EP 77: When Spreadsheets and Reality Collide with Ben Carlson

by Peter Lazaroff | Dec 7, 2022 | Podcast

When it comes to maximizing wealth, there is usually going to be a mathematically optimal solution, but that solution doesn’t always align with our human emotions.

Ben Carlson, co-host of Animal Spirits and author of A Wealth of Common Sense, joins me to talk about the variety of instances where spreadsheets and theory don’t align with human emotions and reality.

Listen now and learn:

Why investors fail to earn the market return
The importance of avoiding bad investments
How personal finance best practices aren’t always the optimal choice for you

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Show Notes

Ben Carlson is the Director of Institutional Asset Management at Ritholtz Wealth Management.

But he is probably even more well known for his blog A Wealth of Common Sense, which focuses on wealth management, investments, financial markets, and investor psychology.

He is the co-host of Animal Spirits, which has received several “best of” recognitions in the finance podcast space, and also has four books on investing (links to all of them below).

I invited Ben to talk about the many instances we both see when things don’t happen as a textbook might suggest as well as situations where the math answer to a financial problem differs from the personally optimal answer.

Here are my notes from the conversation…

Textbook Economics vs Real Life (3:49)

Go back to April 2020. In a little over a month, the unemployment rate screamed to 14% from 3%. The infection rates and death rates from COVID-19 were incredibly high. And yet, the stock market was rallying.

Fast forward to today, unemployment is very low and COVID-19 seems relatively under control and the stock market is in a bear market.

Textbooks would make these relationships seem like they are simple. If A happens, then B should happen — but it rarely works like that.

My economics major has done very little for me in the real world. Ben agreed that his college economics wasn’t much help either. Ben thinks that studying psychology might have been more useful since understanding people and their reactions to a headline is often more important than the headline itself.

Predicting the market’s moves is more than predicting the outcome of any given event. It’s really about predicting the market’s aggregate response to outcomes, which is a mix of psychology and calculus that very few can master.

The Importance of Understanding Market History (5:05)

One of the best ways to learn more about investing and financial markets is to study financial history. From the Great Depression, the go-go years of the 1960s, the 1970s, 1987….all these different periods are helpful to understand.

One thing Ben has noticed when studying history is that human nature is the one constant. People get too excited when things are going well and too pessimistic when things are going poorly. And that pendulum tends to swing back and forth over time.

Every market cycle is different. The economy is always changing and evolving. Market structure is always different. And while peoples’ reactions aren’t identical every time, the cycle of greed and fear is fairly persistent.

Ben notes that the cycle of greed and fear seems to be on hyperspeed these days, perhaps because of technological advancements. Technology also makes it easier for people to magnify the severity of the latest crisis to the point where it feels like it’s the worst thing that’s ever happened.

But having a firm grasp on market history (and human history) makes you realize that bad stuff happens all the time. Studying history will show you that, during a period of crisis or turmoil, people still get up every day wanting to improve themselves and their life situation. That makes it easier to maintain a glass-half-full mindset.

A firm understanding of history makes it hard to bet against the human spirit.

Earning the Average Return is Hard (7:50)

Despite explosive growth in the popularity of index funds, most people still want to do better than what the market return provides via an index fund. But earning the average market return is easier said than done.

The evidence is pretty clear about how hard it is to outperform just in general, but Ben notes that a lot investors underperform their own funds.

Average returns are really lumpy. If you look at multi-decade returns on stocks, regardless of the starting point, you will typically see returns around 8-10%. But for any given year, you’re not going to see a 10% return. In fact, one-third of all years over the last century have been 20% gains.

So you have these lumpy periods with huge gains and huge losses, but investors’ emotions tend to swing from one end of the pendulum to the other. Just look at the three years prior to 2022. We had unbelievable returns in the market from 2019-2021. People felt fantastic then, but now they feel awful with the market being down over 20% this year (as of this recording).

Unfortunately, it should be the opposite. When things are going a little too well, that’s when you should have your guard up. When things are going terribly, that’s when you should be thinking opportunistically.

People have a hard time thinking about stocks being on sale when their life savings are cratering, so they often get in their own way – and that’s a big part of why so many people don’t even earn the average market return over time.

Picking Individual Stocks (9:16)

The interest level in individual stocks spiked during the pandemic. Most people owning individual stocks don’t think of it as trying to beat the market, but that’s what you’re doing.

When you look at the data – whether that’s individual stock returns or the failure of active management – you might wonder why anyone would ever pick stocks.

When you think about all of the ridiculously smart people that still underperform despite having educations from prestigious universities, direct access to company management, and teams of people doing extensive research of companies and the marketplace – how is any individual going to outperform?

So the spreadsheet mentality might suggest that everyone should just own index funds at all times. But behaviorally, some people need to scratch the itch. They want to watch CNBC, pick individual stocks, and talk about it with their friends.

While we know that this behavior is likely to hurt your returns, there’s nothing wrong with having a fun or speculative portfolio to scratch that itch as long as you’re limiting your exposure to 5% of your portfolio.

To be clear, in my opinion, this isn’t a static 5% allocation that you add to over time. You carve out no more than 5% of whatever you have today and that’s it.

Both Ben and I are comfortable with clients doing this because it often makes them feel better about the other 95% of their portfolio which is rules-based and requires patience throughout all market cycles.

There seemed to be a false sense of confidence among individual investors coming out of the pandemic, and this is largely the result of nearly all stocks being positive in the 12 months after the March 2020 bottom. It just felt too easy for people to say, “I’m going to pick this company because I know this company and the stock is going to do well.”

And it doesn’t always work like that where good stock equals good company over the long term. Especially over the short term where a good company could be a REALLY bad stock because it’s way overpriced (because everyone already knows that it’s a good company).

When people get good results in a short period of time, that’s when they are most likely to get into trouble because they start to question the more boring, rules-based, and diversified approach to investing.

So doing a little piece is fine, but keep it portion controlled. And the great thing is that if you give yourself a couple of years, you’re eventually going to see that a smaller piece of your portfolio is underperforming. And if that happens, you can say, “okay that kind of shows me why I’m sticking with this long-term piece over here and not messing with it.”

The Perfect Portfolio (12:45)

There is no such thing as a perfect portfolio. Except with the benefit of hindsight, of course.

But even if we knew with 100% certainty what the perfect portfolio would be for the next 20 years, it’s unlikely people would be able to stick with it.

Wes Gray wrote a brilliant piece in 2016 called Even God Would Get Fired as an Active Investor. In it, he creates a hypothetical portfolio starting in 1927 that owns the best 10% of large-cap stock performers and then rebalances the portfolio every five years to own what would be the best 10% of performers over the next five-year period.

The result of this perfect portfolio is a compound annual growth rate of 29.37% compared to the S&P 500’s compound annual growth rate of 9.87%. But the drawdowns of this portfolio that has perfect foresight were still incredibly large (ranging from -20.13% to -75.94%) and frequent.

That’s why it’s important for investors to not only define what it is you’re going to invest in, but what it is you won’t invest in.

Ben mentions that Josh Brown often uses the analogy of an advisor as a bouncer holding the line. There’s a lot of stuff that you just won’t let in. Even if it could be a good investment opportunity from an income or total return perspective, that doesn’t mean it would make a good complement to what’s already in your portfolio or your financial plan.

Being clear about what you won’t let into your portfolio saves you a lot of time and heartache just from understanding that you don’t have to pay attention to it.

That’s becoming increasingly important since we’re in an environment where there are low-cost options for almost anything you could ever imagine. It’s tempting to invest a little bit here and there along the way, but then you end up with a mishmash that isn’t working together and isn’t aligned with your financial plan.

As my regular readers and listeners know, I’m more concerned about implementing a bad idea than missing out on a good one. That’s a reflection of my belief that good investing is boring and that minimizing mistakes is the real key to investing success.

Optimizing Personal Finance Decisions (16:50)

Prepaying Your Mortgage: The math on prepaying your mortgage is pretty clear: it isn’t as optimal for growing your wealth as investing your excess cash. But neither Ben nor I have ever met a person that regretted paying off their mortgage early. In the end, the decision is a personal one and likely to be influenced by your life experiences with debt and money.

Buying vs Leasing a Car: Buying a car and owning it for a decade is always going to be financially optimal versus leasing a car. But whether that is the right choice for you is circumstantial.

In sharing our own experiences with this decision, Ben mentions a deep dive blog post by Jesse Cramer on The Trust Cost of Car Ownership. Using his assumptions, it’s about five cents more per mile driven to lease. So the biggest things that matter are things like: How much do you drive? How much are you willing to pay for maintenance and upkeep? How much do you want to have a new car every two or three years?

Spend Shaming: One of the things that have changed most in personal finance in the past decade is that there is less spend shaming (e.g. don’t buy coffee every day). If you’re saving in advance, then you should embrace the idea of spending whatever is left over so that you get the most out of your life.

Annuity vs. Lump Sum: We discuss this within the framework of winning the lottery, but it’s a decision that comes up in other situations, too. While the math usually says it’s best to take the lump sum, Ben makes a good case for a lottery winner rationing a bit with annual payments to give themselves something to look forward to every year while also protecting against spending everything too fast.

Investing in Your Health: Financial advisors see first-hand how expensive healthcare becomes as we age, particularly for people that don’t take good care of themselves. Although we can see it in a spreadsheet, it’s harder than fixing people’s finances. With finances, there are a number of things you can do to set it and forget it.

But with your health, people are faced with 100-150 choices when it comes to their diet – you’re constantly forced to make a choice. It’s not like investing where you can make a whole bunch of good choices upfront and then systematically follow through on them with little ongoing choice.

That’s why diet and exercise fads constantly pop up – because people are always looking for something that they can stick with. We don’t have any good solutions, but it’s worth thinking about how you can invest in your healthcare to make your long-term costs lower and (hopefully) your life fuller.

Teaching Kids About Money (31:35)

Ben and I talk about our successes as well as our struggles with instilling good money habits in our kids.

There are several stories that I won’t try to summarize here, but I think you can glean some good ideas for your own kids from our stories about investing, spending, and saving.

Several years ago, I wrote about how I started an allowance for my oldest child. Two books on the topic I find myself recommending most are: Make Your Kid A Money Genius (Even If You’re Not) and/or The Opposite of Spoiled.

We also talk a bit about charitable giving with the kids, which is a topic I recently discussed with Sara Gelshemier.

Ben’s Books:

Find Ben Online:

Website: https://awealthofcommonsense.com/
Twitter: https://twitter.com/awealthofcs
YouTube: https://www.youtube.com/@TheCompoundNews

Resources

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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.

Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.

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