A Planning Checklist, Portfolio Concentration, and Leverage (EP.80)

Episode Summary

Executive Summary: In this episode of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore discuss personal updates, financial planning tips for 2020, and delve into complex investment topics including portfolio concentration versus diversification, the use of leverage in investing, and the fallacy of the '60/40 is dead' narrative. They analyze asset class returns, explore the concept of using concentrated factor portfolios as a form of implied leverage, and provide practical advice on leveraging investments, all while emphasizing evidence-based decision-making and the importance of aligning actions with financial values.

Main Topics: Personal Updates and Podcast Plans (Priority: 2/5): The hosts share personal news (Cameron's engagement, Ben's upcoming baby) and discuss plans for the podcast, including improving the website for community discussions and building a video studio. Book Recommendation: 'What You Do Is Who You Are' by Ben Horowitz (Priority: 3/5): Cameron recommends this book on company culture, emphasizing that culture is a strategic investment and should align with leadership values and company mission, using Amazon and Apple as contrasting examples. 2020 Financial Planning Checklist (Priority: 4/5): A top 10 list of financial planning items for the new year, including clarifying financial values, automating savings, ensuring an evidence-based investment philosophy, optimizing taxes, reviewing insurance and estate plans, and improving financial literacy. Asset Class Returns for 2019 (Priority: 3/5): Review of 2019 returns: Canadian equities up ~23%, US equities up 24.7%, global bonds up 7.43%. Discussion on the underperformance of Canadian small-cap value and the surprising strength of bonds despite low interest rates. Listener Questions: Leasing vs. Buying Cars and Using Leverage in TFSA (Priority: 4/5): Ben explains his shift from buying used cars to leasing new ones, framing it as a lifestyle choice. They discuss the math of leasing vs. buying and the tax implications of borrowing to invest in a TFSA vs. taxable account. Portfolio Concentration vs. Diversification and Implied Leverage (Priority: 5/5): A deep dive into the trade-offs between concentrated factor portfolios (like Alpha Architect) and diversified factor funds. Ben presents a Monte Carlo simulation showing that concentrated portfolios have wider outcome distributions but can offer higher expected returns, acting as a form of implied leverage. Leverage in Investing: Theory and Practical Considerations (Priority: 5/5): Discussion of the Ayers and Nalebuff lifecycle investing paper, which suggests young investors should use leverage to achieve optimal equity exposure. Practical methods include margin loans, HELOCs, futures, and leveraged ETFs, each with pros and cons. Bad Advice of the Week: '60/40 is Dead' (Priority: 4/5): Critique of the popular narrative that the traditional 60% stock/40% bond portfolio is obsolete due to low expected returns. The hosts argue this advice often leads to taking on more risk through alternative assets, ignoring market efficiency.

Key Arguments: Culture is a strategic investment in doing things right when you're not looking, and it must align with leadership values and company mission. Concentrated factor portfolios can be seen as a form of implied leverage, offering higher expected returns but with greater idiosyncratic risk and less reliable outcomes. For young investors, even 100% equity may be too conservative; using leverage (up to 2:1) can significantly improve retirement wealth, as shown by Ayers and Nalebuff's research. The '60/40 is dead' narrative is flawed because it ignores market efficiency and often leads investors to take on more risk through higher-cost, less tax-efficient alternatives. When considering leverage, the cost of debt and tax deductibility are critical; borrowing in a taxable account is generally more advantageous than in a TFSA. Leasing a car can be sensible if you've already decided to buy new, as it provides predictable costs and an option to return the vehicle, though buying used and driving it into the ground remains the superior financial decision.

Data Points: Canadian equity return (2019): ~23% - Canadian market in Canadian dollars was up almost 23% in 2019. US equity return (2019): 24.7% - MSCI US Investment Market Index return for 2019. Global aggregate bond return (2019): 7.43% - Global aggregate hedged to Canadian dollars return for 2019. Canadian small-cap value 5-year annualized return: 3.75% less than broad Canadian market - Underperformance of Canadian small-cap value over five years. US small-cap value 5-year annualized return: 9.49% - US small-cap value return over five years, compared to overall US market at 13.78%. VLUE price-to-book ratio vs IUSV: About one-third cheaper - VLUE (concentrated value ETF) has a much lower price-to-book than IUSV (market-wide value ETF). VLUE underperformance vs IUSV (12 months ending Nov 30): 5.77% - VLUE underperformed IUSV by 5.77% over the 12 months ending November 30. Leveraged ETF portfolio return (10 years): 14.2% - Simulated return of a 2x leveraged ETF portfolio over 10 years, compared to 10.35% for the underlying index portfolio. Wealth increase from leverage strategy vs all-stock: 21% - Ayers and Nalebuff's estimate that following their leverage strategy would result in 21% more wealth than a 100% equity portfolio. Wealth increase from leverage strategy vs target-date funds: 93% - The same leverage strategy resulted in 93% more wealth compared to traditional target-date funds.

Pivotal Quotes: "Culture is a strategic investment in the company doing things the right way when you're not looking." — Ben Horowitz (quoted by Cameron Passmore): Cameron shares this quote from Ben Horowitz's book 'What You Do Is Who You Are' to emphasize the importance of company culture. "If we are actually committed to living our values, however, we need models to be able to test the outcomes of acting on our beliefs in order to see if these outcomes align with our values." — Listener (quoted by Benjamin Felix): A listener's email breaking down the components of a belief, highlighting the need for models to test alignment between values and actions. "The worst outcomes in the Monte Carlo were still higher than the average outcome of the universe of a thousand securities." — Benjamin Felix: Describing the result of his simulation comparing a concentrated portfolio of the 50 highest expected return stocks to a diversified 1000-stock portfolio.

Implications: Investors should reconsider the role of concentration and leverage in their portfolios, understanding that concentrated factor exposure can act as implied leverage. Young investors may benefit from using leverage to increase equity exposure, but must be aware of behavioral risks and implementation costs. The '60/40 is dead' narrative is misguided; a diversified portfolio of stocks and bonds remains a sound foundation.