Greece became obvious, that’s when everybody set up and took notice because there’s no provision for divorce in the eurozone. There’s no provision for somebody; for an economy to leave the eurozone. And so now, the question becomes: Is the entire experiment going to collapse? And if it does, what does that do to France? What does it do to Germany? What does it do to other eurozone economies? And what does it do in the United States? And so, that is the uncertainty that caused the flash crash on May 6 of 2010.

Preston Pysh  33:28

Scott, let’s talk more about this flash crash that happened on May 6, 2010. In your book, you talk about how the algorithms misunderstood the liquidity in the market, and this was really fascinating stuff, so describe this to our audience.

Scott Nations  33:40

Yeah, it’s a great question. Because again, the next crash is going to look like the flash crash. There were certainly reasons to be worried about our stock market in early May of 2010, and there was one investor, one institutional investor in particular, who was worried. And so, they wanted to reduce their exposure for their investments. They wanted to do so by selling stock index futures, which now trade almost exclusively, electronically in 1987. It was a bunch of guys in bright red jackets jumping around in a pit. And in 2010, it was almost exclusively electronic. And so, this investor wanted to sell electronically. They wanted to sell a bunch of futures contracts, which is perfectly a reasonable way to hedge. But they wanted to do so in size. That is to say they wanted to sell a lot of contracts, but that means that they also wanted to sell in a way, which would not drive the price down via their own selling. So they turned to an algorithm.

Actually, they turned to three different algorithms. Eventually, they said that we’re going to sell a certain number of contracts every minute, equal to the volume of the market in the previous minute. And the problem with that is that their own selling ballooned the volume. They had overcome confidence in the liquidity that’s provided via electronic trading. And they essentially tricked themselves into believing that the market could sustain a bunch more selling than it actually could. And so, within the span of just a few minutes, their lack of understanding of real liquidity in the market led them to sell so many futures contracts; overwhelmed the liquidity in the market; and drive the Dow Jones Industrial Average down by 10%. Again, in just a matter of minutes.

Stig Brodersen  35:30

That’s an absolutely amazing story. And keep in mind that you just…as you mentioned before that crashes will probably look different than they have historically; look more like 2010. How should investors position themselves knowing that?

Scott Nations  35:46

That’s a question I get a lot. What should I do? What should I do to protect myself? Well, many of the vehicles that exist are pretty expensive. I spent my time on the trading floors of Chicago’s professional option trader. And you think that options are insurance. I can buy insurance and protect myself. The problem is that insurance ends up being very expensive. So what can you do? What you can do is not get carried away. So right now, the stock market is doing very well. This may be a time to be more fearful than greedy. In early 2009, the market looked horrible. When it looks horrible, it’s probably a time to be more greedy than fearful. In addition, there are certain good old-fashioned ways of approaching the stock market, but have your money spread around. That’s called diversification. Have a little bit of money in the stock market; have a little bit of money in fixed income. We know that diversification is the only free lunch, and investing in that, it can increase your risk adjusted returns. So unfortunately, there’s no silver bullet. There are great vehicles that didn’t exist 20 years ago like traded funds, which are much cheaper for the average investor to use and an old-fashioned mutual fund. Take advantage of those. But also realize that liquidity dries up during a panic. So if you think that when panic hits, I’m simply going to sell, well, you’re going to be really unhappy with your results. It’s important to realize that stocks have been a great way to build wealth for millions of people. But one of the reasons that stocks do so well is that sometimes you are just along for the ride. That is you’re not going to be able to get out during a panic. So how would people position themselves? Kind of old-fashioned, logical, fear versus greed diversification is really the best way to do it.

Stig Brodersen  37:52

So one of the key takeaways, or I guess two of the key takeaways I took from your book was how much more financial markets are now becoming integrated and how fast everything is today. This is not like the old days, where you can do arbitrage between London and New York by calling in by telephone. Believe it or not, that actually did happen once. But what does the increasing financial integration mean for us as investors?

Scott Nations  38:20

That’s a wonderful question. Because you’re right. There was a time when you could call from Chicago or New York to London, and that was considered essentially instantaneous. Now, as an example, we are traders, high-frequency traders are bumping up literally against the speed of light. That is now the problem that they have. That’s the hurdle that they have, when it comes to executing trades. For example, most orders that are sent between New York and Chicago, or Chicago and New York are done via microwave. They’re not done by fiber optic cable because fiber optic is too slow, so it’s done via microwave. And those firms can tell you what the weather is like between Chicago in New York because their trades will be slowed down by a few nanoseconds. If the weather is bad, if it’s raining between Chicago and New York, that will give you an indication of how speed is now critical. But speed cuts both ways, and it’s necessary for a high-frequency trader. But it doesn’t really take anything away from the long-term investor. So when you read about these things, or you hear about these things as a long-term investor, you should be interested, but it doesn’t put you at a disadvantage. The best advantage you have is, again, the right sort of diversification; a strategy that makes sense for you; discipline; and using products that are lower cost for the investor. That’s what people should be doing. And that’s how they can make the stock market work for them.

Stig Brodersen  40:07

Scott, do you have broader concerns for our financial markets today?

Scott Nations  40:11

That’s a great question. Because as a young person; as an investor, I came up at a time when there were people who were required to provide liquidity. For example, in the New York Stock Exchange there were specialists, who had a really lucrative franchise to trade stocks. Here in the United States now, there is no person, nobody, no trader, no investor, who was required to provide liquidity. And I think that that is probably the biggest weakness that our stock market or financial markets in general have right now. And we’ve seen that; we saw that during the flash crash. We saw that some high frequency traders not understanding what was going on, simply refuse to participate, and they’re not required to provide liquidity despite the fact that they have access to some of these markets that other investors don’t. I think that would be the larger concern that I would have.

Stig Brodersen  41:10

This has been absolutely amazing, Scott. The name of the book is, A History of the United States in Five Crashes, and I highly recommend everyone here in the audience to pick it up. Now, Scott, where can the audience learn more about you, your company, and your book?

Scott Nations  41:27

Well, Stig, as you know, I’m a contributor to CNBC, so they can see me on CNBC. They can also go to the author website. Author website is scottnations.com. And I also have a presence on Amazon author page.

Preston Pysh  41:42

Scott, this has really been fantastic. I have thoroughly enjoyed this conversation, and we’ll be sure to provide links to all those resources in the show notes. Thank you so much for taking time out of your busy day to talk with us.

Scott Nations  41:53

Wonderful to be here. Thanks so much for bringing this story to investors around the world!

Stig Brodersen  41:58

All right, guys, so this point time in the show, we’ll play a question from the audience. And this question comes from Herman.

Herman  42:05

Hello, Preston and Stig! This is Herman from Argentina. And I wanted to thank you for your amazing show. I listen every week. My question is specifically on sector ETFs. I found some areas in some sectors there. They have some value, and I was researching some stocks. But then, I thought, why not invest in the sector, which has all the best stocks already in into the ETF? My question specifically is will it be better to invest in a stock; in value stocks or in sectors ETF of the same sector? I hope the question makes sense. And I thank you again for your amazing show. Thank you.

Stig Brodersen  42:54

So, Herman, this is a very interesting question you bring up. Let’s talk about an example that is relevant today. Whenever I’m looking at my screen here on TIP Finance, I see a lot of financial companies that are relatively undervalued. So one approach surely is to buy a sector ETF just with financial companies. Now, what you said was that the sector had the best stocks. The way the sector ETFs work is that they are typically market-weighted, meaning that bigger banks like Bank of America and Wells Fargo would take up a larger part of the ETF than smaller banks. John Green Bland, who you might know have shown that equal-weighted sector ETFs perform better than the market cap index because the stocks that are temporarily out of favor will go up in price. And stocks that are overvalued would go down in price, which would be under and over the percentage in a market capsulized index, respectively. So if you want to go the sector ETF route, you might consider doing an equal-weighted index. But generally, I don’t think that such an ETF is such a bad idea. If you choose the most undervalued sector, which right now would be financials and energy.

Stig Brodersen  44:11

But let me give you another suggestion. If you would buy Vanguard’s value ETF,  you can get it for as cheap as 0.04% in expense ratio, and you will already have an…or a presentation of financial stocks. For instance, you will have *inaudible* .6% compared to 15% in the S&P 500, and you will have the added benefit of not having to rebalance. Because when you rebalance or outright primarily sell your sector ETF, you will have to pay taxes. So if you stay within a solid value ETF, you would save the taxes. Of course, the drawback is that you won’t be as concentrated in that sector. But if you do plan to hold a few sectors, which it sounds like on the question that you are, you really have to be good at picking those sectors, and sell them at just the right time to outweigh the extra cost and taxes. The reason is that if the value ETF is selected properly, it would automatically all represent the most undervalued stocks, and therefore rebalance for you.

Preston Pysh  45:15

Herman, Stig knocked this one out of the ballpark. I don’t have anything else valuable to say on top of what he’s already put out there. But for asking such a great question, we’re going to give you free access to our Intrinsic Value Course. For anyone wanting to check out the course, go to tipintrinsicvalue.com. That’s tipintrinsicvalue.com. The course also comes with access to our TIP Finance tool, which helps you find and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to asktheinvestors.com, and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stuff.

Stig Brodersen  45:52

All right, guys, as you may have noticed, we’ve set up quite a few shows lately: Millennial Investing, Silicon Valley, and most recently, The Good Life. Today, I’m proud to say that we’re launching a brand new show, which is the last show we plan to set up for the time being. And the reason is that this show is very special. Because of all the non-stop investing questions Preston and I are getting. By far, what our listeners are most interested in is real estate. Therefore, I’m also excited to announce that earlier this week, we launched a brand new show called, Real Estate Investing by The Investor’s Podcast Network. And the host of the new show is an experienced real estate investor himself, and it’s our very own Robert Leonard from Millennial Investing. Robert, welcome back on The Investor’s Podcast.

Robert Leonard  46:44

Stig, thanks so much for having me. It still feels a bit surreal to be here on We Study Billionaires and part of the TIP Team. As you know, We Study Billionaires has been my favorite podcast for four to five years now. And it was really the first podcast I ever listened to. It really got me interested in podcasts, so needless to say, I’m super excited to be here.

Stig Brodersen  47:07

Thank you for your kind words. And Robert, the listeners of Millennium Investing are already familiar with your extensive knowledge in real estate investing. But for those of our listeners, who do not know you too well, why are you setting up a real estate podcast?

Robert Leonard  47:22

The Millennial Investing Show has been going great so far, and we’ll continue to cover great topics like stock investing, investing in side hustles, startups, entrepreneurship, and personal finance. But I’m also super passionate about real estate. So I wanted to launch a real estate show to really dive deep into all kinds of real estate strategies, and really be a resource to new investors to help them get started. And if we talked about all the things I want to talk about related to real estate on the Millennial Investing Show, it just become a real estate show itself. So we decided to launch a second show, focusing specifically on that–real estate.

Stig Brodersen  48:00

And Robert, you have such a great personal story. How and why did you start to invest in real estate?

Robert Leonard  48:07

So I actually got started in real estate by accident. I kind of fell into what we now know as a strategy of house hack. So it all started back when I was just entering college. My parents told me that when I graduated college and started to work my first career and started to bring in a salary, that I was going to be required to pay them rent to live in their home, which completely made sense, but I didn’t want to have to do that. And so, I made a pretty big goal to purchase a house as soon as I graduated college. That way, I could buy my own asset. Pay for my own mortgage, rather than paying rent to my parents. And so, what I did was I worked nearly full time my entire time throughout college, and I was fortunate enough to be able to save up my money and purchase a small condo before I even walked at my college graduation. And so, when I graduated college, I moved into the condo, and I realized that there was a bedroom in this house that I never went into. I’d walk by it every day, and I don’t think I opened the door one time in the first two or three months that I lived there. And so, I realized I should probably do something with that room. And so, I ended up renting that room out, and it covered almost all of my mortgage. And so, I was able to live very cheap. And at the time, I didn’t know that this was a strategy known as house hacking, but I would come to find out that it was, and I realized that I was actually a real estate investor. And what was interesting about that was I never thought that I could become a real estate investor.

Robert Leonard  49:34

I always was a stock investor, and I never thought real estate investing was within my reach. I always thought it was an asset class or strategy that only wealthy investors could access. And so, I started to study real estate a lot more. I started to read a lot of books and listen to podcasts. And then I found out that a lot of people are doing this, we’re just like me, and I realized that I could do it, too. And so ever since then, I’ve continued to invest in real estate and continue to scale my portfolio. Fast forward to today, I’m still working on my real estate goals. I’m not where I want to be yet. I’ve done a few real estate deals, and I’ve read a ton of books and listened to a lot of podcasts about real estate. But I’m really still on my journey, too. So I want to take the listeners on my journey through real estate in hopes that that will help them reach their goals as well. And we can all learn the best strategies and tips from successful real estate investors that we have on the show.

Stig Brodersen  50:32

Robert, let’s talk more about your goals and your journey. People have a lot of different reasons to start investing in real estate. You mentioned house hacking, which you did; which is basically a way to lower your mortgage significantly or perhaps even lived there at no cost at all. Others are more ambitious and they want to invest to accumulate properties, and perhaps even become financially independent. I guess you could say you have everything in between. What is your goal with your real estate portfolio?

Robert Leonard  51:03

My ultimate goal is like you mentioned financial independence. And so my goal with the real estate portfolio is to build a portfolio of buy and hold rental properties that will provide passive income that will ultimately allow me to spend more time with the ones I love; doing the things I love. Like I said, I’m not there yet, but I’m working on it. And once I get there, I’ll reassess my goals and decide where I really want to go from there.

Stig Brodersen  51:27

A very value investing mindset to real estate investing. And Robert, we have talked back and forth about you creating various resources for real estate to help beginners and intermediate real estate investors just like we’re doing for TIP Academy, when it comes to stock investing, and we’re very excited to go that route later this year. But right now, all your focus is on your brand new show. Please talk to us more about it. What can we expect?

Robert Leonard  51:57

I certainly do try to take a value investing approach to real estate. And you’ll hear on the first episode of The Real Estate Show with Chad Carson, that he also takes a value investing mindset into real estate. He’s also a big fan of Warren Buffett like I am, and you, Stig, and probably everybody listening to the We Study Billionaires Show. So I think it’s a great segue from this show into real estate. And so, on the show, I’ll be talking with successful investors using various different real estate investing strategies to help educate both the listeners and me on our real estate investing journey, whether they’re just getting started, or they’re looking to grow their business. And I truly believe that one of the most important things about real estate is just doing that first deal. A lot of successful real estate investors I’ve talked to have told me, and I’ve even seen this myself, that real estate investors almost never do just one deal. They’ve either done no deals or multiple deals. And usually, those people that have done multiple deals have done many deals. So for new investors, my goal is to give them all of the resources and information needed to get their first deal. If I can help investors get their first deal by listening to this podcast, I’d consider that a huge success because I know the rest will take care of itself. Once you get that first deal, it really does continue to snowball. And for investors, who have already done a deal or even a few deals, my goal is to help you scale your portfolio or really hit whatever real estate goals you may have.

Stig Brodersen  53:32

So guys, if you like our show, The Investor’s Podcast, you are 100% going to love Robert’s new show. The name of the show is Real Estate Investing by The Investor’s Podcast. And to subscribe to the show, please go to your podcast app on your iPhone, Android, or wherever you listen to a podcast. Make sure to search for The Investor’s Podcast Network to find our new real estate podcast. That is The Investor’s Podcast Network. You can also find a direct link in our show notes with more information on how to subscribe. But guys, that was all that Preston, and Robert, and I have for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 54:14

Thank you for listening to TIP. To access our show notes, courses, or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permissions must be granted before syndication or rebroadcasting.