Episode 36 of the NewRetirement podcast is an interview with David Stein — a former institutional money manager and current world-class podcaster with 12 million downloads, author and speaker — and they discuss his new book Money for the Rest of Us: 10 Questions to Master Successful Investing.
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Steve: Welcome to The NewRetirement Podcast. Today we are going to be talking with David Stein, a former institutional money manager and current world-class podcaster with 12 million downloads, 45,000 listeners per episode. He’s also an author and speaker. He’s coming to us from Idaho falls, Idaho. David and I met at FinCon a couple of years ago and hit it off over our shared interest in investing, lifestyle design and retirement planning. So with that, David, welcome to our show. It’s great to have you join us.
David: Good to be here. Although it’s winter in Idaho. I’m actually in Phoenix.
Steve: I know. Snowbird.
David: I don’t want to be from Idaho in the winter.
Steve: All right, well I do want to talk to you a little bit about kind of your life, your post money management life a little bit. Just as we get started, I always like to share people’s stories and how they got to where they are with our audience. Backing up to when you manage money how much money did you manage back in the day?
David: Well, I started after I was in graduate school. I got an MBA in finance and after a couple of years of corporate finance, I started with a fairly small advisory firm. And so we helped endowments and foundations and really on a non-discretionary basis. So you’d go to a board meeting, you’d make recommendations for asset allocation managers. And probably around 2003, I created a process that’s known as Outsourced Asset Management. So instead of the client making the decision, we could make it within parameters in their investment policy.
David: My partner and I put up not a whole lot of money to establish a track record figuring out whether it would work or not. It was a successful process. So we were able to grow that to over $2 billion through client inflows and appreciation. My live portfolio that was managing on a discretion basis about $2 billion. And then I also had non-discretionary clients like Texas A&M university, University of Puget Sound and so in more of an advisory capacity. I did that for 17 years. So it was a firm to firm, his name’s called Fund Evaluation Group. So I was our chief investment strategist and chief portfolio strategist and just all kinds of research and figuring out how to allocate assets.
Steve: Nice. And so what happened with that? Did you end up selling it or you just kind of said, I’m going to-
David: I got burned out. I was in my mid forties and I just feel like I had kind of peaked. I’d been running that portfolio for 10 years. It felt like I was just kind of writing out the clock that point. It wasn’t as challenging. And so yeah, my partners bought me out in 2012 and I started my podcast a couple of years later. Interesting, I mean, I never really got away from investing. I love to invest. I found I missed the teaching aspect of it. I didn’t miss the stress of managing live portfolios. And so kind of the best of both worlds now. I mean I can still follow the investment markets, teach how the economy works, but not have to actually pull the trigger on other people’s money.
Steve: Right. At least for now. I’ll ask you more about that-
David: What do you mean for now? I know that’s not changing. It’s been seven years now and it’s not enough.
Steve: All right. And how would you say managing money for institutions is different than for yourself and individual retail investors?
David: Well, in some ways it not much because you focus on what’s your asset mix, diversification, understanding what drives the return, the endowment foundation world has their invest for perpetuity, so there’s not a defined life. And so they can be a little more aggressive. They can invest in some longer term holdings, take advantage of what’s known as the liquidity premium. And so they get paid if it’s more of a liquid asset. But beyond that, I mean in terms of the actual holdings, that $2 billion, we manage that primarily with ETFs, which is ready to be available for individuals. When we were doing it, I mean that was pretty new, institutions were not big players in ETFs. It was considered more of a retail product. And now you see institutions very much involved in the ETF space. But in some regards even a billion dollar endowment, they’re facing the same challenges as individuals. How do I decide how much is stocks versus bonds versus other asset classes? How do I adjust my portfolio over time as conditions change? And that’s what’s involved.
Steve: Nice. Got it. Yeah, I totally see the difference between with an individual you have a kind of a lifespan that you’re thinking about and your needs may change over that lifespan in terms of the risks that you’re willing to take. But within institution it’s hopefully in perpetuity.
David: Well, and that’s a big important. I mean in institutions, their definition of risk is volatility. For individuals, it’s what’s the worst case scenario and how it impacts me personally.
Steve: Right. Yeah, exactly. I feel like now it’s the market’s been running up a lot of people are feeling pretty flush, but there’s still an underlying current of fear that I think the standard deviation, the stock market’s like 25%. So you can expect like a 25% drawdown in any given year, which emotionally is hard for individuals to deal with.
David: Well, and you should plan for 60% drawdown. That’s the historical worst case for stocks. When I do my modeling and help my members model. That’s where we focus on. And then you decide, okay, how would a 60% drawdown impact my lifestyle? And for a retiree or someone near retirement, it would clearly have an impact. For a younger investor, not so much because the personal financial harm would be less for them because they have many more years to continue investing in the markets.
Steve: Right. How do you counsel your listeners to deal with the potential of a 60% drawdown?
David: The thing about measuring risk, sometimes they’ll do risk tolerance questionnaires and I find them not useful because our tolerance for risk changes. After the financial crisis people thought stocks were very, very risky. Prior to that, they didn’t think they’re risky at all. And so it could be as simple as a spreadsheet showing 60% drawdown versus no drawdown for cash. I put half in stocks, it’s a potential 30% drawdown. How would that impact my spending if I’m highly dependent on my portfolio? So it’s just really kind of looking at, in actuality, in terms of the numbers, how would it impact my ability to meet my needs as opposed to feeling, would I feel bad? That is some element to it, but because those feelings change, more important to say what would be the hard dollar impact be of those types of losses?
Steve: Right. Well, I think one thing you note in your book is that there’s a chance of a 60% drawdown worst case, but then the bounce back is usually in 48 months. Is that right? For stocks?
David: Yeah. I mean that’s a reasonable assumption. So four years, with a retiree where it gets challenging is if they’re spending, let’s say they have a 4% spending rate and the market fell 6% or 60% then suddenly they’re spending 8% and in which case that if they’re very dependent on that portfolio and aren’t relying on, let’s say an annuity or some other pension plan, then that can be fairly detrimental. And so as a result, I don’t believe retirees should be that aggressive and they don’t want predominantly stocks if they’re dependent on that portfolio for their retirement. I think this is where annuities make way more sense to get some predictability in terms of the income stream and then not be so dependent on the actual stock market for your returns.
Steve: Yeah. I know that there are some financial services companies that are thinking about how do you give like three to five years of income in a very guaranteed way. But if you had that kind of … Then other people use kind of the bucket strategy, right? So if you had a bucket of like low volatility money that was always available to you and your cash or whatever it is, short term investments, that’s another way you can hedge it, because then you could say, okay, well I can digest the 60% drawdown assuming it’s going to bounce back in four years. I’ll be able to ride it out.
David: That’s one way to do it. We used to do version of buckets for institutional clients, but at the end of the day, it’s still one, it’s an overall allocation. A bucket is a psychological trick to say, all right, this money I’m going to spend and so then I can invest the rest more aggressively. The difference between that approach versus let’s say an immediate annuity where you’re getting income for life is you benefit from the longevity credits. If you live longer than the expectation, let’s say 85, you continue to get paid.
David: Wade wrote an excellent book on this, just came out this past Fall on it. And he made a great point that if you have the predictability of an immediate annuity, you can pretend or act as if that’s really part of your bond allocation. And then you can invest the rest of the market more aggressively. A traditional bucket approach where it’s just in, I’m going to put aside some … You don’t benefit from the insurance aspect, the longevity aspect if you live a very long time, in which case you actually have to be a little more conservative in your investing because you don’t know how long you’re going to live. And you have to invest like you’re going to live to be 95 as opposed to 85.
Steve: Right. Yeah. I think for our audience we’re trying to find ways to help them make decisions about how would they behave in a worst case scenario, same thing that you’re doing and lay that out in advance. I think they understand that, Hey, I have a certain amount of income from social security or a pension or an annuity and to adjust my expenses in a worst case scenario, then here’s what I’ll do. I’ll cut my expenses and I’ll live more frugally for a few years and wait for a bounce back. And I feel like my allocated appropriately to deal with that potential job or whatever approach. Or they want to have a bucket, what are they going to call it. But yeah, that’s something we’re working on making simpler for people to see. Okay, cool. Before we get into the book would just love to understand how you chose to get into podcasting and writing books, how did you think about this as kind of the next phase?
David: After I left my advisory firm, it took a couple of years to figure out what I wanted to do. I knew I wanted to do something with investing. I just didn’t know the format, whether they wanted to do a newsletter or … In fact I got my IRA track record audited from essentially an accounting firm thinking I was going to market this track record and start quasi managing money and realize I just hated, I didn’t want anybody to hire me. I was a guest on another podcast, Listen Money Matters, way back in this 2014 and found I enjoyed it. And it was way less competitions and podcast at the time compared to financial blogs. And so I just launched the show. It was unique in that I didn’t do interviews, it was just teaching over 20, 25 minute episode talking about how money works, economy and investing. And I found I enjoyed it and so I continued to do it. It’s been almost six years now, well not every week, but most weeks I do a show.
Steve: Well that’s impressive. I think it’s always amazing to hear people’s stories that start these things up and then bang you’re in front of 12 million people. That’s a lot of … 12 million listeners or at least downloads. Is this something that is … Are you counting on this income from this to help with your plan or you’re kind of financially independent and …
David: No, I live off of my income from my business. So podcasting, I have a membership community tied to the podcast subscription based business. And so we live personal investing, but most of it’s from my day job, my day job is so much fun and I don’t even work about 30 hours a week. But you realize you’re going to be retired a long time. So when I quit at 45, I called myself retired. So I told my clients. We could live off our assets, but it’d be pretty tight and you’d have to work at investing way more. And I suggest this for most near retirees, figure out a way that it possible to make some additional income when just to keep your sanity, to enjoy it and just stay engaged into it. It just takes less pressure off investing.
Steve: For sure. Yeah. Right. I mean, 45 is pretty young, especially if you hopefully live to like 90 years.
David: Some of my clients says, “You can’t retire at 45.” But now you have this whole F.I.R.E. movement, but no, I mean most people when they retire early, very few are traditionally retired out golfing. They usually figure something out. When I left, I knew I’d figure something out.
Steve: Right. So you’re planning to do this for the foreseeable future?
David: Yeah. I take it year by year. If I’m still enjoying it, I’ll do it and I’m taking 2020, I’ll take eight weeks off from the podcast. So I try to not overdo it, but it’s sort of the best of both worlds. I get paid to learn, so I’m learning something and I’m teaching people, one of the best way to learn is to teach, and that’s what I tried to do.
Steve: Yeah. Do you know Doug Nordman over at Military Guide?
Steve: Yeah. You and he should be the post-
David: I don’t serve, but he does.
Steve: Well, he’s been doing it too. He’s been, “Retired for 17 plus years” I think, starting at 43 or something like that, early forties. He seems to be doing pretty well. All right. Let’s jump into your book a little bit=, and I might circle back some of the other questions I had, but I’ve ripped through this thing. I read most of it was definitely good. I liked some of your stories. I definitely liked this first story, how your first stock was $1,000 in Novell, which many people may not even remember, some people may not remember, back in 1991. And then you parlayed that into a down payment on a house. That worked out for you, but it sounds like a little bit more luck than skill at that point.
David: Well it was, I mean that … And we often do that with investing. I bought Novell because I had worked as a temp employee for a subcontractor Novell. And I knew they did something with computers networking and that was it. So I’m going to buy the stock because I think it’s going to go up because computers are getting more popular, which is a lousy reason to buy a stock because you buy a stock because you think it’s mispriced because that’s what a stock is. It’s the value today of a future cashflow stream via dividends, which are funded by earnings.
David: And stocks only outperformed the market if they do better than what everybody is expecting them to do. Better than the consensus, which means when you buy a stock, I mean there’s a level of arrogance there that you believe other people are wrong. I mean that’s the whole basis of active management. Other investors have not got their price of this asset right. I’m going to buy it because things are going to happen, so it’s going to do better than the market. That is what makes investing exciting if you want to buy individual stocks. But it also, what’s makes it incredibly difficult because it’s hard to get that type of informational edge. I clearly didn’t have it when I bought Novell, so yeah, it was luck.
Steve: Right. I do like your approach of like you want to buy things that are cheap today versus things that you think are going to do great in the future because there’s a lot of buzz about it. Obviously you expect them to do well, but you don’t necessarily expect them to outperform. Well, I’m definitely glad that worked out for you. And by the way, where was your house? Where was your first house?
David: That was in Dayton, Ohio. I was working for NCR at the time and at first corporate jobs, a credit analyst for a couple of years. I guess we bought our first house, bought it well, fix it up. I think I burnt myself out redoing that house because it was pretty trashed. Loved it, my wife. She’s got another project house she’s working on remodeling. So she just kept bad at night. I got burnt out after the first …
Steve: Yeah, there’s a lot of money in flipping houses if you love it and you’re into it. It’s a lot of work. When I read your story I was like, Oh, he did this and he bought a house in San Francisco and then I was like, wait, no, I don’t know if he actually lived in San Francisco. Because at that point I was like, Oh.
David: When was that? I guess 92 we bought it. We paid 70 grand for it. It was just a little bungalow. It was one of our favorite houses. It really has been.
Steve: Yeah. That’s awesome. Back to the book, what motivated you to write this book?
David: One of the things with the podcast is each week you do another episode but it’s not necessarily a body of work, in other words organized. And so I wanted to take these investment principles and organize them in a way to help people actually invest. What I find is there’s so many asset classes out there, there’s so many opportunities that individual investors that just … It becomes very difficult to make a choice because there’s so many and they often end up going down the wrong path because they don’t have a framework.
David: I spent years researching hedge funds and other money managers and they have a checklist and an investment discipline that they follow whenever they invest. And I found in the investing book space it wasn’t … And there was very, very basic beginning books, open account, buy an index fund and then they sort of like how do you build out a real estate portfolio, being a value investor. And I wanted this book to give people rules of thumb for figuring out should you be buying real estate, should you be doing cryptocurrency or individual stocks and how do you decide that? And so these 10 questions are really the framework for helping people decide where to invest and how to put together a portfolio.
Steve: Yeah. Well it was super educational to go through it and see how you thought about at it. On the process side I talked to Jim O’Shaughnessy from O’Shaughnessy capital last year about his process. And definitely for him it’s all process and defining the approach and codifying it and sticking to that versus anything else. And it sounds like that’s the same thing your kind of view on this as well.
David: It keeps people out of trouble and it helps them on what should you focus on.
Steve: Right. What’s your view on kind of the Robo Advisor Movement where they are kind of putting the rules into code and there’s very little human if any human oversight versus being more involved. Because reading your book it’s like there is so much, there’s a lot to learn, right? I think individual stocks, yeah, that’s super difficult, right? Because then you have to spend the time to research the individual stock versus everybody and try and have an information advantage. So moving up a level and then looking at kind of like portfolio allocation, you still have to understand how you’re thinking about the world and your portfolio and the different asset classes. How much involvement do you think individual investors should have in their portfolios?
David: Well enough that they can answer for these 10 questions. Even if you use a Robo Advisor, the Robo advisor has made an allocation decision that you need to decide whether their stock or bond split is appropriate for you. Where people get in trouble I think with Robo Advisors, some think of it like a checking account and they don’t necessarily realize the volatility or the potential drawdown in their base because it’s just they made … The Robo Advisor makes an allocation based on your age, your risk tolerance, but at least need to understand how it’s invested in, even with NewRetirement, you’re helping people plan for their retirement, there’s an investment aspect to it, particularly what’s the expected return or stocks versus bonds.
David: In the book, I give an example of a listener to my show who got a big one and a half million dollar windfall from options for his startup that he was involved with. And he thought, Hey, I got it made, I’m wealthy. And so he went and got a planner and the planner agree, he’s wealthy, you can retire today if you earn, I believe it was like 8% on your portfolio. I mean we went through and you realize that the plan or just use historical returns which wasn’t reasonable given the environment and so we need to at least have some basic understanding of investing. A Robo Advisor is an investment vehicle. We need to understand what the fees are, how they’re going about their process and how it fits in our overall portfolio.
Steve: Yeah. And I think one interesting thing about risk is there’s these different risk questionnaires that are out there and some of them are geared to what’s your emotional capacity to deal with the risk? Some of it’s geared to what are your needs going to be? And some of it’s geared to how much risk can you actually digest given your level of wealth. Have you seen great tools that look at everything together? Because some of them only measure like one of those variables and it’s like, yeah, I love risk. I can deal with tons of risk. But you don’t have any money, or you might need a lot of cash that could give you a bad outcome if you then adjust your portfolio according to that one vector.
David: I have not. The latter ones that you mentioned where they’re looking at the actual numbers, not feelings, but the impact on your financial status of losses is what I highly favor. Because I think as I mentioned and in the academic studies, support is people’s perception of risk, it fluctuates. And it fluctuates based on a recency bias, what has recently happened with the markets. And that is not a very good discipline for making decisions because it fluctuates so much.
Steve: Got it. So for yourself, you have a disciplined approach and you’re … It sounds like I heard you refer to it as in the Asset Garden Methodology. Can you describe that a little bit more?
David: Sure. This gets to question nine, how does it impact your portfolio? And the traditional approach to asset allocation is what I did as an institutional advisor is you use what’s known as modern portfolio theory, so you come up with an expected return for every asset that you’re considering and you come up with a volatility, what are the ups and downs and how does those returns move relative to the expected return and then how do the different assets move in conjunction with each other, which is known as correlation. And having done these studies with institutional clients, you realize that they’re seeking the optimal portfolio. Like, what’s the answer? We’re going to go through all analysis and we’re going to get an answer. It’s like this is the optimized portfolio.
David: And having been on the other side and built these models, you realize, well how much assumptions are in there? Embedded assumption. For example, what’s the volatility of an apartment building? It looks less volatile because it’s not priced everyday, you do an appraisal and so you find that with these models you have to make up the data. Well, I can’t just put private real estate in there unless I make up an assumption for how volatile private real estate would be if it was publicly traded.
David: And that’s just a lot of complication for an individual investor. A financial planner might want to do that because they’re managing hundreds of accounts. They have to do the risk questionnaire. But if you’re managing your own money, you can do what I call an Asset Garden Approach. You know with a flower garden there is no optimal flower garden. You just have a variety of plants you have perennials, you have annual, is different colors, some might bear fruit in some way or edible fruit.
David: And it just takes a whole layer of stress off because your approach is there’s not a right portfolio. There’s a good enough portfolio using these rules of thumbs using, what’s the expected return and what’s the maximum drawdown for that asset class. And you can build a portfolio with a simple spreadsheet as opposed to coming with all these other embedded assumptions. And the idea is if you recognize there’s not a correct portfolio, there’s not an optimal portfolio, you’re not afraid to make changes. You can change your portfolio. If you want to try and experiment with 1% of your portfolio, you can do that. I mean that’s fine because you’re not undermining supposedly this optimal allocation.
Steve: Yeah. So how often do you change your portfolio or assess it and change it?
David: Well, I like to invest. I just actually just did a premium episode for my show and I think I made six changes this past year. But we’re talking about changes, I’m not dramatically changing the allocation. I added some preferred stocks earlier in the year. We sold a short term bond fund because found this house she wanted to remodel. Some of the changes are just interesting things that come along that I’m experimenting with. Most investors don’t have to make many changes. Even as an institutional money manager, we would make two to three changes per year.
David: But like in the model portfolios that I run, we haven’t made a change in over a year. You don’t have to make many changes at all. In my case I liked to invest, I’m always kind of looking around and I will make changes to mind, but I haven’t made what I would call significant changes in terms of, let’s say, selling a bunch of stocks to reduce risk. So my overall risk parameter has stayed the same because things haven’t changed a whole lot in the last year. It’s the time to be a little cautious because the risk of an economic slowdown is still there, but it’s not a time to have panicked at the end of 2018 which many did, and they paid the price in 2019 when the stock market goes up over 26%.
Steve: Yeah. It was an amazing run. And when you’re making changes, I think in your book you were saying it’s kind of you’re adjusting maybe five to 10% of your overall portfolio in any given year. You’re not making huge adjustments.
David: Yeah, I know. I use an incremental approach and that’s how I did it as an institutional money manager because you could be wrong. Many of the changes are really just adjusting as conditions change. I mean if expected returns drop a little bit or you see something come along that’s a little more attractive, but they’re not … My basis is money managers get paid because people think they can predict the future accurately. And the reality is we can’t. All we have is the present and I call it investing on the leading edge of the present, understanding where are we today? What are dividend yields today? What are interest rates today? And coming up with some reasonable assumptions based on where we are today and then make your decision as opposed to trying to predict what’s going to happen a year from now or two years from now, that’s extremely difficult to do. Most can’t do it and that’s not how we should invest.
Steve: Right. What do you want the biggest takeaways for people to be from your book, Money For The Rest of Us?
David: That you don’t need to be an expert to invest. That there are some rules of thumb that you can apply to give you peace of mind as you’re investing that you don’t have to know everything. You just have to know some basics. Even the more challenging chapters, so chapter three which kind of goes through how do you come up with an expected return for stocks and bonds? At the end of the day most people aren’t going to be configuring out what the annual growth rate of stocks are and the change in PE, but there are research affiliates provide some reasonable expected returns using the same methodology. You can take that, the idea is to just have reasonable assumptions.
David: I get really worried when investors do two things. One, they depend on historical returns and believe what happened in the past, what happened in the future as opposed to looking at conditions today and having reasonable assumptions based on where we are today. That worries me. And the second worry I have is when investors kind of go down a rabbit hole via cryptocurrencies or they try day trading or they try something and they don’t step back and ask themselves, who am I competing with when I’m investing? Who’s selling me those assets and what has to happen for me to be successful? And I believe as investors we should put most of our money and most of our time in return drivers that are highly dependable, which for most of us is cashflow. It’s an income stream as opposed to trying to outsmart other investors trading options or commodities.
Steve: Yeah. It’s so interesting how … There’s another thing O’Shaughnessy was saying that, humans don’t change very much in terms of their behavior. They’re pretty consistent and being irrational versus the rest of the system is the world we live in as evolving and getting more rational around us. But that whole tension, same thing, it’s like always been kind of the fear and greed, right? There’s this whole emotional side and psychological side of the market that ties into our limbic brain and like how we like to make decisions quickly and act on them versus being rational and stepping back. But from a decision perspective, we’re largely governed by and influenced by this kind of emotional side of our brains and how do you manage that to avoid making mistakes or saying, Oh man, Bitcoin’s going from 20,000. I need to get in right now at 20,000. And watching it go back out of 10,000 or 4,000. And it’s-
David: The fear of missing out is real and the desire to act. I mean, I saw this as institutional manager as I would deal with not-for-profits. They’d meet once a quarter, well, we’re going to meet, we got to do something. We’ve got to make changes. And much of investing is choosing not to do anything, just wait and be patient until something comes along. It’s Jeremy Grantham, he founded the investment from GMO. He says, individual investors, we can be patient and wait for a fat pitch. We don’t have to keep going up swinging like a professional because they have career risk, they have pressure from clients to do something. As individuals we can just patiently bite our time waiting for those opportunities when people get extremely fearful and asset classes get very, very cheap and it might be once a decade or it might every five years.
David: Most of the time we’re not doing anything, which is perfectly fine. And the other sort of mental trick that you can do, if there’s something really exciting and a lot of hype and you feel bad that you’re not participating in, go buy one Bitcoin and see how it works. Question one in the framework is what is it? Be able to explain what the investment is. One of the ways that can help motivate us to figure out what an investment is, is to just buy a little bit and observe it and learn more about it. And how it trades and that’s important component. We can participate without going whole hog into it.
Steve: Right. This goes into one of the things you’ve talked about in your book, which is what’s the difference between investing, speculation and gambling. I would love to hear your take on how you described those things and …
David: Sure. Investing is something with a reasonable expectation that it will have a positive return. And the reason why is because is an income stream or cashflow, so there’s dividends, there’s interest, there’s rents. And because of that cashflow, because you can value the cashflow investments having a positive expected return. A speculation is where there’s disagreement, whether the return will be positive or negative. Generally because there is no cashflow. So the speculation would be gold, cryptocurrencies, art, antique. You will not make money in those speculations unless somebody is willing to pay more in the future.
David: And the challenge with speculations is there is no basis for saying, well, this art piece is undervalued or Bitcoin is undervalued because there is no … We can do that with stocks because we can say all right on a price to earnings basis, what investors are paying for earnings is higher than average or lower than average or cheaper than average, but you can’t do that with speculations.
David: In IO speculation, speculations are fine, but they generally should be less than 10% of your portfolio because the workhorse should be investments where there’s cashflow being generated and you have the predictability of that cashflow. And as a result there’s a positive expected return. A gamble is something has a negative expected return and you do it for entertainment value. Generally a gamble, you’re not trading with somebody else. I mean you’re not working with the intermediary, you’re dealing with the house.
David: So it might be a casino I’m going. If somebody’s at Vegas at a casino, the casino has to have a positive expected return and you have to have a negative expected return. Otherwise, the casino would go bankrupt. Lottery is a gamble, but there are in traditional financial securities, there’s something known as binary options that sometimes you’re just dealing directly with the sponsor of it, in which case, if they’re not acting as an exchange where there’s a seller and a buyer, you’re just structuring contract with entity or broker, then you know it’s a gamble because they can’t be in business unless they have some type of edge and will generate a profit over time.
Steve: Interesting. One thought that occurred to me is that basically every entrepreneur that starts a company from scratch is essentially a gambler. That would fall into that gambling bucket because most startups fail.
David: Or investing in your family startup, I mentioned that. And the way that you approach a gamble or a speculation is you only put enough in that you can lose it all. And so when we talk about a maximum drawdown for speculation, I assume it’s 100%. I’ll scale my exposure to gold, assuming I’ll lose it all. Now, I don’t think I will. I think it’s been around for thousands of years, but I don’t have any basis to say gold should be worth $1,500 an ounce. There isn’t any. And as a result, just assume you’ll lose it all. And how much are you willing to put in if you lost it all?
Steve: Yeah, exactly. Good. Well, I appreciate that the color on how you look at that. It’s definitely helpful. Given your experience, so you’ve got 30 years in investing, right? Is that right? Three decades or more?
David: I’m thinking. 20, 25 years.
Steve: 20, 25 years.
David: I got a late start. I didn’t become an investor until I was 30 I guess. It’s 20, 25 years.
Steve: All right. How do you think it’s going to change over the next 20 years? What do you think … To me, it feels like with more automation, with potential AI, I mean there’s so much more information flow. One thing I definitely feel is that drawdowns and reversals in the market are faster because the information flow is faster. And maybe that because there’s lots of capital sloshing around, but it feels like the cycles are faster. I mean the business cycle, well it seems to be stretching out slower. It’s like we’re not seeing the expected recession, but like just in the day to day behavior of the market, it seems like, okay. Like last December or December 2018 we saw kind of a 20% correction in the market and then it came flooding back by March or something like that in 2019. What do you see as you look forward in terms of behavior?
David: I think because of AI it’s even more difficult to get some type of edge if you’re buying individual securities. I do think because markets are more interconnected and because you have so many participants doing what’s known, so they’re entering strategies where they’re just collecting a premium and then pay out if something goes wrong and then they lose big and when these drawdowns occur, people end up having to sell. And so I think the potential for drawdowns is much greater and there’s much more uncertainty with it, which is why it’s important to invest, recognizing these drawdowns are possible. I still think it does present opportunities because when people panic and investors sell off, that’s when they expect a return goes up. The cheaper you buy an asset, the higher its expected return. So there’s opportunities for that.
David: I think most investors should focus on asset allocation, so focus on different asset types with just plenty to do in that realm as opposed to trying to figure out which stock is going to beat their earnings estimates that quarter or going to do better. I believe we buy baskets of securities through exchange traded funds because when you buy a basket of securities, it’s like getting a handful of unpopped popcorn. You put in the popcorn popper, you don’t know which popcorn kernels going to pop first, but you know that something will pop and you can get that popcorn.
David: It’s the same if you buy an asset class, say there’s a big drawdown and small company stocks, it’s very cheap. We buy an exchange traded fund that has several thousand small company stocks, it’s going to do fine because its dividend yield has now gone up. It’s what investors are willing to pay for that earnings growth is cheaper than it’s been. And then you have all these positive embedded surprises as opposed to buying something like NASDAQ right now that has a lot of … It’s priced for perfection. Better to buy a basket that’s cheap.
Steve: Yeah. That’s awesome. I love the popcorn analogy. Sorry. I knock my whole setup over. All right. Any kind of like top lessons that you’d like to share with people that you’ve kind of learned over? We talked about disciplined investing. I think in your book you talked about you need to be able to explain things. I also saw that you’re a fan of Annie Duke is as am I. And kind of thinking about decisioning and outcomes, process versus the outcomes. Any other big things that come to mind that you have picked up over the years?
David: I think we’ve covered the main thing. The point with Annie Duke, she actually endorsed my book and because I loved the fact that she talked about that going to have bad outcomes sometime. And that doesn’t mean it was a mistake. It means that it was a bad outcome, what matters is whether we had some type of discipline process for making the decision. And that’s why having a framework like these 10 questions or some other discipline is important because it makes sure that we have a checklist and then we don’t beat ourselves up so much over the outcome because sometimes things don’t work out as well or just the timing isn’t right. But if we consistently apply a process, then we’ll be successful over the long haul.
Steve: Yeah. I really love her work. She was on our podcast as well and she definitely, the point about not looking at outcomes, but yeah, looking at the process is huge because so many people today they’re just like, okay, what was the outcome? And that was either good or bad or I’m a good or bad person or whatever it is. What do you think of the F.I.R.E Movement just in general? I know we’re both highly aware of it, but now we have more and more people trying to save a bunch of money, retire pretty young. I guess you retired young, “Retired young” or shifted gears pretty young.
David: Yeah, I did. I guess I’m technically part of the F.I.R.E. Movement. I think it’s fine. I mean, I think it’s a good thing. What worries me is the return assumptions that underlie it sometimes. In other words, you don’t want to retire early and live off your portfolio, assuming you’re going to earn 9% on stocks or 10%, it’s unlikely to happen given where we are today. And so I think the idea of saving, finding ways … Sort of the way that I put is live like you’re already retired. So figure out a way that you can live, generate an income that you’re enjoying life that you could sustain it for decades.
David: So what I do now, I mean I could do this for two more decades if I chose. That’s what I like about the F.I.R.E. Movement is people instead of just toiling away, toiling away at a job they don’t like for this future retirement, they’re saying, no, I could be retired today and I could structure a life that I like today. We just need to make sure that we have reasonable assumptions. Don’t say you have $100,000 I’m now retired because I’m going to earn 10% a year and I can live on $10,000, it’s not going to happen. So have some reasonable assumptions as you go into it.
Steve: For yourself, what do you think about kind of a safest estimated rate of return and the safe withdrawal rate and so forth?
David: Well, I can tell you right now the return on bonds and be very confident that over the next decade they’re going to return about 2%. Two and a half percent because the beauty of bonds and cash it’s mathematical. Your return will be whatever the starting yield is, if you’re holding periods 10 years or so, a reasonable return for stocks is about 6%, and yields are two. If we assume earnings grow at four to five and valuations are not cheap. So I think six to 7% is a reasonable assumption for stocks.
David: And so if you’re half on each, let’s say you want a 50/50 portfolio, then you’re basically at a 4% expected return, in which case if you retired, you shouldn’t be spending 4% because if you’re going to retire for 40, 50 years, you have to keep the spending rate less than the expected return in your portfolio and allows them leeway for inflation. So it kind of depends on the environment. When I quit, in my mind I said, well, if I’m retired, if I don’t make any money at all, my spend rate needs to be two to 3%.
Steve: Okay. I talked to Karsten Jeske, I think he uses kind of a three and a half percent kind of safe withdrawal rate, but he does some more active stuff to generate more income.
David: Well, I mean in this way and then taking it from the endowment world and what an endowment does to make sure that they never run out of money is they come up with their expected return. Let’s say it’s 7% and then they back out inflation, let’s assume 2% so that leaves a 5% return and that’s what they spend. And so as retirees, if we don’t want to eat into principle then we can take our expected return and subtract inflation and then we shouldn’t spend more than that. And hopefully, I just did this analysis, I do it once a year. I look at all right, given what I spent, given what I earned on investing, given what I made through the podcast, did my net worth increase? At a minimum if you’re 30 or 40 your net worth should be increasing each year. You’re 60 or 70 you can start to eat into principal over time and drawdown that principle. But as an early retiree, you get up, come up with a spend rate that you’re not touching the principal.
Steve: Yeah. So do you want to have that continue for the rest of your life though? Keep having it rise. I mean there is data that shows that people that have money tend to pass away with more money. Like they just keep piling it up.
David: No, I mean what I’ll do when I get to be more of retirement age is I’ll go out and I’ll buy an immediate annuity. And with social security and that’ll cover most of my spending and then I can give the rest of the way or I invest it more aggressively. But I did an early episode, it was called Die Broke. How do you die having spent all your money? It’s challenge, you do, but no, the idea is to eventually give it away.
Steve: Right. Nice. What do you think about deferred annuities? So one of the strategies that we think about is if you buy a deferred annuity that kicks in at around your longevity that hedges off your longevity risk. Like, so you buy an annuity that kicks in, you buy annuity now and then have it start at 80 or something and it’s going to be relatively cheap, because you’re not expected to live very much longer pass over 85. But it gives you a hard end date to plan against versus right now we’re all kind of like hedging out an unknown longevity timeframe.
David: I mean, they work. When you do the analysis you have two choices. You can actually buy the annuity when you’re 85 as opposed to deferring it. If you’re deferring it, what’s happening is the insurance company, they’re not genius investors. They’re investing in the bond market. You can go to a site like immediateannuities.com and you could see, how much would I get if I bought an annuity, if I was 85 versus if I bought at 65 or 55 and you just calculate, all right, what’s the return assumption baked into that annuity?
David: So if 85 it’s going give you so much money per year for the rest of your life, you can figure out, all right, what’s the starting value of that annuity at 85, let’s see it, and then you figure out, all right, I put in $50,000 and … Just come up with the expected return and I’ve done it. Generally that was a complicated explanation, but it might be 3% embedded return in that. Then you can say, all right, can I do better than 3% investing and set aside this money that will buy an annuity when I get to be 70 or 85.
Steve: Yeah. So that’s essentially the same thing you’re thinking with your own annuity strategy starting it, 62 or 71 social security kicks in for you, however you’re going to claim it as you’ll just manage your money yourself and don’t buy a deferred annuity that kicks in, don’t buy it now. Just wait. See where the market is.
David: That’s what I did. Exactly. I looked at it and I thought, all right, here’s a couple things. One, annuities what they pay is dependent on interest rates. So if we’re at historically low interest rates, then … I don’t know if it might go higher, they might never go higher. But I know what the hurdle rate is priced in an annuity, if I can beat that. And I also can take advantage of if rates go higher. Now, if we get a spike in rates, maybe I’ll lock in an annuity. But at these levels … And the beauty of annuities, the longer you wait to buy, the more you get and the higher the interest rate is, the more you could get. And so is being young and very low rates, I’ll wait.
Steve: Yeah. Awesome. So your plan though is around like at what age would you do this? When are you claiming social security? At 70?
David: Yeah, I’ll do it at 70.
Steve: Okay. At 70, you would also buy an annuity and then you’d say enough annuity to have enough income to cover your core need or-
David: Yeah. So I mean, if I’ve not bought one beforehand based on interest rates or whatever, yeah, I’d buy one at 70 or buy a series of them in my seventies but I can tell … Wade Foz book really was an eyeopener for me the way he approached it. I wrote my first white paper on annuities in 2008 during the financial crisis, because we were managing money for financial planners and so I’d go and meet with their clients and I saw how shell shocked they were. And I thought there’s no way a retiree should base the retirement on their portfolio only. And I knew nothing about annuities and it’s like, well, there’s got to be something out there. And so I spent six months researching it and wrote a white paper on retirement income.
David: And so I’ve done several episodes on annuities, but just reading it again and realizing, and I always thought, well, I can do better than an annuity. I don’t need to get one. One of his points that really stood out to me is as we get older our ability to invest might not be as great or it might be your spouse doing it. And if you get paid because it is a pool in terms of the … It’s a form of longevity insurance, then why not take advantage of that? Because then you can be more aggressive in your investing because you have your expenses covered by predictable sources.
Steve: Yeah. Awesome. I think we will see more annuity sales in the future, but yeah, I think there’s a lot of people that like you are kind of like, well, interest rates are low, these returns aren’t that great. But there’s a growing awareness of these products. So we-
David: I think every retiree, unless you have a traditional defined benefit pension plan, you should have some type of immediate annuity, lifetime income stream in your retirement portfolio.
Steve: Like what percent of your assets do you think should go into that?
David: I think you should cover your day to day living expenses with social security and a payout from an annuity. Because then you don’t have to figure out what my spend rates should be. And now key is to save enough so that you can do that, but then you’re not, why? We buy insurance for everything else, right? The odds of your house catching on fire is very low. Less than 1% yeah. We buy fire insurance or homeowners insurance. People will go through let’s say some type of Monte Carlo analysis or some type of analysis that shows that they have a five to 10% chance of running out of money. We only get one shot at retirement. I wouldn’t be comfortable entering into a 13 year scenario where I have a 5%, 10% chance of retirement ruined. So how am I going to do it?
Steve: There is a one in 10 chance out of 10 of your friends, one of you is going to be on the street. I mean that’s what we’re working on is trying to make that simple for people to see how to do and understand what their costs are going to look like and think all that stuff through. Okay, this has been good, but I want to circle back to the first thing, which is you know so much about this. You have this huge audience of listeners that probably have a fair amount of money themselves but you’ve never thought like, Oh I should just start a fund or a set of products to help manage money for these audience. Because you could probably accumulate a big pile of money quickly I would think if you wanted to.
David: If I wanted to, but I don’t want to. I provide lots of education. I have a membership site, I share my portfolio to people so they can see how I’m invested. I let them know when I make trades. I have models out there. I do a monthly investment conditions report where we’re looking at conditions. So I give people the tools, but I want them to make the choice. I don’t want to be in the position where I’m choosing where they should invest, because, one, the compliance aspect to it is much greater and the stress level of it is much greater. And I sort of enjoy my life the way it is to not want to mess that up.
Steve: No, I get it. I mean we’ve thought about this as well on our side. We’re doing a parallel process, doing it through content and then software and then do for flat fee advice, but not managing money, at least not right now.
David: I mean people want, there’s market for, people would love to have people, why don’t you just do it for me? That certainly … But I’ve done that. I’d spent almost 20 years doing that and now it’s time to do something else.
Steve: Totally. All right, well, so with that, any questions for me before we wrap this up?
David: No. I’ve been on your software, NewRetirement. It’s very well done and I’ve recommended it to my listeners. It’s a very cool piece of software.
Steve: I appreciate that. Yeah definitely, after this, I do want to circle back with you on some of the stuff. But David, thanks for being on our show. Davorin Robison, thanks for being our sound engineer. Anyone listening, thanks for listening. Hopefully you found this useful and if you made it this far, definitely check out Money For The Rest of Us, both the podcast and the book by David Stein. Our goal is to help anyone plan and manage their retirement so they can make the most of their money in time. And finally, if you’re listening, we’re trying to build the audience for this podcast, so if you could leave us a review on iTunes or Stitcher or anywhere would appreciate it. We read those and update it based on your feedback. With that, thanks again and have a great day.