Episode #1: Global Asset Allocation – Investing 101

Episode #1: Global Asset Allocation – Investing 101

 

Guest: This inaugural episode features just host, Meb Faber.

Date: 6/7/16     |     Run-Time: 39:47

Topics: On this first-ever podcast, Meb provides listeners with a bit about himself and answers the question “What in the world am I doing starting a podcast?” (After all, he is a self-professed former “glorified ski bum.”) He then discusses a broad investing framework – a global asset allocation model – that serves as a helpful starting point for the shows to come. Next, Meb discusses the portfolio returns of a handful of the smartest, most respected fund managers in the world today. Which portfolio allocation has performed the best over the last several decades? The answer is going to surprise you. And while we’re asking questions, why did Charlie Munger (Warren Buffett’s business partner) say “the investment-management business in insane?” That answer, and far more, on Episode 1 of The Meb Faber Show.

Comments or suggestions? Email us Feedback@TheMebFaberShow.com

Links from the Episode:

Running Segment: “Things I find beautiful, useful or downright magical”:

Transcript of Episode 1:

Welcome Message: Welcome to the Meb Faber show! Where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas. All to help you grow wealthier and wiser. Better investing starts here…

Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management of its affiliates. For more information, visit cambriainvestments.com.

Sponsor Message: Today’s podcast is sponsored by The Idea Farm. Do you want the same investing edge as the pros? The Idea Farm gives small investors the same market research usually reserved for only the world’s largest institutions, funds, and money managers. These are reports from some of the most respected research shops in investing. Many of them cost thousands and are only available to institutions or investment professionals but now they’re yours with the Idea Farm subscription. Are you ready for an investing edge? Visit theideafarm.com to learn more.

Meb: Welcome to the show everyone! I’m Meb Faber and thank you for joining us on our very first podcast. What in the world am I doing starting a podcast particularly on investing? There’s lot of wonderful podcast out there already. Michael Covel’s Trend Following, and Barry Ritholtz’s Masters in Business do a great job already of this but I’m also reminded of a quote by LBJ on our topic which is, “Making a speech on economics is a lot like pissing down your leg. It seems hot to you but it never does to anyone else.” And for younger readers by the way, LBJ is not Lebron James but a former president.

So what are we talking about here that’s unique or interesting, and making it worth listening to? Well first, the focus of the show is gonna be three-fold and this will imagine…this would change a bit over time as we get our sea legs under us, but the first topic will be me riffing on ideas in research where it may be a speech I’ve given recently or a topic that a lot is lost with the written word. For those who aren’t familiar, I write an investment blog. It has over 1,500 articles. We’ve done about 10 white papers and five books, but even then a lot of the context is lost. A lot of the stories, a lot of the off-shoots of what we may want to talk about, and a lot of…or the speeches I give they don’t record them.

So one, that’s going to be me simply riffing on a research idea or topic, Two will be more of the traditional interview format. Although a little less interview style and maybe a little more maybe fire side chat with Meb or perhaps Beers with Meb format or it’s just chatting with the person or a group of people about some investing ideas. Lastly, I would like to do a little Q and A mail bag. So think of the investing radio shows where people can email in, ask questions, we’ll read them aloud and talk about those. As we learn this process, and I’m sure there’s going to be some bumps, please shoot us an email. We’d love to hear feedbacks, suggestions and particularly Q and A for the mailbag. Email address is feedback@themebfabershow.com.

For a quick background, I know most of our early listeners will be familiar with us through the blog or various social media, but a quick background on me. Grew up on Colorado and in North Carolina whence I stay home before going to college at the University of Virginia where I studied biology and engineering. I was always pretty terrible at the lab though and so my first job coming out of college was a biotech stock analyst. Really my two favorite loves at the time and this was a really cool time. This was in the 2000s when not only you had that internet stock bubble, but you also you have the biotech sequencing of the genome and biotech stock bubble as well. So it was pretty interesting as well as fun time and after that the one year off for grad school became two. They moved out to the west coast to San Francisco and then on to Lake Tahoe. I was a bit of a glorified ski bum and then moved down to Los Angeles where my one year experiment for living in LA became 10, and started Cambria Investment Management in 2006.

So after that background what we’re going to talk about today? So today is the topic of a recent book we published, but it really lays the foundation for a lot of the podcast to follow. So it’s really important when you think about investing or really any topic that you have a good foundation to which to grow from. So a lot of what we’re going to talk about today is actually in our fourth book called, “Global Asset Allocation”. For you all that took the time out to listen to this first podcast, you can download a free copy at freebook.mebfaber.com. So you don’t have to listen too closely to all the numbers but listen for context and it’s a fun book, a quick read.

But as you think about investing, it’s kind of like talking about religion or talking about politics particularly right now where people tend to have very different views. You’ll meet someone who says, “I’m a gold bug.” or “I’m a dividend guy.” or “I only invest in closed-end bonds or muni bonds.”. Whatever it may be, everyone is usually fairly opinionated on their style and of course they believe their style was right. And one of the challenges of investing is taking a step back and saying “Let’s take a look at history. Let’s try to learn what the lessons of the last 150 years… 200 years of investing may teach us to least know what is possible… what can happen.”

Remind me of another great quote from Winston Churchill. He says, “However beautiful the strategy, occasionally you should look at the results.” Let’s look at the results, what is investing for Americans look like for the past 100 years. So if you go back to the founding of federal reserve early 20th century, this topic is detailed in my favorite investing book called “Triumph of the Optimist”, written by a couple of British professors. You should probably get this book from the library because I think it’s about $100. So check it out, but it’s a beautiful coffee table book. In addition, these professors update an annual study paired with Credit Suisse in a report called the “Global Investment Returns Yearbook” and if you Google that online. We’ll include this in all the show notes for the episode, but they have a yearly update that everyone should go back and read for the past 10 years. It’s almost like getting a graduate degree and investing as well.

So anyway, they publish returns of stock markets around the world for the past 100 years and if you look at U.S. stock returns for the past, since 1913, you’ll find a couple things. First of all, let’s start with inflation and a lot of articles or blogs or books. We’ll see a famous chart of inflation which is a line that starts in the top left and goes all the way down to the bottom and says something like, “A dollar in 1913 is only worth three cents today.”, and there’s usually big bold letters or comes to conclusions that you now need to go buy guns or buy gold or sell stock. Whatever the conclusion maybe but usually it’s implying that the government is out to get you and in reality all that saying is, and it’s factually true that there’s been about a little over 3% inflation over the past century and that’s not terrible. I mean, there have been periods of much higher inflation but also periods of much lower and all that means is if you put your cash under the mattress for the past 100 years, you would have lost 3% a year. And in general, that would have been a fairly dumb thing to do. I mean I know a lot of people that do keep their cash quite literally under their mattress. That’s not a really great investing strategy. So have you put your money instead in treasury bills or short-term bonds? In fact, you would have preserved your wealth just fine.

So over the past 100 years, treasury bills would have returned almost 1% a year, but for most of the period return the century zero. You expect them to keep up basically with inflation. Bonds on the other hands, so tenure bonds had a better return so they returned about 1.7% a year. However, most of that really came since the early 1980s so for the most part of that entire century, tenure bonds didn’t really have a premium over bills. So that’s a long time to wait, but really since the ’80s we have this massive bull market in tenure bonds, and they’ve had now what you call this premium over bills. However, if you look at the chart and look at stocks, Jeremy Siegel’s famous book, “Stocks for the Long Run. “, you see that stocks dominated everything else. Stock returns in the US did 7.4% a year over from the period 1900 to 2014. Just crushed it!

The take away for a lot of people is simple. They say, “Well why not just invest all my money in stocks?”. Well the challenge of course, is you had to live through the period. Stocks often had large draw downs and many can relate to the two relatively large draw downs, bear markets we’ve had since 2000. Both the tech fuel bubble 2000, 2003 as well as 2008, 2009, and global financial crisis where US stocks decline about 50% but that’s not the worst case scenario. In the Great Depression, stocks declined over 80% and to put that into perspective, an 80% decline require a 400% gain to get back to even. A lot of people talk about compounding the eighth wonder of the world, but the bad news is it’s true on the opposite side as well so the more money you lose the harder it is to get out of that hole. The old buffer quote, “First rule, don’t lose money. Second rule don’t forget the first rule because he understands that it gets exponentially harder to recover. So if you think about that the kink really happens around 15%-20%, whereas you loss 50%, it doesn’t take a 50% gain to get back to even. It takes a 100%. It gets worse and worse from there.

So one of the biggest problems in investing and stocks even though you get that 7% return over time is you have to be able to sit through the losses and many of you refuse to take a step back while you’re listening to this on the subway or your car or whatever. Imagine an 80% loss. Just take your net worth, subtract 80% and say, “Will I act rationally throughout that period?” For most, the answer is no. But also the challenge is that stocks can go a very long time periods underperforming bonds. So we’ve had periods where there’s been 40 years or 20 years in the past century where stock under performing bonds. If you count the 19th century, the data is a little more suspect but there was a 68 years span where stocks underperform bonds. That’s a really long time for most people.

By the way, the returns we’re quoting here in the last few minutes are what we call real returns. We may need to make distinction between nominal returns which are what most people think of just you see if the stock market did 10% last year for example, and real returns are net of inflation. So if we have 3% inflation, 10% stock returns, real returns are about 7%. And a good way to think about this is what I call the 521 rule. Historically, stocks are around the world, the US has done a little better. Stocks are on the world of average 5% a year, bonds around 2% a year. I’m averaging up and bills about 1%. Again, averaging up a little bit but it’s easier to remember that way. So a 521 over time for perspective. There are courses of huge spread over time. The best performing country in the 20th century was tiny South Africa and there’s a lot of examples of the worst, two namely being China and Russia where the government say, “Thank you very much. We’re going to confiscate all of the stocks. So basically your return was zero.”

Thinking about what’s possible, we’re giving a little setting the stage with a little background right now. The 521 rule. So you know what’s possible with stocks and my buddy Wes Gray at Alpha Architects did an interesting study where he looked at stock returns in the U.S. and showed just how difficult big stock returns are. So he showed for all intents of purposes earning 20% nominal returns per year is virtually impossible. He says “Warren Buffett, maybe a select handful of others have been able to achieve 20% returns over a very long time periods but that also makes them some of the richest people in the world.”. As you think about this the next time you see a marketing piece that’s promising 15%-20% returns you make take a step back and say “I know that’s pretty difficult.”. Put this in true context, Wes showed, if you basically made 30% returns a year from 1926 to 2010, you would own half of the entire stock market and we ought to know that’s not possible. If you had 33% return, you would own the entire stock market. This is almost like telling someone who doesn’t play basketball, if you’re a marketing. You say, “Hey! This is basketball. This is a new game called basketball.” and these guys can dunk on 15 foot hoop. If you didn’t know anything about basketball, you may say, “Okay, that’s sound interesting.”. If you knew a little bit about basketball you say, “No, that’s impossible.”. So as people think about investing the potential of getting 20% to 30% return, understand that’s incredibly, incredibly difficult.

However, the timing makes a huge difference and there’s been periods over the past 100 years that if you won the genetic lottery and starting your investing period in the late 1940s or early… or late 1990s, you would have realize 10 year returns of 20% a year. However, if you’re on the flip side and started investing in late 1990s. A lot of people can probably relate to that but other periods, the 1960s, you would have had negative returns over the next 10 years, and this place’s out over such a long period but the point being is that the starting point makes a big difference. So you can have this big returns, a lot of it due to luck and there’s another great quote I’m going to read from Charlie monger that talks about… this is one of Warren Buffett’s partner that talks about 20% returns. He says, “I know one guy. He’s an extremely smart and very capable investor.”. I asked him, “What returns do you tell your institutional clients you earn for them?”. He said “20%”. I couldn’t believe it! Because he knows that’s impossible but he said, “Charlie, if I gave them a lower number, they wouldn’t give me any money to invest.”. The Investment Management business is insane.

So think about that for a little bit as we go along and think about this space case for investing. So, we understand the challenge of investing stocks this big draw downs and bonds people see as traditional lower volatility, safer. However bonds have a different but similar risk, and they also have large draw downs and this is not on a nominal bases. This is on a real bases. Bonds are affected much more not by surprise moves but by deep inflationary chipping away at wealth. So bonds for example in the 40s, in the 50s leading up to the 60s and the 70s had a 50% draw down, and draw down is peak to trough lost of an investment. If you think you have a $100, it went down to $50 that’s the erosion of inflation for bonds. So bonds in many ways are as risky as tax, it just plays out on a different level.

So what do you do? Well, the first step for most people do is what’s called the free lunch of investing where you combine two assets that are not perfectly correlated and the results end up being 1+1=3. So the starting point for most people is what we call the traditional 60/40 portfolio: 60% in stocks, 40% in bonds. Rebounce every once in a while. It gives you similar return profiles stocks. Though not as great with lower volatility and draw downs and easier to live with and that’s a perfectly fine portfolio. The challenge of course again, is the draw downs. In the 1930s, all of the volatility is dominated by the stock volatility. So even though stocks are only 60% in the portfolio, they represent really around over 90% of the risk, the volatility and losses. So even in the great depression, you still would have lost two-thirds in that portfolio. We can’t find a stock market around the world with a very long history, where the 60/40 portfolio hasn’t lost two-thirds at some point. Then that’s a stunning revelation for a lot of people because they see 60/40 as a fairly moderate portfolio.

So what do you do? Weill the good news is that Ray Dalio, largest hedge fund manager in the world often says, “The holy grail of investing is putting together more and more uncorrelated assets.”, and I’m paraphrasing here but we live in a world where we’re not just constrained to stocks and bonds. You can put together a portfolio of a lot of different assets. So in our book [inaudible 00:17:32] we looked at about a dozen large asset classes. There’s really only a handful of true asset classes: stocks, bonds, commodities, and current seasons. Some others are combination of those four such as real estate or say corporate bonds is kind of a equity and bond like investment. But really we looked at dozen or so asset classes. So U.S. large and small caps, foreign develop stock, foreign emerging stock, bonds, tips, real estate investment trust, commodities and gold and we look at this really in the modern era of floating currencies. So back to the early 1970s what we said out on this books which we is a fun thought experiments. We said, “There’s been a lot of investors around the world who have talked about what is their ideal portfolio. Some of the most famous investors in the world we cover. You Male1: Welcome to The Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.

Male2: Meb Faber is the co-founder and chief investment officer of Cambria Investment Management which offers a growing family of exchange traded funds currently numbered at seven as well as separately managed investment accounts. In accordance with regulations, Meb will not discuss Cambria’s funds on this podcast. For more information regarding his investment offerings please visit cambriafunds.com and cambriainvestments.com

Female: Today’s podcast is sponsored by The Idea Farm. Do you want the same investing edge as the pros? The Idea Farm gives small investors the same market research usually reserved for only the world’s largest institutions, funds, and money managers. These are reports from some of the most respected research shops in investing. Many of them cost thousands and are only available to institutions or investment professionals but now they’re yours with the Idea Farm subscription. Are you ready for an investing edge? Visit theideafarm.com to learn more.

Meb: Welcome to the show everyone. I’m Meb Faber and thank you for joining us on our very first podcast. What in the world am I doing starting a podcast particularly on investing? There’s lot of wonderful podcasts out there already. Michael Covel’s Trend Following, and Barry Ritholtz’ Masters in Business do a great job already of this. But I’m also reminded of a quote by LBJ on our topic which is, “Making a speech on economics is a lot like pissing down your leg. It seems hot to you but it never does to anyone else.” And for younger readers by the way, LBJ is not LeBron James but a former president.

So what are we talking about here that’s unique or interesting, and making it worth listening to? Well, first, the focus of the show is gonna be three-fold and this will imagine…this will change a bit over time as we get our sea legs under us. But the first topic will be me riffing on ideas in research where it may be a speech I’ve given recently or a topic that a lot is lost with the written word. For those who aren’t familiar, I write an investment blog. It has over 1,500 articles. We’ve done about 10 white papers and five books, but even then a lot of the context is lost, a lot of the stories, a lot of the off-shoots of what we may want to talk about, and a lot of…or the speeches I give, they don’t record them.

So one is gonna be simply me riffing on a research idea or topic. Two will be more of the traditional interview format, although a little less interview style and a little more maybe far side chat with Meb, or perhaps Beers with Meb format, or it’s just chatting with a person or a group of people about some investing ideas. And lastly, I would like to do a little Q and A mail bag. So think of kind of the investing radio shows where people can email in, ask questions, we’ll read them aloud, and talk about those. As we learn this process, and I’m sure there’s going to be some bumps, please shoot us an email. We’d love to hear feedback, suggestions, and particularly Q and A for the mailbag. Email address is feedback@themebfabershow.com.

And for a quick background, I know most of our early listeners will be familiar with us through the blog or various social media, but a quick background on me. Grew up on Colorado and in North Carolina, Winston Salem before going to college at the University of Virginia where I studied biology and engineering. I was always pretty terrible at the lab though, and so my first job coming out of college was as a biotech stock analyst, really my favorite loves at the time. And this was a really cool time. This was in the 2000s when not only you had the Internet stock bubble, but also you had the biotech sequencing of the genome and biotech stock bubble as well. So it was a pretty interesting as well as fun time, and after that, the one year off for grad school became two and then moved out to the West Coast to San Francisco and then on to Lake Tahoe. I was a bit of a glorified ski bum, and then moved down to Los Angeles where my one year experiment for living in LA became 10, and started Cambria Investment Management in 2006.

So after that background, what are we gonna talk about today? So today is the topic of a recent book we published, but it really lays the foundation for a lot of the podcasts to follow. So it’s really important when you think about investing or really any topic, that you have a good foundation to which to grow from. So a lot of what we’re gonna talk about today is actually in our fourth book called “Global Asset Allocation.” For all you all that took the time out to listen to this first podcast, you can download a free copy at freebook.mebfaber.com. So you don’t have to listen too closely to all the numbers, but listen for context, and it’s a fun book, a quick read.

But so as you think about investing, it’s kind of like talking about religion or talking about politics particularly right now where people tend to have very different views. You’ll meet someone who says, you know, “I’m a gold bug,” or, “I’m a dividend guy,” or, “I only invest in closed-end funds or muni bonds.” Whatever it may be, everyone is usually fairly opinionated on their style, and of course they believe their style is right. And one of the challenges of investing is taking a step back and saying, “Wait. Let’s take a look at history. Let’s try to learn what the lessons of the last 150 years, 200 years of investing may teach us to at least know what is possible, what can happen.”

I’m reminded of another great quote from Winston Churchill that says, “However beautiful the strategy, occasionally you should look at the results.” Let’s look at the results, what does investing for Americans look like for the past 100 years? So if you go back to the founding of the Federal Reserve, early 20th century, this topic is detailed in my favorite investing book called “Triumph of the Optimists.” It was written by a couple of British professors. You should probably get this book from the library because I think it’s about $100. So check it out, but it’s a beautiful coffee table book. In addition, these professors update an annual study paired with Credit Suisse in a report called the “Global Investment Returns Yearbook,” GIRY, and if you Google that online, we’ll include this in all the show notes for the episode, but they have a yearly update that everyone should go back and read for the past 10 years. It’s almost like getting a graduate degree in investing as well.

So anyway, they published returns of stock market around the world for the past 100 years, and if you look at U.S. stock returns for the past…since 1913, you’ll find a couple things. First of all, let’s start with inflation, in a lot of articles, or blogs, or books, we’ll see a famous chart of inflation which is a line that starts in the top left and goes all the way down to the bottom and says something like, “A dollar in 1913 is only worth three cents today.” And there’s usually big bold letters or, you know, comes to conclusions that you now need to go buy guns, or buy gold, or sell stocks, whatever the conclusion may be. But usually it’s implying that the government is out to get you, and in reality all that’s saying is, and it’s factually it’s true, that there’s been about a little over 3% inflation over the past century, and that’s not terrible. I mean, there have been periods of much higher inflation but also periods of much lower, and all that means is if you put your cash under the mattress for the past 100 years, you would have lost 3% a year. And in general, that would have been a fairly dumb thing to do. I mean I know a lot of people that do keep their cash quite literally under their mattress. That’s not a really great investing strategy. So had you put your money instead in treasury bills or short-term bonds, in fact, you would have preserved your wealth just fine.

So over the past 100 years, treasury bills would have returned almost 1% a year, but for most of the period returned essentially zero. You expect them to keep up basically with inflation. Bonds on the other hand, so 10-year bonds, had a better return, and so they returned about 1.7% a year. However, most of that really came since the early 1980s, so for the most part of that entire century, 10-year bonds didn’t really have a premium over bills. So that’s a long time to wait, but really since the ’80s, we have this massive bull market in 10-year bonds, and they’ve had now what you call this premium over bills. However, if you look at the chart and look at stocks, Jeremy Siegel’s famous book, “Stocks for the Long Run,” you see that stocks dominated everything else. Stock returns in the U.S. did 7.4% a year from the period 1900 to 2014, just crushed it.

The take away for a lot of people is simple. They say, “Well, why not just invest all my money in stocks?” Well, the challenge of course is you had to live through the period. Stocks often have large drawdowns, and many can relate to the two relatively large drawdowns bear markets we’ve had since 2000. Both the tech fuel bubble of 2000, 2003 as well as 2008, 2009, global financial crisis where U.S. stocks declined about 50%.

But that’s not the worst case scenario. In the Great Depression, stocks declined over 80%, and to put that in perspective, an 80% decline requires a 400% gain to get back to even. A lot of people talk about compounding the eighth wonder of the world, but the bad news is it’s true on the opposite side as well. So the more money you lose, the harder it is to get out of that hole. The old Buffet quote, “First rule is don’t lose money. Second rule, don’t forget the first rule,” because he understands that it gets exponentially harder to recover. So if you think about it, the kink really happens around 15%, 20% whereas you lose 50%, it doesn’t take a 50% gain to get back to even, it takes a 100%. It gets worse and worse from there.

So one of the biggest problems with investing in stocks, even though you get that 7% return over time, is that you have to be able to sit through the losses. And many of you, if you take a step back while you’re listening to this on the subway, or your car, or wherever, imagine an 80% loss. Just take your net worth, subtract 80% and say, “Will I act rationally throughout that period?” For most, the answer is no. But also the challenge is that stocks can go very long time periods underperforming bonds. So we’ve had periods where there’s been 40 years or 20 years in the past century where stocks underperform bonds. If you count the 19th century, the data is a little more suspect, but there was a 68 year span where stocks underperformed bonds. That’s a really long time for most people.

By the way, the returns we were quoting here in the last few minutes are what we call real returns. We mean to make a distinction between nominal returns which are what most people think of, just the returns you see if the stock market did 10% last year for example, and real returns are net of inflation. So if we have 3% inflation, 10% stock returns, real returns are about 7%. And a good way to think about this is what I call the 521 rule. Historically, stocks around the world, the U.S. has done a little better. Stocks around the world have averaged 5% a year, bonds around 2% a year. I’m averaging up, and bills about 1%. Again, averaging up a little bit. But it’s easier to remember that way, so a 521 over time for perspective. There of course is a huge spread over time, the best performing country in the 20th century was tiny South Africa. And there’s a lot of examples of the worst, two namely being China and Russia where the government said, “Thank you very much. We’re going to confiscate all of the stocks.” So basically your return was zero.

Think about what’s possible, you know, we’re giving a little…setting the stage with a little background right now. The 521 rule. So you know what’s possible with stocks. But my buddy, Wes Gray, at Alpha Architects, did an interesting study where he looked at stock returns in the U.S. and showed just how difficult big stock returns are. So he showed for all intents and purposes earning 20% nominal returns per year is virtually impossible. He says, “Warren Buffett, maybe a select handful of others have been able to achieve 20% returns over very long time periods, but that also makes them some of the richest people in the world.” So as you think about this, the next time you see a marketing piece that’s promising 15%, 20% returns, you may take a step back and say, “Hey, actually I know that’s pretty difficult. To put this in true context, Wes showed if you basically made 30% returns a year from 1926 to 2010, you would own half of the entire stock market, and we all know that’s not possible. If you had 33% returns, you would own the entire stock market. You know, this is almost like telling someone who doesn’t play basketball, if you were marketing, you’d say, “Hey, you know. Basketball, this new game called basketball, and these guys can dunk on a 15 foot hoop.” If you didn’t know anything about basketball, you may say, “Okay, that sounds interesting.” If you knew a little bit about basketball, you’d say, “No, that’s impossible.” So as people think about investing, the potential of getting a 20 to 30% return, understand that’s incredibly, incredibly difficult.

But, however, the timing makes a huge difference, and there’s been periods over the past 100 years that if you won the genetic lottery and starting your investing period in the late 1940s or early…or late 1910s, you would have realized 10 year returns of 20% a year. However, if you were on the flip side and started investing in the late 1990s, a lot of people can probably relate to that, but other periods, the 1960s, you would have negative returns over the next 10 years. And this plays out over such a long period, but the point being is that the starting point makes a big difference. So you can have these big returns, a lot of it due to luck. And there’s another great quote I’m gonna read you from Charlie Monger that talks about…this is Warren Buffett’s partner, that talks about 20% returns. He says, “I know one guy. He’s an extremely smart and very capable investor. I asked him, ‘What returns do you tell your institutional clients you’ll earn for them?’ He said ‘Twenty percent.’ I couldn’t believe it because he knows that’s impossible. But he said, ‘Charlie, if I gave them a lower number, they wouldn’t give me any money to invest.’ The Investment Management business is insane.”

So think about that for a little bit as we go along and think about this base case for investing. So we understand the challenge of investing in stocks, these big draw downs, and bonds, people see as traditionally lower volatility, safer. However bonds have a diffident but similar risk, and they also have large drawdowns, and this isn’t on a nominal basis, this is on a real basis. So bonds are affected much more, not by sharp price moves, but by deep inflationary, chipping away at wealth. So bonds for example in the 40s, in the 50s, leading up to the 60s and the 70s had a 50% draw down, and draw down is peak to trough loss of an investment. So if you think, if you had a $100 and went down to $50, that’s the erosion of inflation for bonds. So bonds in many ways are as risky as stocks, it just plays out on a different level.

So what do you do? Well, the first step that most people do is what’s called the free lunch of investing where you combine two assets that are not perfectly correlated and the result ends up being one plus one equals three. So the starting point for most people is what we call the traditional 60/40 portfolio: 60% in stocks, 40% in bonds. Rebalance every once in a while. It gives you similar return profile stock though not as great with lower volatility and draw downs and easier to live. And that’s a perfectly fine portfolio. The challenge of course again is the draw downs. In the 1930s, all of the volatility is dominated by the stock volatility. So even though stocks are only 60% of the portfolio, they represent really around over 90% of the risk, the volatility and losses. So even in the great depression, you still would have lost two-thirds in that portfolio. We can’t find a stock market around the world with a very long history where the 60/40 portfolio hasn’t lost two-thirds at some point. Then that’s a stunning revelation for a lot of people because they 60/40 as a fairly moderate portfolio.

So what do you do? Well, the good news is that Ray Dalio, largest hedge fund manager in the world, often says, “The Holy Grail of investing is putting together more and more uncorrelated assets,” and I’m paraphrasing here, but we live in a world where we’re not just constrained to stocks and bonds. You can put together a portfolio of a lot of different asset. So in our book, “Global Asset Allocation,” we looked at about a dozen large asset classes. There’s really only a handful of true asset classes: stocks, bonds, commodities, and current seasons. Some others are a combination of those four such as real estate or say corporate bonds is kind of a equity and bond-like investment. But really we look at a dozen or so asset classes. So U.S. large and small caps, foreign developed stocks, foreign emerging stocks, bonds, TIPS, real estate investment trusts, commodities, and gold. And we look at this really in the modern era of floating currencies.

So back to the early 1970s, what we set out in this books, which is a fun thought experiment, we said, “There’s been a lot of investors around the world who have talked about what is their ideal portfolio.” Some of the most famous investors in the world we cover. So we mentioned Warren Buffett, Rob Arnott, who manages Research Affiliates, $180 billion money manager. Dave Swensen, manager of the Yale Endowment. Marc Faber no relation, but Swiss economist. Ray Dalio, largest hedge fund in the world at Bridgewater. And others like Mohamed El-Erian, former PIMCO and also Harvard Endowment manager. And all these guys, what they share a common characteristic is at one point, they recommended a portfolio for individual investors where they say that each investor should put X amount in U.S. stocks, X amount in TIPS, X amount in gold.

So we said, “Hey, why don’t we go back and take a look at what all these guys have suggested and see how it’s performed back to the 1970s?” And so they had hugely different allocations. Warren Buffet famously says, “Put 90% in the S&P 500 and 10% in cash or bonds.” I forget which. But most of all the others, so we look at permanent portfolio of Harry Browne. Hugely different, it’s 25% each in T-bills, bonds, gold and stocks. We look at the Global Market Portfolio which is simply what happens if you just went out and bought the world. And then we look at a lot of these other guru portfolios. And the interesting thing is there’s a lot of variation. Some have saved 50% in stocks. Some have as little as 25% in stocks. You expect a huge variation in returns of these portfolios going back in time. And you do see huge variation in short periods.

In the ’70s, certain portfolios performed wonderfully. The Permanent Portfolio, Marc Faber’s portfolio, in a period where almost all portfolios did horrible. And then of course over the next 20 years, you had more traditional investment portfolios, 60/40 endowment style performed better when you had a world of growth. In the endowment style model, very heavy on global equities, equity-like investments, and very little in bonds. One of the takeaways, you saw this huge dispersion in returns for all the underlying assets. Some very volatile, some like T-bills, low volatility, but what you found for all of the portfolios in the book, and this is a bit of a stunning conclusion, with the exception of the Permanent Portfolio which isn’t really fair because it has half in bonds, all the other portfolios clustered within one percentage point distance of each other. And that was a stunning finding, not at all something that I was expecting. Although they took different paths to get there, they all had very similar returns, and it took me a second and a couple rules of thumb.

There’s a ratio we call the “Sharp Ratio,” which is simply a risk adjusted of measure of return. It’s trying to equalize assets or portfolios for volatility. So for example, the formula, and not to get jargony, is simply the return minus the risk free rate which we call T-bills over volatility. So almost all asset classes have a sharp ratio of around 0.2 to 0.3 over time. Now that can vary hugely, if you look at U.S. stocks over the past 100 years, there’s been decades when the U.S. stocks have had a sharp ratio over one, and there’s been decades when there’s been a negative sharp ratio. But over very long periods, most assets cluster around that 0.2 to 0.3 range. If you get to portfolios, they all cluster in that 0.4 to 0.6 range. You’ll see some of the best funds of all time, Berkshire has a sharp ratio…Warren Buffett’s Berkshire Hathaway, of around 0.6. Some of the best hedge funds, George Soros’s Quantum, Tiger Management, Julian Robertson’s really struggled to get past one.

So just to give a little context, if you ever someone marketing a 2.0 sharp ratio, you probably want to run in the other direction. It’s very hard to achieve over time and be sustainable. So if you’re thinking about this portfolio, going back to 1972, Howard Marks from Oaktree has a great quote, and he says, “Thus timing, and in particular the selection of the beginning point and end point for studying a performance record plays an incredibly important role in perceptions of success or failure.” And so one of the things we were talking about here is, we said… Look, if you started in the 70s and then said, “You know what? We’re gonna…” and then 1979 we said, “We’re going to draw all of our conclusions over the past decade, and we’re gonna pick the best performing portfolios, and that will be our portfolios for the next 10 years because we all know inflation is rampant, and we have to protect our assets.” Well, it turns out, those would’ve been the worst performing portfolios. And if you simply chase the best allocation over the past 5 or 10 years, that would have hurt your returns by about one and a half percent a year. And if you remember, the best performing portfolio relative to the worst was only about one percentage point a year. That goes to show that you would destroy your entire return just by mucking around with a strategy. It didn’t even matter which strategy you had so much as long you kept with it over time.

And so these are really the three biggest problems with implementing a portfolio. We often have said in the past that a buy and hold investment portfolio is somewhat of a commodity. It doesn’t matter exactly how much you have in stocks, exactly how much you have in bonds, exactly how much you have in real assets which we characterize as gold, TIPS, and REITS, as long as you have some of each. But the biggest problems with the implementation of this portfolio are three things: Behavioral implementation, so not mucking around with it. Two, fees, and three, taxes. I’m gonna touch on each of those real quickly just to demonstrate the importance of all three. One of the things we were talking about recently was there’s a sentiment survey that comes out once a week from the American Association of Individual Investors, AAII, and they simply asked people on stocks, “Are you bullish? Are you neutral? Are you bearish?” This survey goes all the way back to the 1980s, and so you’ll see a range of bullishness. It looks like it’s ranged from as low as the low teens all the way up into the highest 70s, so pretty wide range. But the average over time is around 40% bullishness, and then the same thing bearishness. It’s about the same range.

But the interesting thing is if you look back and say, “Over this period, when were people most bullish?” The week that they were most bullish was literally January of 2000, the absolute worst time in our entire sample to have been bullish. When were people most bearish? I’m sure you can guess it at this point, March of 2009, the literal exact bottom of the market in the global financial crisis. And what this goes to show is a couple of things. One, the animal spirits of crowds can often be wrong at the extremes. In the middle they’re usually not that far apart, but when things are truly, there’s blood in the streets or true bubbles, the investing crowd is often wrong.

There’s some great books here, “Extraordinary Popular Delusions and the Madness of Crowds,” is probably my favorite. We’ve done a few papers on bubbles, and booms, and busts. One called, “What if Sir Isaac Newton would have been a trend follower?” But in general, the point we’re making here is that your emotions work against you. And this is actually a little bit interesting because a few weeks ago we find ourselves right now in early June in year seven, eight bull market. Great returns. The U.S. has really dominated everything else. We had a reading, and one of the lowest bullish readings we’ve ever seen in this survey, and ironically enough, when you see readings this low and this was below 20 bulls, future returns for one year in the S&P 500 are around 20% a year. And I originally had to scratch my head and think about this for a while. I said, “Why in the world? Usually at year seven bull market, people are starting to get a little ecstatic, a little excited, and we have the opposite.” And one of the reasons I think is that people know that U.S. stocks are getting a little expensive. They know we’re probably at the end of the run here, but they don’t know what else to do. In a world of declining interest rates, they know that bond yields are low. They don’t know where else to go.

We’ll tackle that topic in the upcoming podcast, but maybe that’s one explanation, I’m not sure. But your emotions work against you. But there’s a million of other ways to demonstrate this. James Montier has some great examples in many of his behavioral finance books. A simple one is what people think are the most deadliest animals in the world and what kills the most people. In reality this is a chart that I think Barry shared, but, you know, number one is mosquito. No one almost would ever answer that. And two of course is each other, other humans. And rounding out the top five, snake, dog, man’s best friend, you know, giving us rabies, and then of course the fly and about three other things I can’t even pronounce: A freshwater snail, and a roundworm, and a tapeworm. Way down the list, the things that people probably are most afraid of, I live here Manhattan Beach, California, shark, only kills about 10 people a year compared to the almost a million for mosquito, and 50,000 for snake, and wolf, which I was deadly afraid off as a child kills about 10 people as well. Lion about 100, a little scarier.

So emotions work against us. And so there’s a lot of research that shows that individual investors are really poor at their timing. They buy at market tops, they chase performance, and they sell at market bottom. And there’s a number of different studies, a lot of academics estimate the gap is around 1 to 2 percentage points a year. Vanguard calculates it usually as around a percent and a half. The famous DALBAR study calculates it as higher. A great example is Ken Heebner, one of the best performing mutual funds in the 2000s, did something like 14% a year. But if you look at the time weighted versus dollar weighted performance, meaning how much people put in money and how much they earned on the money that went in, you found that not only did the investors not make 14% a year, they didn’t even make 7% a year. They had negative dollar weighted returns, and the reason being is they chased performance.

So after he had a monster 70% year, all this money flooded in. And of course what happened after he had a really bad year? All the money floods right back out. So I mean with a lot of institutions and buyers is we tend to be a little hoity toity about this and say we’re much better than getting into these very basic mistakes but the literature doesn’t really support it. And so if you look, there’s an academic paper called, “The Selection and Termination of Investment Management Firms by Plan Sponsors.” That sounds about right for most academic papers. Fairly boring title, but what they found is looked at 8,700 hiring and firing decisions by over 3,000 big money managers who were delegating over 600 billion in assets. And what they found is you look at the three year performance of the manager they’re firing and the three year performance of the new manager coming in, and of course what do they find? The new manager coming in has great three year performance. The manager going out has terrible. But what happens after they make the firing decision? I’m pretty sure you’re gonna guess it. The manager they fired did much better than the manager they hired.

And so a lot of the institutions, a lot of the people in charge of the big money, they make the same mistakes. They disguise it under different names. They’ll talk about a rigorous investment process, and will have a committee to implement this very rigorous process, and you find that of course that it’s still… We’re all human and it’s really, really hard to be able to implement a long-term investing plan. Second, as important, if not more, is fees, and this all kind of the boring part of asset allocation. You know, this is never going to win you any interesting combos at a cocktail party. You’re never gonna be the most exciting person in the room because what are people talking about? The hot stock du jour, probably angel investing now, or investing in stocks like Tesla, or companies that are really exciting: Amazon, the new tech companies of the world, virtual reality, drones, who knows?

If you do a crystal ball experiment and we went back to 1973 and said “You know what? Reader, I’m gonna give you the best performing asset allocation out of this book which is the Mohamed El-Erian portfolio from his endowment investing book.” And ironically, for some odd reason, the portfolio doesn’t add up to 100% of the book, but we made some adjustments to make it 100%. That was the best performing portfolio in our book. Endowment style makes sense, a lot of those assets, volatile, high growth, and compared it to the worst performing portfolio which is Permanent Portfolio. Oddly enough a fairly stable portfolio over the all decades, one of the very few that had great returns or positive returns in each decade. And he said, “You know what? We’re gonna layer on the average fee of an average mutual fund. That’s 1.25% a year currently. Probably be more expensive historically, but we’re gonna layer on that fee just to implement this portfolio.”

That would have turned the best performing portfolio in this book into almost as bad as the worst performing portfolio. Let that sink in for a second. All right, you had perfect foresight of the best portfolio to implement for the next 40 years, and just by implementing with the average mutual fund, you made it almost the worst. If you then, on top of that, said, “I’m gonna implement this through my friendly financial advisor,” on average charges 1%, who then implements it with the average mutual fund at 1.25%. And this isn’t even talking about the top quarter of financial advisors in mutual funds that each charge over 2%. So that would be 4% a year.

Well, let’s say you get up to 2.25%, that would have turned the best performing allocation into far worse than the worst. So a lot of this basic blocking and tackling, the fees, the not mucking up your portfolio, have a far greater impact on buy and hold portfolio than a lot of the sexy stuff, how much should I put in gold, you know? Most of investors stress so much, is the fed manipulating interest rates? Are U.S. stocks expensive? Should I allocate to frontier markets? What’s going on? Is Greece going to default on whatever they’re gonna default on? What about Zika? Really what you should be focusing on is how much do I pay to implement this? Commissions, taxes, bid-ask and then not messing around with it. There’s a famous Fidelity study where they looked at the best performing portfolios of their brokerage clients and found that two of the best categories where people that either forgot they had an account or that had died.

So if you come up with an investing approach, whatever it maybe and stick with it, try to implement it in the cheapest possible way. So the good news is there’s plenty of index funds, low-cost investing strategies. John Bogle, a lot of people get caught up on the active versus passive debate. He says, “Look,” and this is the founder of Vanguard. He says, “Active versus passive is the wrong question. It’s high fee versus low fee.” So if you implement this portfolio with ETFs which we are huge fans are because we think they’re structurally more efficient than mutual funds, but many mutual funds are fine as well as long as you’re paying less than, say, half a percent, but really as little as possible. That’s the best way to do it.

If you want to implement through many of these many new automated investing solutions, the Betterments of the world, the Schwabs of the world, we think those are perfectly fine. And I would be remiss to say we are big fans of financial advisors. Vanguard’s study that I referenced earlier says that the average financial advisor could have up to three percentage points a year savings in fees over someone trying to do it on their own. Now half of that is simply behavioral coaching on not doing the really dumb stuff, but a lot of the other things is paying low cost, and we think a low cost financial advisor makes total sense. The challenge is of course, that the asset allocation process is not where most financial advisors really deliver their value add. But really their big value add is…we mentioned behavioral coaching, doing financial planning, doing wealth management, helping you with insurance and all the other elements of a life with financial wealth management, but it’s not really the asset allocation side.

And so a lot of these guys that charge one and a half, two plus percent, most investors don’t think about it, and they don’t think about fees in general because they get skimmed off the top. One of the best implementations Wall Street ever did was come up with a fee structure where you never see the fees getting paid, they just get taken out of the account. And we framed this in the book, we said, “Look, if you instead had to, every year deliver a briefcase with $20,000, which is a 2% fee on a million dollar account, to your financial advisor each year, go to the bank, pick out $20,000, deliver it. That would be a lot harder to do than just saying, ‘I get my statements in the mail,’ and realize there’s some fees that have left.”

So anyway, just be mindful of your fees, particularly any mutual funds. If anything charges over probably a percent, go ahead and sell it. And I’m not going to even get started on hedge funds which are really, really expensive and tax inefficient. And that leads us to taxes of course. Taxes also play a huge role. I often say I’m structure agnostic whether it’s mutual funds or ETFs, but as a mutual ETF manager, I came to that decision because we think that is the best structure for most. They end up being much more tax-efficient on average. The average ETF is also half the cost of the average mutual fund. But there’s been some good studies, iShares of course did one called Managing Tax Challenges that shows that the average active mutual fund has a .3 to 2% per year tax advantage to an ETF. But just be mindful of it. You know, mutual funds have to buy and sell stocks when money comes in and out, whereas an ETF doesn’t. We’re not gonna go down that rabbit hole now, but just realize we think ETFs are wonderful.

There’s another…and we’ll link to all these in the show notes later, but another white paper by a buddy of mine, Peter Mladina, called Portfolio Implications of Triple Net Returns, that talks about the importance of taxes as well as fees as well. So we’re sort of winding down to the end of this global asset allocation talk. A couple of things, one is you can always find the show notes. We’ll post it on the blog at mebfaber.com/podcast. Please, if you have any feedback for us, as well as any questions for our mailbag Q and A, we’d love to include you. Shoot us an email at feedback@themebfabershow.com. Also if you enjoyed the podcast or hated it, please feel free to share with your friends and coworkers, and it would help us greatly to leave a review on iTunes.

And lastly, I’m gonna finish up every episode with a little segment, there was a really popular blog post we did a few months ago, and it was sparked by conversation I was having with a couple in New York. We were having a dinner in a little Italian restaurant in Brooklyn. And as usual when I travel, we start veering off conversation into beautiful places you’ve been, wonderful new apps that you’ve used, or things that you find just really wonderful. And we were having a conversation, I mentioned a few, and they said, “Man, I wish someone had told me about that a year ago.” I said, “You never heard about this? This is such a…it’s made a huge impact in my life.” And I said, “You know what, maybe a lot of other people would like to hear about some of these things as well.”

So we did a blog post called, “Things I Find Beautiful, Useful, or Downright Magical.” You can look up the whole list on there. But I figure on each episode, we’ll tackle just one thing I find that fits into one of those categories that people may find of interest as well, and I’ll start with the first one that sparked the conversation in general, and that was using a password manager called Dashlane. And there’s a number of these out there, I think LastPass is another one. But it’s a very simple piece of software that sits on your computer, sits on your phone, and every time you get to a website, it stores your password, auto completes all of them, auto completes your name, address, you can save credit card information, airline information, everything possible on the planet. It probably saves me 20 minutes a day inputting all these things. Also on your phone, so if you’re going to a hotel or car rental and you want to show your points number, all in one place, it’s a really wonderful resource called Dashlane.

So we’re going to wind down now. That’s all we have for you today. That’s the end of the show. We’ll see you next time, and best of luck investing.

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