Everyone will tell you they lost money, even with a big sample set. If I look at the news, there's front pages saying more layoffs, bankruptcies, and that actually may be the best time to invest. How do I even think about why I should invest and how to invest? How would you start that conversation with them?

A lot of it comes from what that person already knows about the markets, investing, trying to understand where they are. There are a few quite important decisions you need to make. There's the kind of risk you want to take on and the risks your financial situation will allow you to take on.

When thinking about these types of questions, what is the maximum value going to tell you? And then there's, what should you actually do? If you don't want to be exposed to idiosyncratic things that happen in a country, you can diversify and say, "I'm going to invest some in the U.S., I'm going to invest some in Europe, I'm going to invest some in Asia." It's certainly true that there's that opportunity for additional optimization.

It's like, because things are taxed differently, then there's opportunity to optimize that. There was a study by this group of economists. They wrote this book called Triumph of the Optimists. They did this huge study over 20 countries and they found... Chris, thanks for being here. Thanks for having me in this lovely home studio you've built.

Yeah. So we go way back. And the reason I wanted to have you join me today is because we get so many questions from people that are so confused about the process of investing. And I go back in time and think, "Gosh, when I had a lot of friends ask me how to invest, I would call you all the time." And that led to us starting a company together to help people figure out what to do with their money and invest.

And so who better to join me for a conversation about how people should think about building their investment portfolio than the person that I called all the time and started a company with. So that's the goal is helping people understand how to think about their investment portfolio. And we did this a lot at Grove.

And I'm curious if you were sitting in a meeting with a client and they said, "How do I even think about why I should invest and how to invest?" How would you start that conversation with them? I think a lot of it comes from what that person already knows about the markets, investing, trying to understand where they are.

But I think there are a few quite important decisions you need to make when you're thinking about building a portfolio. There's the risk you want to take on and the risks your financial situation will allow you to take on. And then there's given that risk, what's the mix of investments that make sense to achieve your goals?

Back up for one second and say, "The reason anyone should even do this is that their money wants to keep up with inflation." Is that the premise of why even invest your money in the first place? Well, I think most people want to invest their money to reach to spend it in the future.

So I think beating inflation is a great goal. But I think people want to go beyond that and try to get as much out as they can. And the question is, well, how do you do that? What investments do you need to do that? Yeah. And the reason why you wouldn't just invest it in the riskiest thing in the world, as you said, is risk is very important.

How much you can and are comfortable taking. And there are lots of questionnaires online to answer those things. And so I'd say someone could go get a risk score. One of the things that I think we noticed when we were talking with clients was people are a little bit maybe more optimistic about their own tolerance for risk than might actually happen.

And depending on whether you've ever invested in the stock market or some investment that went down, the typical question is like, "If the market goes down 30%, what do you do? Do you buy more? Do you sell? Do you freak out?" Do you feel like those questions actually can gauge someone's risk?

Yeah. I'm skeptical of the online risk scores. Some of them ask questions about what would you do if it was down 30%. Some of them ask questions, which are even worse, which are how much would you be willing to pay for a coin flip bet or something like that.

They're trying to get at some fundamental characteristic of the person, but I think that's oversimplifies it. So I think you can try to take those questionnaires and see what they say as a general guide. But I think one of the exercises that we did with clients at Grove, which I think is the most helpful, is to really try to imagine yourself in your current situation with your brokerage account, with your retirement portfolio.

And if the equity market were to go down 20%, 30%, 40%, how would you react? And is there a percentage loss or dollar loss that you say, "This would be extremely uncomfortable for me"? So I think playing out a scenario could actually be a really helpful way to understand what your risk tolerance is at this point for you.

And I think not everyone that's an investor today was an investor four years ago. But I think you could ask yourself four years ago during the middle of the pandemic, when a lot of portfolios dropped, "How did you feel then?" These kind of major market corrections don't always happen so frequently that the average investor even sees multiple of them.

In the last four years, we saw one. And yes, the recovery was quite quick, but I had friends that after a 20% loss were like, "I'm out." And then I had people that wrote it all the way to the bottom and wrote it all the way back up to the top and beyond.

And so we have one data point that if you were an investor four years ago, you could maybe say, "How did I feel?" Yeah, I think that's really helpful. But as you point out, the recent drops have been pretty shallow and pretty quick recovery. It's helpful to look a little further back in history and say, "Okay, well, can you put yourself in the mind of if the drop had been 50% and was there for a little bit and the economic news was consistently bad for a long time, like it was in the 2008, 2009, where you had a lot of investors say, "What am I doing?

I'm going to take a step back and sell." And I think from the trough over the next year, the market was up 65% or something. And I think a lot of people missed out on that. Yeah. And so the reason why this is important is because you want a portfolio that you're not going to sell out of when it's down, because if you do, you will often miss out on the ride back to the top.

Yeah. I think that's one of the major mistakes that retail investors make. And it's a very easy mistake to make because all these signals are negative. And the market is a very different type of system than the ones we're used to dealing with. If you want a good restaurant to go to, then you need to ask your friends, "Hey, what was your experience at this restaurant?" If all your friends said they had a great experience or a terrible experience, that's a really good indication of how your experience will be.

A different type of system that's maybe, if you're trying to buy a reliable car, you may ask your friends who have a similar car if their car breaks down, but it probably doesn't. But is that a signal that it's going to be a reliable car for you? Maybe, but you probably need a bigger sample set, right?

You got to turn to Consumer Reports. Right. You go to the Consumer Reports, the reliability survey where they survey thousands of people. But for the market, either of those strategies in these downturns would not be a good one, right? Everyone will tell you they lost money, even with a big sample set.

So you say, "Okay, well, not only have all my friends lost money, if I look at the news, the front page is saying more layoffs, bankruptcies. And that actually may be the best time to invest." Yeah. Yeah. I mean, if you invested all of your money at the bottom of the crash in '08 or the bottom of the crash, that would be great.

But I think we could probably talk about it a little later. Waiting for that bottom might not actually be as good a strategy as just being invested now. I did an interview with a guy named Nick Majulie, who wrote a book that I believe is just "Just Keep Buying." And his argument was like, "Don't stop and wait.

Just keep buying." We won't go down that path yet. So okay. So when we think about constructing a portfolio, I think before you start, you need to think about your risk and how much you can tolerate, because that's going to come into play. And how much you can emotionally tolerate and actually financially.

If all the money you have is in the market, and you need it for lots of things in your life, you might be comfortable with a 50% drop, but you might not be able to financially afford it. So that's this other component that I think is often missed is can your financial situation tolerate?

Yeah. And I think a lot of that is a function of what money do you need in the near future. If you're planning on buying a house in two months, then you probably shouldn't have that all in the equity market, because the market could easily drop and you could lose money and not be able to buy the house.

So that affects your capacity to take risks, we would call it. Yeah. Okay. So now I've kind of understood, hopefully a little bit about my own personality, my own capacity and tolerance. But we actually have to build a portfolio. And so there are a seemingly unlimited number of things you can invest in.

And I'm going to assume that most people here are looking to grow their money over time and beat inflation and earn more than just leaving their money in a bank account. How do you even begin to think about how to construct the portfolio? Yeah. So I think one principle would be diversification.

And there's a lot of reasons for diversification. One is that you don't want necessarily a portfolio that's going to do well only in one set of conditions, because it's very hard to know what the future holds, right? So we think about asset class diversification as being important so that the portfolio can do well both in periods of high economic growth, and it doesn't totally fall apart in low economic growth, that it can withstand periods of high inflation and low inflation.

So different asset classes can do well in different circumstances, right? So like stocks, in periods of high economic growth, stocks can do well. Low economic growth, you have government bonds can perform better. Periods of high inflation, you have TIPS, which are inflation-indexed government bonds. Those can do well, and also commodities, and in some circumstances, real estate.

Yeah. So you're thinking about having a mix of asset classes that can benefit you a lot. And is it just asset classes, or is it geographies, size of the companies in those asset classes? How far can you go down the diversification path, and can you go too far? Yeah.

So going further down the diversification, there are kind of two other axes I would think about the diversification. One is across geographies. If you don't want to be exposed to idiosyncratic things that happen in a country, you can diversify and say, "I'm going to invest some in the US, I'm going to invest some in Europe, and invest some in Asia." And you can also think about diversifying within a geography across companies.

So you may not want to say, "Oh, I'm going to put all my money into one company in the US or in each country." There's benefits in owning a lot of different companies so that you're not exposed to. What if there's fraud or something that happened, or the company has a product that becomes less competitive?

So yeah, I think there are benefits on those two axes too. Okay. So I think it's pretty agreed by most people that you want to diversify your portfolio. You want to diversify it, like you said, across asset classes, across geographies. How do you actually figure out what it is?

So I'm thinking there's the old school portfolio, which is just like 60/40 stocks and bonds. Then you can go online and search these lazy portfolios and it's like, "Well, here's if you wanted three index funds, or four, or five." And you could build a portfolio of 50 index funds.

Is there a principle or a guideline of how you find something that's going to do well for you, but isn't so complicated that you're either not getting any benefit for the level of work you're doing, or it's just too complicated that doesn't actually, you can't maintain it? Even with a simple two-fund, three-fund portfolio, there is a huge amount of diversification in that.

If you look at some of these index funds, they have 3000 companies inside. If you're trying to think about all of these aspects to diversify upon, different types of companies, different geographies, different types of asset classes, at the end of the day, you have to pick something to put your money into.

And you could go as far as you want and have all these asset classes. And we had a conversation years ago where it was like, "Well, if you want to add some China, but you want small cap and large cap China, and now all of a sudden you could build a portfolio with a lot of things." Or there are people out there who say, "You could just buy VTI, the total stock market, and then just call it a day." And you might miss out on international there.

You might miss out on bonds, but that is unapproached. How do you think you find the place on that spectrum that makes sense? Yeah. So I think if you have your list of ways that you'd like to diversify your asset classes and geographies you'd like to hit, I would say almost the simpler, the better.

If you can achieve all the ways you'd like to diversify with fewer funds, that's why I think the three fund portfolio is very popular in that people have their... A three fund portfolio can get you diversification across asset classes because it has bonds and domestic stocks and international stocks.

And you get geographic diversification because it invests across a lot of countries and you get the company diversification. So I think the three fund portfolio is a great place to start because it seems to check all the boxes. I think if you wanted to go further and say, "Well, I'm actually concerned that this is not going to be...

There's not enough exposure to assets that will do well in an inflationary environment." For example, it may not include things that are particularly exposed to commodities. It may not have enough real estate for your taste. It may not have enough inflation-indexed treasuries. Then you would look at expanding the set of funds that you need to include.

Now, I'm imagining people might be thinking like I am right now, which is, "Well, I don't know. Do I need more inflationary protection in my portfolio? Do I need to have more real estate? Do I need..." I actually, even for myself, struggle with this. In a way, I would say over the years, I've done everything from three-fund to 12-fund to put money in an online investment advisor that you just give a risk score and they build the portfolio to then tweaking that portfolio.

And I've never left feeling like, "I know this is the perfect portfolio for me because I don't know if my international exposure should be 40% or 30% or whether 40% or 30% even matters. I know I should have some." How do you even know which asset classes you might want to include?

I think a lot of smart people disagree about this. I think if you surveyed recommended portfolios from professional investors, you could look at portfolios recommended by David Swenson, who's the former CIO of the Yale Endowment, or if you look at robo-advisors, Wealthfront, Betterment, they all, I think, have reasonable methodologies that get you to...

You're checking the boxes, but there's different implementations of the things that check the boxes. And a lot of the difference comes from assumptions, beliefs of the person constructing the portfolio and different assumptions that go into the... about what the future will hold. Okay. So you could start as a baseline, go search for lazy portfolios, and there's this great Bogleheads wiki page with a bunch of options from three to six.

You could go to Wealthfront or Betterment or any other online advisor and just say, "Here's my risk score. What portfolio do they give me?" At the end of the day, from a return standpoint, is there even going to be that much difference between, "Oh, well, one of them says 40% here and 60% here.

One of them says 38 and 62." Should we even get caught up in these on-the-margin, single-digit changes to different allocations? Or is it kind of all who knows what the exact outcome will be, and they're all going to correlate with each other pretty well? Well, I think there are two parts to that question.

This incremental changes to... If you're talking about, "Are you going to be 60% bonds or 60% stocks or 59% stocks?" That's not going to really matter. I think you do... If you look at the lazy portfolios, you'll see different... You'll see meaningfully different asset allocations. That will produce different returns.

These things will not perform exactly the same. I think the problem that I don't know, no one knows, is what's going to do better. I think they all... I think that's the really hard question. What you could do is look at the rationale behind them and see which one makes the most sense to you.

But yeah, I'm not going to say they're going to perform the same, but it's really hard to tell beforehand which one's going to be better. And you can have multiple reasonable approaches that you could decide from. What would the very sophisticated professional investor be doing that maybe isn't something we want to emulate, but might help us understand how anyone could come to the conclusion that 59 and 20 and 21, whatever combo of things, is actually correct?

Yeah. Where do the numbers come from that a lot of these people will come up with? An approach that a lot of investors can use when building a portfolio is that they have some selection of assets and that from those assets, you can assign an expected return and you can try to predict what you think the average return is going to be of those assets over whatever time period you're looking at and what you think the correlation between returns are.

And these are numbers that are hard to come up with. What's your expected equity returns? Again, a lot of smart people disagree about that. What's the correlation of equities going to be with bonds and real estate and commodities? Also very hard to predict. You can look at history, but correlations change over time just like returns do.

So you can take this, then you can add further constraints on about, "Well, I don't want to have more than this type of exposure in this asset. I don't want to have more than this type of exposure in this asset." You can add complicated constraints. And then you put it through a big optimization algorithm where you ask the computer to say, "Okay, given a certain amount of risk that I'm willing to take or a certain potential loss that I can tolerate, what is the best combination?" So you can have an algorithm come up with that.

Now, there's a long process of coming up with those expected returns, coming up with the correlations, putting the constraints on, building the optimization to solve it that get you those numbers. But that's a process a lot of professionals do follow. - Yeah. It seems complicated for someone like me to go build an optimization engine to do all of this.

And at the end of the day, I'd probably be borrowing someone else's work on correlations and returns, which I could probably just borrow their assumption. If I'm going to use all of their assumptions for things, then optimizing that to the right portfolio is probably going to be easier to just say, "Well, what did they optimize to if I'm going to use all of their assumptions?" I think almost all of the portfolios out there that I've seen have some mix between equities and bonds and maybe some international.

And so I think you're probably going to end up with a portfolio there. The things that there's probably more disagreement on is some have international and some break it out into developed and emerging market. Why break it out? Is it because the general international buckets of index funds you would buy just don't have the right balance?

Or why do a lot of people add on this emerging market category to their portfolio? - So I guess, assuming we're talking about an international fund that includes some emerging market in it, the reason to break it out is, I guess, there are at least two reasons. One is that you may disagree with the total allocation to it.

So you want to make it either higher or lower. Another is it gives you the opportunity to kind of rebalance in that if you say, "Okay, I want emerging markets to be 10% of my portfolio," or whatever, then if emerging markets underperforms, then it may stay lower if it's indexed.

Whereas if you had it broken out, you would potentially buy more and bring it back up to 10% of the portfolio. But again, the reason to do that, you need some type of opinion about whether you want more or less emerging markets in there. - Yeah. And I hear a lot of people say, "Okay, well, I live in the United States.

If I buy a home and the US market is down, my home's going to be cheaper." Is the argument to include international because you want to do well even in a case when the American stock market does poorly? Or is there some other argument to being more globally diversified?

- I think that's the primary one where you may not want your wealth only linked to the performance of the US stock market and that there are going to be years where the rest of the stock markets on average will do better than the US stock market. So to the extent you have that, then your portfolio as a whole will be less volatile.

So that could potentially allow you to have a higher percentage of your assets in equities and get you to the same risk level. - Yeah, I think that's a really important point that I want to undermine. So by having more of your portfolio in equities, which have a typically higher return than fixed income bond, typically, historically at least, but you're taking on more risk.

But if you diversify within that equities to say, "Well, in case the US stock market goes down, I can have a little bit of international in there, balance it out. It lets me take more overall risk in the portfolio." And so the, I guess the- - Or the same overall risk, but with more equities.

A higher percentage of equities, yeah. - Okay. So we've got equities, we've got fixed income. We'll come back to, what are some of these other asset classes that you see on some portfolios and not? Maybe we'll talk first about real estate. Like someone listening might say, "Well, I already own a home, so I already have real estate exposure." What is the case for or against including real estate as part of your investment portfolio for someone who is not a professional real estate investor buying rental properties and commercial real estate and all that?

- Yeah, so I guess the question is, including real estate in the portfolio being like buying REITs, so buying these publicly- - Yes, sorry. - Traded real estate trusts. And I guess one perspective on it is like, "Well, REITs are already in the S&P or sorry, these index funds to some extent." So there's a small amount of exposure that you're getting to these REITs already.

And then there's a saying, "Well, do you want more than the default amount in the index fund?" And I think there's some historical evidence that the value of real estate moves differently than the value of the stock market. So you're potentially introducing more diversification into your portfolio, which again, allows you to potentially have a higher percentage of risky assets while keeping the same amount of total risk in the portfolio.

And because of that, you expect that owning real estate is different than owning equity in a company. You'd expect it to perform well in different economic environments also. - Yeah, so I mean, 2008 is probably not the right example, but there were probably periods- - Yeah, not 2008. - But there were probably periods of time where real estate is doing well, the stock market is not doing well, and that would be a reason to dial it up.

But an important thing, I think, to keep in mind is, okay, so you already have some exposure to real estate in your index funds. And the same thing is probably true, maybe not, about commodities? - So commodity-producing companies, yeah. Yeah, like Exxon and then miners, yeah. - So you probably have exposure to the commodity market maybe indirectly, but I've seen a lot of people talking about recently, energy has done well.

Is there a case to put those commodities in your portfolio, the actual commodities? I'm sure, I think there are index funds that you can invest in energy or in timber or agriculture. Is there a reason to or not to add that on? Because I don't see it too often in most of the lazy portfolios, but I hear people talking about it.

- Mm-hmm. So I think owning commodities themselves is challenging, right? You don't actually want to own a bunch of wood or oil. So the way that people can do this are through some of these funds that can trade commodity futures. And I think there's an argument among investors are like, "Well, what are you actually getting with commodity futures?

How direct is that exposure to the underlying price of the commodity?" But I think there's some pass-through, it's not nothing. So I think one is the kind of the directness of the exposure. Another concern is of the management fees of some of these funds. So I think that would be worth taking a hard look at if they're charging 1% or more to manage this trading strategy of commodities futures, then that's something to be aware of that.

It may give you additional diversification and that the commodities futures aren't going to behave the same as the rest of the assets of the portfolio, but you may pay for that in terms of management fees. - Yeah. Which I think is a overarching important theme, which is as you're picking ways to invest in various assets, there are a lot of ways to do it.

If you want to invest in the stock market, you could invest in an actively managed index fund or mutual fund, you can invest in a passive one. What do you look for when you're trying to pick a way to invest in an asset class? - I think the two main ways are, what's a good index to track and try to find an asset that can track that index.

If you're looking for the S&P 500, look for something that is tracking that. If you're looking for the, or maybe better the kind of the overall equity, the US equity market, look for funds that track the thing you're looking for. Then second is the fee that they charge on the management of the fund.

You'll see this varies a huge amount. I mean, Vanguard has done an amazing job of offering these exceptionally low fees on a lot of index funds. I think those two things are basically what I would look for. - When you find these funds that, my buddy in college is in this fund and he says, "It's great.

There's a great fund manager." You look at it and you're like, "Well, this fund is investing in the US stock market. It's got a 1.5% expense ratio." VTI, the Vanguard total stock market fund, I don't know what it is now, but it's probably like 0.03, 0.05, some minuscule amount.

Is there any argument to be looking at these funds that are much more expensive, but managed by what I'm sure they would tell you are really smart investors that are making decisions that are supposed to outperform? - Yeah. This is an important distinction between these passively managed index funds, which their only goal is to track a defined index.

Versus the active funds are frequently have an index that they're compared with, but they're trying to make investment decisions based on their analysis of companies or assets that are going to return more than others. They're trying to use some investment process to beat the index. They try to beat the index, but they also have to pay their managers to try to do that.

They end up costing significantly more, a lot of times in the order of 1% or more. I think a helpful framing of that challenge is like, okay, well, it doesn't sound unreasonable that you put a bunch of smart people in a room and have them pick stocks and they're going to do better than the market.

It doesn't sound unreasonable. But I think a framing that makes it harder is that, well, if you bucket all the people trying to beat the market together, and you call them the active investors, on average, they're going to have the same performance as the market. So that means there are going to be winners and losers to that.

So you say, okay, well, maybe I can pick a fund in the winner half. Maybe, but all of those funds will also charge a management fee. So the question is, can you pick one that will win enough to overcome the 1% management fee? Because on average, they're not going to outperform because they have this management fee on top of it.

Yeah, I remember looking and seeing this data. And it wasn't that people don't beat the market. They do all the time. It was that the person who beats the market in one year doesn't usually beat the market every other year. And so, it especially can be hard to pick someone.

It's like, oh, they beat the market last year. Could be the worst indicator of whether they beat the market next year or not. And so, I think the data, and I don't know the exact stats, I will find an article, I'll link to it in the show notes. But the data is that net of fees, active investors don't beat the market.

Would that be fair? In general, or even the average one? Net of fees. Yeah. Net of fees. I think that's probably true. Yeah. So, all of what, at least I'm investing in, is the only active management is anything that I'm doing myself, which is usually not beating the market.

So, I've proven this point on myself. How do you think about newer assets like crypto fitting into a portfolio? I think with newer assets... So, let me take a step back and say, why do we have the confidence to include equities or something in the portfolio at all? And I think there are a few reasons that people feel comfortable with equities.

A few reasons that people feel comfortable with equities. One is that there is a long historical record of them doing well. And it's not just, oh, in the US over the last 40 years, it's had a good return. It's that over... There was a study by this group of economists.

They wrote this book called Triumph of the Optimists. And they did this huge study over 20 countries, over a hundred years of history. And they found over the hundred years, on average, global equities beat the market, but beat inflation by 5%. And some countries did better. The US, I think, was closer to six and a half percent overinflation over the hundred-year period they looked at.

And some countries did worse. Even ones that faced a lot of hardship over that period, Germany, Japan, they had inflation war that caused a lot of destruction. And they still beat the market, or beat inflation by 3% over that period. So it's this kind of longstanding, consistent performance of history is one thing that makes it comfortable, people comfortable with it.

Second is that you're getting ownership in a big, global, a lot of times profitable company when you buy a stock, or a group of them if you're buying an index. And that means you own a part of Apple, and Visa, and Johnson & Johnson, each of which has thousands of people trying to make new products, trying to be more efficient, make more money next year.

And all the money they earn, they're going to reinvest in the business or distribute it to you. And a lot of these have big dividends they pay out every quarter. So you own something that is making money, and it has a long history of success. And so when you think about developing a long-term investment strategy, that's the type of thing that I would look to include.

And you have an understanding of equities, and government bonds, and real estate, and these things you can get a handle around. When you think about including crypto in that strategy... - It's kind of missing both of them. - It's missing both the history and the unclear use of it.

- It's certainly not an income-producing thing. You can't take it. I mean, sure, there are ways to stake it and earn income and all that, but it's effectively just a speculation that the reason it would go up is because people think it's more valuable, not because it tripled its revenue, built a new iPhone, those kinds of things, reasons that Apple stock might go up.

It's going up because people think it's worth more because there's a limited supply of it, and more people want it, which is much more of a speculative bet than a kind of fundamental bet. - Yeah. I mean, to me, it's closer to a commodity that within maybe an unclear kind of total use of, or a currency, where there are reasons you don't include those directly in an investment portfolio traditionally.

- Yeah. What about other alternative things? I want to invest in a friend of mine's company. I want to invest in a winery. I want to buy some art. Do those things fit in your investment portfolio? - I think it depends a lot on kind of what the purpose is.

I think if you want to own a winery and/or art, there's probably a lot of value that you'll personally accrue from it other than the money. I imagine a winery, or a winery at least, it could be a very different approach of whether you're trying to run a winery to create a few bottles of wine for you and your friends, or as like a huge business venture that you're going to expect to make a lot of money on.

- There are a lot of other ways people can invest their money, and there's a lot of platforms online that make it easier to buy art, to buy shares in private companies, to buy sneaker collections. I don't mean that you would own things that you can own a piece of as an investment.

Those aren't things that necessarily have index funds. Those aren't things that you would traditionally see in an investment portfolio. But I think a lot of people that invest in companies and startups think of it as an investment. Do you think of that as something inside your investment portfolio, or do you like to carve a piece of your assets that you want to invest out, set them separately, and not call them part of your portfolio?

- I would recommend thinking about them as different things. It's helpful to have a liquid investment portfolio with a defined strategy that you can manage. Then I think to the extent that you want to be involved with more speculative things with a much less clear risk and return profile than a traditional investment portfolio, it could be helpful to assign a pool of money that you're going to spend toward those things.

- Yeah. I think I've often heard people say anywhere from 5% to 10% should be your cap. We're not going to tell people what they should do on this episode. This is not investment advice. It's a conversation. But when you think about these alternatives, I think the interesting thing is a lot of times there's not liquidity.

You can't just sell them if you need the money. You might need to keep them locked up for years and years. I know in the case of angel investing, yes, you could make lots of money, but most of the time you make no money. I've always personally thought of them as a separate pool.

But I guess in my mind, it's like, "Well, 10% of my investment portfolio is for this other stuff." It's not easy to track. It's not easy to value. So I keep it separate. But you might not even have them in your portfolio in the first place. There are a lot of sophisticated investors that probably don't also.

But I think they're always so flashy. I think people are excited about all these opportunities. I think it's hard for people to figure out what to do with them. Yeah. I think either with illiquid, uncertain assets, or I think you have maybe a similar problem in a situation where, let's say, the market's going up a lot and there's an opportunity to invest in either a really promising stock or some other thing, and maybe your friends are telling you about it.

And the question is, "Well, how do you make a good decision at that point?" And I think it comes back to having some investment philosophy that you understand and can stay in tune with. And then I think having a separate pool of money that you can be a little less restricted with.

And if you're going to gain a lot of value or you think you really... I mean, you could be totally right about an angel investment opportunity. So I think it makes sense to carve out and say, "This is how much I'm willing to allocate to my other bets portfolios." Yeah.

And in a conversation, I think with Andy Ratcliffe, he was like, "If you need to set aside money to satisfy your desire to be more active so that you can let all of the passive stuff to do its thing, go for it. Because it's better for you to put 5% and mess around than it is to put 0% and then mess around on the overall pool." And I think, unfortunately, and maybe fortunately, passive index fund investing is not sexy.

It's not like you're in there making trades. For the most part, at least in my portfolio, it's just sitting there. I'm not even checking it every day. I'm just letting it do its thing over a long period of time. Yeah. That makes sense. Yeah. I mean, I think that's right.

It's not something that is fun to talk about at a party. Yes. What are you doing? The market's up a ton. What are you doing? Oh, I'm waiting in my index fund. But I think for a lot of people, that's the... Well, I mean, there's a benefit in that, one, you're not spending a lot of time thinking about investing.

You could spend it doing other things that maybe you like more. And you have the market working for you. So you're in it, you're benefiting from it. Yeah. Without a lot of effort. So we talked about almost all of these major asset classes, and we left off this big bucket that is really in a simple two-fund portfolio.

It's your equities and your bonds or fixed income. You mentioned a few various types. But in today's market, how do you even think about the allocation to bonds and fixed income? I know in some portfolios, if you dial your risk score up, they don't even exist. And then you'll meet some people that are like, "Well, you need to have at least 30% or 40% of your portfolio in them." I feel like that bucket has the widest variation and lots of different opinions about how that fits in.

And now, at least in 2024, with high interest rates, is cash fall in that bucket or not? So I guess, how do you think about it? Well, I think it's worth breaking down some of the arguments of why it's helpful to have in there. Because I think both the historical record and estimates of future returns are that, on average, bonds are going to return less than equities.

That's historically, and that's I think what people are still projecting. So it's not to necessarily increase your return. What it can do is act as a bit of a ballast in your portfolio in that it can offer return if you don't want to dial the risk further up. But it also, in some economic situations, the price can move inversely with stocks.

So there may be a situation where stocks go down if growth expectations are low, and the value of your fixed income increases. So it not only can offer... Yeah, so it can kind of lower the overall volatility in your portfolio in some circumstances. And that's a reason to have it.

And if you go back in time and look at major market corrections, 2008, the dot-com bubble, before that, I would imagine that if your portfolio was a 50/50 portfolio in stocks and bonds versus 100% in equities, you probably would have not dropped as much. Right. Yeah. So I think there's a question, though, of...

Okay, so let's say your risk... If you only said, "I'm going to hide some amount of my money under my mattress, and I'm going to put the rest in equities, then... And the amount I'm going to put in equities, I'm going to determine by my risk tolerance and capacity." Right?

And let's say, "Okay, that means 50% of my money is in equities, and I'm going to put 50% under my mattress." Then the question is, "Well, what else can you do with it?" And what you find is if you assign some amount of diversification and actually negative correlation to the bonds, that means you may actually be able to put 55% or 60% of your portfolio in equities and the rest in bonds.

Because if equities move down and bonds move up, then your total portfolio drop is going to be lower than if you just had 50% in equities and the rest under your mattress. So that's the difference. But instead of putting it on the mattress, you could have it in cash or in treasury bills, for example.

So in a way... And this actually was the mattress example, really clarified things. You could think of your investment portfolio as all equities and then leave a large allocation to cash or outside of your portfolio to balance your risk. You've got $100,000. You don't want to lose it all.

You only invest $50,000 and you leave $50,000 in cash. Not because you needed to buy a house, just because you don't want to invest all your money in the market and see it all go away. Or you could invest the full $100,000 in your portfolio, but just not have 100% of the portfolio in stocks and put them in some income-producing asset that isn't equities.

And today, that could be cash at a high-yield savings account. It could be treasuries. It could be corporate bonds. How do you think about what to do with that pool of non-equity, I guess, fixed-income assets? So I think there are kind of two parts of that question. One is how much risks should you take in the other side of your portfolio, the bond side of your portfolio?

And I think people disagree about this, but my perspective is take the market risk on the other side, on the equity side. So that means I don't really like for individuals investing in corporate bonds, high-yield bonds. I'd say I'd focus on government bonds, which consider to be risk-free, credit risk-free.

And then the question is within government bonds, what's the duration that you want to take on? And what that means is how much exposure to interest rate risk do you have? Cash on one side or very short treasury bills? No matter, you're going to earn the amount on the bill and the price of that bill is not going to really go up or down if the rest of the interest rates move.

You're just going to earn that amount. Versus a longer duration, if you buy a 30-year treasury bond or invest in a fund that has long treasury bonds, the value of that fund will go up and down as interest rates move. So if interest rates all go up, then let's say you want a 30-year treasury bond that yields 5%.

If interest rates go up to 10% tomorrow and you own a 5% bond, then you could buy another bond at 10%. So your 5% bond is not worth nearly as much. So you're taking more interest rate risk. And that can be good or bad. I think in a down economic scenario where growth is low and the Fed cuts rates, long-term rates will probably drop.

And that means the value of your longer-term bond holdings will go up. And it could go up at the exact point that the stocks may be falling. So longer duration means more interest rate risk, but potentially an offset to the equity risk. Which we saw over the last few years, after the recovery from the pandemic, the stock market heated up, it grew, inflation went up.

And to combat that, we raised rates in the environment and your equity portfolio went up. But if you held a long-duration bond fund, it probably went down. And if that inverse happens, it could be a good hedge against that. And I think it's something interesting because if you hold a portfolio of bonds and you see, "Gosh, interest rates are rising on bonds.

That's good, right?" Actually, it's good if you're about to buy the bond. It's not good if you already own the fund that has them. And I think a challenge here is you look at these long-term bonds and you see lower yields and you think, "Wouldn't my money just be better in a 5% high yield savings account?" And the answer is probably for the next week, yes.

But as we've seen in the past, I think just in the last five years, I think we've seen interest rates go from 2%, 3% all the way down to zero, all the way back up to five. If right now interest rates in a high yield savings account are 5% and let's say next year, for whatever reason, they drop to zero, that 3% long-term bond is probably not going to be the price it is.

You're not going to get the return you will get now on the long-term bond that you would then. So you might think, "Gosh, getting three now doesn't make sense because I'm getting five." But if the rate in your high yield savings account dropped to zero, you probably couldn't get three for 30 years anymore.

Maybe it's one or one and a half. I don't know the right numbers. I think sometimes people look at these long-term things and think, "Well, the return's not as good as what I'm getting now, so I'll just stick with treasuries or I'll just stick with cash because it's a higher return." But if that return goes away, you can't get that seemingly higher long-term rate.

So how could we compare a cash interest rate to a longer-term bond interest rate? Yeah. I think the comparison I would make is that if you have cash, let's say cash versus a 10-year treasury bond. If you own cash or a three-month treasury bill, then you're saying, "Okay, every day or every three months or whatever the amount of time you need to reinvest, that you're going to basically take the average interest rate over the next 10 years." If it's 5% today and then it goes to zero and stays there, then your average is going to be just above zero interest rate you'll have earned.

Versus with a 10-year treasury bond, if you buy it and hold it, you're going to, if it's four point something percent, you're going to earn that four point something percent over the 10 years. So your average interest rate will be four something versus just above zero if interest rates go down tomorrow.

So if you look at this 10-year bond, how is it priced? Is it just a bunch of really smart people trying to guess what the interest rates are going to do over the next 10 years and price it such that unless I disagree with a bunch of smart people who are all trading in the open market, presumably I don't have inside knowledge.

The same reason I don't like picking stocks is there's a bunch of smart people pricing any individual stock. I don't think I can do better than them. Does the same principle apply to bonds in that if I want to get the best interest rate over 10 years, am I not just better buying the market than trying to pick and choose 5% now and something else later?

So that's a big component of how that number comes about. Why does the 10-year bond trade it for something is because a lot of smart people have said, "Okay, well, I think the interest rate here is going to be here. At one year out, it's going to be this.

Two years out, it's going to be this." And that's a market that is traded. You can trade these future prices. So a big part is people making an estimate of what the average short-term rate is going to be over that time. There's also this idea of a bond risk premium in that maybe you should be compensated additionally for the fact that you're buying a longer-term riskier security that can go up and down versus cash you have a guaranteed return.

It's not the only component, but it's a major one that goes into it. In addition to potentially being compensated for having a riskier asset, there's also potential supply-demand factors as the Fed is going to be buying or selling these bonds that can also affect that rate. I guess it means depending on the economic climate, the Fed can make these actions to try to slow down or speed up the economy that will affect rates, and that'll affect all of these prices.

We don't really know what they are. The Fed chose to do quantitative easing, which meant buying treasury bonds and mortgage bonds, which drove the yields lower. I think a lot of people believed lower than what that average rate would have been. Okay. That changed the assumptions people were making, and depending on which side you were on, you had a better or worse outcome.

Right. Think about risk. Just to quickly recap building the portfolio, because I want to talk a lot about implementing it. First, you need to think about your risk, your tolerance for it, your capacity for it. You can go online. You can look at questionnaires. You can think about it internally.

You can look at how you behaved in the past and come up with an idea of that. Then you have to build a portfolio. We talked about a lot of places you could get inspiration. We talked about some of the different asset classes. You can go look at the lazy portfolios online.

You could use any one of these investment advisors like a Wealthfront or a Betterment to build a portfolio and see how it works and dial in what you want. Now we have a portfolio. You could potentially even have a conversation with ChatGPT to say, "Help me think about how to build this portfolio," if you want someone that's not a paid investment advisor, but a dialogue partner.

We'll come back to that, because I think there are some challenges and some benefits to doing that. Let's assume that everyone listening has paused and created a portfolio, so they have something. How do you put that into place? I imagine some people will have already had this in place.

First, let's talk about putting it into place. Then what happens if you realize that what you have now isn't what you necessarily want? For someone listening that has some money ready to invest and now has gone through this process, do you just pick your index funds, decide, "I'm going to do, for the sake of argument, 70/30 split and total global market in the 70 and total bond market in the 30," and you just dump it all in now?

How do you think about whether it makes sense to slowly invest over time, invest all up front, or even potentially hold out and wait for the market to drop and try to buy at the bottom? I think a lot of the decisions... Thinking about these types of questions, there's what is the maximum theoretical value going to tell you?

Then there's what should you actually do? What you should actually do is not necessarily the thing that's going to maximize to the scent of the expected value of your portfolio. You have to behave in a way that makes sense to you, that you're comfortable with. I think if you're sitting ready to invest, but you haven't invested a lot now, investing everything at once and then seeing the ups and downs in the portfolio as the market moves around, that may be a very painful experience if you're not used to seeing that.

That would be an argument to step in a little bit at a time. Yeah. I remember this Vanguard study where it said, "Technically, lump sum investing was better." That makes sense because in the long run, the market goes up. If you assume that on average, the market goes up every day, not that it actually does, but if you assume on average, it always goes up, then you're better off putting it all in now than waiting.

But in the circumstance, it goes down. If you're going to be able to not live with yourself for making the decision to put it all in the day before the market went down, you could invest over time. That might not have the highest expected value, but it might make you feel better.

Yeah. If it's something that you can actually do and feel better about versus hesitate or not do or feel terrible about, that seems like a good approach to step in over time. Yeah. When a lot of these studies say the expected value is better to invest it all up front, it's not better 99.999% of the time.

If it was, then the expected value would be so much higher. It's probably, and I'm making this number up, but it's probably better more closer to 60% or 70% of the time, or maybe even less than that, maybe like 55%. It's not like dollar-cost averaging versus investing all at once.

The outcome is not, on average, five times better. It's probably marginally better. I think sometimes it's like, "Let's minimize the regrets I might have about the way I acted instead of get the best possible value." Yeah. That makes sense. I think if you had to put an order of magnitude, if I had to guess the order of magnitude of the benefit, it's like, "Okay, on average, if the global equity market has outperformed inflation by 5% and call inflation to be 2%, that's 7% gross return.

If you average in over the course of a year, then on average, you're going to be half invested. That's 3.5% of expected return that you'd be missing out on." If that means that it's something that you're much more comfortable with, that may be a 3.5% you're happy to pay.

Also, I don't even think you factored in in that math, the fact that while that money is all sitting in cash waiting for you to invest it right now, Oh, that's true. you're probably also earning 5% on that cash. The delta is really that 2% spread out over the year, and it just shrinks down a lot more.

That's a good point with the higher interest rates currently. Yeah. Right now is actually a better time to dollar cost average than lump sum invest just because the money while you're not investing is actually earning a return. Whereas a handful of years ago, if it was earning zero, it might give you a little bit more angst about not investing.

Maybe not investing, watching the market go up while your money earned zero would actually be the thing that stresses you out a lot, and it might push you in the other direction to actually want to invest everything right now. What do you think about if someone's thinking, "Gosh, I already have an investment portfolio.

I've now gone through this process and realized it was either too complicated or it wasn't right for me, or I just want to simplify it and do something different." How do you think about that transition when it's already in the market, but you need to transition to something else?

What are the ways you would decide when and how and over what period of time to migrate from one portfolio to the next? I think one thing that comes to mind is I guess a potential blocker to moving could be if you have a lot of gains that have unrealized gains in the portfolio, then if you were to sell those positions and buy other different ones, then you can actually realize those gains and then that can have an impact on your taxes, maybe a significant impact on your taxes.

I think that would be a reason to think harder about what a change in strategy can look like. But yeah, if you're thinking about simplifying and you don't have that issue, yeah, I don't see what- You would just sell and buy something different. And buy something different. Yeah. What do you think would slow someone down or should?

Yeah. I guess the taxes one for me has always been one because I had some old index funds that I was like, "I don't really want these," but they're at a low cost basis. I would say my one thing was at least wait till you've held them a year because you get better tax treatment in the US holding equities for a year and selling them than you do paying short term cap gains.

I think sometimes there's an emotional hold up, which is like I meet a lot of people who, especially people that work at companies like tech companies that they own a piece of the company and say, "Gosh, my portfolio right now is 50% Google." And listening to this makes me think it's not very diversified.

And I probably shouldn't hold 50% Google. And I remember we would always ask these clients this question of, "Okay, if you sold it all now by mistake and you sat on a pile of cash and you had to decide how to invest it, would you invest 50% of it back into Google?" And people are like, "No, no, I would never do that." And then we'd say, "Great.

So then we agree you should sell the Google stock now and you should buy this new portfolio." And they're like, "Yeah, yeah. As soon as Google hits like 120..." I don't even know what Google's priced at right now, but it was always like, "As soon as it gets 20% more, then I'll sell it." And I feel like that, not necessarily because of taxes, but more about trying to time the sale of the asset they hold now and feeling like it's not where it should be has always hung up a lot of people.

Yeah. Well, I think... I really like that framing, saying, "Okay, if you were all in cash today, what would your ideal investment portfolio be?" Because I think it's really clarifying to move away from where you are now, because putting aside the potential tax complications of actually moving it, it's a good framing to say, "Okay, where should I be?" And then you can move there either quickly or more slowly.

And I think that's a really hard decision for people to make, to sell their company stock. They feel personally invested in it. In a lot of cases, people have, particularly Google, gained a lot of wealth by holding it. So it seems like maybe that's not the best decision to sell all this thing that's worked so well for them.

But yeah, I think that framing is really helpful. I think one thing that I've also done, which I think is something not everyone does... I think you will probably lose if you compare Google to investing in the total stock market since Google's IPO. I think Google's probably outperformed the total stock market by a lot, but it won't look as good if you compare it to zero.

And so I think sometimes people that are holding a stock for five years and they look at it and they're like, "Wow, my stock's up 100%." Well, if you had invested in the stock market for five years, I'm not saying it would have gone up 100%, but you want to make sure you're at least comparing things apples to apples.

And so a lot of times I see people say, "Gosh, I don't want to sell this thing. It's been doing so great." And it's like, "Has the market also been doing so great?" Because the US stock market for the last century has been doing pretty great. There are windows of time it hasn't.

So I think making sure you realize that by selling a few stocks and buying an index, well, one, you're still even holding those stocks. Google is a big chunk of the total stock market also. So you're not getting rid of all of it, or at least all the exposure.

But also you're buying into a asset class that also goes up over time. And so you're not giving up all the returns. Okay. So we moved into this portfolio. A question that I've both gotten and thought about a lot is, well, it's easy to think about your investment portfolio and say, "Great.

We want a 70/30 split of these two index funds. That's pretty simple." But I actually have between me and my partner, what if I have five accounts? What if I have my 401k, we've got a Roth IRA in both of our names, and then we've got this taxable brokerage account.

Now I have five accounts. They have three different types of tax treatments. Do I just buy the same portfolio in all five? Or as I'm sure some people listening know, there is a case to be made for certain types of investments being really tax efficient or tax inefficient, and that putting them in different accounts could make the overall portfolio perform better.

Yeah. It's certainly true that there's that opportunity for additional optimization. It's like, because assets are taxed differently and accounts have different tax treatment of the assets inside, then there's opportunity to optimize that. And I think there is additional value to doing that. The question is, how much value is there?

And that depends on your tax situation and how much money you have invested, and also how complicated is it? And what's your appetite to do it yourself? And how much do you value your own time? So I think it's just like a rough ballpark way to think about the benefit of it.

If you say you have, call it you're considering moving 20% of your portfolio to a tax-advantaged account, and that 20% that wasn't there, you're going to move somewhere else. And you say, okay, well, and that 20%, I expect to earn, let's say, 5%, have a 5% return. So then you're talking about, okay, how is that 1% of your portfolio return taxed?

Because you're talking about the 5% return of 20% of the portfolio, 20% of- Yeah, so we're doing 1%, and we're saying, okay, we're going to optimize the taxation of that 1% return. And say, okay, well, in a high marginal tax rate of, let's say, call it 37%, in that one asset gets poor tax treatment, and one asset gets good tax treatment, and it's taxed at 15%.

And you're saying, okay, what's the difference in that? It's like, that's 22% difference in the tax rate. So you're saying, okay, well, I'm going to have a 22% difference in the tax rate on that 1% of return. That ends up being 0.2% of your portfolio in additional return due to this tax optimization.

And I would consider a pretty good scenario where you're doing 20% in the best tax treatment or the worst tax treatment. So 0.2%, that's something, that's not nothing. And depending on the size of your portfolio, that could be significant, and that could compound over time. But I think the implementation of it is usually not so straightforward.

And I think it's something that I've done, maybe you've tried and done, that you need a spreadsheet, and you need to figure out what assets go where to make sure you have the right overall balance. So there is really a time and mental overhead of cost to doing it.

Yeah, I think one thing that I learned trying to do this, because there's this great image that I'll link to in the show notes, or I'll overlay right here if you're watching on video, where it's like, what are the most to the least tax efficient things? And there's kind of two components to it.

One is the tax treatment, and one is the expected growth. If your equities are going to grow at a rate that you expect to be higher than your bonds, then having your equities be in your Roth IRA that will not have any taxes in the future versus your bonds that will have a lower return, that could make sense.

Your bonds also, though, might be taxed depending on whether they're qualified at higher rates. So maybe there's a counter argument there. There's a great story about a handful of people who have taken their Roth IRAs and invested in startups that have been the highest returning things. And because they had no future taxes in their Roth IRA, they got all those things tax free.

The downside there would be obviously you're taking your retirement money and betting it on something that could go to zero, which is not a good retirement plan for most people. What I found doing this was there's another part that makes it complicated, which is it's unlikely that whatever your allocation to one asset is, is the exact balance of your 401(k).

So in our circumstance, we had two Roth IRAs, two 401(k)s, and a taxable account. So we had five accounts. And if we decided that our perfect portfolio was even 70/30, which would be the easiest one, or a two fund portfolio, obviously 100% zero would be the easiest one. Then we're not doing any optimization.

You're like, "Okay, well, I'm going to put these in here." One of the accounts is ultimately going to have two things in it. And as one account grows, it's going to grow faster or differently because they don't have the same thing in it. And now when you're trying to rebalance between them to stick to your core portfolio, I found myself being like, "Okay, in my 401(k), I need to sell a little bit of this to make up for this.

And oh, wait, wait, wait, hold on. My 401(k) is all pre-tax. So even though there's 50 grand in my 401(k), 50 grand in my 401(k) isn't the same as 50 grand in my taxable account. So what should I actually count that at? And if I'm thinking about this overall portfolio, should I think about it after tax?" And then all of a sudden, I'm like, "Oh, wait.

Well, these things are up and I'm going to have to pay long-term capital gains because they're in my taxable account. The Roth IRA, I'm going to pay no taxes." Even just figuring out how many dollars I had was so much headache that I couldn't actually manage it. It just didn't make sense.

And I just couldn't figure out how to rebalance it. And I just stuck with it. And I just didn't make changes. And I was in a portfolio that wasn't the portfolio I wanted because it was too complicated to figure out how to get to the portfolio I wanted. And ultimately, I just switched and said, "I'm just going to have the same portfolio in all of them," because it was a little easier.

Is it the most tax efficient? Absolutely not. Could I get that little extra return doing something? Probably. But would I actually manage it? No. And we'll get to some optimizations next, like tax loss harvesting or rebalancing. Is the expected value of being able to do those things higher than the expected value of the tax aware allocation?

And if so, then you're actually better off making sure you can do that. However, if you are someone who loves to keep these spreadsheets, can value all of these balances appropriately and figure out what they're worth based on their future taxes, and do this and with ease, you're probably going to end up better in the long run in terms of returns by putting your most tax efficient things in one account and your least tax efficient things in another and your highest returning assets in another and balancing it.

I just wasn't someone who could keep on top of it. And I think another thing to consider when considering a strategy like this, when you're kind of in your head, mixing together your retirement account and your brokerage account is that I think a lot of people may find it helpful to say, "Okay, this is my retirement money that you could think about investing.

And this is my brokerage money. I'm going to set aside my retirement account money as something else." So a prerequisite to thinking about this tax aware application is that you really have to think about everything as the same thing, just with different features to it, which I don't think everyone's there.

Yeah. Especially if you're thinking, "I'm a little bit younger. One day I'm going to buy a house. So the money in my investment portfolio might have a 10-year horizon, but the money in my retirement account might have a 40-year horizon." Those are very different. And we didn't talk about this at the outset, but I think because we both had this discussion for hours and years ago, the investment portfolio is for money that you don't need to touch in the short term.

Now, we could debate whether the short term is three years or five years or 10 years, but the general principle was we're not going to take an investment. Our investment portfolio is money we don't need soon. It's not for the house we want in a few years. It's not for the company that we're going to start, or it's not to fund our life to take a sabbatical because we don't want to be in a circumstance where we need that money and the market's down and we have to sell while the market's down and we miss on the upswing because in the long run, the reason the market returns over 30, 40, 50 years or however many years your horizon is, is because it goes down and up and you need the down and the up.

Yeah, I think that's a really good point in that this consistency of good returns for equities, it's always over a long time horizon. If you look at two or three-year chunks of equities, there are wild swings so that you want to give yourself the benefit if you're coming up with a investment strategy that has historical support for producing good returns over inflation, over long time periods.

You want to give yourself that long time period to let it work. Yep. Let's talk about some of these other optimizations. Rebalancing. Unfortunately, it's not one thing to figure out, "Here's my portfolio and don't touch it for 30 years." Mm-hmm (affirmative). Because if you're in a portfolio of equities and bonds and the equities went up a lot and the bonds didn't, you're now at a different portfolio than you planned.

If you wanted 70/30, maybe now you're at 75/25 or 80/20. How important is it to rebalance the portfolio and how often should people be thinking about when to do it? Yeah. I do think it's important because that asset allocation is important to keep the target risk that you're looking for in the portfolio.

Rebalancing, make sure that you don't stray too far, either too low or too high from that target risk. In terms of when to rebalance, there's certainly a lot of diminishing returns to it. If you rebalance every day to make sure that you have the exact, you're not 70.01%, then that's going to take a lot of time and not provide a lot of value to you.

If you rebalance once a year, I think that's going to get you the vast majority of the benefit. I'd say one other potential... You could say, "On one day a year, I'm going to go rebalance." That's a reasonable approach. Another way to augment that a little bit is that when there's a big market move, you may consider rebalancing.

If there's a big move down or up, depending on the size of it, you may say, "Okay, well, I know it's not December 15th yet, but I'm going to take this time to say, 'Okay, well, now it's an opportunity to make sure I have the right amount of risk.'" What about tax-loss harvesting?

How do you think about that as something worth doing or doing at a similar cadence or more frequently? For those who aren't familiar, I'll just give a quick overview, which is that when you have an asset, let's say you invest in the total stock market and it's down 20% because we're in the middle of a pandemic, you could leave it down.

Let's say you bought it at $100, and now it's at $80. It's down. You could leave it there, or you could sell it at $80, spend that $80 to buy something very correlated and similar, but not exactly the same. Not the same VTI, but maybe a Schwab index fund that tracks the market.

Now you'll have a lower cost basis. You'll have an $80 cost basis, but that $20 loss from that first purchase, you can actually use to offset some income up to $3,000 a year or other gains and continue to grow that other position over time. The more you collect these losses, I will say in some cases, the easier it is for you to change things in your portfolio that create taxable events.

Do you think you can go overboard, or is it rebalancing? Once a year is probably enough. I think before you embark on the tax loss harvesting, there are a lot of rules that you need to follow, and there are some logistical challenges of doing it. You'd want to become familiar with what is a realized versus unrealized loss.

What are the different types of these losses? Are there short-term losses, long-term losses? There's this complexity, because if you sell something and rebuy it, you can create a wash sale. None of this is tax advice. It's a way of saying that there are a lot of rules around how to actually achieve these realized losses that you need to be aware of before you start going down this road.

If you want to go down the road, then I think you need a spreadsheet to approach it, because you need to track how much loss is in each of your positions, potentially each lot that you've bought of your positions, and then what are equivalent funds that you could sell one of and then buy more to get the right allocation.

I think that's the minimum requirements to get started. The benefit of it is really dependent on your situation. If you're already in a portfolio that has a lot of gains in it, you may not really have a lot of opportunity to harvest tax losses, because the investments have already been going up.

Yeah, yeah. If you bought the total stock market 10, 15, 20 years ago, your cost basis at this point is so low that even if the market crashed 20%, you probably wouldn't have a loss. Whereas if you just started investing last year and we have a market correction of 20% next week, you'll probably have losses in your portfolio.

You can harvest the whole portfolio. Yeah. I think it's fair to say, one, yeah, you have to understand all these rules. These rules don't just apply in one account. If you are in five different accounts, your retirement account, your taxable account, and you're selling one thing and buying it in another, that can create an issue.

I find that if you want to do tax loss harvesting on your own, you should really understand it. I know some people that even trade in different funds in all their different accounts because they want to make sure they're not mistakenly triggering any of these rules and causing taxes when they think they're saving money.

Maybe not. Now, if you have two funds, right? If you have a two-fund portfolio and let's say you have no retirement accounts, you just have your taxable account, maybe you could make a case that it's a little easier. Who's going to benefit most from the tax loss harvesting? I think it's people who don't have investments that already have a lot of gains in them and that they're either adding money or they're adding money investing currently so that they can monitor if those investments go down and they could try to sell them and realize gains.

Then I think there's, again, significantly diminishing returns from doing it more frequently. I think one of the big benefits of tax loss harvesting is that for some people, if they have a net realized loss in their account, they can offset their income with their capital losses. I will flag, we're talking about being able to take a loss that you would have been able to in the future offset your gains, which means maybe you could offset your long-term capital gains rate at 20 plus state taxes.

Let's call it 25%. Instead, you can offset your income, which could be at 45%. You're getting a 20% arbitrage. The one that's like best case, and two, it's capped at $3,000 a year. You might think, "Well, $3,000 is a meaningful part, but if you're at a lower income, you're probably not at a high enough tax rate that it's going to do that much for you anyways." I think the real value where it comes into play is if you have a really substantial existing gains, let's say you've held that Google stock for many, many years and you want to trade it into your portfolio.

If you're able over time to accumulate losses, it'll make the gains from selling that Google position much more tolerable because you might not have to pay those taxes. I know I needed to sell a lot of my portfolio sometime, I don't know, maybe two, three years ago. Because I had tax loss harvested in the middle of the pandemic, I was able to create a lot of losses.

When I had to make that portfolio change, it didn't cost me any taxes because I'd been holding onto these losses. I felt good. I was not managing that myself. Our investments are at Wealthfront, they're automating all the tax loss harvesting, they've written some white papers about the value of tax loss harvesting.

My personal non-advice belief is that there is value, probably more than the 0.25% fee, if you also factor that that fee means I don't have to think about it. But if I try to execute it on my own, it goes back to the tax aware allocation thing, which is like, I just, I'm not going to do it.

I think it's possible to do on your own. I think it's not possible to do it at the level of sophistication that Wealthfront does it on their own, but you can capture a lot of the benefit. But like I said before, you have to know all the rules, have a plan, make your spreadsheet and do it.

I think your points are exactly right in that if, well, I think, yeah, I think one, if you have some big sale of an asset with a gain, that makes it super helpful, but also in the rebalancing, if you imagine what rebalancing would look like from a tax perspective, right?

It's like if equities go up, then you're going to be, if equities go up more than bonds, then you would sell some equities and invest that into bonds. So that's going to potentially produce a gain that if you have done tax loss harvesting and have been kind of in the right place, right time, and that you've invested money and it's gone down, you're able to realize that and you're able to offset that gain.

So you wouldn't necessarily have to pay taxes on that. Yeah. One other downside I find of tax loss harvesting is just that depending on the times at which all of these things happen, your US stock market allocation might now have two or even three different index funds. And for some people, that's not a problem.

For some people like me, it's like, I just want it to be simple. And now I find myself saying, well, now I just want to sell one of them so that I just have one of the same index fund. I don't want two or three. It's just easier for me to look at.

And having to sell those things and pay taxes on them is like- Then you have gains in those. Yeah. Yeah. So I think if you want something simple, I would say either let someone else manage it or be excited about managing something complex or wait until very, very big moments, like the entire market's down 30% and those could be the times, but doing it regularly on your own seems like a nightmare.

Yeah. And you still have to learn all the rules, even if you're doing it once at a time. Yes, you definitely do. What do you think about direct indexing? Because I know there's this company FRAC, which just launched, which is like direct indexing as a service. And the general idea is you could buy the S&P 500 index fund, but you could also just buy the 500 companies in the S&P and you could, one, avoid the expense ratio and two- 0.05%.

Yeah. And to be clear, to pay for any- How much is that company? I think it's like 15 basis points. So you're not going to really avoid the expense ratio, I guess. The upside would be now that you own 500 companies, at any given point in time, there are companies that are failing in the U.S.

stock market. And so if you own the whole stock market, on average, it goes up. If you own every company, then you can harvest the losses of the companies that fail while they're failing and capture more stock, obviously not something you'd want to do on your own, but you could capture more tax losses than you would otherwise.

So I think the reason why I would not do that myself, are they a sponsor? No, I don't know. No sponsor. The reason I would not do that myself is I think the... I'm a little bit risk averse here, right? Imagine the circumstance where you have this company managing the 500 stocks for you, doing the tax loss harvesting.

Okay, great. Sounds reasonable. What if they stop doing that? And they say, "Okay, we're not offering the service anymore. Here are your 500 stocks with gains in them." Because yeah, all the other ones have... They've sold all the ones with losses. What do you do then? Yeah, then you're managing a brokerage account with 500 individuals.

Really, what would you do though? I don't know. I really don't know what I'd do in that circumstance. I guess at that point, you'd hope another company had started that you could say, "Can I transfer my 500 stocks to you so you can manage them?" Maybe try to find a company that Angel invest in that could manage it for you.

Yeah. That is the biggest downside I've heard from people who use a service that does direct indexing, decide they don't want to use that service. And now they're stuck either managing 500 individual positions, which I can assure you rebalancing in between is going to be next to impossible on your own, or they're forced to sell out of them at probably a gain just because the market goes up over time.

And so that would be the downside. If you are using a company for direct indexing, you are probably making a bet that that company or a company that can take over that portfolio will be around for a very long time, or you will be managing 500 or however many individual stocks, or you will be forced to sell them if that company stops operating.

It sounds like for you, it's like, "Not a risk I want to take." It doesn't sound like a good trade to me. I'm still doing it, but I think maybe I'm- You may be too late now. Now you can't stop. Now I can't. I'm still doing it because I can't stop doing it.

So another potential threat is what if they raise prices? Yeah. You're stuck paying those prices. Yeah. You're stuck paying those prices. Yeah. It's something that now that that portfolio is up, I'm like, "Well, I guess I'm-" I can either pay the prices or realize all the gains in these stocks.

Yeah. So I guess I'm stuck in it. But because of it, I have harvested way more losses than I would have otherwise. So at least if I ever wanted to sell out of it- You'd be partially offset. I'd be partially offset. Other things along the lines of maintenance and ongoing stuff, when should people think about changing their portfolio?

Because we talked about how to think about constructing it, but does it change over time? I think there are a couple of ways that the risk tolerance could change. One is become a more experienced investor where you become more familiar with how the market will move and you become more comfortable with seeing up and down in your portfolio.

Another is your financial situation can change where you may have continued to save more money and say, "Oh, I'm actually comfortable putting more at risk." Or you could say, "I'm less comfortable putting more at risk because I don't expect to be earning as much or whatever in the future." And then I think an important way it could change is if you're combining finances with a partner.

And then you're not only thinking about what your tolerance is, but you're thinking about what your combined tolerance is and what's the lowest tolerance of the combination of you. Yeah. Okay. And when that happens, it's like rebalancing. It's time to adjust things over time. How do you think about...

Maybe we'll slot this earlier, Ben. When it comes to all of these changes, how do you think about doing them by buying and selling things, doing them as you're investing each month, doing them by reinvesting dividends? Are there easier ways to make the ongoing management work when it comes to ongoing investments and what you tell your brokerage firm to do with any dividends?

I think it probably doesn't matter too much practically. The amounts you'll probably be changing are relatively small. I think the easier to manage is just have a reinvest dividends and you don't have to think about it if you let it go a little bit longer between rebalancing. But an approach that I use and I think some other people use is that you don't reinvest the dividends and you take the money that's spit off every month or quarter and use that to true up to the right allocation to the extent you can.

And then you may have to make a bigger change if the market moves or something, and you may have to buy and sell. But that's a way of avoiding a little bit of the friction. And that strategy probably feels better right now when the money that's uninvested is probably in a money market fund earning 5%.

Would you probably feel a little differently if the uninvested cash was earning 0% or is the headache it saves kind of? Well, I think the uninvested cash is only uninvested for a little bit because you can get the dividend either each month, maybe it's a bond fund or each quarter.

And then you let all the dividends come in and then you can take those dividends and invest it. So they would only be sitting there for maybe a couple of weeks or a few weeks. So yeah, I mean, maybe it's not super optimal, but I don't know. It seems reasonable to me.

Didn't stress you out. Yeah, it didn't stress me out. And let's talk about uninvested cash because I think we already talked about the portfolio and how you could leave cash outside to adjust your risk. But I remember when the pandemic was going on and we were down 30% and all I could think was, "Well, I'm pretty confident the market's going to go up over time.

Really wish I had some of my money not invested." Not just because it wouldn't have been down. Obviously, anytime the market drops, it would be nice to have not been invested. But mostly because I was like, "Gosh, this seems like a once-in-a-decade buying opportunity right now. The market's down 30%, but I would have had to leave this money uninvested and had the market not gone down." So how do you think about leaving cash aside for opportunities, whether the market is down or some other thing happens?

I know you used to call this your elephant hunting fund, but how do you think about that? I think on average, it's not going to be a good idea. On average, you're going to do better, I think, by having it invested. There could be a psychological benefit to having money set aside, but I don't think it's going to be on average better to wait for a downturn.

You may feel very smart if you set the money aside and then a year later, there's a big downturn, you can invest it all and make 30% of the money. But yeah, I think on average, it's probably not going to work out. I also think it's incredibly hard to know when the market is at the bottom.

Yes, yes. And I would say most people will get that number wrong. So it's one thing to say, "I wish I had money at the bottom of the pandemic to invest." It was another thing when the market was down 15% to either say, "Okay, now's the time." When is the time to actually do that is another challenge with that approach.

Yeah. I think it's like, "What's your capability of timing the market?" Because timing the market is very, very hard to do. I will say maybe a slightly modified version is if your dollar cost averaging, if you're like, "I have $100,000 to put in the market over the next six months, and a month from now, the market is down 10%," well, maybe you can accelerate your strategy and just put the rest of it in the market.

You're not necessarily keeping it all on the sidelines just for that purpose. But if you're already in the middle of deploying money, maybe that's a time you could accelerate how quickly you're doing it. I remember I had a chunk of money to invest, and my rule was like, "I'm going to put in X amount a month, but any time the market in any given day is down by more than 2%, I'm just going to rein in one of those months and do it today." Yeah.

I think it's a lot about what can you do. You want a strategy that you can actually follow and that you feel good about. And if you feel good about getting a bargain by investing on down days or investing when the market goes down 10%, it's not going to hurt you, I think, unless you're having money out of the market for a long time, waiting for the crash that never comes.

What would you say to someone who's listening to this conversation, is excited to dial things in, but just is an over-optimizer and is having analysis paralysis about picking the right, perfect portfolio? Yeah. I think once you can dial in what the appropriate risk is and what the right balance between equities and bonds and come to some basic asset allocation, then I would say there's always opportunity to add complexity on top of the strategy later.

I think you don't want to put yourself in a situation where you're not confident in your investment strategy, which would cause you to potentially sell when it goes down because you don't really believe in it. But if you can get across that threshold where you think you're in something you can believe in, then starting simple sounds like a great way to get going.

And then if you want to continue to do research about tax loss harvesting, tax aware allocation, and potentially add that complexity on later, that seems like a good approach. Yeah. I want to caution people not to make perfect the enemy of good here. I think that if you're on the fence between whether you should be in a 65/35 or a 70/30 portfolio and it takes you a year to dial in that decision, you probably would have been better off in either of them.

Or start with the less risky one. If you think you may not have the tolerance for the 70%, start with the lower risk version of it. Yeah. My challenge has always just been there's no perfect answer. You could take a million risk scores and they'd give you a million different...

Not a million, but you'd get a lot of different allocation amounts. At the end of the day, you just have to pick one that feels right, knowing that either direction for any of the assets in your portfolio could do better or worse. But a 70/30 and a 75/25 portfolio are going to be pretty correlated to each other.

Even though they're not going to be perfectly correlated, they're going to be pretty correlated. And you will never know which one was actually the better one for a given period of time. Yeah. And you're making a choice by not being invested or being all in cash. You're making that your portfolio instead.

Yeah, which is definitely not your portfolio. So it's also a choice you're making. And you're like, "Well, is that the right one?" Because you should think about what is the best one that you know now. Yeah. And to your point about complexity, even if that complexity... You can always add complexity.

You can also always change it. If you decide you want to dial up the amount of equities you have, great. You can do that. You can change this over time. So finding something that feels good is great. For me, I think I have a four-fund portfolio. And I was like, "I just want them at 40/30/20/10." I felt really good about them all being very even numbers.

No rationale there. It could have had 38, 40, whatever those numbers... I'm going to do the math right. I could have had 38, 22, 30, and 10. Those all would have also summed up to 100, I think. Double-check my math if you want. And I just feel good about it.

I know it sounds crazy, but the difference between all these numbers got me caught up in thinking, "Gosh, I don't know if it should be this or this or this." So I just picked round numbers. And I was okay with that decision, even if it's not... Some other person's algorithm would have spit out a more optimal allocation.

It just felt easy for me to look at and manage if I always knew that they were simple round numbers. Yeah. Makes sense. I think having something you can have confidence in and stick with if the market's down or up is probably one of the most important pieces. Yeah.

And so if people do need someone to talk about it, and maybe they have a spouse that's not interested, I'm curious how you think about in light of the world now. When we were starting our company, there was no chat GPT. There were no other models you could have a conversation with about things like this.

And so we built something that was a hybrid of software and human financial advisors. Human financial advisors still exist. If you're struggling to make these decisions, might make sense to work with one. I think the advice I would give, which is probably I assume is yours, is work with someone who has your best interest at heart.

Work with a fiduciary. And understand that there is a difference between a financial planner who can help you think through planning and investing decisions and an investment manager. And so there are lots of people out there that can help you come up with a portfolio that can help you think about how much to invest, what to invest, that you don't need to pay an ongoing fee to manage your portfolio.

You could pay a financial planning fee, but not a 1% of AUM assets under management fee on an ongoing basis. I don't know. Without going down a whole episode about picking a financial advisor in general, you could... Anything you would say about picking one? Yeah. I think picking advisors who's a fiduciary, who has experience working with clients in your general situation is a great place to start.

And I think they're people with their own experiences. So I think interviewing them and interviewing a few of them and seeing this one you get along with, agree with their philosophy is the right thing to do if you want to work with someone. And what about AI here? Because I know you've been working on a lot of this in your lab and thinking about language models.

Could you get a lot of what you get out of working with a financial advisor just by having a conversation about your portfolio with chat GPT, perplexity, whatever model you want? Maybe in the future. Right now, there's the hallucination problem where if you're relying on the model to give a good investment portfolio, it could just make up something.

It could make up data. It could make up rationales. So I think there's a lot of... There's a lot of caution that would be needed. I think if you're using it to bounce around ideas and want feedback, but are not going to make any decisions based on it, maybe you could convince it to talk about it with you.

But I think there are a lot of innovations that are happening on the model side themselves that'll be really interesting and lead to really interesting financial products in the future. For example, one of the approaches to improving the hallucination problem is this strategy called retrieval augmented generation or RAG, where the idea is given the question, can it integrate information from documents into what it analyzes and how it gives an answer?

So maybe it could give a footnote about why it thinks this investment could be good or this portfolio could be good or why you should do something in this circumstance. There's also opportunity to not just have a one prompt. You send one message and it sends one message back.

It's an opportunity to chain the outputs of the language model together and say, "Okay, well, the first prompt could be a set of ideas that it then goes and explores and then comes back and it writes a summary for you." I think there's a lot of innovations that will make these things more useful and more accurate in the future that I think is going to be a huge advantage for people who don't necessarily want to hire a financial advisor, but want to collect information in a lot better way than a Google search.

Yeah. I'd push back a little and say, "I bet if you pull up any AI tool of choice right now and say, 'Hey, I'm trying to think about building an investment portfolio. Can you help me think about what my risk score could be?' You might be able to have a dialogue.

Is the answer going to be the answer that I would say, trust it and execute it? No. Ask two or three different AIs a few different questions. If everything seems to get you to the same point and you look at other portfolios online that people show in lazy portfolios or whatever, and you look at what the portfolio wealth front or betterment would spit out and you're all in the same ballpark and you got something you feel good about, it could be a good thought partner as long as you're using other sources to check." Yeah.

I think it can provide insight into what types of things you can be thinking about. But I think I'd be hesitant to rely on the output. Yeah. At this point. This has been awesome. I miss these conversations. Chris and I used to stay up late when we had no children and debate all of these things because we were thinking about how we build it for clients.

So I'm really excited we got to do it again. Yeah. Thanks so much for having me.