28 October 2019

On today’s show we talk to David Stein about his new book and how to construct the optimal portfolio.

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  • How to construct the optimal portfolio
  • How to determine the expected return, upside, and downside of an asset class
  • If you should ever be 100% invested in stocks?
  • Why you should consider owning more than a dozen asset classes.
  • Ask The Investors: How should I rebalance my portfolio?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  00:02

On today’s show, we’re really excited to bring you Mr. David Stein. David is a former chief investment strategist and a chief portfolio strategist for a $70 billion investment advisory firm. Today, he’s the founder of a very popular podcast called, Money For the Rest of Us. And he has a new book that covers the top 10 questions that master successful investing under the same name of Money For the Rest of Us. David gave an incredible interview here, so we are really excited to get this one going. So without further delay, here’s our interview with David Stein.

Intro  00:35

You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Stig Brodersen  00:56

Welcome to The Investor’s Podcast! I’m your host Stig Brodersen, and as always, I’m here with my co-host Preston Pysh. We have David Stein from Money For the Rest of Us with us here today. David, welcome to the show!

David Stein  01:08

Thank you. It’s great to be here.

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Stig Brodersen  01:10

Fantastic to have you here, David. The framework of our conversation today is how to build the optimal portfolio for us as investors. Before we go into details, let’s zoom out here for a moment. David, could you talk to us high level about your thought process of building the portfolio that matches both our financial goals, but also our individual personalities?

David Stein  01:31

For sure. And certainly my background, I spent 17 years as an institutional money manager working with very high net worth individuals, as well as, mostly with endowments and foundations. And so, I approach investing like a portfolio manager. What a portfolio manager does is they allocate their money among different asset categories. And so, the traditional way to do that is what’s known as modern portfolio theory, where you have expected returns. You have expected volatility for different asset classes; how do they move relative to each other in terms of correlation. I don’t use that approach because what I found as an institutional money manager, much of the data you makeup.

David Stein  02:08

What’s the volatility of an apartment building? What’s the volatility of a venture capital fund? And so, essentially, it’s garbage in, garbage out. Diversification, obviously, is key; having different asset categories. But in terms of the weight, my approach is more like a hedge fund manager, where you look at the universe of potential investments. You choose those that perhaps have a unique return driver, and you have some confidence in the ability of those return drivers to come through. And maybe the analogy that best fits it is more of an…what I call an asset garden approach, where the goal of modern portfolio theory is to come up with this optimized portfolio. And as investors it’s very difficult to optimize. We don’t know what the exact right answer is, particularly, when we have a lot of made up data in terms of some of these more illiquid asset classes that don’t have volatility assumptions, or at least we don’t see the day-to-day volatility that you would with stocks. And so, with an asset garden approach, you’re not trying to optimize. You can’t optimize a flower garden. You have variety; a variety of plants; a variety of flowers; variety of fruits. So we do the same thing with a portfolio. We just want a variety of different asset categories. We have some confidence about the expected return. And we’ll talk about how to estimate that perhaps later, but just have different return drivers. So that’s kind of how I approach investing. It’s how I approached it as an institutional money manager in the later years, when I was running portfolios, and it’s how I manage my own portfolio today.

Preston Pysh  03:31

So David, one of the things that I often hear from our audience is that they have analysis paralysis. There are simply too many types of investments out there and too many scenarios that can unfold, so in fear of making a wrong decision, they don’t invest in anything, which is also a decision in itself. So how do you determine investments expected return, its potential upside, and its potential downside?

David Stein  03:57

When I mentioned that, we need to look at return drivers. There really are three return drivers for most asset classes. And here, we’re talking about investments. Something that has a positive expected return. And, let’s just take stocks. When you look at the historical returns for stocks, it’s driven by first the cash flow, which is the dividends. Most investments have some type of cash flow. That’s the first component. The second component is how is that cash flow growing over the time. So with stocks, it’s the earnings that grow and as earnings grow, a company is able to pay more dividends. And so you have this second element, and those two really form what I call the math of investing. You have the cash flow, and the cash flow growth. It works the same way for real estate. You have the rents. How are the rents growing over the time? Those are important components that drive return. The third component is what’s known as the emotion of investing. What are investors willing to pay for those cash flows? And in a time, where the valuation for stocks are very high like now, then they’re willing to pay a lot. And one measure of how much they’re willing to pay is the price to earnings ratio. What are investors willing to pay for dollars or a monetary value worth of earnings, and as a result, we can combine those three. And this is how the math works (*inaudible*). I mean, you can break down the historical return for stocks. And generally, dividends have been 3-4%; earnings growth have been 4-5%. And then, the valuation increase like going back to 1926 or further is about 1%, so that combines together.

David Stein  05:19

So when we’re looking at other asset categories, and that’s what we are as portfolio managers. If we can get for example, let’s say at 6-7% income stream or yield, that’s very attractive because then we’re not so focused on being dependent on the cash flow growth. And so, there’s always a balance between how much cash am I getting? What does this cash flow need to grow in order to meet my return expectations, and what are investors paying for it? Now, on your show, you talk about being value investors. When investors aren’t paying very much for that cash flow growth, and that’s an attractive time for an asset class. And I think sometimes just simplifying the universe and having some rules of thumb or frames of reference to look at asset categories makes it easier to narrow down the universe because we didn’t talk about, for example, asset classes that have no cash flow, which I would call, and we’ll probably talk a little bit more about this more, speculative asset classes because you have to be absolutely right ’cause the only thing driving it is people willing to pay more for that particular category of asset.

Stig Brodersen  06:16

And yes, David, you have a sharp distinction between investing and speculation. Whenever I hear you talk about this, you mentioned specific examples of investments would be stocks; bonds; real estate, while an example of speculations would more include something like commodities such as gold and oil futures. We know that our listeners have strong opinion of what is an investment and what is not. Many people define it differently. Could you please elaborate on your opinion, and why you make that distinction?

David Stein  06:46

In my view of what’s an investment versus a speculation versus a gamble comes from an asset manager named Kingsley Jones. He is based in Australia; founded investment firm; and his definition was, “An investment is something with a reasonable expectation will have a positive return.” And that’s where I go back to, and say, “Well, investments generally have a cash flow component to it or an earnings component. A speculation is where there’s some disagreement, whether the return will be positive or negative, and commodity futures is an example of that.” You have some investors that believe that commodity will go up in price. You have others that believe it’ll go down in price, but it’s a zero-sum game. The speculators on one side win at the expense of somebody on the other side. You know, gold; gold coins. You know, gold, what’s the right price for gold? There’s no cash flow. You can’t value gold per se. And as a result, it’s a speculation in that the only way that an investor will make money owning gold is if it goes up in price. You can own stocks, and they might not go up in price, but you can still make money because of the dividend or other cash flow generating assets, and so speculations aren’t bad. It’s important to recognize that speculations, their success depends on somebody paying more, and there isn’t really an objective criteria often to figure out what more is; why it should be worth more other than just underlying demand from other investors. I typically recommend keeping less than 10% of your investments in speculations. I mean, I own speculations. I own some art. I own some antiques. I own gold coins. You can’t reasonably say this is going to have a positive expected return. Now, a gamble is something that in fact that has a negative expect of return. You to do it for the entertainment value.

Preston Pysh  08:23

So David, if we look at the historical returns of major asset classes in the 20th century, equities have performed the best. Well, it’s a volatile type of investment. We also have many listeners who believe that they can emotionally and financially handle the volatility. Which type of investor should be 100% invested in equities? Or is that ever even a good strategy to have?

David Stein  08:46

I don’t think it’s a great strategy. It’s like playing the same key on the piano. Why not have a little more variety? There are asset classes out there, where you can earn as much as stocks. Private capital for example; venture capital. I have debt investments, where I’ve done direct lending or asset-based lending, where the yield is as high as the expectation for the stock market. And so, typically younger investors and when you’re starting out, you want to probably start with stocks as we talked about what drives it. It’s a great introduction. It’s a great way to figure out how do I react when the market falls 30%. Yesterday, the Dow briefly fell 600 points. And everybody was on Twitter saying, “Well, this is the big one!” No, not necessarily. It’s just volatility. That’s normal volatility. And as a stock investor, you get used to that. But it shouldn’t be the only asset class. There’s so many other interesting asset categories. If you’re interested in investing that you can make just as much as stocks. And so, that’s why again, we go back to the three criteria. You know, what is the cash flow for the investment? Has that cash flow growing over time and what’s the valuation? And there are times and there are securities, closed in funds for example. This is a type of mutual fund. It trades on an exchange like an ETF, but you can look at the value and see at times that particular closed end fund. Let’s say I invest in bonds in a leveraged fashion, so it has a distribution yield. That’s the amount of the dividends paying of 8-9%. And it might be selling at a 20% discount to the value of the underlying assets. Now, this isn’t the theoretical undervaluation like you do with stocks. Well, the stocks undervalued. This is looking at the net asset value: the value of the assets compared to the price and seeing a discount of 20%. One can make much more than a stock market. Now, it doesn’t happen all the time, but it happens during down markets. And so, I think just siloing only investments or only stocks is…you’re gonna take some of the variety and some of the fun out of the investing. I’ve invested in stocks, but I approach it–I like the variety. I like looking at different asset categories, learning about them, understanding what the return drivers are, and then implementing them in my portfolio.

Stig Brodersen  10:55

So it’s interesting that you would say that. And we talk about stocks. We talk about bonds and other listed assets. But you also briefly mentioned there, private investments, which might seem like a blackbox for most investors. We have a reasonably good idea of how to buy a stock, or how to buy a bond, or whatever it might be. But there was this huge market for private investments. They are not a financial asset. It’s something that many investors would be interested in because it’s so uncorrelated to perhaps a stock or bond portfolio. How do you find private investments?

David Stein  11:27

There are certainly platforms out there that you can experiment with. Crowdfunding platforms, particularly on the real estate side, where they’re investing in private real estate deals. There are just in your own opportunity, in a sense of I have found investments that people have brought to my attention, particularly I mentioned this debt deal, where I’d lent some money on property. I’ll admit that in the private investments sometimes take a little more capital. So as a young investor, you’re often not able to get into those opportunities in the US. Many of those opportunities, you have to be a qualified investor, and so there’s certain income thresholds or asset thresholds. But I think the principle of not having our entire net worth tied up in the financial markets; the public financial markets is important. I mean, we could get some virus that shuts down the financial markets for days at a time. And so, having what I call “pockets of independence” outside of the financial system, I think it’s important. It could be something as simple as owning a plot of land. I mean, there’s platforms out there, where you can invest in foreign land, or you can invest in land directly. When you look at my portfolio, I’ve well over a dozen asset categories. One because I enjoy it, but two, I typically have about half of my portfolio and assets outside of the financial system. I mean, it could be something as simple as lending money on a student loan or something. Maybe on unsecured basis, but there’s ways that you can invest; that you can earn just as much as stocks or close to what you can own in stocks, but in a way that’s not so tied to the stock market with as much volatility.

Stig Brodersen  12:56

So let’s talk about stocks. What we’ve seen especially in the 20th century is that stock returns have been driven by dividends to a huge extent. Many investors would say that it doesn’t impact the return, since the access cash, they are not being used to pay out dividends. That’s just being reinvested in the business, especially in recent years have been used for share buyback. You argue that the lower dividend payment that we experienced today will result in the lower long-term return on stocks. Why is that?

David Stein  13:28

Well, it’s because company managers, they can pay out a share of the profits as a form of dividends, or they can reinvest it, or buy back stocks. And so, being less reliant on the income component that we’re gonna do a bottom up estimate of what stocks return. Historically, dividends have been a 4% of that. Now, it’s two. So if we want to get a historical return, let’s say, 9%, then we need the earnings growth component to grow at 7%, assuming that valuation stay the same over the next 10 years. Well, when you actually look look at how earnings per share have grown, and the right measure that drive stock returns is not overall earnings across the country. It’s earnings per share. Historically, there’s always been new share issuance as new companies come to market; new IPOs. There’s just more of it. And so generally speaking, in most decades, earnings per share grows less than the nominal growth in the economy because it’s interconnected. When we look at in the US, earnings per share growth, and this is data from Ned Davis Research, which is a research firm. It’s been around for decades. When you look at earnings, it’s very volatile. You have periods, where they’re greater than 10%. You have periods, where they’re less than their negative. But if you do a regression analysis, so a statistical analysis, and do a best bit line to figure out well, what have earnings grown on average? Since 1980, earnings have grown 5.3%. So if you add 2% dividend yield to that you’re about a 7% expected return, which is kinda as I…you know, I also would argue the US stock market is overvalued. And so, maybe valuations are not going to get more…maybe they get more expensive, but perhaps they are gonna get cheaper. And so, I think a reasonable return assumption for stocks in the US is 6-7%. Now, you mentioned the buybacks. Buybacks have certainly helped, particularly over the past five years in terms of just boosting earnings per share. But when you look at what is funding that, it’s primarily been driven by new debt. The S&P 500 right now, the companies within that; those 500 companies have $7 trillion worth of debt. It’s an all-time high. Their interest expense is close to an all-time high, even with very low interest rates. And so, when we look at quality of earnings within the US, they’re becoming more manufactured. It’s being driven by buybacks. If stocks are gonna grow, you need the revenue growth. You need overall earnings growth. It can’t just be manufactured earnings per share by buybacks. And so, those earnings track the overall economy, typically. In fact, a little less than that, and that’s why I think that 6-7% of US stocks is a reasonable expectation. And so, then we start looking at other asset categories that perhaps, you can get just as an attractive return. Preferred stock for example. There were preferred stocks earlier this year that were yielding 6%, so you don’t have to worry about earnings growth. You could just lock in your 6% return.

Stig Brodersen  16:17

So David, one of the reasons why we wanted to talk to you today is that you talk a lot about diversification and the power of diversification. We typically have guests here on the show, who specialize within certain type of asset class. And for that reason, they might and might not also be prone to some of the biases of how much to allocate into that specific asset class. For instance, we might interview a guest, who specializes in precious metals. So not only would that person say that you should buy gold, but you should also diversify into a number of other precious metals. Or it could be a stock investor, who would argue that you can be 100% diversified in stocks because you can buy into 10 or 20 different stock investing strategies. How do you think about asset allocation and diversification?

David Stein  17:03

Well, I think more like a hedge fund manager. One of my virtual investment mentors was a man named Seth Klarman. He runs the hedge fund, the Baupost Group. He was one of my private foundation clients; had half their money with the Baupost Group, where there’s this huge amount for an institution. And they had been investing with him since the early 80s. So I would go once a year, around the year 2000 and meet with Seth Klarman and his team, and spent years kind of reading through their letters; following their portfolio. And when you see how he and his team invest; they’re asset allocators. So they’re looking across the universe at the opportunities and if they see something attractive, maybe they’re not an expert in it, but they’ll learn the asset class. They’ll get experts in, and they’ll try to figure out because they see an area of the market, where people are ignoring it, or there’s compelled to get out of it for whatever reason, maybe not economic reasons. And so, my approach is to look across the universe and see what’s most of attractive. Now, we can start very simply. We can start with stocks. We’ve just gone through the analysis to assume all right stocks are gonna reasonably expect to return over the next decade is 6-7%. We could be a 100% allocated to that. And then, the potential downside. When I consider the downside of an investment is its maximum loss and the personal harm that loss could cause. For a young investor, a 60% loss; if you only have $5,000 invested, not gonna harm you. Once you get up, let’s say you have a seven figure portfolio, then a 60% loss could be very damaging, particularly if you’re near retirement. But you can start with a foundation of stocks. And then, if you want to reduce risk, you could add cash. Cash, there is no downside to cash other than the inflation cost of it. So you’re always weighing the volatility downside versus inflation, but that’s kind of the foundation for talking about just simple investing. But from there, you can explore all the other opportunities. So I’m sort of as a class agnostic, you know, I’ll do the main separation like, well, this is a diversification because there is no cash flow, so it just has to go up in price. Now, that tends to be less than 10%. I just want to go with what’s most interesting at any given time.

Preston Pysh  19:12

So David in the next question, I would like to talk about how you manage your portfolio. Our listeners are predominant stock investors and will rebalance if one position grows too big. If a stock on their watch list suddenly becomes very attractive and other specific reasons for an investor, who is invested in multiple individual stocks or equity ETFs, how do you manage your portfolio? If possible, talk about years to retirement valuation and rebalancing.

David Stein  19:38

Well, first off, I don’t buy individual stocks. That’s a key. I have spent decades meeting with; trying to identify the smartest stock investors out there. One of our charges as investment advisors to endowments and foundations was to recommend managers that could find 20 or 30 of the best performing stocks. Most managers, professional managers underperform, and they maybe they find one or two stocks, but to find a number of them gets very, very difficult because when you approach buying individual stocks, because the intrinsic value of the stock is the value of its future cash flow; its dividends, which is influenced by its earnings. So there’s an embedded earnings growth assumption in the price of any stock. When an investor is buying a stock, they’re saying the market is wrong; that this stock is mispriced. We don’t buy individual stock because we think it’s a good company, or it has a cool product. We buy an individual stock because we believe the company will grow faster than what the market has priced in that is cheap. And I find from an investment perspective that I’m just, I don’t have an informational edge to do that. I mean, I tried. And I’m sure many of our listeners do have that informational edge. I see people go buy stocks because well this is a great company–Netflix, they’re growing really fast. Doesn’t matter if Netflix is growing very fast, quickly. What matters is it’s growing faster than what the market is assuming because that’s how…that’s what the market is. When we invest, we should always ask ourselves, “Who’s on the other side of the trade?” Back when Benjamin Graham was investing, most stocks were owned by individuals, so he could get an informational edge. He could do the analysis and say, “Yeah, this stock is mispriced.” But now, when you buy an individual stock, you’re competing against quantitative algorithms and institutional investors that spend their entire lives focusing on finding mispriced stocks. I don’t have the wherewithal to do that. So I again, I focus on asset categories. So if I own stocks, I own global stocks. I own a very cheap ETF. For the more fun investments. I’ll focus on closed end funds that are primarily owned by individual investors that tend to dump them, when the market sells off indiscriminately. And so, there I can see undervalued asset classes with investor on the other side of the trade is an individual, often a naive investor. And there, I can pick up some excess return.

Stig Brodersen  22:01

You said an interesting term there. You said a closed end fund. There might be some of our listeners, who are not too familiar what that means. Could you please elaborate?

David Stein  22:09

Sure. So the original mutual fund was the closed end fund. So they’re just like an exchange traded fund in that they trade on an exchange. So a manager might decide I want to do a closed end fund, so they’ll do an initial public offering. And so, there’s a certain amount of shares outstanding that differs from an open end mutual fund, which creates new shares every day, and it only trades at the end of the day. A closed end fund is a limited number of shares. And as a result, the price is set by the trading of investors in terms of their buy and sells. The manager strikes a net asset value at the end of each day, but the price because it’s only contributed, or it’s determined by investors can differ from that. So sometimes they trade at a premium. Like there’s some closed end funds that trade at a 40% premium to the net asset value. It makes no economic sense, but because it’s mostly individual investors, institutions can’t get enough assets or enough liquidity to close that gap. And so, it’s an inherently inefficient market. That shouldn’t even exist. Expense ratios are high, but it does exist. And so, it’s kind of a very niche market. But as an individual investor, I want to focus on where can I get an edge. I’m not managing a 100 billion dollar portfolio. (I have) [SIC] a much smaller portfolio, so I can take advantage of a niche opportunity, where I can see the undervaluation. I look at investors or traders, right? They want to trade Forex or commodities. Why trade an asset class, where you are competing against institutions, when you could trade closed end funds, and you’re actually getting an income yield, and you can see the undervaluation? A much more compelling opportunity in my opinion.

Stig Brodersen  23:47

Very interesting. So let’s talk about another market that perhaps shouldn’t exist. I’m very curious to hear your response to my next question. Very few people think about the bond market as attractive these days, especially to government bonds. What is getting a lot of attention is the…even negative yields for government bonds in some countries. United States is very, very low. Which role should government bonds play in investors portfolios today?

David Stein  24:15

Basically to preserve some capital. So the reason why I own bonds because you own them for income. So it goes back to what is that income or that yield to maturity on bonds? ‘Cause the best estimate over a 10-year period for bonds is its current yield to maturity. If a bond fund or a segment of the bond fund has a negative yield to maturity, just don’t own it. If it’s earning zero, you don’t own it. The reason why people own long-term bonds (*inaudible*) as investors is because they believe rates will go down further, or they’ll be, they’re willing to own negative yielding bonds because they believe rates will go down further because you can pick up the price of appreciation because rates move inverse to the price. Well, that’s a speculation. And speculations mean you have to be absolutely right to make money, so I want to focus on the income component. And so, yes, and looking at bonds right now; government bonds, probably not terribly attractive unless you’re just comfortable, at least in the US with that 2% yield. Now, there are other bonds out there that at times are attractive; non investment grade bonds or high yield bond, particularly coming out of the Great Recession. Their incremental yield above government bonds was close to 16-18%. You could make more money coming out of the Great Recession, investing in bonds than you could in stock, so it’s just another asset class. But you’re right, it makes no sense to own negative yielding bonds in this environment.

Preston Pysh  25:36

So David, if there’s one thing we’ve learned from financial markets in the 21st century, it’s that in investing, there’s no step-by-step instructions that can guarantee a successful outcome. Instead, I’ve heard you refer to this as being “wayfinders.” And that we have frames and rules of thumb that give us a sense, where we’re heading in the right direction. Talk to us a little bit about this idea.

David Stein  25:57

Well, the wayfinder is somebody that’s generally heading in the right direction, but doesn’t know exactly how to get there. And probably the best example is Lewis and Clark. Lewis and Clark were explorers that in the US back in the late or the 19th century; were trying to find a passage, a water passage from the east US to the Pacific Ocean. They had a whole list of tools they brought. Very, very long list. Some tools that actually helped them navigate, but they didn’t have a map. They had a just…use these tools to sort of figure out they were heading in the right direction. Investing’s the same way. When I have, I mentioned hedge fund managers that are used to research other money managers, the best investors I know, they know there’s no guarantees. They can’t guarantee a return. But they have an investment discipline. They have tools that they use. They have some type of framework that they systematically look at investments and helps them make the decision. And as individuals, we should do the same thing. One of the other things that these managers do is they’re always measuring themselves. If individuals are buying individual stocks, they should actually be measuring their performance as a portfolio. We tend to ignore the ones that didn’t do so well. We sell them and move on. But no, if you’re gonna be an individual stock investor; buying individual stocks, then measure your performance. Warren Buffett does, right? Every year in the Berkshire Hathaway report, they list out the performance of the stock, which is driven by the underlying holdings. We should do the same thing in our own investing just to quantify it. You know, as wayfinders or having an investment discipline, I believe it’s very important, which is why in terms of how I’ve invested professionally and individually, I focus on certain filters, and we’ve talked about some of those. Now, is this an investment or is it in speculation? What are the return drivers? What’s the income yield? How is that cash flow growing? What’s the valuation? What, how are investors valuing that cash flow? You know, who am I competing with in terms of trading? You know, who’s on the other side of that trade? So these are just steps I go through to decide do I have high confidence that this particular investment will meet my return objective.

Stig Brodersen  28:05

Very, very interesting. I would like to talk about biases here for the next segment of the show. I would like to hear more about your experience, David. We all had different paths to where we are today as investors. You’ve been heavily invested with a client in high yield bonds in late 1990s. And you briefly mentioned before that you also were again in 2008 with very different results. Please tell the audience about how the various bull and bear markets have made you vulnerable to different biases, and which type of biases investors here in October 2019 should guard themselves against.

David Stein  28:43

I started investing professionally in 1995. Now even though I had an MBA in finance; I had invested in my own, I probably didn’t know…I didn’t really know what I was doing. So the first year I was in the stock market, it was up 37%, which is pretty good return, but I had no historical context. I’d say, “Oh, the market’s up 37%. That’s great.” But what I found myself doing is relying on historical returns and expectations to invest; to figure out how an asset class return, and an example that you mentioned in high yield bonds, so non investment grade bonds. I had a client. They were primarily in government bonds in their bond portfolio. This was about a $200 million endowment. As an investment advisor, you know, my job was to introduce diversification. So I introduced high yield bonds to this client without really understanding the driver of the return. For high yield bonds, the important metric is how much yield are you getting relative to treasury bonds. And you want to invest in non investment grade bonds, when that incremental yield or spread is above average. The long-term average has been about 5%. We went into those high yield bonds with about a spread of 3%, so much narrower, and after a period of strong return. But I already mentioned that the best estimate of a return for bonds its current yield to maturity. So with a very low spread and yield, they didn’t do very well because what happens is as the internet bubble crashed in 2000, spreads widened dramatically, which means the value of these bonds fell. And so, what I took from that is, “Look at the value. What are investors placing in terms of the valuation on cash flows?” So in 2008, coming out of the recession, we were much more confident investing in high yield bonds. And so, when I talk about biases, my initial bias was just rely on history. Now, my bias is to focus on what are the return drivers and how is the asset class being valued. Now, one of my biases, I would say is I don’t, as I mentioned, I don’t invest in individual stocks. That’s definitely a bias. I’m not saying it can’t be done. I’m saying most that do it, fail at it if they actually measure their performance, and they don’t go in recognizing that they have to assume that the market is wrong. Now in October 2019, you know, one bias is people think interest rates are gonna keep falling. And as a result, they’re willing to own very low yielding bonds; long-term duration bonds or long duration bonds in terms of those that will do very well if rates fall further. That’s a bias.

David Stein  31:07

Another bias in October 2019 is people seem to ignore inflation. They think inflation will stay low forever; that the central banks are in control; that there’s a deflationary bias. Well, one aspect of inflation, it’s very much there’s a human component to it. If individuals and businesses start acting like they’ll be inflation, they will change the behavior. And we could get inflation. If we lose trust in the central banks, we saw an example just in the last couple of weeks with the repo rate. You did an episode on it. The central bank, the Federal Reserve lost control of their policy rate. One of their jobs is to maintain their target interest rate and they failed at it, and the rates spiked to 10%. Now, they’re able to resolve the issue. But you know, little by little if we start to lose trust in central banks and their ability to control inflation that could change behavior. We could go into a high inflation environment. I’m not predicting it, but that’s a bias. We have a low inflation bias, most investors right now. We should be aware of what inflation is and that regime’s change. And one of the things that I’m always doing as an investor is looking at market conditions to understand what the regime is. And is there something that changing and other opportunities arising because of those changes; because investors might be panicking or might be overly zealous.

Stig Brodersen  32:19

That’s such a good point. And you know, especially in this time, it’s so important that we know which type of biases that we are prone to, especially if we compare ourselves to other people because they, not surprisingly, would have the same biases because they’re also shaped by the experiences of the current market conditions.

Preston Pysh  32:36

So David, let’s wrap up your key takeaways about the principles of building a portfolio. Which steps would you encourage our listeners to go through?

David Stein  32:44

Well, I think it’s important to write down your investment philosophy. What is your investment discipline? You know, if you’re focusing on researching individual stocks, how do you go about doing that? You know, what are you looking for? What are the steps you’re doing? If you’re focusing on asset categories like I do, what are the steps that you use? You know, one of the things that I always want to know is I want to estimate what the return will be for a given investment, so I go back again to those three drivers that we’ve talked about: the cash flow, the cash flow growth, and how are investors valuing those cash flows. And so that’s, I think, an important component. Everybody you should just list it out, and not just kind of go where everybody’s going. One of the things that I see, particularly new investors, who get involved in; they kind of go whatever is the hottest craze. I want to be an investor. Well, next thing you know, there’s a signing up for a trading academy and learning how to trade, which is just the absolute wrong direction because then, there’s a phrase in the investment, in the hedge fund space, “You’re going to get your face ripped off.” That means you’re going to be taken advantage of.

David Stein  33:39

I actually, I met a 65-year old man, who said he needed to invest in himself, and he spent $23,000 to join an online trading academy. This is a guy that had never participated in his work sponsored defined contribution plan, where he could get a 100% guaranteed match on his investments, but he didn’t do it because he said stocks are risky. Now, he’s 65. He wants to retire in five years. He pays $23,000 to join this trading academy. I went to the trading academy. I sat there for four hours to figure out how did they convince this guy. They basically said, “We’ll teach you how to invest or trade. But to be a successful trader, you need to take advantage of naive traders. Exploit them.” It’s in their patent. That’s an example of a zero-sum game; a speculation. And as investors, we don’t want to be in a position where we have to outsmart other investors in order to be successful. We certainly don’t want our retirements based on that. We want to be in investments where we can have a high degree of predictability. We don’t have to outsmart other investors because there’s cash flow. We can see the cash coming in, and we can see that investors have undervalued that cash flow, so have an investment discipline to approach your investing.

Stig Brodersen  34:49

Fantastic. David, thank you so much for coming here on the show. I would really like to give you a chance to give a hand up here at the end of the episode because you are the host of Money For the Rest of Us, one of the world’s most successful investment podcasts. I’m 100% an avid listener. I’m not just saying that because David is a good friend. It is an amazing podcast. You’re also author of the book, Money For the Rest of Us: Ten Questions for Masterful Investing, and McGraw-Hill just published this book, October 25th. Could you please tell the audience about your new book and where the audience can learn more about you?

David Stein  35:25

Well, the book essentially goes through the ten questions that we should ask to help us to narrow down where we invest, and we’ve alluded to many of these questions in this particular episode. But this is my investment discipline. This is my philosophy for how I approach investing. And I think it’s a very good framework for helping us decide where and how we should invest. And so, it’s basically what I’ve learned over the past 20 years investing as an institutional money manager, helping individuals invest, and I think it’s a great foundation. And it goes into a little more depth for example, in terms of talking about the drivers of return and how you calculate that. I show what I’m doing in my portfolio and that whole asset garden approach. But yeah, that’s Ten Questions to Master Successful Investing.

Stig Brodersen  36:10

All right, fantastic. And we will definitely make sure to link to that in your show notes, together with your podcast. I really highly encourage our listeners to pick up David’s book. I already read it, and it’s a great read. Before we went on the show here today, I convinced David to participate in one of our TIP live events in Los Angeles, and that will be February 11 with a local chapter. It’s going to be a very casual event at a bar that is owned by two of TIP’s biggest fans, and you just need to pay for your own food and drinks. But the event in itself is of course completely free just like all the other events are. David will be there if you want to hang out and talk investing. Another cool guest that’s also coming, that is Tobias Carlisle from our Mastermind Group, so please make sure to sign up for the event. You can just send me an email at stigattheinvestorspodcast.com, and I’ll make sure to send you more information. David is there anything else we need to talk about here before we let you go?

David Stein  37:07

No, I appreciate the opportunity to chat about investing. It’s been fun.

Stig Brodersen  37:11

Fantastic. And David, thank you again so much for joining us on the show. And we really hope we can invite you on again.

David Stein  37:18

Thank you.

Stig Brodersen  37:19

All right, so at this point in time this show, we play a question from the audience. And this question comes from Leon.

Leon  37:25

Hi, guys! Thanks for a great program. I have a question on portfolio rebalancing. I have a bucket of stocks and some are on high ground (*inaudible*) and some does not. So over the years, the portfolio goes out balanced. But in order to rebalance it, it seems to suggest that I need to sell away my winners and buy some of my losers. This does not intuitively sound right. So is there an other way to do it such where I can reduce my exposure and risk? Thanks.

Stig Brodersen  37:55

So I absolutely love this question. And I think it’s very timely for the episode here with David because whenever you hear about portfolio management, everyone always talks about rebalancing. And yes, for most investors, I do think rebalancing is a great idea. For instance, many endowments and hedge funds have portfolios with multiple asset classes. And they don’t pick individual stocks, but they look broadly at the exposure to stocks, bonds, commodities, and currencies. For them, I think rebalancing makes a lot of sense and also for many individual investors, who has a lot part of their portfolio in the stock market and also own bonds. As they become older, they might want to own more bonds and to preserve wealth. And because they want to lower volatility, they continue to rebalance. Now, the idea of rebalancing is to utilize the power of mean reversion and exposure. So if stocks do really well and bonds do not, you assume this will likely change in the future due to mean reversion. And you make sure to rebalance to have more bonds, when they’re soon next expected to perform better, and you sell some of your stocks before they’re expected to perform worse relatively. So yes, on an asset class basis, I think it makes a lot of sense to rebalance.

Stig Brodersen  39:12

What you specifically addressed here in your question is slightly different, and you might need a slightly different approach because you’re only looking at stocks. And you’re asking why should sell your winners and buy more of your losers. And I agree, that is generally not a good approach. The stock market can be very volatile in the short run, but overall, there’s a reason why some stocks do better than others. So to answer your question about whether you should rebalance, I would say make sure to conduct an intrinsic value assessment of all your stocks once per year, and be very careful not to be emotionally attached. Make a rule with yourself, and then, every two or three years after you buy a stock, if it hasn’t performed well or not as well as you hoped, consider if you’re simply wrong in your assessment of that stock, and you would need to sell it. You would really need a good reason not to. And for the winners, I would suggest that you should not feel shy by adding more to that position. As painful as it might be to buy a stock at $15 that used to cost $10, consider if there’s a good reason why it has jumped 50%, and if it’s still a good investment. Sometimes it is.

Preston Pysh  40:27

So Leon, this is really a tough question. I personally look at rebalancing in two different buckets. So the first thing that I would ask myself: Am I dealing with an ETF? Or am I dealing with an individual company? And if…this is just if we’re talking equities. When dealing with an individual company, it’s kind of complicated because you’re dealing with a current intrinsic value of the company compared to your opportunity cost of owning something else that would give you a higher yield or a higher intrinsic value; IRR. As you’re looking at all these other companies that you could then take that money after you would sell, and then plug it into that other pick. More importantly, it’s the opportunity cost of buying the new company with the higher expected yield after you pay the capital gains tax on the existing pick. For example, one of the reasons Warren Buffett continues to hold so many of his non operational stock picks for decades is because his tax burden to sell the position, and then swap the remaining funds into something else with a high level of confidence that the new pick will outperform the previous pick is difficult and kind of risky to project with a high level of confidence. And he’s dealing with significant capital gains. And he’s also dealing with companies that are often paying enormous dividends compared to the principle that he originally paid to own it.

Preston Pysh  41:43

Now, if you’re dealing with a company that hasn’t really had any gains, then the tax burden is nothing, and the decision becomes much easier. And you can kind of look at it just from an apples to apples comparison without that administrative friction in order to transfer into the new pick. You saw this, oh, I can’t remember the exact timing. But after the 2009 crash; the 2000 and 2009 crash, Buffett took a pretty big position in Exxon Mobil. And then, as the oil prices looked like they were getting ready to drop significantly, Buffett sold his entire position in Exxon Mobil. And you know, a lot of people suggest that Warren, once Warren Buffett buys a company, he rarely sells it. Well, if he doesn’t have high capital gains, he does sell companies. You also saw this with IBM, where his capital gains on these companies were not very, very high. His intrinsic value on what he originally had calculated for the business had changed over that period of time. And so he will sell these companies because there’s not really any type of tax burden.

Preston Pysh  42:44

Now, when you’re talking about ETFs, I would argue these decisions may be even more difficult because you’re dealing with macro themes driving, whether there’s opportunity costs are not. For example, if you had some of your portfolio in the S&P 500, it’s really difficult to have confidence in how much of your portfolio should have exposure to the overall market versus all the other opportunities that are out there. I think correlation, when you’re looking at the correlation of the S&P 500 versus some other ETF or an individual stock pick. Really kind of becomes the point, where you can maybe adjust your sizing inside of your portfolio. Because if things are correlated, it might make more sense, especially if your intrinsic values are kind of similar. So like if the S&P 500 were to be valued today, I would argue you’re around a 3% return to own the S&P 500 is what your expectation should be moving forward. So if you have another stock pick, and it’s also at 3%. Well, you should probably own the S&P 500. So then, it comes down to how correlated is just plowing that capital into the S&P 500; how correlated is that S&P 500 to all your other picks that are inside your portfolio. So that’s kind of how I think through the sizing and the adjustments; the rebalancing of my investments is I’m constantly looking at what do I think it’s worth today versus what do I think my other opportunity costs are? And what do I think that those are gonna get me with respect to an IRR, an internal rate of return calculation as a percentage? And I compare those percentages across the risk-free rate versus all the other investments that I have and how correlated they are.

Preston Pysh  44:24

So Leon for asking such a great question. We have an online course called our Intrinsic Value Course that we’re gonna give you completely for free. Additionally, we have a filtering and momentum tool, which we call TIP Finance. We’re going to give you a year-long subscription to TIP Finance completely for free. Leave us a question at asktheinvestors.com. That’s asktheinvestors.com. If you’re interested in these tools, simply go to our website, theinvestorspodcast.com, and you can see right there in our top level navigation, there’s links to TIP Finance and also the TIP Academy, where you’d find the Intrinsic Value Course.

Stig Brodersen  44:59

All right, guys. There was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 45:06

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