Stig Brodersen 1:13

So Cullen, again, thank you so much for making time to speak with us because on today’s show we’ll debunk different myths in economics and investing. But before we do that, I want to talk to you about a very hot topic these days. I want to talk about this whole discussion about active and passive investing and more funds than ever really invested in so-called passive indexes than ever before. And a lot of people talk about that creating a bubble. But before we talk about that; before we talk about if it’s truly passive, which I know you have an opinion about that, I would like to take a step back and talk about the very basic. So perhaps you can first explain the importance for the investors about the confusion of the term active and passive.

Cullen Roche 2:02

Yeah, I really tried to formulate a foundation for understanding the whole financial world that is very sort of operational in nature and sort of looking at the world through the lens of…like an engineer would look at the way that he might construct a plane, so you understand the basics of, you know, dynamics of flight, and then you can construct whatever you want that will actually achieve the goals that you want. And from a financial perspective, the active versus passive debate, it doesn’t really make a lot of sense. I mean, from, from a strict, I think, industry perspective, the reason these terms exist is pretty simple. They’re basically just marketing BS. I think that the, the passive community created the term passive, so that they could create an opposing side that they could demonize to some degree for marketing purposes. So, when you look at it from a very sort of operational perspective, it doesn’t make a lot of sense to refer to anything as really active versus passive because the reality is that everything we’re doing in investment management involves a certain level of activity. And, you know, this really hit me over the head.

In 2008, I was studying a prospectus. I’m the type of nerd who will go through and actually read a full prospectus from a new ETF, and I’m sitting there reading a prospectus from a new hedge fund ETF. One of the first few pages of it described the fund as a passive index fund, and I was sitting there thinking to myself, “Man, what a load of garbage!” This is a fund that is gonna charge a 3% management fee; has a super active underlying element of it that is invested in a bunch of sort of opaque and very active strategies by any definition; but they’re calling themselves a passive index. And it’s interesting with the rise of ETFs, that they kind of expose this reality that nothing is really passive because an ETF is basically a, it’s a structure that takes an investment strategy and creates its own index. And so by creating its own index, all it does is it tries to track that index.

So an example that your listeners might enjoy is, for instance, let’s say Warren Buffett wanted to start an ETF. He would, I mean, Warren Buffett is by no measure, a passive investor. He’s an active investor by any use of the word. But if he started an ETF, and he created the Warren Buffett index, and he tracked that index, he could technically say that he tracks a passive index. He’s just passively tracking the index that he subjectively created. And in doing so, he would be able to refer to himself technically as a passive investor. And that’s what is happening with a lot of these, these index funds and passive funds. They basically create their own index fund or their own index, and then they track it in what they refer to as a passive way. But then, the actual activity of managing an index fund is highly active. If you look at the what’s going on underneath the surface, when someone goes out and buys for instance, the Vanguard S&P 500 Fund, which, by the way, the S&P 500 is a very active fund. It’s just a subjectively created set of 500 companies in a world of tens of thousands of public companies that are subjectively picked by the S&P indexing committee. But when someone goes out and buys that index, they’re actually–what they’re not seeing under the surface is that there is a huge amount of market-making activity and a lot of action that goes on in the actual underlying management of the fund that investors don’t see.

So one way to think of this is that if you were thinking of the, the end investor; the person with the Vanguard account as the person, who is passive, they actually are enabled by the market makers and Vanguard itself, who is very actively managing the fund itself. And so, when you look at the totality of everything that makes that passive index fund available and workable, there is no one side of the argument. It’s a very two-sided perspective, where you have to understand that the passive investor in that relationship is allowed or able to be passive because there is all of this activity on the other side; the market making in the, the interaction with, you know, building the actual index, and maintaining the index, and rebalancing the index, and this is going on every single minute of every single day in these index funds. These index funds are some of the–some of them are the most active funds in the markets on a daily basis that exists and increasingly so as they grow in popularity. So the distinction is more to me a marketing term for the fund management companies than anything else. And so, it’s, it’s not as black and white as people tend to portray it as.

Preston Pysh 7:29

So, Cullen, I know you’re a big fan of Vanguard’s low-cost ETFs. But with that said, you have some quibbles about the procyclical portfolios, and you’ve gone on the record to talk about the advantages of a counter cyclical approach to control risk. So tell us what this is all about.

Cullen Roche 7:46

Yeah, here I am criticizing marketing terms in the–our industry and I’m probably contributing some, some of the bad stuff to it myself. But no, I–to me, investment management is more than anything else, it is a battle with ourselves. And we are fighting our own behavioral biases every day. We’re bombarded with news and things that are confusing and things that even people in the industry don’t fully understand. And so it’s a constant battle to stay disciplined and really control yourself from being badly behaved, basically. And I think that one of the, the things that can be problematic with the way that a lot of funds are constructed, and in the way that just a lot of investment management strategies are constructed is that they have an inherent degree of risk embedded in them that people don’t fully understand; that doesn’t necessarily control for behavior.

So for instance, let’s take a really simple index fund like a 60/40 fund. A 60/40 stock bond index fund is–it’s actually a much riskier fund than most people realize, and specifically, I mean that it is risky, when you need it to, to really help you control for your bad behavior. And so, a specific example is 2008, where–in 2008, a 60/40 Fund, which Vanguard called their balanced fund might lead somebody to think that they’re invested in a fairly moderate type of risk profile; type of portfolio. When the reality is that roughly 85% of the actual risk or the volatility in that portfolio is coming only from the 60% piece. And that’s because the stock component of that portfolio is just so much more volatile than the 40% bond piece. It’s not really very balanced at all.

So you’re–in terms of where your behavioral risk is coming from, you’re incredibly unbalanced; you’re massively overweight, the stock market. And so, you know, for the last whatever, eight, nine, ten years, 60/40 or any–even a 100% stock index looks like a cakewalk, you know? It’s an easy behavioral ride because it, it’s gone nothing but one directional up. But when the you-know-what hits the fan, and people are exposed to what their real risk profile is; their real risk tolerance, 60/40 exposes them to a 35% drawdown. And for someone who thinks they’re a moderate type of risk profile, that’s one hell of a big drawdown to go through. And that will really test people.

I mean, I had a–the moment where that hit me was also 2008, 2009, where I had a client, who was invested in that–in the Vanguard balance fund, and he called me up, and he said, “This is killing me–to be invested in a fund that seems to me to be a moderate risk profile and feels extremely risky,” and he couldn’t take it. So the behavioral risk was really outsized in a moment, where he needed behavioral control and some discipline in the portfolio to reduce the amount of behavioral risk that he was exposed to. And so, the result or the cause of that is the fact that the stock market is inherently procyclical. The stock market is not really–if you build a stock portfolio, I mean, in a–even in a 60/40, and you just let it ride, your portfolio will always grow to become increasingly exposed to the stock market.

So, Vanguard, interestingly 60/40 is actually a somewhat counter cyclical portfolio in that 60/40 in a good year like this year, for instance. 60/40 grows into whatever like 75/25 or something like that. And Vanguard actually rebalances it back to 60/40. So they’re actually implementing an element of a counter cyclical like rebalancing methodology intheir portfolio, which I would argue that helps control for risk. Certainly more so than just letting it ride and letting it become the, the market cap weighted portfolio that it would inevitably become, which would be increasingly exposed to the stock market. But there’s a lot of people out there, who I would argue need an even greater degree of counter cyclical management in controlling their behavioral risks in the portfolio. And so that’s why I have become a big advocate of, of what I call counter cyclical indexing because I believe that it just better controls for behavioral risk. By being better behaved consistently, you reduce the risk for big, big mistakes. And in doing so, I think for a lot of people, you actually increase your average annual return over long periods of time because you don’t make the big mistakes that result in really catastrophic downside.

Stig Brodersen 13:04

You know, it’s very interesting you would say that because we had you on the show here back on, in 2015. That was Episode 60. And I would ust want to say it definitely won’t be another four years before we bring your back on, but it’s crazy how time flies, but–

Cullen Roche 13:21

All right, I, I know people that–people don’t want to hear from me too often.

Stig Brodersen 13:25

Back then, you know, I, I really listened to that episode, whenever I was doing the, the research for this episode. And we talked about, you know, economic modeling. And it really made me think of this question that I wanted to ask to you. So perhaps, first, if you can talk about how you make models that reflects the economic realities, and then in turn, how has it changed, perhaps just over the past four years? Because I remember even back then; back in 2015, we were, we were looking at each other, and said, “Hmm, it’s not like we find a lot of cheap stocks right now,” so, so I’m very curious to hear your response to that.

Cullen Roche 14:05

Yeah! Well, I, I think that’s one of the things that has made at least value investing so difficult for so long is that by almost any metric, stocks have been overvalued for years. And this isn’t that unusual of an environment. And we could have had the same exact conversation in, you know, the mid 90s, and then, the late 90s, and even the early 2000s. And people, you know, would have been saying that the stock market was overvalued. And that’s just the way that bull markets tend to work. The stock market gets overvalued, and it stays overvalued. And my view on the, the stock market is that I actually, you know, I’m not even a–I’m not a big stock picker in part because I don’t think it’s really possible to decipher where the risks are in the stock market, specifically. I mean in terms of looking at like industries or even segments; I mean, looking at like global index funds. I’m, I’m not a big believer in the idea that even anyone can pick, where the best stocks around the world will perform at a, at an indexing level.

Alot of people like to cherry pick the United States, but, you know, we can go through long cycles, where United States under performs. You saw that in the the early 2000s, and whatnot, when Europe massively outperformed United States. So the way I view the economy is very similar to the way that I view the financial world, and that I try to look at the, the most procyclical elements of the the macro economy. And the reason I look at the most procyclical elements of the macro economy, and I’m referring to things like, I mean, if you look at things like the, the yield curve, and unemployment rates, and these sort of big macro indicators that tend to…they tend to change somewhat predictably over the course of an economic cycle, and they tend to be highly procyclical. And the reason that that’s valuable to look at is because the big bus in any economic cycle tend to actually come from wherever the big booms are. So if you can to some degree identify where a big boom is, you can begin to then can kind of compartmentalize and mitigate the risks that you might be exposed to in the future. And this is a, I, I guess, it’s kind of the antithesis of momentum investing or something like that. But it’s more for me, again, it’s kind of coming back to that behavioral control element. It’s not necessarily trying to predict exactly where the risks are in the future. But identifying, you know, where their sort of frothiness is and trying to control for potential risks ’cause you never really know where the big blow ups are gonna come from.

If you can mitigate and try to control for potential risks, then you can reduce your potential exposure to the behavioral risks that will arise when a big blow up does occur. And that’s why I think it’s valuable to look at places, where there have been, been big, big booms in an economy because that’s almost always where the big bust end up coming from. So the–you know a lot of people look at the financial crisis, and you know, they think it was like a regulatory problem or just Wall Street doing a bunch of funny stuff. And that was all probably played a, a role. But at the end of the day, the financial crisis was really about people bidding up home prices. People bid up home prices in an unsustainable way that resulted in a big bust that when the prices fell, it just reverberated through everything. It reverberated through the economy; through the construction section of the economy; through people get unemployed, and then when people start getting unemployed, it, it multiplies through Wall Street and the–all the products that were leveraged related to the prices of homes, and unemployment, and all this stuff. It all kind of starts to fall apart. And so the, the seeds of a bust are really planted in a boom. And so, if you can kind of understand the degree to which a, an economy is exposed to procyclical elements, you can understand where the potential risks are. And you know, one of the really weird things about this economic cycle is that there really hasn’t been a huge boom anywhere. It’s been this sort of malaise almost across most of the economy.

There’s been, I think sort of segments maybe, where there’s certain real estate markets that have certainly gotten out of control, I think, like places like San Francisco are probably way riskier than they otherwise would be. A lot of the Pacific Northwest is similar. So there’s localized kind of frothiness in certain real estate markets, and, and even pockets of like you could argue that the, the WeWork blow up, and some of this venture capital stuff is, is evidence of a fair degree of frothiness in some of the venture capital funding and things like that. But in general, there hasn’t been anything that looks like, certainly not like a 2006, 2007 type of, of economic environment, where you have this really big procyclical boom in some segment of the economy that could cause a big, big blow up. It’s strange. You have, you obviously have the financial markets, where the financial markets have done really well. Or at least the, you know, I should say, the United States financial markets have done really well. The global stock market has not done nearly well. And even from a valuation perspective is–the international markets are much more attractive. It’s strange because you have this really long late cycle occurring in US stocks, and you have a really, I think, limited macro economic downside risk coming from where the way the economy has performed. So it’s like always, it’s just a difficult thing to, I think, analyze. But to me, you come back to the stock boom. The–even without necessarily trying to predict where the next recession or where the next big bust is gonna come from, I think you still have to look at the stock market from a valuation perspective, and view it as a value investor because it’s the only reliable way to try to control for risks in your equity piece because the, the evidence is pretty clear.

When valuations are high; when the stock market does really, really well, for a long period of time, it tends to in the future generate lower risk adjusted returns. And so, it doesn’t necessarily mean that when valuations are high that the stock market has to do both through a 2008 or some sort of big crisis, but it means that the amount of risk you have to take to earn the same unit of return. People, especially, in today’s environment, I think they feel almost trapped into feeling like they have to pile into the stock market because the, the bond market maybe isn’t providing the returns that they have become accustomed to, or you know, interest rates just are too low to provide people with the income that they need. And so, they feel like they have to take more risk than they’re, they’re comfortable with. And I think you have to be, I think you have to be careful of that type of mentality of chasing the stock market really late in a market cycle just because you feel like it’s the only place to be.

Stig Brodersen 21:45

You know, I think that’s a very good segue into the next segment of the show here because on pragcap.com, you’re writing these fantastic blog posts, and this is a blog we’ve been syndicating for years on the site, whenever we had syndication up and running. But one of my favorite sections is your myth-busting section. So what I would like to do for the rest of this episode is to go through a number of the myths that you debunk. And to do that together with you because one of my favorites really relates to what you just said before, and it’s, it’s about how we as investors, we just have this perceived need to be beating the market. You know, that’s, that’s what we hear all the time, you know? You should beat the market or you should go passive, and as we established whatever passive might mean. So I guess that’s the first of the myths that, that I would like to talk about–investors beating the market.

Cullen Roche 22:40

It’s funny, I mean, I, I view the world probably more like a, a financial planner, when I sit down with somebody and talk to them about their portfolio because I try to view money and financial asset management for what it is, which is something that’s very, very personal. And most people at a very sort of personalized planning level, they just have no need to try to beat the market. And in fact, I think that most people, who end up trying to beat the market, what they really end up doing is they end up taking a lot of behavioral risk that actually creates the potential for exposure that they’ll, they’ll behave poorly, which will result in actually lower returns going forward if they do behave badly.

If you sat down with a CFP though, or a financial planner, they would never say, “Our goal is to beat the market.” They would say, “Okay, what is your target return? What is your risk profile? And how can we create a portfolio that’s going to meet your financial goals, whatever those are?” Whether it’s, you know, a retiree who has a 4% withdrawal rate and needs, you know, maybe they need a 4 1/2 or 5% type of return to sort of maintain, or you know, reduce the amount of principal reduction that’s gonna go on in the future. I know everybody would like to generate, you know, 8%, 10%, 20%, whatever. Obviously, we’re all trying to maximize the amount of return. But I think that you have to be careful in trying to beat the market because it does expose you to that behavior risk, and it creates this inconsistency with people’s financial goals. And my view of the–especially of the secondary markets is that secondary markets, and when I refer to secondary markets, I mean the stock market and places, where stocks are basically just exchanged. The stock market to me is a place, where people allocate their savings, and it generates a return that is a function of the primary market.

So for instance, when you buy ExxonMobil stock. Exxon, you’re not funding Exxon’s operations or you’re, you’re not really impacting Exxon’s operations in any meaningful way. But the return that you’re going to generate from Exxon’s stock is a function of what they due on the primary market, so you, you see this a lot I’ve been really critical of some of these ESG funds, the more like socially responsible type of investing strategies because the place to impact a corporation is not on the secondary market. They’re not funding their operations from the secondary markets. And so, if you don’t like what Exxon does, you should stop buying Exxon gas. That’s where you make an impact on their business that will filter through to the way that the secondary market then prices their stock, but boycotting the stock really has no impact. So, you know, people tend to have this sort of, I think misunderstanding of the, the relationship between primary markets and secondary markets. And secondary markets are where we just allocate our savings. It’s where we, we all go about and exchange stocks and bonds to allocate our savings. And most people just they have no reason to try to beat the market on a secondary market because A in the aggregate they can’t, and B from a planning perspective, it creates more inconsistencies with your risk profile and your behavioral management of the portfolio than anything else.

Preston Pysh 26:14

So, Cullen, there’s a lot of people saying gold is the place to be these days. Although Stig and I have our own personal opinions on the matter, we really like to hear alternative points of view, so our audience can decide for themselves what kind of approach they want to take themselves. So with that said, let’s hear your point of view on gold.

Cullen Roche 26:32

Yeah, this is, I know, this is a controversial one. So, to me, I think the problem that I see with framing gold as a portfolio hedge is that if you actually look at the amount of volatility involved in gold over the course of, of its entire history really, it’s an incredibly volatile asset, and so it has no consistent history of necessarily providing you with a good hedge in crisis periods. So I think the problem with gold is not necessarily that gold is bad. It’s that in a relative sense, there are other assets that better protect you in specific environments. And so for instance, a lot of people say that gold is a, is the ideal inflation hedge. And that’s actually interesting because I would argue that the stock market is, is actually a much better inflation hedge than the gold market is because the stock market provides you with a much more consistent inflation adjusted return that in periods of a big boom, especially, when the economy is expanding and inflation is rising. The stock market tends to perform really well in those environments; very consistently, much more consistently so than the gold does. And so from a risk adjusted basis, the stock market is actually a great, great inflation hedge.

You even see this in a lot of cases of hyperinflation. The asset that actually performs the very best is a local currency stock market. Venezuela just saw this. Venezuela stock market went bonkers in the recent hyperinflation. So the stock market is oftentimes more consistently, the much more reliable risk adjusted hedge for inflation than something like gold is. So yeah, so in periods of economic turmoil, where there’s a high degree of uncertainty and potential for recession risk, the bond market is actually the–and specifically, the treasury bond market is the market that tends to perform the best because it is the–in a world of financial assets that are limited, the treasury bond market ends up being the market that everybody wants to hold in a, in a crisis environment because it’s the highest quality asset in the world, and that’s, you know, a lot of people get this one wrong because they, I think, have a perceived political bias. But the, the simple reality is that the reason treasury bonds are such a good hedge in periods of crisis is simply because the US government issues this liability that is attached to the biggest income stream in the entire world. And that’s a function of just the US private sector being the most profitable, most productive economy in the world. And the US government just happens to be the entity that can tax all of that income. So when the sort of turmoil starts to rise up, people will fluctuate towards treasury bonds because treasury bonds are secured by this massive private sector income stream that people trust and believe is reliable in the future.

And so, you see this in any period, where really the stock market starts to go through a lot of turmoil. Treasury bonds tend to perform really well. You saw it last December during the big trade downturn; you saw it in in 2008. Treasury bonds are up, you know, 25-30% day year. So, you know, when you look at relative portfolio hedges I would it’s not necessarily that gold is so bad, it’s that I just believe there are better hedges in specific environments. And so in inflation, I would argue the stock market is superior. And in a crisis period, where you really need a behavioral hedge, treasury bonds and really high quality bonds in general, tend to be a superior downside hedge than gold; a more reliable downside hedge. So, you know, I don’t want to, I don’t want to beat up on gold too much. And there’s also, there’s a fair amount of evidence that adding in a third, you know, portfolio element there with gold is perfectly fine. And I’m not going to bad mouth anybody, who adds more and more diversification to their portfolio with something like gold and non financial assets. But to me, understanding that bonds and stocks have specific sort of risk management structures for specific environments is important, and they’re, they tend to be superior in terms of inflation hedging and downside hedging than gold is in those specific environments.

Stig Brodersen 31:09

So this is probably one of the favorite myths that you have in there that you debunk here because you have this, where you say, “More information will give me an immediate advantage.” You know, that’s how a lot of people are looking at it. But could you please elaborate on why you want to debunk that myth?

Cullen Roche 31:27

I run into an endless number of people, who they have watched something on the financial media, CNBC, or Bloomberg, or mainstream media about what’s going on in the financial world, and something that sounds really scary, or sounds like a big risk. And people have this tendency to think that the more financial news they watch, the better informed they’ll be, and the better they’ll be able to manage their risks. And the reality that I often find for people is that watching financial TV and exposing yourself to these persistent narratives creates a lot of behavioral risk. And they create the urgency to, to need to do something, and change something, and act, and try to control for something that you probably can’t control for or predict in the first place. And so, it creates this big conflict of interest, where the financial media is incentivized to, I think, rile people up; to incite emotion, and get people to feel like they need to keep watching more; that they need to, you know, keep tuning into, so that they can be prepared in case the big one comes. And the reality is that for the most part, the financial markets are really boring. And there just isn’t a lot of big exciting things going on. And it probably isn’t even worth having, you know, a daily full time 24/7 running financial TV show about any of this stuff.

That’s the narrative that were sold, and people pay attention to this. And in doing so, they end up creating a lot of behavioral risks for their own portfolio that expose them to the potential that they’re gonna perform poorly because they’re just behaving badly. They’re overreacting to things that really just aren’t that important. And so, I’m not a big believer in the idea that people should just, you know, not pay attention at all. But I think you need to be mindful of the reality that it’s fine to be informed. In fact, I would, I mean, I pay attention to the financial markets all day, every day. But I probably act on, I don’t know, not even 1% of the things that I actually hear about going on, on any monthly or, or daily basis. And I think that that’s where it’s important to, to build some balance in the way that you consume financial media, but don’t feel prone to overreact to everything that is going on. So it’s fine to be informed; it’s important to be informed. But that information won’t necessarily help you react to all of the little changes that are going on. So it’s, it’s important to understand that more information is not necessarily giving you better information. It’s just giving you more information. And so, you don’t–shouldn’t feel the need to react more just because you’re listening to more information.

Stig Brodersen 34:27

We’ve talked about myth busting in regards to investing. And now, I’d like to talk about myth busting in economics. But before we do that, perhaps we need to take a step back, and, and really geek it out here because there is actually the difference between economics and investing. And it is also important to know that difference, so a lot of people seems to be using these terms interchangeable. You know, that’s something with money. Could you talk to us about that first? So what’s, what’s the difference? And then, we can go in and debunk some of the myths about economics.

Cullen Roche 35:01

There’s so much overlap in finance and economics. And at the same time though, the financial markets are not the economy. So a lot of people tend to look at these things as sort of interchangeable. And the reality is that there’s, there’s big, big differences between the financial markets, and, and what the economy is doing. And you see this now with the way the stock market is performing versus the US economy. The US stock market has really boomed in the last 10 years, whereas the economy has sort of been in this big malaise for the most part, and, and a lot of that, to me, is, is understanding that the financial markets, they can perform in certain ways because mainly–because certain segments of that financial market do really well.

So, for instance, in the last 10 years, the majority of the outperformance of US stocks has come specifically from the tech sector. So the tech sector has done really well. And you see this, again, this is going back to San Francisco. This is consistent in the way that you see San Francisco real estate prices going, and the venture capital market going. You had a segment of the US economy that has done really, really well. But on the whole, the US economy has not done that. Well. And that’s really the, I think, the key to understand is that the financial markets are made up of these kind of smaller components of the macro economy, and you can have a macro economy that is just doing okay, and a financial market that is doing really well related to that economy because a component of that economy is doing really well. And people have a tendency to conflate the two, and, and think of the two as being the same thing, and they’re not!

It’s helpful to understand this both from a macro economic perspective, but then kind of, you know, really narrow down and hammer into: Why does a macro market like the S&P 500 looks so good? And the reality is, well, the reason it looks so good is in large part because a very micro piece of it has performed really, really well. And so, that makes the whole thing look good. But in the grand scheme of things, the reality is that the whole thing hasn’t performed that great. It’s just that the performance of it is due to some degree because of an outlier. And that tends to be just the way the stock market works. The vast majority of the stock markets performance tends to come from a smaller section of it, but people have this, I think, tendency to to then confuse that with the way the macro economy is, is performing or more so today, you see people arguing that the stock market just–it has to be on the verge of a collapse because the economy just isn’t performing that well. And that’s, that’s just not necessarily true. That, that one section of the stock market might be exposing you to a lot more risk, but it doesn’t necessarily mean that the, the whole thing is necessarily exposing you to a huge amount of risk.

So I think it’s more important to look at these things from a global perspective. I mean, getting outside of the United States, for instance, these days is important because the global economy is also pretty weak. And the, the global stock market, I think better reflects the state of the global economy than what you see in the United States, where you see basically a big tech boom that is driving the outperformance of US stocks and generating a huge amount of out performance. And creating this illusion that the US economy and the US–that all of corporate America is performing really well, when the reality is that a lot more localized than people think. So it’s useful to differentiate between the two because the stock market is not the economy.

Stig Brodersen 38:57

That’s a good point you bring up and continue talking about myth busting in economics, one of the myths that you debunk is the government printing money. Could you please explain the reason for this misconception? Because it’s something that we often hear like now the government has printed a trillion dollars, or whatever that number might be. How should we think about that?

Cullen Roche 39:19

Well, this one’s hard to communicate sometimes. The government literally does print the money that–the physical money that we have in our wallets. But I, you know, again, going back to kind of a first principles type of thinking on this, and more thinking of the world of finance from a, an operational perspective. Who really creates most of the financial assets that we use on a daily basis to pay for things? So when I go out and I get a loan. A loan will create a deposit. The bank expands its balance sheet. It, it creates both a loan asset for itself, which is a liability for me. And it creates a deposit asset for me, which is a liability for the bank. And so it expands its balance sheet, and it applies some interest rate to that. That’s how the bank is going to make money on the loan going forward. But the important point is that, that deposit is money in every sense of the word, and that I can take that deposit anywhere to almost any store via credit card or debit card, and I can buy almost anything in the US economy with that deposit. And this is the way that most of the money is created in our economy.

The interesting thing about physical cash is that–and this is true of most of the money that the government creates. I refer to this in some historical academic papers; refer to the two different forms of money as “inside money” and “outside money.” Inside money is the money that we all use on a daily basis for the most part. It is the money that is created inside the private sector, so primarily by banks. Banks create inside money in the form of bank deposits. The government creates outside money. Outside money is money that’s created outside the private sector, mostly in the forms of cash and coins. And the important thing to understand about that relationship is that the outside money, the cash and coins, they mostly facilitate the use of the inside money. So how does anybody get physical cash or coin these days, you need to have a bank account. That money came from somewhere. I know most people get their cash from another person probably. But from a first principles perspective, that money all filters through the banking system. So you need to have a bank deposit before somebody withdraws the cash, and then starts to distribute it into the economy. So the real money creators are the banks, and the government mostly just facilitates the use of the deposit system for the rest of us.

This is true even of the the interbank system. You want to get more nerdy and wonky about this, the, the other big type of money that banks or that the government creates is outside money is bank reserves. And you hear about this a lot these days with the, the kind of repo crisis that everybody’s talking about. The Federal Reserve is creating reserves because the banking system uses its own banking system. And that’s what the interbank reserve system is. So you can think of the deposit system that we all use is the inside private sector bank system for us. And then, the banking system uses its own banking system, which is basically the, the Federal Reserve System, and their deposits inside of that system are federal reserves. So literally, the reserves that they use are the deposits that the banks use themselves. And so, that’s the other side of the outside money component. But again, all of the reserves that exist, they only exist to facilitate the use of the banking system.

So all of this forms of outside money, I like to think of them as being–they’re just facilitating forms of money. They help the private banking system operate the payment system that it’s in the business of operating on a daily basis. And so the government doesn’t really print money in the sense of creating the money that we really use. Really, the printing of the money occurs when banks create loans and create deposits. And the government mostly just prints money that facilitates the use of a bank account. So people like to talk about, you know, the Federal Reserve, you know, printing money and doing QE and really, all of that is tangential to the reality of where the real money creation comes from, which is mostly through the deposit system. And I think that, you know, an interesting related topic to this is the, the fact that there hasn’t been a lot of inflation despite all of this supposed money printing. And the, the reason why that is is because if you look at data on lending and whatnot, there just hasn’t been a lot of the real money printing.

There hasn’t been a lot of banks making loans to the degree that they historically have. And so, you’ve that’s contributed to this low level of inflation. Because no matter how much the government tries to facilitate and improve the banking system, they don’t directly control the quantity of loans that are made. They can’t force banks to make loans. And so, it’s another related myth here that the government controls the money supply, or the Fed controls the money supply through a money multiplier process. That if they, they add reserves, the banks will then lend out those reserves, and–you know, banks can’t even lend out reserves in the first place except to one another because the reserve system is a closed system. But the government doesn’t control the actual quantity of money that is printed in the banking system, and–because they can’t control the quantity of, of loans that are made. And so that’s one of the main reasons why we haven’t seen a high inflation is because despite the government doing all these things to facilitate the banking system, it hasn’t translated into real money printing, which is lending in essence.

Preston Pysh 45:13

So Cullen, you have a take on sovereign debt that’s quite different than my own personal opinions. You have the opinion that the expanding fiscal deficit is not as big of a deal that everyone’s making it out to be. I’d really like for you to describe to our audience your point of view on this one.

Cullen Roche 45:29

Yeah. So from an aggregate perspective, it’s useful to look at all of the sectors in the economy and understand that, actually, in the long run, nobody pays back their debts. So it’s kind of a big fallacy of composition. I might pay back my some of my debts on a monthly basis. But in the aggregate over the long term, the amount of debt that is outstanding will tend to only grow across the entire segment of the economy because the population is growing; economic activity is increasing. People are just they’re taking out more loans to do more things on a monthly and annual basis almost every year for all of modern financial history. And so, you see this persistent growth in the amount of debt that is, is in the economy at an aggregate level because nobody, I mean, the household sector, for instance, cannot in the aggregate pay back its debts. That would mean literally writing down not only all of the liabilities in the economy, it would mean writing down all of the financial assets in the economy. And that’s the, the other kind of misunderstanding with all of this is that again, when a bank creates a new loan, they’re not just creating a liability, you know?

People who say; they use the term, debt, in mainly a sort of pejorative or negative way. And the reality is that, that is neither necessarily good nor bad. Debt can be good or it can be bad. And because it creates an asset and a liability, it’s more so about how people use those assets. You know, so for instance, if I borrowed a million dollars tomorrow to create some sort of world changing technology I have created from a lending perspective just an asset and a liability with an interest rate. And then, I used that asset to then go out and create this enormously socially valuable asset that will actually add net financial assets. It will add net wealth to our economy in the aggregate; in the long run. That’s a good thing. That’s not–there’s lots of examples of people just sort of frivolously, you know, spending on credit cards on nonsense and things like that. And that’s not necessarily the best type of debt to have. But it’s an error of composition to argue that debt is necessarily always bad or that it has to go down at some point and be paid back because the reality is that in the long run, we want debt to go on. We want people to borrow, and do good things, and grow the economy, and take out loans, and expand that money supply because they’re doing great things. They’re doing innovative things that will help us grow in the long run and improve the living standards that we’re all experiencing around the world. And at the government level, I tend to view the government as just sort of a function of the size of its private sector to a large degree.

I mean, the reason the US government is so big, it’s not because the US government is, is some sort of, you know, great entity or this, you know, behemoth all in and of itself, it’s in large part large because it’s attached to this humongous and complex private sector. And it’s servicing that private sector as it grows. And the tendency will be that the more the private sector grows, the more complex the needs of that private sector become. And so, you end up getting a government that services that private sector more and more so. So, you know, but again, going back to the paying back of the debts, it’s the same basic thing with the government. In order for the government to pay back its debts, you’d have to write down all of the assets that the government has basically issued. So you’re not just eliminating the liabilities, again, you’re eliminating all of the assets. And that would be the equivalent of, you know, in the government’s case, you’re writing down a lot of pension plans, and treasury bonds, and savings accounts, and programs that, that might be actually a bad idea to wind down and, you know, to kind of caveat that I’m not a huge fan of an ever growing government or anything like that. I don’t want to give people that impression. I actually think there’s a, a lot of segments of the US government that could be substantially reduced, and there’s probably a lot of areas, where they just have no business being involved in the things that they’re, they’re involved in. So there are certainly sections of it that could probably be wound down and technically paid back. But in the aggregate, the US government is never going to pay back all of its debts because it literally cannot because there are components of it that just economically cannot be reduced to zero, which is the equivalent of what people are saying, when they say we need to pay back the national debt.

Stig Brodersen 50:17

All right. Thank you so much, Cullen, for coming here on the show to speak with Preston me. It’s always highly educational to speak with you, and I hope that it won’t be another–wow, this comes out in 2020. I hope it won’t be another five years before we bring you on again.

Cullen Roche 50:34

Yeah, me too! Will try to do–let’s schedule something in three years this time. I love the show. I hope that I can get on, you know, more frequently. So, I love what you guys are doing and I appreciate you having me on.

Stig Brodersen 50:48

Thank you so much for saying that. So for this segment of the show, we play a question from the audience. And this question comes from Harrison.

Harrison 50:57

Hi, guys! Harrison here from Melbourne, Australia. Longtime listener, first-time caller. I have a question about using leverage to improve returns and relatively safe, well diversified index funds or ETFs. In what ways can this be done? And what are the associated risks given a long term time horizon of say, 20 or 30 years? Cheers, guys!

Stig Brodersen 51:19

So, Harrison, I really like the question because what we’re taught about the stock market is that it generally always go up, which is not surprising given that over the last 55 years, world GDP growth has been positive, 51 of those years. So if we think that the stock market will go up say, 10% annually, just like it has done from 1900 to 2000. Why not say double or triple that return with a leveraged ETF? Unfortunately, that is not how leveraged ETFs work. They are not set up for long-term investors, but short-term investors. So if you want to speculate in what the S&P 500 does the next day, a leveraged ETF can be a very effective way if you’re right. But there are several problems with this approach.

First of all, you shouldn’t really speculate at any time. And what the market does short term is highly unpredictable. And another thing is that just as you gain more if the stock market is moving in your favor, it also punish you really, really hard if it goes against you. Also consider that leveraged ETFs are very expensive, often around 1% in expense ratio, which comes right out of your pocket as an investor. And one of the reasons it’s expensive is that it uses a combination of swaps and derivatives to get that leveraged exposure, which is just very expensive to acquire. I would highly discourage you to use leverage, whenever you invest in ETFs. And if you are, which I again, do not suggest that you do.

A better approach is to buy a traditional ETF and buy it on margin, meaning that you borrow against the value of the ETF that can in theory work short to medium basis. But over years as a long position, it’s not sustainable, when the market tanks, and you will get called on, meaning that you’ll be forced to sell your position at just the wrong time, unless you can back up your position with cash, which defeats the entire purpose of using leverage in the first place. That being said, as much as we can come up with exceptions to using leverage position as hatching and short-term bets. I really think it’s the wrong question to ask. And again, I would really for the fourth or fifth time discourage any of our listeners to go that route. You need to know exactly what you’re doing. And even if you do, the emotional biases with using leverage in stock investing will exponentially make it more difficult to manage your portfolio.

Preston Pysh 53:56

All right, so Harrison, one of two things is probably going on right now for you. You’ve either got a really good idea or you’re just being a little impatient, and you’re trying to, to make some returns. And I’m speaking–I’m saying that because I’ve been in your same shoes, and I’ve done the same things. And I’ve experienced this–the pain that Stig’s talking about. And so, it’s, it’s interesting that you bring this question up because I think there’s a lot of people, probably in our audience that have asked themselves the same thing and that have maybe even participated in some leveraged ETFs.

So here’s what I’ll tell you. Sometimes you have great ideas, and sometimes you just want to kind of lever up on those ideas in order to maximize returns, and that’s perfectly fine, and perfectly acceptable. I do it. I would tell you the better vehicle for doing that is not a levered ETF, though. So what you can do, and the best way that I found to kind of leverage a position, and not have so much administrative friction eating away at your capital, which is how I view a levered ETF. I look at leaps; I look at options, long-term options like two-year options, in order to put on those positions because I don’t feel like I get so much administrative friction.

Let me define that for you. So when you do a levered ETF, Stig mentioned the fee. But the other part of that that really chews away at your capital is volatility. So if you put on a–let’s just say you buy an S&P 500; levered ETF. It’s a three X or two X ETF. When that–when let’s just say there’s a lot of volatility in the S&P 500 even though there, there hasn’t been that much volatility to date, but let’s just say that that position has volatility to it. What happens is, is as the managers of that ETF are rebalancing that position, that volatility really chews away at its ability to go two X to the underlying security. So, let’s just say that the S&P 500; went up 10%. But there was a ton of chop in it going up 10%, meaning a lot of volatility going up 10%. Your–let’s just say you’re in a two X S&P 500 ETF, I would highly doubt you’re going to see that thing at 20%. If it went through a lot of volatility to get up; if the underlying took a lot of volatility to get up to 10%. So the future’s and all the things that they’re doing in order to manage that levered position takes a lot of frictional cost, and that is reflected in the fact that it doesn’t actually get to 20%. It might get to 18%, and you’re paying for that.

So what I would suggest if you really, really want to lever a position, which Stig and I really don’t recommend for people to do, but I know people are going to do it anyway. So this is how I would tell you is probably a better way to go about it is through an option. Just go out, buy an option, and I would suggest a long-term option. In fact, I would tell you, and I would highly suggest that you go read Joel Greenblatt’s book, and the name of the book is, You Can Be a Stock Market Genius. And Joel Greenblatt is a highly, highly accomplished investor for people that are not familiar with him, I would say his his net worth is hundreds of millions of dollars, in–probably close to a billion dollars. And he is brilliant, absolutely brilliant. I forget what his returns were with his Gotham fund that he ran for more than a decade, but I know that they were in, in excess of 20%. I actually want to say they’re around 30%. They were extremely high. But anyway, in this book, he talks about his opinions on options.

Particularly Chapter Six in the book is where I would focus, and what he talks about, and I remember some rules very clearly from this book. Rule one for, for Joel was: Don’t mess with anything other than a call option. And I have kept this rule for myself for years. If I’m going to do an option, I pretty much only do call options. And he talks about the reasons why in the book. The other thing that, that he talks about in the book is your position size for your total portfolio, so let’s say you have $1,000 in your portfolio, your options should not be more than–your, your entire options that you own should not be more than 15% of that entire portfolio. So if, if you have $1,000, you shouldn’t have more than $150 invested in call options leaps, which are the two-year long-term options. So that would be my recommendation. If you’re interested in getting your hands into something that gives you a levered position, so that you can put a little bit of capital forward, and have a huge massive return. But you got to realize that anytime you’re dealing with options that if they–whatever you put, put at the money, if it closes out below that, you’re going to lose everything. I think the way that you manage that risk is you take smaller position sizes with the call options than you would with the levered ETF.

Let me close by saying you probably shouldn’t be doing any of this stuff because they, they most often are the result of being impatient opposed to having a super really, really high probability idea. All right, so Harrison for asking such a great question, we’re going to give you free access to our Intrinsic Value Course. For anyone wanting to check out the course, go to tipintrinsicvalue.com. That’s tipintrinsicvalue.com. The course also comes with access to our TIP Finance tool, which helps you find and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to asktheinvestors.com, and you can record your question there. If it gets played on the show, you get bunch of free and valuable stuff.

Stig Brodersen 1:00:02

For you guys out there, that was all that Preston I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 1:00:10

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