[00:02:45] Cullen Roche: Yeah, this is a good topic to go over. Cause I think that, you know, a lot of people tend to discuss inflation in just the headline CPI and not really dig down into the guts of why there are all these different metrics and why we do things like [00:03:00] strip out, for instance, food and energy to create what is called the core indices for a lot of these inflation measures.

[00:03:06] Cullen Roche: And I think that, I think the best way to look at this and the reason why there are all these different indicators, and some of them are stripped out of like more volatile instruments, is that I think economists, and especially the Federal Reserve, they’re just trying to get a better gauge of what is going on with trend inflation.

[00:03:23] Cullen Roche: And so, you know, a lot of, having a lot of different indices I think provides a more useful data set to look at. It’s not. I don’t like to think of one as necessarily being better than the other, or one being the true indicator versus one not being a true indicator. I like to think of them all as sort of being, you know, complimentary to each other and they all kind of give us a different bit of information about what’s going on with inflation.

[00:03:48] Cullen Roche: But the big kicker, like you said with PCE versus CPI, is that consumer price index is really, it’s a household survey basically. So they’re trying to get a survey of what is really only urban consumers and what their price basket looks like on. It used to be a biennial basis that I think they, they just moved it to January 2023.

[00:04:13] Cullen Roche: I think they just moved it to, they’re updating it annually. So it’s still, though, it’s not necessarily, the basket is sort of fixed at an annual basket rather than the PCE actually updates the basket every month. And so, like you were alluding to what this does, and the advantage [00:04:30] of the PCE there with that is that this allows for what’s called substitution effects in the way that consumers actually perceive these things.

[00:04:38] Cullen Roche: So for instance, like right now, eggs are crazy expensive because there’s a shortage of eggs. And so, like, this is a, actually a good real time example. My, I have a one year old and a two and a half year old, and they love love waffles. So I make waffles every Sunday for the whole week. In the last few weeks, it’s weirdly, I have chickens that haven’t been laying because it’s the winter time here in San Diego and they lose all their feathers.

[00:05:03] Cullen Roche: So I won’t get into all that nonsense about how chickens work but anyways, I know that the price of eggs is crazy high. And so, rather than making the waffles with eggs, I’m using bananas. So you can substitute bananas out for eggs. And so that’s what I’ve been doing. So literally there’s this substitution effect in the way that I’m making waffles because I see the price of eggs and I’m just substituting something that is, you know, similarly delicious inside of this meal.

[00:05:30] Cullen Roche: But I’m actually buying something that is less expensive. And so the PCE actually updates monthly and it actually accounts for that. And so the difference that’s actually much more substantial in the PCE versus the CPI is that the PCE is really a business based index. They’re surveying.

[00:05:48] Cullen Roche: Businesses to get the cost of goods and services. And the advantage of that is that you actually end up getting a broader price index because there’s a lot of things that businesses actually pay for on [00:06:00] behalf of consumers. And the biggie there is actually healthcare. So businesses in the healthcare market tend to go out and actually they’re bidding for, you know, the cost of insurance on behalf of consumers.

[00:06:11] Cullen Roche: So like if you have a healthcare package through your employer is actually the one that is paying for that. And so you’re getting a broader subset of all of these different things. And the, one of the things that the PCE ends up doing as a result of this, because it’s such a broader index, You end up getting, I think of a lesser effect from a lot of the different items.

[00:06:32] Cullen Roche: So for instance, shelter in the CPI is like 35% of the index versus in the PCE shelter is only like 20% of the index. And so one of the ways that I like to think about all this stuff is like, think of it like from the stock market perspective. Like why do we have the Dow Jones Index and the Standard and Poor 500 Index and the Wilshire 5,000 index and the NASDAQ 100 index.

[00:06:58] Cullen Roche: Well, all of these indices provide us with a price of different but similar things. And so they’re different ways of viewing what are the price trends going on inside of the stock market and all of that information. It just provides us with a better idea of what is going on with the broader stock market.

[00:07:17] Cullen Roche: And the same thing is true here with these consumer price indices, where we’re looking at all these things and economists are just trying to get an idea. Of what are all the different inflation trends that are going on with the underlying [00:07:30] data. And so PCE is a nice compliment to CPI and economists will then, you know, strip out food and energy from these two indices to get a better idea of, you know, for instance, is oil providing a an outsized impact on the overall index?

[00:07:45] Cullen Roche: Because if something is silly, like, you know, the Saudi Arabians just decide to stop, you know, pumping oil or whatever, and all of a sudden the price of oil goes up crazily and creates this huge outlier impact on the overall inflation rate that doesn’t really reflect the underlying trends of consumers.

[00:08:02] Cullen Roche: And so all these things are kind of compliments to each other. I wouldn’t say one is necessarily better than the other, but they all kind of give us an idea of what are potential future inflation trends based on just looking at a lot of different types of indicators.

[00:08:18] Stig Brodersen: And Cullen, whenever we talk about inflation, we must also talk about central banks.

[00:08:24] Stig Brodersen: One argument you often hear is that it’s a problem that central bankers are not elected. And I read Gavin Jackson’s new book, Money in One Lesson and he sees this differently. His take is it’s more of a trade-off. So on the one hand, central bankers are independent governments. So for example, Presidents are not supposed to tell them what to do beyond the dual mandate that they have about controlling inflation and also stabilizing the economy and that insulates expert decision making from political pressure, at least in theory.

[00:08:55] Stig Brodersen: I’m sure some people would not. Whenever I say that we’ve seen Presidents or Presidential candidates wanting [00:09:00] a low interest rate up to an election because short term, that’s good for unemployment and the economy, which is crucial in terms of winning the election. And I also think that if you ask most voters would you like a low interest rate or a high interest rate, they were also, you know, they wanted a low interest rate.

[00:09:15] Stig Brodersen: However, what given Jackson going back to his argument, what he’s talking about is that this is a trade off because not having democratically elected central bankers comes at a cost of accountability and democratic control. So with all of that being said, do you think that central bankers should be elected?

[00:09:34] Cullen Roche: You know, this is an interesting question. I, you could get into the weeds on all sorts of debates, like, is the Fed truly independent, or, you know, the Fed likes to describe itself as independent within government. And obviously there’s lots of, with the Fed being directly in government and being influenced by politicians, there would obviously be lots of conflicts of interest.

[00:09:55] Cullen Roche: Like Trump for years was arguing that Jerome Powell was, you know, being too tight with monetary policy. And so, you know, whereas the Fed is looking, trying to look at things more objectively, more independently and saying, you know, like for instance, right now is a great example of an economy where the Fed is being very aggressive, really trying to cram down growth.

[00:10:13] Cullen Roche: They’re trying to, they’ve literally said they’re trying to increase the unemployment rate, which obviously no president wants to see that happen. But if the trade-off here is that you have to beat inflation by causing some unemployment, well, from the Fed’s perspective, that’s a battle they have to fight.

[00:10:29] Cullen Roche: And it’s [00:10:30] a, you know, you kind of have to have some casualties along the way as sort of the way that the Fed would view it, which might sound kind of crazy, but that’s the trade-off there in the Fed’s mind. And so, you know, being independent. I mean, gosh, I, to be honest, I mean, I’ve always sort of said that the Fed shouldn’t be run by human beings in the first place.

[00:10:50] Cullen Roche: That there should be basically an administrative staff that operates certain facets of the Fed, but that I have never loved the discretionary monetary policy side of everything, where you get the, even these independent, very objective thinkers, you are obviously brilliant people, but people that are just as prone to mistakes as anybody else.

[00:11:13] Cullen Roche: And so you can have the smartest guys in the room, you know, doing very stupid things or just doing things that are, I think, you know, when it comes to setting interest rates and predicting inflation is just incredibly difficult to do. And. Having a discretionary approach to this, to me, has never really made a lot of sense, and I’ve always been more in favor of doing something that was a little more systematic, where the Fed was operating more like an algorithm when it comes to interest rates.

[00:11:39] Cullen Roche: And then, you know, obviously there’s some manual override that’s required in certain environments, or certainly with certain facets of the Fed’s operations. But me personally, I mean, I wish that the Fed wasn’t even manned by people. I wish there weren’t, you know, 12 board members and a FOMC Chief that were just talking about the economy and trying to [00:12:00] predict things that.

[00:12:01] Cullen Roche: In the macro economy are just virtually impossible to predict. But in terms of being elected versus not being elected, I think that the Fed is structured in a about as I think, practical way as it could be in the present environment, because what the Fed is really, their primary role is to operate as the independent regulator for the banking system and as a really, as a payment processor, that’s their primary role.

[00:12:27] Cullen Roche: The, a lot of the stuff they do tangentially to that, like setting interest rates and quantitative easing, it gets a lot of press, but it’s not really their primary role. They really are operating as like an independent regulator over the banking system for the most part. And they don’t get enough credit for how good they are at that.

[00:12:43] Cullen Roche: They’re, the Fed actually operates very seamlessly in meeting that. Where things get tricky is when they start getting involved in these discretionary changes, in terms of changing their balance sheet and interest rates. And those are the sorts of things where I do think it’s I don’t want to say counterproductive, but not a very efficient way to set policy.

[00:13:01] Cullen Roche: So at least the way it’s structured now, though, they’re able to be independent enough where, like, Powell has done a, he did a pretty good job in the last four years, you know, looking at certain presidents and saying, you know, I know you’re very loud and influential, but I am going to stick to my guns here because I see the data and I’m trying to be objective.

[00:13:24] Cullen Roche: And so it, it’s a flawed. Institution in the way that it’s set up [00:13:30] inherently, because I think that the institution itself just isn’t able to actually achieve a lot of the things that’s demanded from it. Like I’ve always said, that the Fed, even when they’re fighting policy, they have extraordinarily blunt instruments.

[00:13:42] Cullen Roche: So even if these people, you know, if they were super objective, independent, you know, non-elected officials running the Fed, even in that environment, given the tools that they have interest rates and things like balance sheet changes, they’re very blunt instruments. So very ineffective, lagging sort of policies that don’t have an immediate impact on the rate of inflation.

[00:14:04] Cullen Roche: And so it, it’s very easy to look at this whole institution and be super critical because it’s structure is sort of inherently inefficient in the way that it’s designed. I don’t know. I try to be somewhat forgiving of the people running it, just because I know how hard it is to predict inflation and try to manage it given the tools that they have.

[00:14:26] Stig Brodersen: So Cullen, let’s talk about the velocity of money and how that’s related to inflation. And let’s set the scene and look at the three actors. So you have money, supply, production, and inflation. And let’s say that money supply grows by 20% and production is only half of that. So 10% what happens to inflation?

[00:14:49] Cullen Roche: You know, I love this debate because you get into a really nuanced discussion about really the key variable here is what is money? [00:15:00] And money in the modern economy is a really messy definition. So in a standard sort of textbook traditional sense, We would say that things that are really super liquid inside the banking system are money things like cash and coins and bank reserves and bank deposits.

[00:15:19] Cullen Roche: Really, those are the things that were sort of traditionally thought of as money. And you know, I’ve always talked about how certain financial assets have varying degrees of moneyness and so you even non-financial assets have a certain degree of moneyness, like, gold is money, but gold’s moneyness is lower than that of a deposit in a modern monetary system. In large part, just because gold is, you know, obviously very hard to transport. You can’t walk into Walmart and put a block of gold on the, you know, the counter there and pay for anything. And so the moneyness of gold, even though it is absolutely a form of money, you could argue that the moneyness of gold is lower than that of a bank deposit.

[00:16:00] Cullen Roche: But in terms of this debate, you get into things like, well, our treasury bills money, our treasury bonds money. I would argue, you know, even stocks are money in a certain sense, in the sense that, you know, a lot of people get paid in stock options and, you know, corporations use their stock as cash in transactions and things like that.

[00:16:22] Cullen Roche: So there’s a moneyness factor even in things like, you know, traditional financial assets that we typically would never think of as money. When [00:16:30] you get into things like the equation of exchange and the velocity of money, you necessarily have to hammer down what is money. And so for instance, in 2008, when the Fed expanded their balance sheet in a big way, you would argue that what the Fed was doing was they were taking treasury bonds out of the private sector and they were flooding the private sector with bank reserves and bank deposits.

[00:16:55] Cullen Roche: And so looking at the equation of exchange from that perspective, you would argue, well, this has got to cause inflation. But the problem is you in, you instantly get into a debate about what is money there? Because was the treasury bonds money more similar to deposits than a lot of people assume? Like I always like to describe quantitative easing as being a situation where the treasury bond is essentially a savings.

[00:17:20] Cullen Roche: And what the Fed does is the Fed creates a checking account as a bank deposit, and they remove a savings account from the private sector. And so from that perspective, when you describe it that way and you ask yourself, well, does the consumer there that sold the bond, do they have more money now or do they have less money?

[00:17:40] Cullen Roche: And you, so you see, you get into this sort of semantic debate about moneyness and what is money. But the lesson coming out of the financial crisis for sure is that, you know, adding more bank deposits, adding more reserves, did not cause big inflation because that would be the obvious impact that you would expect from this.

[00:17:57] Cullen Roche: But then you have certain economists [00:18:00] that will just look at the equation of exchange and say, well, no, inflation stayed low and growth stayed low, which means that the velocity of money simply went down. Because as a matter of simple arithmetic, that’s the only way that the equation can balance out the way that it would.

[00:18:18] Cullen Roche: And whereas I would look at it and say, well no, your definition of money never made any sense in the first place. And so even though you added what you’re calling more money, well you were really just exchanging two very similar instruments in terms of their moneyness. And so you could take this in a million different directions, but you get into this very interesting debate about what is money and moneyness and all these different things.

[00:18:41] Cullen Roche: And it’s part of, this is part of what makes the prediction of inflation so difficult is that you get into a lot of the nuance and when you get into the nuance of all this stuff, you start realizing, whoa, there’s a lot more that goes into predicting inflation than something like just saying, you know, Hey, money, more money leads to chasing, you know, fewer or the same amount of goods and services, which leads to inflation. It’s so much more complex than that.

[00:19:08] Stig Brodersen: So speaking of complexity Cullen, let me use that as a transition into my next question here. So, central banker’s most effective tool to control inflation is to raise interest rates. But let’s put a geopolitical filter over this. There is a feedback loop between globalization and interest rates.

[00:19:28] Stig Brodersen: Could you please paint some color [00:19:30] around that feedback loop and the implication of what we are seeing right now with the US, Europe, and China continuing to decouple?

[00:19:38] Cullen Roche: It’s interesting cause even as the world is decoupling from the dollar increasingly, but this is a very gradual exercise. So, I mean, the dollar is still by a huge margin, the world’s most important reserve currency.

[00:19:53] Cullen Roche: So there’s lots of reserve currencies around the world. And reserve currency basically just means is does a foreign government hold your currency in reserve for some strategic purpose or do they end up inheriting lots of dollars for some strategic purpose or from a trade relationship? In the case of the United States, the rest of the world ends up with lots of dollars in large part because US consumers just buy lots of stuff.

[00:20:17] Cullen Roche: And so foreigners are big sellers of things into the United States. So China for instance, you know, they send us lots of paper plates, but we send them lots of dollars. So when you look at the Chinese balance sheet, you know, they necessarily end up holding lots of dollars in reserve just as a function of trade.

[00:20:35] Cullen Roche: And so the interesting thing with what’s going on with, you know, the current environment especially, and dollars is that. Foreign countries don’t just inherit lots of dollars, they actually borrow lots of dollars in large part because, you know, the simplest example of something like this is that, let’s say that a Saudi Arabian company wants to, you know, let’s say they’ve discovered some oil and they want to go in and drill this new oil well, [00:21:00] in a lot of times what they’ll do there is they might hire a group of drill rig operators from Texas, because the Texans have the best oil rig technology, and they’ll be flown in they’ll work as contractors for the Saudi Arabian government, let’s say.

[00:21:17] Cullen Roche: And what will happen a lot of the times is those contractors will say, pay me in dollars. We don’t, I don’t want to be paid in you know, the Riyadh or whatever the local currency is. I want to be paid in my home currency. And in a lot of those cases, if the government or that entity doesn’t have dollars on hand, they’ll end up borrowing dollars.

[00:21:32] Cullen Roche: And so, and this is a huge market, the dollar borrowing market, you know what’s commonly called the euro dollar market is a huge market. It’s, there aren’t exact figures on it, but it’s in the tens of trillions of dollars and so this is a huge foreign market and Euro dollars for listeners is just basically any dollar denominated bank deposit in a foreign country.

[00:21:51] Cullen Roche: So any country that, that has a banking system where they basically are able to produce dollars denominated outside of the United States, not so dollars in bank accounts held outside of the United States at foreign banks. And so the Euro dollar market, though is hugely important in large part because.

[00:22:12] Cullen Roche: Not only is it extremely large, but it requires the Federal Reserve and US monetary policy to be accommodated to whatever is going on, not just in the domestic US economy, but whatever’s going on in the foreign markets. Because when the Federal Reserve starts making [00:22:30] dollars harder to obtain through interest rate policy and relative currency exchange rates, well, what happens there is that this all filters into the foreign economy.

[00:22:39] Cullen Roche: So in an environment like today, where the Fed is increasing rates, they’re not just making dollars harder to get for domestic residents, they’re tightening global monetary policy because they’re making it more expensive for foreigners to also get dollars. And so there’s this weird sort of knock on effect where when the Fed tightens the United States, because they’re the dominant reserve currency issuer, they’re actually tightening really the whole world.

[00:23:06] Cullen Roche: They’re tightening, they’re really putting the clamps on a lot of these foreign economies that. Rely on dollar funding markets. And so, you know, what is the knock-on effect there? Well, the knock on effect you would expect to be, you know, lower growth eventually. And certainly, you know, the potential for a, sort of like a credit event in foreign markets because as these, especially as these foreign economies rely on starting to roll over a lot of this dollar denominated debt, as the dollar becomes more expensive, it gets harder and harder to do that.

[00:23:35] Cullen Roche: And so there’s a sort of unintended consequence of domestic interest rate policy because it has such a big impact, not just on the domestic dollar funding market, but on the global dollar funding market.

[00:23:49] Stig Brodersen: So Cullen having discussed the future, let’s discuss the past and the present After the housing bubble burst, during the great financial crisis, consumers found themselves saddled [00:24:00] with too much debt and one could argue that the US economy was at the brink of a balance sheet recession.

[00:24:07] Stig Brodersen: So perhaps our listeners haven’t heard the expression before, balance sheet recession. Could you please talk a bit about what is that and why is it relevant for us to understand as consumers and also as investors?

[00:24:21] Cullen Roche: So, balance sheet recession is a term coined by Richard Koo, and Koo is a macro economist, who studied primarily the boom and bust that occurred in the Japanese economy during the big real estate and asset price boom in the late nineties and early two thousands.

[00:24:36] Cullen Roche: And a balance sheet recession is when there’s really a disequilibrium, not just in asset prices, but in debt markets where primarily consumers or businesses or maybe both have leveraged them up substantially and they’ve become so over levered relative to where asset prices are that when asset prices come down, they necessarily end up.

[00:24:59] Cullen Roche: With basically upside down balance sheets. So they don’t have the equity, for instance, to support the amount of debt that they’ve incurred. And so what happens in that environment is that you get a forced de-leveraging and that forced deleveraging forces balance sheets to contract. And so that’s why coup calls it a balance sheet recession is that you get this sort of inherent or natural process of balance sheet decline or shrinkage because consumers and households end up having to repay a lot of their debt as a function of just being [00:25:30] over levered in the past.

[00:25:31] Cullen Roche: And so this typically coincides with big asset price booms. And it’s always interesting to understand. I mean, I think it’s super interesting in the context of today’s environment. You’ve had this sort of extraordinary boom in real estate around the world again, and you know, and you could argue that it’s not as levered as it was, for instance, during the financial crisis, but it’s still a really interesting and timely topic to look at in large part because the real estate market, especially, the thing that I think that is sort of interesting and corollary to Japan in a lot of ways is that consumers have started using real estate more and more as a speculative instrument.

[00:26:16] Cullen Roche: And so the stock market has traditionally been the instrument that people would’ve, you know, say, used some leverage on to get exposure to, you know, a certain price trend. And then, you know, as things typically get out of control, consumers oftentimes borrow more, or households borrow more corporations borrow more.

[00:26:34] Cullen Roche: And there’s sort of this, you know, debt effect in the stock market and the corporate markets obviously where. When you get a disequilibrium in prices and that the air comes out of that, you get a lot of volatility. Real estate has traditionally been much more stable in large part because people haven’t treated that asset class as this sort of speculative instrument where they borrow against it just to try to actually earn a return on investment necessarily.[00:27:00]

[00:27:00] Cullen Roche: In the last, really the last 20, 30 years, as the global economy has kind of grown, the real estate market has become a much more speculative instrument. And so there’s a huge leverage effect in real estate inherently. And the thing that makes us all interesting in the current environment is that if real estate is becoming a more volatile instrument because people are using it as a more speculative type of instrument, well does that financialization in the economy create a lot more instability in the long run because, do you have this very inherently fragile debt-based market that is tied to a much more volatile asset class?

[00:27:41] Cullen Roche: And you know, the traditionally real estate has been very stable. And that’s the thing that has made it, you know, such a good investment for a lot of people, but also made it a, it hasn’t created a lot of contagion risk in the economy traditionally, because it’s, the asset price itself has been so much more stable relative to the amount of debt that is used to leverage that instrument.

[00:28:04] Cullen Roche: Whereas going forward, I think that the really sort of crazy thing is that you look at periods like the Covid boom, you have a 40% price increase in real estate. Well, it would take just a 25% decline to go back to where we were just two years ago in the United. That’s a huge move in the short term that in the long run does not look like a very big move.

[00:28:26] Cullen Roche: But what does that sort of volatility do to [00:28:30] the underlying leverage effects and the knock on effects that real estate could potentially have? And so yeah. As this instrument becomes more volatile, does the discussion around balance sheet recessions and the potential for sort of, you know, more of a force de-leveraging in certain environments, does that become a more pertinent, more, more common outcome as we kind of move forward?

[00:28:54] Cullen Roche: And my guess is yes, that, you know, I mean, I’ve kind of, been of the view for a long time that, well, Japan is very unique demographically and economically. It is, it’s in a lot of ways, it’s almost like looking into the future, I think for a lot of the global developed economy. And I think that, You know, well, we may not be on the cusp of like a, you know, a Japanese style 1990s sort of de-leveraging and balance sheet recession.

[00:29:23] Cullen Roche: I think that the dynamics of the balance sheet recession are much more important to understand today than they ever have been in large part because the future of the borrowing markets, especially in the real estate market, they look more and more Japanese as time goes on.

[00:29:39] Stig Brodersen: You know, one of the things that, that’s also being debated these days is the 60/40 portfolio of stocks and bonds allocation.

[00:29:47] Stig Brodersen: And now that we are recording here at the very end of January, and a lot of economist looking back at what happened in 2020/22. And you know, if you go to business school, you know you are taught that stocks and bonds are inversely correlated, [00:30:00] which is why you need to have both in your portfolio.

[00:30:03] Stig Brodersen: And so for example, in a recession, whenever stocks dive, the FED will lower the interest rate, thereby increasing the value of your bonds. And if you look at last year in 2022, the 60/40 portfolio lost 16%. And just for this calculation, I used the S&P 500 and Bloomberg’s US aggregate bond index. You can choose your own metrics, but it would more or less give you the same thing.

[00:30:24] Stig Brodersen: Now, why did it happen? And should we rewrite or should we write off the 60/40 portfolio as no longer working?

[00:30:34] Cullen Roche: Well, first of all, why did this happen last year? It happened in large part because of what the Fed did. I mean, The Fed’s very fast acting move in interest rate policy resulted in when interest rates go up, bond prices go down in the short term.

[00:30:48] Cullen Roche: And this also caused a lot of, you know, consternation for the stock market because people were worried increasingly that the Fed was going to move so aggressively that, you know, this would, that this would put a lot of pressure on the economy and ultimately that would feed back to corporate America and lower valuations.

[00:31:05] Cullen Roche: And so you had this sort of, you know, double whammy inside of a very short time horizon where, you know, over the course of an 18 month period, as the Fed moved very quickly, this had a huge outsized impact on both asset classes. But. I don’t know. We talked about this a little bit in the last time we talked.

[00:31:21] Cullen Roche: I increasingly love to think of asset classes as being instruments that exist across very specific time horizons. [00:31:30] So for instance, if you were buying treasury bills last year, you really didn’t care what the Fed was doing. I mean, you were losing money in real terms, but you were just clipping a coupon that was based on a, let’s say, a one year instrument.

[00:31:42] Cullen Roche: You weren’t losing any principle over that one year time horizon. Whereas the aggregate bond market, something like a g that you referenced, that thing is closer to like a six year instrument when you actually look at the underlying, especially the duration, the interest rate, sensitivity of the instrument.

[00:31:57] Cullen Roche: And so, yeah. Is that thing sensitive to price changes inside of a one year period? Sure it is. But in the six to seven, eight year time horizon, the likelihood of that instrument losing money is very low because the underlying will evolve, rolled over and that time horizon. So, The stock market is an even longer duration instrument.

[00:32:18] Cullen Roche: I like to think of the stock market as being basically like an 18 or multi 18 year, multi-decade type of instrument. And so, you know, what is going to happen to that instrument inside of an 18 minute or 18 month time horizon? Boy, I mean, who knows? But over the course of an 18 year time horizon, the odds of you losing money on that instrument are very low because it’s, you know, the way that the underlying firms accrue their profits over that time horizon is very stable actually, when you look at it on a rolling sort of 18 year time horizon.

[00:32:47] Cullen Roche: So, In the scope of 60/40. You know, if you’re looking for more short-term stability, then yes, the 60/40 is absolutely [00:33:00] inappropriate for you because the stock market is, I mean, there’s a lot of different things going on in 60/40 that people don’t talk about. So, for instance, in a 60/40, 85% of the volatility comes from the 60% slice.

[00:33:12] Cullen Roche: And so right off the bat, you’re buying something that isn’t, you know, Vanguard calls there, 60/40 a balanced. It’s not really a, when you look at it from, in terms of where the risk is coming from, 60/40 is not really that balanced. It’s really way overbalanced to the stock market. And so if you need something that is going to dampen the volatility or reduce really the risk inside of that portfolio, you need something other than the 60 or the 40.

[00:33:40] Cullen Roche: You need instruments to compliment it. Whether that is treasury bills or something that is, you know, uncorrelated like commodities or gold or whatever it might be. You need a compliment to that to dampen the volatility. So it totally depends in the long run, if you’ve got time horizon that is, I mean, when you look at a 60/40, if you blend the durations of all those instruments, you end up at something about 12 years.

[00:34:06] Cullen Roche: So when you buy a 60/40, I always tell people you have to think of even that thing as though it’s at least a decade long type of instrument. And so, Looking at that thing and judging it based on one year performance, to me it’s the equivalent of like buying a CD that pays you a one-time coupon it a 12 month, you know, period.

[00:34:24] Cullen Roche: And complaining about how the price doesn’t change inside of a one month period. It doesn’t make any [00:34:30] sense because the instrument is literally not designed to do that, and a 60/40 is designed functionally. As a multi-decade instrument because it’s underlying instruments are multi-decade instruments. So it depends.

[00:34:43] Cullen Roche: It depends totally on the investor. When people say 60/40 is dead, that to me is overreach because what they’re really saying is that the stock and bond markets are dead in the long run. And that to me, just mathematically, I mean the bond market for instance, unless you think every single instrument inside of a bond aggregate is going to default.

[00:35:03] Cullen Roche: Well, it’s just sort of silly to say that the bond market is dead because the bond market over the course of the next five or six years actually pays a very predictable coupon. The treasury bill market inside of, you know, something like that, pays a very predictable coupon over certain very specific periods.

[00:35:19] Cullen Roche: And so none of this stuff is dead, but it does expose us to certain risks in the short term that people need to account for in the bond market, even though it is a much lower risk instrument than the stock market. It’s not a zero-risk instrument. So to me, we talk a lot about asset price movements over certain periods.

[00:35:41] Cullen Roche: We don’t talk about time horizons enough. And to me, especially as I find myself getting older and whatnot, time is really, it’s the essential ingredient in all of this stuff that we discuss and we like to try to make the stock market operate as a short-term instrument. But the reality is that the stock market [00:36:00] isn’t a short-term instrument and there’s nothing you can do that will change that underlying operational fact.

[00:36:05] Cullen Roche: So it’s all, to me, it’s all about time horizons. 60/40 is good for a longer time horizon. If you need more stability, it’s probably, it probably is dead for you.

[00:36:18] Stig Brodersen: So I want to talk to you about the human mind and the biases that we have. And you know, we have this bias to. Extrapolate trends in financial markets.

[00:36:29] Stig Brodersen: So if it’s going up, it always goes up. If it goes down, it will always go down. And I remember how sound investing was equated to real estate before the great financial crisis. I don’t know if I was just like in the echo chamber at the time, but it seems like no one saw a problem about you’re just putting your money into real estate.

[00:36:47] Stig Brodersen: And then after the great financing crisis, we slowly started to forget that real estate wasn’t always a great investment. And then we went back to the old narrative again, up to the recent crash, billionaire Ray Dalio argues that we have a problem separating the business cycle, which might be, I don’t know, five, eight years depending on how you want to define it.

[00:37:08] Stig Brodersen: We have a problem separating that from the longer cycles because we experienced those long cycles. Too rarely. And I would say to my point before, even with the shower cycles, we also tend to forget what happened perhaps 10, 12 years ago. And most people just don’t study financial history.

[00:37:25] Stig Brodersen: Now, with all of that being said, which longer cycles should we pay [00:37:30] attention to as investors going into 2023 in

[00:37:34] Cullen Roche: terms of, you know, history and looking at the markets going forward? You know, this is a really actually important question because I think that, you know, like the other day I was talking about on my website, pragmatic capitalism is the next 40 years of stock market performance going to look like the past 40 years.

[00:37:52] Cullen Roche: And you can look at the last 40 years and there were a lot of dynamics there that operated as tailwinds, especially in the United States that are no longer necessarily going to be there. The big one obviously was interest rates falling for 40 years, created this, you know, this huge tailwind to the stock market that in the environment we’re in now, obviously interest rates just can’t fall nearly as much as they did starting from the 1980 period.

[00:38:16] Cullen Roche: And so, The other biggie I would argue in the United States was the development of the technology markets in especially the United States where, you know, the sort of the big technology firms in the USA seemingly dominated a lot of the tech development. And I think that’s going to, that’s going to mitigate or at least converge with a lot of, especially foreign technology companies as time goes on.

[00:38:37] Cullen Roche: And so these two tailwinds are increasingly becoming sort of headwinds as we move through the next 40 years, but, The other biggie, you know, I was kind of alluding to this earlier, is that the debt markets have completely changed. And so Dalio would argue there’s a long-term debt cycle and a short-term debt cycle.

[00:38:52] Cullen Roche: And, you know, it’s sort of weird to think of the economy in terms of cycles because the, in the long run, I think it’s easy to [00:39:00] look at things like, they’re, like, the market is sort of like a sine wave, and the market doesn’t move exactly like a sine wave. The market really in the long run, if you look at things like even GDP growth, well you won’t find a lot of variants in long-term GDP growth.

[00:39:13] Cullen Roche: It actually just kind of looks like a steady line from bottom left to top right. But in the short term, you have much clearer cyclicality, especially in the short term. And the big driver of that is not just debt and borrowing and, you know, these sort of things that are related to creating what Dalio would call more of a long-term debt cycle.

[00:39:32] Cullen Roche: But really, I would argue a lot of it is, most of it probably is just behavior. People who. God, look at the last two years where people are, you know, bidding up crazy assets like you know, Bitcoin going to 67,000 and AMC and GameStop and all these stocks that seemingly had no underlying fundamental basis for what they were doing.

[00:39:54] Cullen Roche: That, you know, in an efficient market hypothesis world, these things shouldn’t move the way they do, but they did, and a lot of them have stayed that way. I think in large part because the more behavioral aspects of a lot of these debates has become very clear that the markets are not nearly as efficient as someone like Eugene Fama would argue.

[00:40:15] Cullen Roche: And that, you know, the sort of behavioralist the Richard Thaler type views or the Robert Shiller type of views that human emotions and animal spirits drive so much of this stuff that it can lead people to do stupid things and actually result in stupid [00:40:30] crisis for much longer than people might expect.

[00:40:33] Cullen Roche: And so in the short term, I think human behavior is hugely important to understand. When we look in terms of cyclicality, I mean, yeah, in the long run, markets will look very efficient. But in the short term the way you get to an efficient looking long-term market is through lots of short-term behavioral mistakes in essence.

[00:40:52] Cullen Roche: And so that’s the primary driver of these boom and bust cycles. And you know, right now I think we’re kind of in the middle of what is the, you know, the basically the decompression of like the irrational exuberance of the covid boom. And we’re kind of digesting that big asset price boom that occurred in the last few years.

[00:41:10] Cullen Roche: And that’s all that’s, this is all a behavioral exercise where, you know, we’re all grappling with what is the Fed doing in the short term and what are, you know, where are interest rates going to end up be? Where is inflation going to end up being in a couple years? And this is all an exercise in basically us making our best guesses in trying to grapple with our emotions in the short term.

[00:41:29] Cullen Roche: In the process of creating what looks like a relatively efficient, long-term pricing market. To me, you know, you have to understand these big, long-term sort of secular dynamics, like things like demographics. And I think it’s very useful to, to use sort of a multi-tiered approach where you’re looking at, you know, what is the baseline long-term sort of secular trend in certain things like technology and globalization and demographics, these things that have huge macroeconomic impacts, but then also layer that in with something that is more short-term, [00:42:00] like looking at human behavior and the way that behavior drives markets to sort of gyrate more than maybe they should be based on what a lot of the long-term demographic trends or, you know, technology trends might expect things to look like.

[00:42:14] Cullen Roche: So it’s difficult. You have to sort of, I think, understand the cyclicality of human behavior inside of the short term relative to the longer term, more sort of secular trends that are more long term by nature.

[00:42:28] Stig Brodersen: So, Cullen, shifting gears here. I can’t help but tell a quick and funny story about the 19th century.

[00:42:34] Stig Brodersen: So this is about the Bank of England and the Bank of England installed a weather vein to track Tradewinds. And why did they do that? Well, whenever they could tell whenever the wind allowed more ships to dog in London’s ports, because that could, or it would affect the number of goods for sale, or if they carry gold, then the money supply.

[00:42:54] Stig Brodersen: And I just kind of feel like that’s a funny story because continue talking about central banks and making predictions and how to act. Well my next question is not about whether we bad about central bank interventions in general. And Christina Guard the president of the European Central Bank plus in 2020.

[00:43:15] Stig Brodersen: To use the Central Bank’s QE program to tackle global warming. For example, one of the theories that were discussed was one could imagine excluding companies that were not green from their bond repurchase programs. So my [00:43:30] question you and I’ll try not to make it too value-based, even though that’s, I kind of feel like I’ve lost the battle already on that one, but my question to you is, should the central bank, other than the dual mandate of maximizing employment and stabilizing prices, you already talked about should they also have the mandate to fight global warming?

[00:43:49] Cullen Roche: Oh gosh. You have to love a story where, I mean, what is more unpredictable than the weather? You know, there’s a, you could joke that you know, the only people who are worse at their job than economists are weathermen, and it’s, that’s not to knock on weather people, but. Being predicting the weather is just hugely complex.

[00:44:10] Cullen Roche: You can, you know, God looking at like long-term cycles and stuff like, you know, people for years have been saying that, you know, California was going to run out of water. I’m watching California just get flooded away this year. So it’s, you know, all this stuff is so hard to predict, especially in the short term, and you just, you have to die laughing.

[00:44:29] Cullen Roche: Looking at a group of economists trying to use the weather to then predict economic trends in the future. Like, talk about creating a, an indicator that is just going to be complexly wrong in the long run endlessly. So, you know, in terms of the whole ESG debate, the environmental sustainability governance debate, you know, should, how involved should governments be in this and how involved should, especially central banks be?

[00:44:56] Cullen Roche: I mean, God, we talked about how blunt the central bank’s [00:45:00] instruments are. Already. I mean, I think that using the balance sheet and interest rate policy in anything like that in a discretionary manner is already sort of misguided. So I think that adding a layer of sort of morality to it is even more misguided.

[00:45:17] Cullen Roche: Because, I mean, this is the interesting facet of this debate is that I always tell people that within the realms of legality, how do you argue morality? On top of that, I mean, is. You know, is a company like ExxonMobil Immoral? Well, you know, think of it from ExxonMobil’s perspective. Well, ExxonMobil runs obviously big oil rigs that, you know, do damage to the climate or whatever.

[00:45:39] Cullen Roche: But Exxon also is one of becoming one of the greenest companies in the world. They’re one of the biggest investors in green energies in the entire world. And so the natural transition for ExxonMobil, if you’re thinking strategically over the course of the next 20 years, is for, I’m sure Exxon wants to be a 100% green company, if that’s where the world is going, if that’s where technology trends are taking them, well then Exxon is, you know, if they’re run by even remotely competent people, that’s obviously where they’re trying to take this whole business.

[00:46:11] Cullen Roche: But at the same time, the world doesn’t move that fast. You can’t just transition completely off of carbon and petroleum based products and jump into. You know, wind and solar automatically because the technology just isn’t there yet. We don’t have everything in place to actually meet the [00:46:30] demands of the world running solely based on these environmentally friendly technologies at this point.

[00:46:36] Cullen Roche: And so, Exxon is necessarily making sort of a slow transition, but they are making a transition. But if you looked at that company from an ESG perspective, well, it’s very weird because if you’re building an ESG index, you might say, oh, well Exxon doesn’t qualify because they do too much carbon. But from my perspective, it’s actually the opposite.

[00:46:54] Cullen Roche: It’s, no, you would, you actually should want to own ExxonMobil in an ESG portfolio because Exxon is one of the biggest investors in the whole environmentally friendly and climate change perspective because they’re the ones that are pouring tons of their cash coming in from the carbon business back into green energy based businesses trying to be proactive.

[00:47:17] Cullen Roche: They want to survive. Obviously, they know that oil is probably the thing of the past. And so they’re trying to be proactive with this. And so to me, you know, having the central bank use very blunt instruments to try to predict, you know, the future trend of whether Exxon is going to be an ESG friendly company, to me is just.

[00:47:35] Cullen Roche: I don’t know. It seems like a recipe for disaster. It seems very misguided in large part because you get into this very subjective debate about morality. That doesn’t really make a lot of sense when you think about it. I mean, ExxonMobil, I don’t think can be objectively called an immoral company just because they operate a business that is, you know, even though it’s still very carbon based, you know, they’re investing so much money [00:48:00] into the climate change, you know, process going forward.

[00:48:03] Cullen Roche: That I think you have to argue that they’re also somewhat ESG friendly. So where do you come down on this debate? I mean, it’s very, it just gets very subjective and messy, and I don’t think that there’s a real clean way to actually decipher whether a company is ESG friendly or not. I mean, with the exception of obviously some, probably very sort of, you know, ugly companies that do exist.

[00:48:24] Cullen Roche: But on the whole, I think in the realm of legality, it’s very hard to start getting into a morality debate. And so, You know, my bottom line is that I don’t mind governments nudging corporations in the right direction and, you know, creating say laws that incentivize long-term changes in the way that we think about things so that we don’t just, you know, pollute the world in a sort of nonsensical way.

[00:48:49] Cullen Roche: But at the same time I really don’t like the whole ESG debate in large part because I just think it comes down to it so many subjective narratives and values that I think when you think of things in the aggregate macroeconomic sense, you know, your vice is my value and vice versa. And you can’t just say that, you know, just because, you know, one person’s vice is this thing that, that makes it immoral.

[00:49:15] Cullen Roche: Well, it’s, is it legal? Yes, it’s legal. So therefore how can you just subjectively argue that, you know, there’s it’s immoral based on how you feel about the thing. I. I don’t know. I’ve never really understood the [00:49:30] premise of ESG investing, to be honest. I’ve always sort of thought that it was more of a, you know, subjective morality player than anything else.

[00:49:37] Cullen Roche: It’s a really nice sounding narrative that I don’t think actually translates into necessarily positive change. And you see this actually in a lot of Europe. You know, a lot of the energy policies have kind of come back to backfire in the last few years with the way that, you know, Russia now kind of has dominance over the energy markets in large part because we, you know, the Europeans failed to actually diversify across, you know, the existing subset of technologies that make a lot of sense in transition more slowly into, you know, more of these green friendly sorts of technology.

[00:50:13] Cullen Roche: The world moves at a slower pace than people think and thinking in things in terms of, you know, this sort of cycles again, you know, we want the world to transition very quickly, and the reality is that, you know, the world just doesn’t operate that way. And so we can kind of nudge things in a certain direction, but I don’t think you can force it overnight.

[00:50:31] Stig Brodersen: Well, Cullen, thank you for your thoughts on that. And I wanted to transition into your recent blog post where you quote Morgan Housel and his quote on risk is what you don’t see. And I found that quote profound, but it also makes me think of the former Secretary of Defense, Donald Rumsfeld, and he has this wonderful, insightful quote about known unknowns and unknown unknowns.

[00:50:55] Stig Brodersen: And in Morgan Housel’s book, the Psychology of Money, Morgan [00:51:00] talks about how he invests including that he has no debt in his house. And he talks about how he acknowledges that it’s a terrible financial decision if you have the perspective of. Of optimizing for investment returns. That’s absolutely terrible not to have a mortgage.

[00:51:16] Stig Brodersen: But he claims that he basically has two objectives. The first one is independence, and the second is sleeping well at night. And I love that. love the approach that he has. Even though I should say for the record, I definitely have a mortgage in my home. But I love it because as I get older and have a bit more money, I also value my time differently.

[00:51:36] Stig Brodersen: And I just find those two things, independence and sleeping at night, increasingly important. And it also should say that independence to modern house. And what I would like to bring into this conversation, it does not mean stop working. It doesn’t mean like going to the beach for the next 10 years and sipping a margarita, whatever.

[00:51:54] Stig Brodersen: It means that you only work on what you like to do with the people you like to do at times that you want to do, and for law as you want to do. And, you know, can use this example here with you, Cullen as an example of that. At least on, and I won’t speak for you, but at least here on my end.

[00:52:10] Stig Brodersen: But knowing that risk is what we don’t see and we have unknown unknowns, how can we build a portfolio? If I can see if I can type a bow around all this, how can we build a portfolio with those two objectives in mind? So a portfolio that secures us [00:52:30] independence, but also sleeping well at night. Yeah. How can we even start to approach that?

[00:52:33] Stig Brodersen: I know that’s, I know I covered a lot of ground for that question.

[00:52:37] Cullen Roche: You know, I’ve started writing a lot about this and I don’t know if it’s just the fact that I’m getting old and, you know, worried about dying now. But , I I’m just endlessly obsessed with time and optimizing for time. And, you know, I listened to this another, and I’m pitching a podcast on a podcast, but I listened to the drive with Peter Attia and Bill Perkins the other day, and they were, Perkins wrote the book, Die with Zero, and he talks a lot about all of the issues that are kind of involved in this question and optimizing your life for time rather than, you know, we, we seem to optimize our lives in lots of other ways rather than thinking about them as being time optimized.

[00:53:13] Cullen Roche: And I love this concept inside of portfolio construction because I’ve spent my entire career optimizing portfolios for asset returns. And everyone in the entire industry does this. They basically, what we do is we look at a big subset of asset classes, and mostly what we do is we run, you know, expected future return analysis or we run back tests and then we take, let’s say five to 10 instruments that create the optimized risk adjusted.

[00:53:47] Cullen Roche: And then you take those five, let’s just say five asset classes and you put them in your portfolio, and that portfolio is the optimal risk adjusted return portfolio. [00:54:00] Okay? What that portfolio does not do at all is it doesn’t account for the concept of time. It does not optimize for time inside of that portfolio.

[00:54:09] Cullen Roche: So this risk adjusted portfolio that is optimized for returns, well, that thing might be filled with, let’s just say it’s filled with super long duration style instruments. Let’s say it’s filled with venture capital, it’s filled with technology stocks, it’s filled with long-term treasury bonds, it’s filled with gold, and you’ve got all these instruments that are inherently very long term instruments.

[00:54:32] Cullen Roche: All of those things. What they’ll do across time is even if in the long term, they give you the most risk optimized portfolio, so they’re creating the most, the best risk adjusted returns. They don’t necessarily help with the sleep well at night aspect of all of this. And so for me, I’ve increasingly become just a huge advocate of what I’ve started calling all duration investing, where I actually go in and I’m looking at the time horizons over which certain instruments exist.

[00:55:00] Cullen Roche: And so, you know, Morgan’s a great example. I know Morgan fairly well and I know Morgan like me, holds way more cash than he probably ever should. And he does that because that’s his sleep well bucket. And to me, you know, there’s, what you’re really doing there is when you hold cash, you hold what is an inherently short term instrument.

[00:55:20] Cullen Roche: And the trade-off there is that you have nominal principle stability inside of a cash deposit account or something like a treasury. But [00:55:30] you’ve, you’re giving up the potential for much more long-term principle growth, basically. And so the stock market, you know, it’s the exact opposite of cash in the sense that the stock market will give you great real returns in the long-term.

[00:55:45] Cullen Roche: But the sacrifice or the trade-off there is that you’re going to have a lot of overnight instability in that portfolio. And so to me, When you are building a portfolio that’s giving you not only independence and helping you sleep all night, well, you have to really understand time and how it relates to the way that, not only the way you think, but the way that you spend money.

[00:56:05] Cullen Roche: Most importantly, because in terms of, you know, this is basically the way that a lot of big pensions think about this too, because pensions naturally pay out a lot of their investment returns over time. And so they have what’s called an inherent asset liability matching process over which they exist because they want to have very long-term asset growth, but they necessarily have short-term liabilities that they have to pay out.

[00:56:28] Cullen Roche: I mean, they’re almost like operating a, you know, a, a 4% withdrawal rate every year or something like that, and they have to have a certain degree of liquidity. The pension fund operates like a retiree to a large degree and. You need liquidity inside of that portfolio to compliment your long-term growth.

[00:56:44] Cullen Roche: And so pensions end up inherently having to think across very specific time horizons. And I think a lot of independent retail investors don’t do that. They think of what’s the best way to generate the highest returns in the most efficient way without a lot of downside [00:57:00] volatility. And that process doesn’t necessarily involve thinking in terms of time horizons.

[00:57:05] Cullen Roche: And I think that when you come at it from the opposite angle, where you start attacking the equation from the liability side, and especially from the time horizon side, well, You accept a lot of the sort of trade-offs that exist where you can’t sleep well and have a pure 100% stock market portfolio because the stock market won’t help you sleep well at night because the stock market’s going to move 1%.

[00:57:29] Cullen Roche: So that’s the big kicker for me within the context of this debate. And, you know, the related topic to this with fire and the financial independence retire early movement is similar in the sense that a lot of people will, in the, especially in the fire movement, I think end up creating very aggressive portfolios because they necessarily need to take more risk in the long term because they’re going to necessarily lose.

[00:57:57] Cullen Roche: Their source of primary income because they’re, the whole goal is to retire early, of course. And so they almost end up necessarily having to take more risk in the long run than they might otherwise, because the real fixed income asset that they own, their job is going to go away sooner than it will for the average person, which in a weird way, it actually creates a lot more potential financial instability because especially as you retire, you typically end up needing a portfolio that is actually lower risk because you [00:58:30] start having to meet these withdrawals and so you create your own sort of asset liability mismatch inside of that perspective.

[00:58:37] Cullen Roche: That I think creates a lot of risk. It’s one of the reasons why I’m not a huge fan of, I love a lot, all the principles of the fire movement, you know? The idea of creating financial independence and saving a lot of your income, trying to optimize your income to generate a high income, and then basically just plowing the money into low cost index funds.

[00:58:57] Cullen Roche: I think all of that is brilliant. Not necessarily a huge fan of the retire early part, in large part, not just because I think you can create this portfolio imbalance that I was just alluding to, but the whole retire early mentality to me, sometimes it creates a lot of risk where I see people that retire, they oftentimes lose their sense of purpose.

[00:59:16] Cullen Roche: And I think that’s the bigger behavioral risk with the fire movement is that people who oftentimes transition into retirement struggle with what is their purpose in life now because they’ve spent, you know, 30, 40 years where their purpose was their work to a large degree. I don’t know, I’m a bigger fan of sort of easing into it or transitioning into a retirement of sorts where you’re maybe never fully retired or you still maintain a certain sense of purpose doing things for other people that is providing value and still maintaining an income of some sort that, you know, doesn’t leave you being a slave to a corporation, but helps you ease into a less rigorous employment process where you’re still technically retiring, but still [01:00:00] maintaining a sense of purpose to a large degree.

[01:00:02] Stig Brodersen: That’s interesting. And I wanted to continue along those lines about this new generation of investors, whether they’re in in or not. You know, I read Ray Dalio’s book quite a few times, Principles and he talks about how he lost all of his money whenever he started his finance career, and he was 32 whenever he incorrectly predicted a huge crash in 1982.

[01:00:26] Stig Brodersen: And it got so bad that he had to borrow $4,000 from his dad to support his growing family. And Dalio says that looking back, it was the best thing that could happen to him because it was just, it was crucial in terms of what he learned about diversification and as a building block to how he later grew his wealth to be one of the wealthiest people on the planet.

[01:00:46] Stig Brodersen: And I come from a place where different generations experience different things in the financial markets and therefore have a financial and therefore have different realities. And today you have a new generation of investors. Who might have read about the financial crisis in 2008, but haven’t experienced a prolonged painful recession.

[01:01:05] Stig Brodersen: You know, they might have experienced the COVID crisis and that came with some painful social cost. But from a financial mug perspective, it really can’t be compared to what happened 2008 or the ones before. You know, what happened? You know, you had a lot of money printing, and you had a bunch of fun stuff going on.

[01:01:22] Stig Brodersen: You had a lot of subsidies. It wasn’t really like a recession, like what you’ve seen in the past. Now, this new generation of investors [01:01:30] that might have experienced a recent bear market in last year and are perhaps staring into a recession, perhaps not, depending on how you want to define it, but they really haven’t really felt the pain that other generations have.

[01:01:43] Stig Brodersen: So I guess my question to you is, which blind spots would you think would you say that this new generation investors have, and perhaps using yourself as an example, coming from another generation, where do you think you have blind spots? Which I know is paradox in itself for me to ask about.

[01:02:00] Cullen Roche: Yeah, I mean, it’s interesting because going back to the discussion about, you know, behavioral biases and especially, you know, behavioral cycles and the way that human emotions impact all of this, well, you know, this is always the variable that you can never eliminate.

[01:02:16] Cullen Roche: So no matter how efficient the markets might become, there are always facets of all of this that are inefficient because all of the participants are inherently inefficient behaviorally. And so, even in the case of someone like me who, you know, I’ve, I haven’t been around forever, but I’ve been, I’ve lived through now, You know, gosh, I mean, three, four pretty big bear markets.

[01:02:42] Cullen Roche: That shaped me in a lot of ways, and I’ve seen though the way that a, you know, not just a persistent sort of grind like the early two thousands can wear on you, but the, you know, that was for people listening. I mean, that was basically three years of the stock market just kind of ticking lower or [01:03:00] you know, every single month basically.

[01:03:01] Cullen Roche: And that’s, you know, it was a grind. It just it was only three years, but it felt like 20 years just because it seemed to never end. And so that was very different though from the financial crisis. Where the financial crisis was really, I mean, it was half as long, but it was twice as painful in large part because, I mean, God, in, in February, March of 2009, it really felt like the wheels were coming off of the financial.

[01:03:28] Cullen Roche: And it was a really frightening environment in a way that was very different from the more drawn out, prolonged sort of 2002 environment. But, you know, then again, looking through history, you know, like I never lived through the 1970s, with the seventies we’re a totally different type of grind where I’ve read a lot of the economic history of that.

[01:03:46] Cullen Roche: Going back even further, you know, looking at the post-war period there the big booms and busts that occurred in the, you know, across the war period, God, if you lived in Europe, it was a, you know, in certain economies got totally decimated. Go back and look at a, you know, a picture of the German stock market back in, in the forties.

[01:04:04] Cullen Roche: It’s unbelievable to see the way that it sort of boomed when it looked like they were winning the war. And then everything just, you know, the rug got pulled out of them as soon as they started to lose the. You can read about all that stuff, but you can never actually experience it until you really experience it and you never know how you’re going to respond until you actually are in the thick of it.

[01:04:27] Cullen Roche: And so, yeah, I mean, looking at even [01:04:30] someone like me, I might be more behaviorally robust to market gyrations then say someone who’s 20 years old and fresh, you know, on Wall Street or something. But we are both going to be challenged across environments in very similar ways as we navigate all of this.

[01:04:47] Cullen Roche: And I still, I mean, even in, you know, periods like, gosh, March, 2020 or April, 2020, I mean, I remember all that stuff. And remember seeing the stock market down 35%. And when you’re in that environment, even if you’re like a seasoned professional, you can find yourself in that environment and say, this feels different.

[01:05:05] Cullen Roche: You know? And it’s actually interesting thinking of people like Bill Gates and Warren Buffett. They were basically saying that at the time that, you know, Buffett for like the first time in. I think maybe forever was not just gobbling up every company in the world back then. I think in large part because the pandemic was so weird that you look at an environment like that and you say this is different.

[01:05:26] Cullen Roche: There’s a real practical reason why the market is down 35% and you need to ask yourself in that environment, is it different this time? And I think that felt in a lot of ways, like it was different at the time, which is, that’s the thing that makes investing so behaviorally challenging, is that when you’re in the throes of a bear market like that, it always feels different.

[01:05:47] Cullen Roche: There’s always a rationale for what’s going on and it makes sense in the context of that. And then the future changes and people get back to, you know, living their lives and producing things and stuff in the long run. And you know, everything kind [01:06:00] of plays out, you know, more optimistically than I think we typically tend to think in the short term.

[01:06:05] Cullen Roche: But, That’s the behavioral challenge of thinking in terms of what are the blind spots and risk is, you know, as Warren said before, risk is what we don’t know. And so a risk is what you can’t see, and there are always going to be things in the future that we can’t see or haven’t seen. And so behaviorally, even being someone of a newer generation, I think you have to sort of, you have to live through these things to sort of become, I guess, you know, Nassim Teeb would say it’s becoming anti-fragile to this sort of stuff that you have to sort of live through the tough periods to, you know, become tougher, I guess it is.

[01:06:46] Cullen Roche: And that’s the only way to do that, is to actually experience it and find out, you know, how are you going to actually experience it. One of the great things about being young and not having a lot of money is that, I mean, like I lost percentage wise, I lost huge amounts of money in the 2000 downturn. I had no idea what I was doing, and I was learning a lot about myself behaviorally and what that, you know, the way that I would actually experience all of that, in the way that I would actually navigate.

[01:07:14] Cullen Roche: And now I’m in a position where I’m much better off financially. And you know, interestingly, I am, I don’t have the time though to worry about all of this stuff in the same way that I did back then where I could lose a lot of money back then, percentage [01:07:30] wise. And it didn’t matter because I had time on my side.

[01:07:32] Cullen Roche: Whereas now it’s kind of the opposite. Now I’ve got the money, but now I don’t have the time. And so it’s a very different equation where I’m naturally taking less risk, you know, even than I probably should be, because in large part, because the future is so uncertain for me. And so I have more information.

[01:07:49] Cullen Roche: But because my time horizon is compressed, it’s a whole different risk dynamic. So, but yeah, for young people, I mean, gosh, I don’t know a lot of them I mean, they might have tougher skin than we do because they live through, they’re so involved in the crypto stuff that you know, they’ve lived through all the gyrations of that in a way that a lot of the old sort of traditional finance people shunned it off and you know, didn’t experience that in the same way.

[01:08:11] Cullen Roche: So they, I don’t know, I think the younger generations are going to be more resilient than maybe we think, and, you know, they’ll evolve the same way that we all will through financial markets, ups and downs and booms and busts. But in the long run, that’s the equation or the variable in the equation that you can never remove is that humans are irrational and inefficient.

[01:08:33] Cullen Roche: And this cycle always continues in large part because you always have fresh entrance into this dynamic system that necessarily results in people behaving badly at times.

[01:08:46] Stig Brodersen: You know, it’s interesting that you said about, you know, the young generation and how they might be more resilient because a lot of them invested in crypto and, you know, you’ve seen the swings in crypto and you compare them to the stock market.

[01:08:57] Stig Brodersen: I was still in school whenever we had the great financial [01:09:00] crisis, and I didn’t really experience it on, on, like, I, I saw the news and all I, but you know, it’s very different whenever you have skin in the game and whenever you don’t, you know, we have all these play money portfolios, like, oh, build this and like, sure I encourage people to do it if they want to, but they should just know that I, if you lose a hundred thousand dollars or 10,000, whatever a number it is, it’s just very different if it’s play money or your own money, especially as you get older and might get more responsibilities.

[01:09:28] Stig Brodersen: But I remember whenever I was a student playing poker and you know, in, in that game, if you play no limit, hold them, like you, you are losing your shirt if you don’t know what you’re doing. So, Coming into the stock market after upon graduation, starting to make a bit of money and putting it into the stock market.

[01:09:43] Stig Brodersen: Like whenever CNBC was talking about, you know, minus 3%, whatever, and it was just was crazy. It was like, yeah, but you know, playing poker is like you lose all your money or you have like 300% or whatnot. And so I, I just wanted to paint some color around that. I didn’t think about it like that. I more thought about it as the young generation have mainly seen things go up and they might be in for a shock because that’s just not the way it is in the stock market.

[01:10:07] Stig Brodersen: I haven’t considered the whole crypto piece of it, and who knows whether it’s good or bad that they might be more resilient than, and they’re used to see things drop by, I don’t know, 50% or whatnot.

[01:10:18] Cullen Roche: I spend so much of my time thinking about what are the outlier risks that are going to, you know, hurt portfolios and cause people to potentially overreact to certain [01:10:30] things and.

[01:10:30] Cullen Roche: I mean, pandemic. Pandemic was not on my bingo card for my life. So, you know, you never know. I think that’s one of the big lessons about the pandemic, is that you really don’t know what’s coming down the pike here. And so you have to build a portfolio that is resilient to all of these potential outcomes.

[01:10:51] Cullen Roche: It’s why, I mean, I’ve become such a big advocate of all-weather investing in what I call all duration investing. Because when you build these portfolios that account for all these different time horizons and all these different potential weather impacts, you don’t really need to try to, do, you know what the Bank of England was doing with the weather vein?

[01:11:09] Cullen Roche: You don’t. You just sort of accept that the weather vein is going to fail you at times. And that is part of good investing is that your portfolio should always have components of it that are potentially failing at times. You know, like. Brian Portnoy is famous for saying that diversification is learning to hate part of your portfolio.

[01:11:29] Cullen Roche: And that’s the essence of it. Is that a good portfolio that is properly diversified, it should never move all in the same direction, especially in the short term. It should have all these components that are moving in different directions. And that’s part of what makes investing really hard is that you look at things that are going down in value when lots of other things are doing well, and you say, I, this part of my portfolio is driving me crazy.

[01:11:54] Cullen Roche: I don’t know why I own this thing. And you sell that and you buy, it’s very easy for people to say, oh, let your winners run [01:12:00] and sell your losers. And that’s, you know, the reality is that good diversification involves owning all of that. It’s part of why, I mean, index funds are beautiful in large part because that’s what they do.

[01:12:10] Cullen Roche: They, a really diversified index fund, like the S&P 500 works great because it’s a systematic process by which the underlying index. Basically it gets rid of its losers, but it owns losers for very long periods. But the kicker is that it doesn’t ride its losers to zero. They have a systematic manner by which they kick things out and then they bring new entrance in.

[01:12:34] Cullen Roche: But in the process of doing that, they ride losers down all through the whole process. But the kicker with that is that they’re diversified enough that they don’t have sort of an asymmetric exposure to the losers. They have actually an asymmetric upside to the winners because they’re constantly replacing losers with winners in the long run, but they still have lots of exposure to the losers in the short term.

[01:12:57] Cullen Roche: So yeah, good portfolio management is about learning to hate big parts of your portfolio across time, and that’s part of the behavioral challenge of managing a good portfolio.

[01:13:08] Stig Brodersen: What a wonderful way to end this episode. Learning how to hate your portfolio but it makes it better, it makes a bunch of sense here.

[01:13:17] Stig Brodersen: Cullen, before we let you go, where can the audience learn more about you and Pragmatic Capitalism?

[01:13:23] Cullen Roche: Yeah, so I’m the Chief Investment Officer at Discipline Funds and we manage, you know, these all duration style [01:13:30] portfolios for people, low cost sort of financial planning based approaches to investment management.

[01:13:35] Cullen Roche: But most people can find my writing and work either at the Discipline Funds website or Pragmatic Capitalism, which is pragcap.com, P R A G C A P. That’s where we write our blog, and we’ve recently started doing these three minute macro videos where I’m trying to do sort of, you know, speaking of time, trying to produce these very concise macroeconomic lessons of sorts for people that help them rather than, you know, I know people don’t like to read anymore, so people prefer to listen to podcasts and watch videos. So you can find us there or you know, everything kind of through Prag Cap.

[01:14:08] Stig Brodersen: Yeah, and I highly recommend, I think the name of the channel is Three Minute Money. Is that right?

[01:14:12] Cullen Roche: Three Minute Macro.

[01:14:14] Stig Brodersen: Three Minute Macro, yeah. I’ve checked out a few of the videos in there and you’re like, taking questions from the audience and that’s pretty cool. And of course also it’s a longtime reader of your blog on pragcap.com, so also highly, I recommend that everyone takes that out.

[01:14:26] Stig Brodersen: Cullen, thank you so much for your time. I hope we can bring you on again sometime.

[01:14:30] Cullen Roche: Absolutely. I love being here. Thanks, Stig.

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