Stig Brodersen  2:25  

The way that Charles Duhigg explains motivation is that he explains it as if it were a skill. It’s not something you’re born with. Some people might have a better starting camp than others but basically, this is a skill that you can hone and you can train. The way to think about motivation is that the more control you have of a situation, the more motivated you typically also are. 

So this works from an employee perspective. It also works from a leadership perspective. So for instance, if you are a leader, it’s very important that you give your staff autonomy and you basically lay out different options to your staff, instead of giving the commands, even though you think one option might be better. If you can’t summon the support from the staff, it probably won’t turn out good for you anyway.

Preston Pysh  3:13  

So one of the things that I wanted to highlight from this first chapter that I personally really agree with and like that he brought up is this idea of internal locus of control and external locus of control. So I’m going to tell a story about my time at West Point. So one of the first things that I learned when I went to West Point was you don’t blame anybody else for anything. In fact, you take the blame for everything, no matter what. 

I know for a person listening to that, they might think that that’s really extreme and they might not necessarily understand how a person could just automatically take the blame for anything. But that’s one of the things that the first year which is difficult, is you just start taking responsibility for everything. You know, you walk out and maybe your friend did something wrong, and you had nothing to do with it, ad you’d have an upperclassman say, “Well, why in the world did that happen?” And you know, darn well that it was your buddy that just messed up and got you in trouble. But the response that you would say is, “Sir, there’s no excuse.” 

If they dug deeper, and they wanted to know, “No, there’s a reason why did this happen?” Then my next response would be, “Sir, I failed to do whatever,” that response would be. I didn’t have an appreciation for what I was being taught at the time. But now when I look back at that experience, what I was really learning is exactly what Charles Duhigg is talking about in this first chapter about internal locus of control. 

What that is, is when you charge yourself with being responsible for anything and everything around you, you start to view the world through a different lens. You start to analyze things more, you start to say, “Okay, well, if I would have done this thing differently, actually, I might have been able to completely avoid this altogether.” 

I know that that might be very hard for some people to make that transition. But I think that even if some of that wears off on your personality, where you start taking more ownership for what goes wrong, that’s going to have a profound impact on your progress and your ability to control your circumstances in the future, because now instead of blaming… And you see this all across America, and I’m sure you see this all around the world, I’m not just saying America. 

But you see these parents, when they go to a sports game, and Johnny doesn’t do well. When Johnny comes off the field, they don’t say, “Hey, if you would work harder or whatever.” No, they’re blaming the ref. They’re saying, “Oh, well, you know, if so and so would have passed you the ball better, you would have made the shot or if the ref didn’t mess up on the call, you would have won.”

I think a lot of people do this beyond sports. They do it in their personal life. They’re quick to blame others instead of just saying, “What could I have done differently? What could I have controlled?” which is the key word here. What could I have controlled in order to create a better circumstances for myself?

Stig Brodersen  6:06  

At the end of the day, it really doesn’t matter if it’s your fault or not, because you typically can’t do anything about other people’s actions anyway. I mean, if it is a bad rep, you know, tough luck. That’s just the way it is. So that’s also why he’s transitioned into this discussion about complimenting for instance, your kids for hard work and give them the feeling that they can control the outcome through hard work.

Preston Pysh  6:30  

I’ve had experiences where you’re sitting in a board meeting or sitting in some type of group discussion and somebody says, “Well, why did you do this wrong?” And they’re basically coming at you and I’ve been amazed at, and this comes from my time at West Point, where this was drilled into my head, where you just say, “You know what? There’s no excuse, I failed.” Like that’s my response, is “You know what? I just did a poor job at doing X,Y and Z.” Then, I will basically lay out why I wasn’t able to maybe do something appropriately.

Then it’s always, “So this is what I did all wrong and basically moving forward, this is what I think I can do in order to fix that or to remedy that.” And you know what kind of response you typically get back from somebody who asked you that hard question or who is poking you? They have nothing. In fact, they’re like, “Okay, sounds good. Do that.” 

There’s no more back and forth, you just you cut off the entire conversation. I guess whenever I’m in a professional setting with some people, I see this time and time again, where people just try to develop some type of excuse for something. Usually the person asking doesn’t want to hear the excuse, they might want to hear maybe some of the reasons that led to it, but at the end of the day, they’re like, “Just own up to it, you’re wrong. You know, if you’re wrong, you’re wrong. Just admit that.” It’s amazing how fast the conversation ,the direction of everything, the productivity will go in a completely different direction, because you own up to it. Like, “Hey, this was a failure, I could have done this better. These are the three things that I’m going to do in order to fix that.” And the conversation is done. It is just done.

Stig Brodersen  8:11  

So in the second chapter, we’re going to talk about teams. Specifically, we’re going to talk about how do you form the best teams. 

Charles Duhigg starts out by telling a story about this female going to Yale and the terrible experiences she had with a study group. The way she explained was that there was way too competition and everyone tried to be a leader. Then the chapter goes on, and it talks about how Google tried to form the very best teams and they were looking into what is it really? What does the empirical evidence tell us about how to form good teams? Should there be heavy rivalry among team members, for instance, as in the example before?

Actually some evidence shows that that could be a good idea. All of a sudden, it should be different personalities. Again, other papers said if they have similar hobbies, the rest can take care of itself. Now, Google concluded, based on those findings, was basically that they couldn’t conclude anything. Too many things was just pointing in opposite directions. So they needed to figure out what is really that creates the best teams.

Now, Preston, we actually don’t coordinate our notes before we start. So I actually had a session about West Point I want to talk to you about after this introduction. So I just want to say for people out there that it is completely coincidental. It’s something we rarely talk about and we actually already mentioned it twice, and are we doing it thrice? 

So whenever I heard this story about this female going to Yale and everyone trying to be the leader in a group, you are basically taught in leadership and you’re surrounded by hundreds of other cadets, that also I assume, I might be wrong, but I also assume that they wanted to excel in leadership. How do you fit into a role?  I think everyone has tried this like in a team, in a start-up group and workplace where more people want to be the leader. What is the process? And how did you experience that as a cadet but also as you advanced in the ranks?

Preston Pysh  10:09  

That’s an interesting question because I didn’t really think of it in terms of everyone at West Point wanted to fill a leadership role, whenever we’d be doing group projects are anything. Where I noticed it more is when I went to Johns Hopkins to do my Masters, because not everyone came from that background of hardcore leadership. That was new for me. I wasn’t used to a lot of people not being comfortable with wanting to be in a leadership role. So I think people might have the impression that there was a lot of people trying to take on a leadership role at West Point for every project, but I would tell you that that wasn’t the case. I think that the reason it wasn’t the case is because there were so many other opportunities to lead something else while you were there, whether it was a sports team or people might not realize this, but the whole school is broken down into a military formation. 

So  when I went to school there, I was assigned a company that I basically lived with out of 120 people, and then that company was broken down into four platoons. And so then I was assigned to a platoon and I was assigned to a squad. So whenever I would be struggling with a test or whatever, I could go to my squad leader who might be an expert at physics, and say, “Hey, I’m struggling in physics, can you help me out?” And so you could get that help and assistance. So there was all these little opportunities because the school puts you into all these different leadership roles, and they change that up every single semester. 

So I think a lot of people when they get in a group project or whatever, there’s so many opportunities to lead at that point that I don’t think a lot of people were saying, “Hey, I’ve got to be the leader on this project.” That didn’t really happen maybe as much as what some outsiders might think. 

Stig Brodersen  11:51  

Would you say it’s also a question about the roles were so formalized, because we’re also going to talk about roles later in this episode? Whereas for instance, in a study group, like no one is typically appointed the leader of the group. So that’s why you have this struggle for power. Do you think that is probably why it works so good at West Point? 

Preston Pysh  12:10  

Yeah, I think maybe that might be the case because there were so many other opportunities to lead something. I don’t think a lot of people were wanting to do any more than they had to because they’re already strapped for time and involved in so many different things. So yeah, I’d agree with that.

Stig Brodersen  12:24  

If we continue the podcast and talk about what Google found, and they have two very important findings in terms of figuring out why is it that a group really works? So why is it that a team really works out? What they found was that empathy is very, very important. If they’re able at reading each other’s body language, it’s very, very important for the performance of the team. 

It’s also important to mention that you don’t necessarily need to be friends. There’s this notion about like, if everyone’s good friends, you will achieve great things. There was something that Google found that was definitely not the case. It was not necessarily a bad thing, but it didn’t have any important factor. Rather, everyone should feel that they were listened to. 

So one thing that had a lot of emphasis on was always to ask every person in the room, “What is your opinion?” Or if someone has really not said anything for a long time, then directly ask, “What is your opinion? You haven’t spoken in a while.” Afterwards, you would repeat what the other person was saying. And as a leader, actually make a big deal out of sending a little checkmark next to that person’s name.

Preston Pysh  13:30  

So I love where this is going, because it goes back to what you originally said, Stig, which is this is all about control. Okay, when everyone’s participating on the team, everyone feels like they are in control, and that they’re contributing. That is so important, because whenever you have… Let’s say you have one person that’s just totally dominating everything and you’re part of this team, and any feedback that you provide is immediately written off by maybe this one person, this leader who’s running the team. That person now doesn’t feel like they have any control or input into the group. And so then they immediately start to shut down. 

So what I find amazing about what Duhigg is outlining in the book is he first talks about it from an individual perspective of why an individual might be productive. But then the fundamental thesis that it’s all about control applies to the group dynamic as well, when you take a step back, and you look at that from… I mean, you could even scope this out to maybe even a national level, where when a country doesn’t feel like it has any kind of control, maybe it’s less productive. It’s an interesting idea. I mean, I don’t know how much you could really apply to that. But it’s an idea that’s worth exploring. I think that understanding that fundamental thesis is so important to really wrap your head around this episode. 

Whenever I think about the control dynamic, I often think about teenagers. When you see a teenager who has a very controlling parent, that teenager isn’t productive. They want to sleep till 12 o’clock. They don’t want to go do anything. They just want to lay around because they don’t feel like they can impact or control anything in their life. And that might be one of the reasons why you see teenagers that are very productive versus aren’t productive at all. But we’ll keep going here. 

So the next chapter is chapter three. This is called “Focus.” I didn’t like this chapter and the reason I didn’t like this chapter is because for me, it was a little repetitive to some of the other things that I’ve read in other books. In fact, I can’t even remember, Stig, which book did we read that it was talking about the airplanes and the focus of the pilots? 

Stig Brodersen  15:34  

We read the Malcolm Gladwell book.

Preston Pysh  15:36  

Yeah, that’s right. It was Malcolm Gladwell’s book. 

Stig Brodersen  15:38  

“Outliers.”

Preston Pysh  15:39  

Yeah. So for me this chapter was really very similar to the Malcolm Gladwell book that we read. If you guys remember, if you guys were with us for the Malcolm Gladwell book, quick recap: It talks about the dynamics in a cockpit when you’re talking about pilots flying, how when one pilot… You get into these different cultures and how some cultures are more aggressive. And people feel like they can speak up versus others that where they don’t feel like they can speak up, and how that plays into the productivity of flying an aircraft.

Stig Brodersen  16:09  

Instead of reading this chapter, I would really refer people to episode 75. Maybe read Keller’s book,”The ONE Thing,” which is really about focus, and I think he does a much better job at explaining what focus is. 

The way the Charles do explains this is that you need to build up your models of a certain situation before you experience it. For instance, it might be if you’re a pilot and something goes wrong, and by building up those models, you are better at reacting if you are in emergency. But he also applies it to… Envision before it comes to your desk. What is the first task as you do and then push through that task no matter what happens. So I definitely think that focus is very, very important. I think the way he explained this was probably a bit abstract and not really applicable for most people.

Preston Pysh  16:53  

All right, so the next chapter was chapter four. This is all about goal-setting. We’ve covered this topic in different directions in the past. But the main premise that he’s talking about here is you’ve got to set really lofty goals. I like how he talks about sometimes where you set these lofty goals and you give yourself kind of a short time horizon to get there, to force that productivity, and to force a person to really go after something. I think anybody can relate to that when you give yourself just a small amount of time to knock something out, you have no choice but to be productive in order to hit that suspense. 

But I think the example uses in the book, which is a really cool example he talks about General Electric and how they set a really high and lofty goal in order to improve the efficiencies of some of the engines that they were designing. It’s a fantastic story. 

As a side note, you can’t get a better writer to tell a story than Duhigg. He is very, very good at telling you his thesis or his idea of why something might work. Rhen he gives such a great, fantastic story on how it unfolds and how he basically teaches you through the story. I really like that it’s fun to read his books.

Stig Brodersen  18:02  

So, in particular for GE managers, they figured out that they needed to set two type of goals, that we needed to set a SMART goal and the Stretch goal. Just really briefly about a SMART goal, that’s an abbreviation for the goal has to be “specific, measurable, attainable, realistic, and trackable.” And if I just give you an example, and this is especially something I’m struggling with as a professor, is that you would be speaking with a student, and that student would set a goal and that goal could be, “I will do better on my next report card.” That’s definitely not a SMART goal. 

So just to give you an example of how you could make this into a SMART goal. So it could be for instance, in the next marking period, I will take careful notes and review them at least two days before tests and quizzes so I can ask the teacher questions that I don’t understand. I would do my math homework before doing things with friends and when I hand it in, I’ll ask the teacher about anything I’m not sure about. When I get anything wrong, I’ll make sure to ask a teacher or my classmates for the right answer. That’s an example of a SMART goal. 

So GE implemented this and what they figured out is that the employees loved it. They really made them feel like they’re progressing all the time. It gives them the feeling of accomplishment. It’s very important for us as human beings that we have closure, that now this is solved, and then we can go on to the next thing. 

Now, what they also found at GE was that the SMART goals in itself was not enough, it was really not the one solution they were looking for, because they found that more and more of the employees and the managers, they were kind of using the SMART goals as a checklist, and not necessarily setting the right SMART goals, but basically they just want to accomplish as many goals as possible and not really be focusing on the quality. 

So instead, they decided to have two different type of goals. So the first one was the SMART goal, which is more operational, and then everyone needs to have a Stretch goal. And the interesting thing about a sSretch goal is that it’s very, very hard to achieve. So that also make people think outside of the box, aside from the SMART goal. 

One example that he uses was whenever Jack Welch, the CEO of GE, said to his managers, “We need to limit the amount of mistakes in our production by 70%. I don’t know how. I’m not giving you any directions, but that is what you need to achieve. I know it’s a stretch, but you need to figure out how do we get to that point within two years.” 

Now the managers at GE said it was ridiculous. It simply couldn’t be done. The manufacturing process was so complicated, having more than 10,000 components for each engine. Now, since that was what Jack Welch told them, they had to get on into and they decided to analyze all errors recorded in the past 12 months. And they quickly figured out that hiring more *inaudible insurance people wouldn’t do the trick. So the solution was to make every employee an expert. 

Now, they actually tried that and did that for nine months. And they figured out that the massive retraining of the current staff was not sufficient. They could not reach 70%. So they decided to hire more technical staff. But they’re already in high demand and very expensive. So to attract people, they had to give the engineers more autonomy, but also change the scheduling system that they’ve been accustomed of using at GE. 

So this turned into a Stretch goal, and basically meant that to succeed on mitigating 70% of the errors, everything needed to be changed from workers, from how workers were trained, from how they were hired, and also the way the site ran. But in the end, after three years, errors were cut down 75% and that really shows the strength of a Stretch goal.

Preston Pysh  21:45  

Alright, so the next chapter is chapter five, this was titled “Managing others.” This was a very interesting discussion as to what kind of culture creates the best productivity within an organization.

So he cites a study that was conducted, I think out of Stanford. And the Stanford professors did something like 15 years of research on what kind of company culture works the best. What they found was that of all the different companies that they were modeling or assessing, there was what they called the “star model,” where there was five different ways that culture usually developed inside of a company. There was the engineering culture, there was the autocratic, the bureaucratic, the commitment model. What they uncovered from this research was that often the companies that ignored the commitment model, which wasn’t really any of the five, those companies typically had some of the best results. 

The reason why that these companies had the best results by ignoring this commitment model, was because any person within the company had the control and again, that’s the key word: had the control and ability to induce change into the organization. 

So let’s take the example that he talks about in the book, there’s a small auto factory out in California, and down to the very lowest level person that’s working at the company, they had the ability to first of all stop the assembly line, had the ability to implement changes at their organic level. And that person had a lot of control that was decentralized away from the higher headquarters.

Now, those companies also had the framework in order to have… I guess that bureaucratic model that I think most people are accustomed to with large organizations that they might work for. That was still in place, but I think that the power and authority was pushed down as much as possible to the lowest level. And those are the companies that had the most productive workforce. I think it all goes back to the word “control.”

Stig Brodersen  23:57  

I also think it has to do with pride, it really has to do with do you feel that you are creating a quality product? And if you don’t have control, it’s really, really hard to make that product your own. Specifically, he was talking about in the book how the old management told them that you can never ever stop the assembly line because they cost $15,000 a minute to stop the line. 

The way that the workers perceived that was that they were working for someone else. It was their line, it was them making money. And actually what happened was they actually sabotage the production, which was a crazy story, simply because they had these clashes with the management all the time. 

Now, what happened when they got this new system in place, was that they took another different pride in the job because now it was their product. The management made sure that they wouldn’t fire employees. So for instance, when the financial crisis hit, the management took a big pay cut and the workers that were about to be laid off, instead, they were retrained to other tasks, lower level task, though, but tasks that needed to be solved within the company. So they actually went through the financial crisis without laying off anyone. And this is really the strength of the commitment model is that management and workers, they are together through thick and thin.

Preston Pysh  25:17  

So real quick to piggyback off that comment in order to distribute that authority, down to the lowest level, you’ve got to have trust in the people that are around you. I immediately think of the book from Stephen Covey, “The Speed of Trust” was the name of the book. What a fantastic read where he talks about when you extend trust to other people, you will get it back in return because it’s reciprocal. It works through the law of reciprocity. I think a lot of people might not necessarily understand how true and how that is at work every single day when you’re interacting with anybody. That law is absolutely in play. So that I think goes hand in hand with what Stig was talking about. 

All right. So chapter six, “Decision making.” I’m gonna throw this over to Stig to kick this one off.

Stig Brodersen  26:04  

So the way that Charles Duhigg explains decision making is that he’s saying that most people are predicting the future or trying to predict the future. Actually, all the choices that we make in our lives, that is an estimate of what the future will bring. If you are having kids, it’s typically because you have thought, “Will life become better by having the kids than not having kids?” 

Or if you’re getting married, you’re more or less be thinking, “What will happen to my life if I married my significant other compared to if I didn’t?” And the way he explains this is that it’s actually a very bad way of estimating what’s going to happen in the future because he’s really talking about how we come up with these binary decisions, saying, “If I am gonna have kids, my life will be good. Or if I’m going to get married, my life will be bad.” And that’s the wrong way of looking at it. 

He introduces a concept called probabilistic thinking, where he encouraged us ever wants to say, “Okay, so what is it that I think will happen now?” And he said, “Okay, if I will have kids, there’s 20% of this happening, that might be a good scenario, a bad scenario.” Now, there might be also be another option. And there might be another 20% probability of this happening. 

What he’s basically doing with this is that he is outlining and clarifying the consequences of our choices. He’s not saying, “This is what will happen,” which we as humans are very inclined to do. He’s outlining the options, so we can figure out how do I increase my chance of the positive thing to happen? Or is this too risky of a bet, if you want? So I should stay out of it in the first place, if I can’t mitigate any of the bad consequences. Basically, his point is that even though that you imply probabilistic thinking, it’s not the same as you can always be right. It’s simply a question of shifting the odds in your favor, before making a big decision in your life.

Preston Pysh  27:58  

Okay, so the next chapter was chapter seven and this was called “Innovation.” I think that this is something that is kind of obvious, the point that was being made in this chapter, which is that when you’re creating something new, the stress and the setbacks are part of the process. I think everybody kind of knows that. 

With that said, I think he told a really cool story to represent that idea. It wasn’t anything groundbreaking. So I guess for me, the chapter was, as far as value add to the book, and not so much, but it had a really cool story where it talked about Disney and their development of the movie Frozen, and how they went through all these re-edits of this movie because when they first put it out there, it had all these different mistakes. They talked about how, I don’t know if anyone’s seen Frozen, but as a parent with young kids, I’ve seen it a few times. And in the movie, the snowman character is really funny. Duhigg talks about how the snowman character was really annoying and not funny at all in the original versions. He talks about all these kind of errors and mistakes that they had when they were doing this. 

But as we discovered in the book, Creativity, Inc., it’s all about Pixar and how they go about this creative process, which is where I would definitely tell you to go if you’re wanting to learn more about innovation and this process of being creative and developing things that are creative. Ghat’s the book to go to. 

But what Duhigg talks about here is how they work through that process. They work through the setbacks. And then at the very last moment, they had this person that they hired to help with a song and then that person came in and it just really kind of spun the movie in a whole different direction, and gave it the clarity that it needed in the end to be this massive blockbuster. The story is really cool to listen to, regardless of the learning that’s kind of taking place as to the point that he’s making there. I think the story is really worth listening to. I thoroughly enjoyed the recap on all the inside pieces of that.

Stig Brodersen  29:56  

One of the things he put a lot of emphasis on was the term spinning and apparently spinning is something that happens in creative teams, when they stop being creative. When they’re too stuck in the role to come up with a solution to, for instance, how do we do the ending of Frozen? And to spark creativity, you need intermediate disturbance. Basically, you need to distort the team to make it dynamic. And the reason why he does that was actually founding from nature, and uses the analogy about a reef. If you don’t interfere, one species will become dominant. But if you interfere all the time, only very few other species will survive all the hardship. What you need to do is to create intermediate disturbance, because that’s when the most species bloom. And *inaudible, the CEO of Pixar was very aware of this. So that was also why he went the team got stuck in Frozen, distorted the team to spark the creativity basically.

Preston Pysh  30:55  

And he only changed up and the management architecture of the movie. He only changed one person’s position, because he felt like that slight change was enough to kind of jarr the movie and the creative process that takes place by just changing up that leadership architecture. Just a touch, which was interesting. 

Okay, so then the last chapter that we had was chapter eight. And this was all about absorbing data. In this chapterm he’s talking about, and this is really applicable to today where you have access to just unbound amounts of information, and how do you cope with this information overload? So Stig will cover some of the highlights from this chapter.

Stig Brodersen  31:36  

So the first thing I thought about when I was reading this was whenever I’m teaching a class and very often, for instance, in accounting class, you will need to have the students understand the concept. So for instance, that concept might be the networking capital. What I quickly figured out whenever I started out teaching was that if I asked my students what is networking capital, what they will do is they will Google networking capital, and then there will copy paste that into the response. So it would be a very, very correct answer. But the whole process of turning information into knowledge, that will be completely lost. 

So the way that Duhigg explains this is that you need to interact with your information one way or the other. You need to engage with it. Otherwise, it can’t be turned into knowledge, and what use is information if you can’t absorb it? So for instance, one thing you might do is you might ask the student, so you know what networking capital is, but could you please explain to the rest of the class or just yourself what happens if you take out the inventory in that equation? What’s the influence of the operations of the company? Now, that question is very, very difficult to find on Google. You really need to understand what you’re talking about. And that’s really the key concept for you as a leader and for you as an employee, to make sure that the team understands where we’re going. You need to turn all that information that you have acquired into knowledg. You need to constantly engage with it.

Preston Pysh  33:04  

Alright guys, so that’s the summary of “Smarter Faster Better” by Charles Duhigg. If you guys want to get our executive summary, it’s about five pages long, where we type up our notes from each chapter, go to our website, you can drop down on the subscribe link, click on the one for emails. We don’t send out any spam. We send out our executive summaries about once a month, twice a month, something like that, and you get them completely for free. There’s no cost or anything. So get our notes for free. 

At this point in the show, what we’re going to do is we’re going to go ahead and take a question from the audience. And this question comes from Wendy Davies,

Wendy Davies  33:41  

Hi, Preston and Stig, my name is Wendy and I’m from Vancouver, Canada. I found The Investor’s Podcast after avidly watching your free “How to invest in stocks” video series on buffettsbooks.com 

I’m new to investing and I’m learning so much from every podcast and guests. It’s phenomenal. My question for you is this: for a brand new investor in today’s market without an existing portfolio, what would be an approach to managing a fairly significant windfall of greater than $500,000? I know investment in low cost index funds and ETFs is a recommended strategy, but is it so even when the investment is a large percent of an individual’s total net worth, or executed all at one time?

Preston Pysh  34:23  

So Wendy, that’s a fantastic question. I’m hesitant to respond with just a cookie cutter response, though, because a lot of it has to do with you personally. And so let me expound on that. How old are you? What you plan on doing as far as more work? All those kind of things come into play. You know, do you have children? Do you have other interests? There’s so many different things that come into play as to how you would respond to that. 

But let me give you an example. Recently, I had a friend who contacted me, and he said, “Preston, I need some help. I just retired out of the military.” He was a pilot that I knew and his income was basically going to start doubling if not tripling from where it was when he was in the military. And he says, “I am going to have a lot of extra money to invest. What should I do? You know, what should I do with the money?” 

And I started asking him a few questions. So one of the questions I said, “Do you own a house? Did you just buy a house?” “Yeah, I just bought a house.” And he still had a lot of money to pay down on the house. 

And I said, “Well, what’s the interest rate on the house?” And he says, “Well, it’s a fixed loan, 30 year loan at 3.75%.” I said, “Okay.” 

And so for me, when I was trying to help him through this, now he has children, and so then you had to come and you had to think about the college expenses. But basically my advice to him after laying some of this stuff out, and it’s important to note that this conversation recently took place in March of 2016. And the reason I say that that’s important is because in 2016 of March, the stock market right now in the US if you’re going to invest in the US stock market, it’s priced around a 3% return. So if he takes his money, it’s all this extra money that he’s making, and he puts it straight into the stock market, 3% return is what he could expect by putting it into an S&P 500 index. 

Now, when you look at the 10 Year Treasury, if you were going to do a bond that’s at around 2.6%, so not much of a difference, they’re 2.6 to 3%. That’s almost the exact same return. But he also has this house loan that’s at 3.75%. So for me, when I’m thinking through where’s he going to get the highest return on his money that’s for the house, it’s like, very low risk. I mean, the only risk that he’s gonna have is if the house starts losing value, and he needs to turn around and sell it, which, in my opinion, probably wasn’t the case for him because I think he’d be in that area for a long period of time. 

For me, the best advice for him was, start paying down the house loan as much as you can, because you’re actually probably getting the best return that you could based on the current market conditions. As those market conditions change, let’s say in two years from now, the stock market has a big correction and prices are a lot better. And now you can go get 6% in the stock market. 

Now he needs to be taking his cash flow and putting it into the stock market. So that’s why answering that question is extremely hard, because a lot of our listeners are from the future. They’re listening to us four years from now they’re listening to this episode. And so, if I’m giving you advice to buy the stock market today, that’s really bad advice for that person who’s listening to this four years from now, because it might be completely different. I would guess it actually be better. But it’s different advice based on where you’re at a certain point in time and all the other conditions that are happening. 

So with all of that said, because this is a really long response. But I think it’s important for you to hear my thought process. That’s what I really want to convey to you. This is how I would go about this. Lay out different asset classes and understand where they’re priced know where the stock market is, and all you got to do is take the inverse of the Shiller PE ratio for the US. Figure out what that ratio is and what percent that’s giving you in the stock market, figure out what you can get in a government bond, figure out what you can get in a corporate bond. Do you have a house loan? What’s the percent on that? Those kind of things are the questions that you guys have to ask. And then you have to make that assessment, what’s going to give me the highest return for the lowest amount of risk that I’m comfortable with? I know that was long, but I’m curious to hear your thoughts, Stig.

Stig Brodersen  38:26  

I have a very lengthy response too, Preston. So I definitely won’t blame you here. The one thing I really wanted to talk about in your question was basically a two part question was also the thing about high percent of net worth, because that’s something that we really haven’t been talking too much about before. When you say that these call it $500,000. That’s a huge part of your net worth. I would assume that you have savings to live by and you also have an emergency fund and then at least quite some time until you plan to retire. 

Again, like Preston said, there’s so much information we need to know like, age and children and which kind of different scenarios are you considering going to happen with your life? But the thing I really want to talk about more from a general perspective, that is 100% stock exposure, a good investmen, is it risky? Do you need to diversify more into different asset classes? Because I think that’s something that a lot of people have thought about. At least, I’ve thought a lot about it. Am I really diversified if I have 100% in stocks? 

Now, it’s not a simple yes or no question. But I would definitely like to give it a go, if we look away from the current market conditions. Again, a lot of the listeners whenever you’re listening to this, you might be in the future and the stock market might look very, very different. So just from a general perspective, are you diversified if you have 100% stocks given that it’s only one asset class, and you might have seen your chart saying, if you have stocks, you will, on average, be making 8% or if you’re investing in bonds, then average it would be 4%. Commodities, perhaps 3%. Then you’re also showing charts about how those asset classes correlates and how you will have less risk if one asset class goes up when the other asset class goes down. 

And we’ve talked about risk quite a few times in the podcast, and we usually don’t consider volatility to be a good measure of risk. And for me, I don’t think that having many asset classes for the sake of having many asset classes is a good investment. I don’t necessarily think that you are more diversified. And I don’t think as an investor that you have respect for the underlying drivers, in terms of what drives returns. 

So please allow me to elaborate. I don’t look at stocks as one asset class rather, I look at it as, can I imagine a scenario where companies in aggregate are not making a profit anymore? And the answer to that is pretty simple. No, I can’t. So basically, the underlying premise is that if a company makes money, it will be returned to the shareholder, dividend, share buyback or capital gains. So I would say that I can’t imagine scenario where companies won’t be making any money. 

So basically what you’re saying in terms of the low cost ETF, as you’re talking about, over the long term, yes, there will be a good investment. If I need to build up on that thesis, I can’t think about any point in time, since we have human beings on this planet, where we didn’t have a corporation making an output. Now, it might not have been called the SEC or they might not have antitrust laws, and they might not be filing in 10K, but we always have a corporation structure one way or the other. I mean, even back when we were living in tribes, you know, we had owner management, worker structure, and in aggregate, those societies got wealthier.

So you might be also be thinking okay so that’s a good point. Okay, so up until this story, we can see that companies are making profit, can we expect that to happen in the future? If you investigate how a company makes profit and how societies prosper, it basically comes down to innovation. The more productive we become, the richer we get. And that generates profit. 

You can think of it in terms of inventions, people become more productive after electricity was invented, the assembly line computers for that matter. And it’s basically a rule of nature, you will always find a corporate structure. Unless we completely dissolve the structure of a corporation by telling people that they can’t be working together, we can always create more output by work together in a structure one way or the other. 

I know that this was a very philosophical and very lengthy approach to understanding stocks. But I think it’s important to understand the underlying factors of what drives the stock market, again, over the long run. So just to sum up, if you’re not thinking about retiring anytime soon, and you’re thinking about should I be 100% exposed to stocks, if you disregard the current price level, I don’t think that you will need diversification into other asset classes.

Preston Pysh  42:57  

All right. So Wendy, thank you so much for submitting your question. If anybody else out there wants to get your question played on the show, go to asktheinvestors.com and you can click on the little recording link there on our website and you can record your question. 

If you get it played on the show like Wendy, she’s going to get either our ETF course for free or the Intelligent Investor video course for free which is a paid course that Stig and I have on our website. She can pick either one of those for getting your question played on the show. And that was the same offer that we have for anybody else out there. If you get your question played on the show. you get access to one of those courses for free.

Stig Brodersen  43:32  

That was all the Preston and I had for this week’s episode on The Investor’s Podcast. We will see each other again next week.

Outro  43:38  

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