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• Rubin Miller, CFA
  • Peltoma Capital
  • Fortunes and Frictions
    • Reality Meets Expectations
    • The Only Equation That Matters
    • Yield is For Farmers
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• Stay Wealthy Episodes Referenced:
  • Investing in Bonds: Part 1, Part 2, Part 3, and Part 4
  • Should Retirement Savers Own Bonds?
  • Tail Risk: The Biggest Investment Risk
• The Arithmetic of Active Management [William Sharpe]

Intro

Taylor Schulte: Welcome to the Stay Wealthy podcast. I’m your host Taylor Schulte and today I have a great conversation to share with you. I’m joined by my good friend, Rubin Miller, founder and CIO of Peltoma Capital. In addition to being one of the most brilliant people I know in the investment space, Rubin is also an amazingly talented writer and for the first time in his career, he’s sharing his writing publicly on his investment blog Fortunes and Frictions.

In this conversation today, Rubin and I talk about three big things. Number one, why chess players don’t make great investors. Number two, how retirement savers should think about their future investment returns from their portfolio. And number three, what everyone needs to know about expectations versus reality.

We also talk about risk-free investments, the importance of your time horizon, and growth versus value stocks. So, if you’re ready to learn what it takes to have a successful investing experience and how we can use evidence to make informed retirement planning decisions, today’s episode is for you.

To grab the links and resources from today’s show, just head over to youstaywealthy.com/185.

Why You Shouldn’t Be Surprised By Your Investment Returns

Taylor Schulte: We talk about a lot of nerdy things here on the show, but one topic I’ve never covered here is the game of chess and you were, fun fact, a national chess champion in fourth and sixth grade and you became a chess master at age 15. So I’m personally curious, what’s the backstory here? Who introduced you to the game of chess? What drew you in and how the heck did you become a national champion at age 10?

Rubin Miller: It’s probably easier at the age 10 than it is at like age 17 to be totally blunt. Actually, both of my brothers were also national chess champions. They were, I believe they were both in kindergarten, so they were like five or six years old. And that would be kind of the, the lowest hanging fruit if you ever wanted to be a national chess champion because they’re the least amount of players in the tournament.

But to take a step back, yeah I had a, I guess call it unique childhood and my dad introduced me to the game of chess when I was probably four or five. I spent my first 10 years of my life in Rochester, New York and there was a local chess club and my parents would basically drop me off at this place. And at this point in my life, I’m 39 now, I kind of realized I was probably just free babysitting for them, but I dove headfirst into it. I loved it. I played a lot.

There’s the ability to just kind of spend a whole day there or whatever on the weekends. And I always kind of tell people I had like the rating of a chess master but I was never as smart as my peers that were kind of also young elite chess players back then. So I stopped playing competitively I guess towards the end of high school. And it was very clear to me at that point that many of my peers were not only good at chess but also very smart and they were kind of, their trajectories kept going up with the game and I was kind of plateauing.

But that’s how I started. As I said, it was easier to be a fourth-grade national champion than it would be to be a junior high school national champion when players are a lot better and there’s a lot more than so maybe some fortuitous timer when I started and when I plateau.

Taylor Schulte: There’s often a lot of analogies drawn from chess to investing and you wrote a great article about chess and stated that chess players surprisingly don’t make great investors. So I’d be curious for you to share a little bit more about why you make that argument that chess players don’t make great investors.

Rubin Miller: It is true. I mean I think I started that article by basically saying there’s so many darn commercials that these fun companies who want you to see them as strategic and forward-thinking. And so they have these moving chess pieces and then it’s kind of like, so buy our product.

And I’ve never really thought about investing or good investing as having the same skillset as good chess play. And that relates to I think what those companies that have these moving chess pieces on their ads are trying to say, which is, you know, we see 15 moves into the future, investing just doesn’t work that way.

Which is why I make this comment that chess and investing really aren’t the same that I don’t think is an appropriate analogy. Markets are very forward-looking themselves, which is to say there are buyers and sellers, they come together in this market and the price has to clear where there’s smart people buying, there’s smart people selling. And so prices already tell us a lot of information about what we can expect from a security and what you call it, the expected return. And I’m sure we’ll get into some more of that later.

Whereas forecasting what’s gonna happen in the future when it comes to the stock market or the economies basically impossible. Whereas forecasting 15 moves ahead in chess where you have all the information right there on the board is not only possible but it’s basically how you become a great chess player.

So there are two very different things and the variable is just that you know, chess has no randomness involved. All of the information is right there on the board. Whereas in investing, if you think about how outcomes are delivered to investors in the similar way to how an outcome that a chess game or some sort of sport or match would be delivered to the players is in chess it’s delivered, all the information is there. You might not be able to see 15 moves ahead, but all the information’s there, there’s no dice get roled, no coins get tossed.

And in markets, think about our kind of career tailor, like we’re similar age and we’ve been through oh eight in this industry. We’ve been through COVID in this industry, we’ve been through 2022 together in this industry. Most of the things that happen that deliver our outcomes in investing are just random. Not only did we not know about them ahead of time, like we had never even really thought about them ahead of time.

And so the big difference is just this idea of uncertainty and unknown variables and to me sure there’s an alignment on is it good to be strategic in both of them? Yeah, it’s good to be thoughtful and playing ahead and all that, but once you introduce a random variable, kind of their two very different games.

Taylor Schulte: Yeah. Last month I dedicated an entire episode to talking about tail risk and introducing what tail risk is and why it’s so important. And of course had to relate it back to an article that Morgan Housel wrote a few years back that I’m sure you’re familiar with. Maybe just talk to us a little bit more about tail risk. You kinda loosely referred to it there, but tail risk, chess investing, kinda how all these things intertwine and work together.

Rubin Miller: Who’s Morgan Housel? No, I’m just kidding. I mean tail risks are everything. And I say that almost knowing that that’s probably like a quote per Morgan, but tail risks really do drive everything when it comes to investing. Which is that our job as long-term investors is to make sure we stay in the game. We never want to do something that might potentially take us out. Whether it’s too speculative of a bet, not having enough of our assets say in safer securities or more conservative part of a portfolio.

Terrorists, they can manifest in investing from different ways. I mean I could put all my money in one stock and I have tail risks. I can put all my money in a diversified portfolio and I still have tail risks. So that in there in investing it’s more like what does that distribution of outcomes kind of look like? And obviously your tail or how far away you get from an average outcome when you own a risky portfolio like one stock. It’s just the whole distribution of expected outcomes is so challenging. You have a ton of really potentially positive outcomes.

Like my wife, she works at Amazon. Imagine you put all your money in Amazon 15 years ago, you’ve had a remarkable outcome to the right side of the tail. But imagine you put all your money in Amazon 18 months ago, you’ve had a pretty bad outcome.

So you have a left-side tail. But again, if you concentrate like that, the tails just have a different shape than what we think Taylor and the way we manage money for clients about tails which are they’re tiny tails and they’re tucked into these corners on the left and right side of the distribution. And you and I tend to be willing to say, you know what, I don’t need to chase the right side of this tail. I don’t need to try and deliver my client’s 25% returns year after year after year given what I would be risking by trying to accomplish that.

And in doing so by mitigating the right side of the tail, we also say thankfully I can push in the left side of the tail as well and say you know what, this is never gonna go to zero. And so tail risks, we talked about as tail risk, but honestly they’re also, you can have positive tails. I think what we do as planners is talk to clients, what’s a life that you’re trying to live and these outcomes that I need to be trying to deliver to you?

And almost always, I mean I’ve never been in a situation otherwise, we are better off cutting off these tails and saying we don’t need to swing for the fences here. We wanna move in or narrow this distribution of outcomes because the truth is prudent long-term investing pays spades. I mean it’s an incredible track record if you can stay the course and be disciplined. And so we’re willing to cut off that right tail for the sake of never having to experience the left.

I’m now sure what to say about terrorists in chess. They’re less applicable in the sense that there’s no uncertainty when you play chess. So do they exist? Yeah, kind of like in comical ways. Like if I were playing in a tournament and there’s a really, really great player that’s also in the tournament, one of the tail risks might just be I get paired up with that person, I have to play that. That’s an unknown.

But as far as when you’re at the board itself, it’s unforced errors that are gonna cause most losses in a game like chess, similar to like tennis, the really, really great players, what they do is they just don’t goof up.

So sure tales exist but you never have to experience them for unknown reasons like you do in investing. And it makes it, to me, chess is a much simpler game than trying to play the markets or however people describe that because you play all these behavioral biases on yourself because you think you know stuff, you think things happen for certain reasons. And the truth is most of the time nobody knows anything.

Taylor Schulte: Yeah. And you made a comment in your article, you know it’s easier for people who are not great chess players to be great investors because they don’t expect things to always work out perfectly. Whereas a great chess player might have that expectation that they have all the information and that everything will work out perfectly.

Rubin Miller: Yeah, I was gonna say it’s a great point but it’s my point so I don’t wanna say that. Sounds like you’re right.

I mean I see that and maybe you see that with your clients, but I see that with my clients in the sense that I work with a lot of really, really smart intellectually curious people and it doesn’t always resonate well when I try to share with them that look as a successful person, this client might be taught to wake up early and try to go to nice schools and work hard and collaborate with your peers and do all the right things to have this flourishing career.

And the market’s just, they don’t care about that stuff because there’s a pricing mechanism where good companies end up having high prices and bad companies end up having lower prices. And we as investors wanna just see that spread as being fair. Like that is the mechanism telling us what to expect in the future. What would be weird is if bad companies, a good companies all have the same price, that wouldn’t make sense.

So there’s no point in waking up early and studying stocks because the price already reflects the opinions of a lot of smart people out in the world that trade these stocks every day. It’s not worth trying to go out and guess them. So what advisors like you and I do and other people in our community of evidence-based advisors is say what’s the research say? What does the empirical data on what drives outcomes for stock and bond investors tell us about how we should spend our time.

And what you and I know is that it’s not waking up early to do security research, it’s talking to clients about what are we trying to accomplish here with your life and how can we build a portfolio that reflects our trajectory to meet that outcome.

Taylor Schulte: Yeah. And before we dig into kind of expected returns and how we might think about that in the world of financial planning, kind of back to tail risk for a moment and we’ll segue into that. I had mentioned in my episode last month about tail risk that one of the ways we can protect ourselves or you know mitigate tail risk is through time.

Being long-term investors, we know we’re gonna go through these unexpected traumatic events but if we are long-term investors and we have the proper time horizon, we can mitigate tail risk.

You wrote in your article about chess players and investing, you had this quote that said investing in stocks is about knowing that over time they go up, yet the time horizon may not match up with our own preferred timeline. It’s about expecting and embracing that we don’t know what events will happen in the future to move prices, just that they will occur.

And I think this is a nice segue into talking about reality versus expectations when it comes to investing. And perhaps a good place to start is to touch on, briefly, the current banking debacle with Silicon Valley Bank and how their time horizon has been disconnected maybe from their expectations and what’s happened here in reality. So maybe talk to us about your thoughts on Silicon Valley Bank and expectations versus reality and we’ll dig in from there.

Rubin Miller: Yeah, that’s a great question. Funny enough, I had a sense you were going towards the Silicon Valley bank question just when you started because that’s really what the story should be that everyday investors should all take away. In 2008 and 2009. If we also want to call it some sort of like banking crisis.

The problem was the quality of the assets or securities we’re talking about. And so the challenges people had back then was what type of risk does this thing reflect based on what the underlying holding is. So if it’s mortgages or whatever child we’re talking about or if it’s owning the stock of a bank, the sort of what’s the underlying thing and how credit worthy is this?

That is not the case with Silicon Valley bank. Banks like Silicon Valley and then particularly that we have this information now that’s come out, they own very safe assets so can, let’s just use an example of like a treasury bond or a treasury bill which is a risk-free loan with the US government and banks like Silicon Valley Bank own securities like that and ones that are like slightly more risky but that you and I would determine or call very, very high-quality securities.

And it’s not that those securities have necessarily been downgraded or anything like that. It’s that Silicon Valley bank needed their money before those securities matured and in 2022 when the bond market had, you know, the worst year it’s had in a hundred years. And so prices of bonds were down.

The easiest way to get your money back when you own a quality bond, especially a treasury bond, which is risk-free, is to wait until it matures. And so some of these bonds that Silicon Valley bank own and might mature in five or seven or nine years or something like that.

But unfortunately, when there’s a bank run and people say we want our money back right now you don’t have five or seven, nine years to deliver that money to them, you have to give it to them now. And that’s the issue or the timeline problem that Silicon Valley Bank had which was they had really safe assets that they didn’t have perfect clarity around when they could get them back. They only knew that if they could wait long enough they’d get them back at full par.

So for us or everyday investors, when we think about timeline, I actually love starting with people at the same place, which is the risk-free asset treasury bonds and treasury bills. And so those securities can deliver investors the utmost clarity, basically a hundred percent clarity around your outcome. You just have to be able to hold on until they mature.

So if you have a shorter-term liability, you’re gonna want to own a bond that matures in the near term say like three months. Whereas if you want the utmost clarity but you don’t really need the money for 10 years, let’s say you like wanna pay for your kid’s wedding and your kid’s like 15 and you know that your kid’s gonna get married at 25, you don’t want any risk on that but you also wanna earn a little return. You could buy a 10-year bond, a treasury bond and just have them mature around the time your kid’s gonna get married at 25 because you know that ahead of time for some reason.

So you can use them to match up liabilities quite well but if you want higher expected returns you have to move away from these risk-free assets like treasury bills. And just to set the benchmark, you know treasury bills a couple years ago, they almost all yield between basically zero and 3% and today they almost all yield north of 4%, kind of really volatile right now day to day. So I’ll call above 3%, it’s probably better, more broad answer.

But you might want more than that and for most people when I do their financial plans they need more than that. So what investors need to do is start to deviate away from a risk-free portfolio and almost everybody should and that move that deviation, what you need to be thinking about is timeline, which is if things don’t go according to plan, how much time should I expect a need to recover from say a downturn?

And that’s a conversation people need to have with their advisor. It’s more fun to talk about stocks and specific companies and do all that. But in reality, what you want to talk about is how can I build a portfolio that is robust to downturns and that I have a very high clarity that on the timeline I’m identifying when I need this money back that the outcome is gonna be something I’m comfortable with.

Taylor Schulte: Yeah, a question that is popped up on my end. Do you think using the term, and I know it’s you know, the technical compliant friendly term to use risk free, do you think maybe it’s is dangerous to call these assets risk free? Because I mean the risk as you’ve brought up and the risk that we’ve seen play out with Silicon Valley Bank and we’ll talk about everyday investors here in a moment, but the risk is really time, right?

An event happening where you need access to your money before those bonds mature. So again, technically you could call them a risk-free asset but I mean do you think there’s some danger in calling these things risk-free assets when in fact if your time horizon doesn’t match up with that investment it could actually be a giant risk, which is what we’re seeing play out right now.

Rubin Miller: Taylor I think it’s a fabulous point and yes probably, I mean the reason why we call them risk-free assets is cuz any of your listeners that have sat through a finance 101 class know this is how it’s described and it’s a really important building block for anyone, whether they’ve taken finance classes or not, to begin to contextualize expected future returns of their portfolio because this is what you can get for free.

So any other offering that isn’t risk-free, you better stinkin’ be expecting more return than the risk-free return. Why that’s so important right now is because risk-free assets, the yields are up so much right now you can, like I was saying kind of all lowers of 3% but on the short end of the yield curve, bonds that mature in three months or six months, they’re between four and 5% right now.

And so you can get guaranteed that. And so it’s such a great foundational building block not only for equations when you are doing sort of financial work, but just logically for non-professionals to use. It’s like okay I can get that for free. How much risk am I willing to take to pursue a little bit higher return than that?

And at this point it’s a harder argument or it should be harder for anyone to want to take more risk compared to two years ago when most treasuries yielded basically very little close to nothing.

So I think that you’re right, what we learned from Silicon Valley Bank is this idea of a risk-free rate. It’s true unless you get in your own way, unless you are a nuisance to your portfolio and you become the risk. And I think it’d probably be a great blog post for you if you wanna write it for people to stop talking that way.

Taylor, I wanted to get back to your comment about expectations versus reality and I’m sure we’ll go into this a little bit but I just wanted to say that the reason people haven’t talked about risk-free rates that much and for many people ever.

I would say until last year is because for a lot of us, like I graduated college in ‘06 and I’ve been in the same industry ever since and rates were a little bit higher then and then they kept going down and they basically went down my whole career until last year. And so when the risk-free rate was close to zero, there wasn’t much to talk about. You’re like, well your opportunity cost is zero so you’re probably gonna take some risk.

Now when opportunity costs are 4% for free. Well now it’s a big part of the conversation and I would say I wish we had talked about this more with everyday investors before but it just didn’t become part of many conversations because the opportunity cost was zero.

But what’s so important to know about reality and expectations is that we know a lot about expectations for various asset classes, especially traditional asset classes. So for stocks we have about a hundred years of data that tells us you know, a nice diversified portfolio, keep it low cost probably about 9-10% a year. And that’s what the data kind of tells us.

That’s what investors have been rewarded for, for giving their capital to buy shares of various companies around the world and part with that and take the risk of volatility and potentially that some of those companies might go bankrupt to appreciate in the, you know, hopeful growth of those, a lot of those companies and the average return ends up being around 9-10%. And then with bonds, let’s use a corporate bond for example. So like a Coca-Cola bond from a company that could go bankrupt and might not pay you back on your bond, there’s some risk there.

And so it’s not as risky as stocks per se because they pay you coupons along the way And there’s some other qualities about nice corporate bonds that are a little bit less risky I’d say than stocks. And so you know, the average return of corporate bonds, again it’s kind of loose but call it between 4% and 6% on average.

So a little bit less than stocks but you have a little bit more clarity around that and for that you don’t get as high of a realized return the last a hundred years. But the risk-free rate, why it’s so cool is your reality is going to match the expectation. There is no risk. Again, assuming as you kind of shared that your timeline matches the bond’s timeline, that you don’t need that money back until it matures.

And that’s really important and it’s a variable that doesn’t exist with corporate bonds and stocks because with stocks my expectation is that they’re gonna go up every year, otherwise I wouldn’t invest in them.

The reality is they only go up, you know, about six out of 10 years. So I’m wrong 40% of the time, with bonds I have a little bit higher probability of reality matching expectations every year. But 2022 is such a great example where it doesn’t have to happen. We can have terrible years but the risk-free rate as long as your timeline is the same as the bond’s timeline and your reality will match your expectation.

Taylor Schulte: Yeah, I was gonna bring up 2022 and I don’t know if you have any additional thoughts but you know last year 2022 stocks and bonds both down multiple quarters in a row, not just any bonds but like safe AAA-rated government bonds and high-quality stocks down multiple quarters in a row, which I believe is the first time in history where we saw that happen multiple quarters.

Any other thoughts on like what 2022 can teach us about expectations versus reality in our state of time horizons as retirement planning and investors?

Rubin Miller: I think that 2022 is a great reminder to investors to stop thinking you know more than you actually know and to start thinking more holistically about distributions of possible outcomes. Stocks going down and bonds going down is a very, very, very rare event but is not 0% of the time.

And our job as retirement plan investors and everyday investors, whatever your goal is, is to realize that that’s the tail risk that Taylor you were talking about earlier, which is we always have this tail risk that all of our portfolio might go down at the same time, you know, assuming we own these assets that we’re talking about like stocks and bots and when investors have been told through time that we diversify across stocks and bonds that way if stocks go down, bonds will go up.

Well that’s not true, that’s true most of the time is true the great majority of the time but portfolios need to be robust to the fact that sometimes that might not happen. And what’s so challenging about investing is that the timeline for what I’m describing might be once in a hundred years people can live entire lifetimes and never have to experience a year like 2022. But we need to build portfolios like that. We might go through a 2022 because we never know when they’re gonna pop up.

So what I hope people take away from 2022 is that they add a little bit more robustness to their portfolio. What I mean by that is resilience to negative outcomes. I don’t think everyone should go rush to buy treasury bills and risk-free assets because we’re scared from 2022. It doesn’t really change the way I think about anything in investing because I already was prepared for tail risks or negative outcomes for client portfolios. It’s a matter of communicating with clients that this might happen sometimes and we’ve designed our portfolios to be somewhat prepared for that.

It can be very disappointing when it happens but investors should not be surprised when we have negative outcomes in portfolios. So my takeaway is I hope people can look at the large dataset about how often do stocks and bonds go down at the same time. It’s not very often and when they start 2023 we’re now almost a quarter into it, we should have the same mindset that it’s a rare but possible outcome, not have this bias that it just happens so it’s more likely to happen again.

That’s actually most likely quite the opposite because with bond yields, as bonds go down, their yields go up with yields starting the year much, much higher than they were the last few years. That tends to actually be a huge advantage to client portfolios with being able to capture those higher yields despite taking a little bit of a hit on the price.

I’m sure we could talk about this more, but the truth of the matter is, and you and I can remember last year we talked about this a lot, this is a truth that all investors should know. That if your time horizon is five, 10 plus years and you own bonds that might mature in 3, 4, 5 or six years, you really should try not to care too much about this downturn because at this point the price has gone down a little bit in your portfolio but you’re collecting much higher yields along the way assuming you stay disciplined and there’s a breakeven point.

So to give you an example, if you have a bond that yields 3% and you lose say 6% in price, so you have something that you’re gonna collect 3% on but it goes down in price compared to now you lose a little bit in price but the yields now 6% going forward. If you start simulating a lot of 6% years, there’s a breakeven point that happens a lot quicker than people realizing where you don’t actually care about taking a quick hit in a price decline as you capture higher yields.

But the same thing as Silicon Valley Bank, if your timeline does not match up with when those bonds mature, that’s a big problem. So the issue is if you needed that money before you can collect those higher coupon payments for a long time, that’s an issue.

Taylor Schulte: Yeah and I’ve talked a lot about in the last year a lot about bonds and how bonds work and the misconceptions around individual bonds and bond mutual funds. So if you’re a new listener go back and listen to some of those episodes from last year. I think one of the titles is should retirement investors own bonds?

I also have talked a lot about the importance of cash management, especially in retirement when you’re leaning on your portfolio for income and we go through strange, crazy weird events like 2022 having cash becomes really, really important.

I do wanna pivot the conversation a little bit and I just wanna get into expected returns and I wanna get into expected returns because one of the most common questions I get from listeners, although most of our listeners kinda share our philosophy, they don’t believe they have a crystal ball.

They’re not trying to predict the future. However, they realize that assumptions about the future do matter for their long-term financial plans. So one, we use this term a lot in the world of investing expected returns, higher expected rates of returns. And again we also use it in our retirement planning when we’re running these long-term projections for clients, we have to use something right in order to get an output we have to have an input.

So how do you think about making informed decisions, evidence-based informed decisions about expected returns that you might use in a long-term financial plan for your clients?

Rubin Miller: Yeah, great question and you know, I lived in this world of term expected returns, future expected returns for a long time cause I’ve worked at Dimensional Fund Advisors for seven years and that’s how we spoke when we would work with advisors and clients thinking about portfolio days.

And I’ve been an advisor for 18 months now when I kind of pivoted to the other side of the table and again I still use this language, but it’s often in a different context dealing with actual end clients.

And it relates to the asset classes again. So different types of assets have different types of expected returns and at the same time they also have different levels of clarity that we should have around those expected returns, which is to say how confident we are that expectations will match reality. And I think the most important thing to note about realized returns, so what people actually get.

So at the end of 2022 what you actually got looking back is that realize returns are a function of just two things, which is expected returns, plus unexpected returns. And in the short run related to this timeline we’ve been talking about in the short run, unexpected returns drive almost everything that’s covid, that’s 2022, that’s 9/11 unexpected events that we didn’t really foresee that sort of change everything.

And in the short run, that’s everything in longer horizons expected returns are very, very helpful and if you look at the hundred years of data that we have on the stock market, break those up into like 20-year rolling returns or 25-year rolling returns. And what researchers see is that, yeah it’s like nine 10% almost every time meaning the average over that timeline that’s despite 9/11 and despite ‘08, ‘09, and despite covid.

So the uncertainty or the unexpected events that pop up and change everything in our lives over long time horizons, they end up being kind of blips on the radar of realized market returns. So in the short run, unexpected returns are everything and in the long run, I think investors need to think that the expected value of unexpected returns is zero.

At the same time expect yourself to be wrong every year but over a long time horizon. That’s kind of the best way to think about it. We do have to build financial plans for clients cuz we have to know well how many risky assets do these people need to own and how many safer assets do they need to own to sort of live these nourishing lives that you and I and other players are trying to deliver to them and help them empower them to live.

So for stocks I use historical average like I’ve been talking about and the reason why I’m comfortable using historical averages is because I believe there’s a lot of information in the fact that in the last a hundred years it looks like again for buying stakes in companies across the globe, giving up your capital for equity in these firms, risking the volatility, risking that something might go bankrupt.

The opportunity cost of not having that money yourself for all those reasons it looks like you get paid about nine, 10% a year over long periods. I’m comfortable with that. I don’t have any reason to believe that’s gonna be meaningfully higher or lower over long periods. Again, I expect to be proven wrong, many, many short periods but not sound my expectation over longer periods.

I will say there’s pretty compelling research that if stocks are relatively lower priced, so let’s say there’s a big downturn like we had last year in 2022 and stocks are down, let’s call it 25% or 30%, you know, the next few years it’s pretty compelling and the research is pretty robust that you should probably expect a little bit more than nine or 10% a year go forward.

So when prices are lower, expected returns are a little bit higher and when prices are really high, like right before the tech bust in sort of you know ‘99, 2000 when prices are really really high, it does seem like over the next few years to expect to return our stocks is a little bit lower.

And what I would caution people to doing is doing too much about that information because again our timelines don’t have to match up. Stocks can seem very expensive and then they can get more expensive for a couple more years. So I try to not use that information too much but that is true, what people want to do with that information is very different. There’s obviously a lot of people who like to time the market, that’s not something I encourage people to do. So stocks long-term average is pretty good over the shore run.

If somebody asks me what do you think stocks do this year? I don’t have any idea. I always think about, there’s this Picasso quote that’s like when our critics get together and they talk about like form and meaning and structure of art and when painters get together they talk about where can you buy the cheapest turpen time.

And I feel that way about me like when I talk with my friends like you and evidence-based planners, like people expect us to have all these forecasts and talk about what stocks gonna do and all that In a reality I’m like how can I control what outcomes I can control best? I really don’t know what stocks are gonna do and so I’m much more comfortable when I brainstorm with peers in the industry or just think about client portfolios. I’m much more comfortable spending my time on things I can control and not forecasting or thinking I hassle some crystal ball.

Taylor Schulte: One of the things that we do have control over as investors, as financial planners and as you know just retail public, one of the things we have control over is investing in active managed fund or a passively managed fund. Active managed meaning there’s a person behind the scenes that’s managing that portfolio and buying and selling individual securities in an attempt to outsmart the markets versus just buying the whole market and you know, being patient and buying and holding.

So we do have control over what decision we make and what types of investments we invest in. I’d love to hear your thoughts on how should someone change their banking around, or maybe I should say, how do expected returns change when we start to get active with our portfolio decisions?

Rubin Miller: Great question. Fabulous question. So I think about this really simply, do you as an investor believe that returns come from the market or do you as an investor believe that returns come from a manager?

It’s a question that I don’t think an everyday investor out the street has ever really thought about. We tend to associate returns with managers or we tend to associate returns with the six o’clock news and whenever the Dow Jones did that day. But very rarely do people actually dig in like what does that actually mean?

And for me and other financial planners who again are trying to deliver high predictability around future client outcomes, I don’t want anyone to hijack returns from me. So when I think about expected returns and I see that a globally diversified low-cost portfolio stocks does on average
9% to 10% a year, I want that 9%, 10%.

And if we refer back to our conversation about tail risks, yeah it seems like I should expect some people to be able to go out and pick stocks and on a year where the market does 9 or 10% they’re gonna do 14 or 15% and by random flips of the coin I expect that to happen.

At the same time, some people to go out and pick stocks are gonna get five or 6% that year and I expect that to happen as well. The problem is that the right tail of someone getting that 14 or 15% in this distribution of possible outcomes is small. I mean there’s not that many people that consistently beat the market and the longer time horizon you have and go from one year to three year to 10 years, you get smaller and smaller and smaller. And then the left side there’s a lot of people that are gonna perform.

So my average expectation, if you pay someone active management fees since your realized return is going to be minus their fee, the expectation is that if you’re gonna pay some a lot of money to manage your money, they’re probably gonna underperform the average return you can get in a low-cost passive investment as you described.

It’s a well-documented concept. There’s a great, it’s not a paper, it’s like a three-paragraph essay called The Arithmetic of Active Management by William Sharp at Stanford. It’s a lovely little read for if listeners have never read it, but it describes this idea perfectly, which is that it’s not that these people are dumb or anything like that, it’s that they charge fees and the average expected return of everyone is the market because that’s what we’re all just breaking up. We all just own different parts of the market.

So on average we all get the market return but some people are gonna get a little higher and some people are gonna get a little lower and if you pay high fees then certainly your average expected return is gonna be below the average return.

Taylor Schulte: One of the other things that we have control over as investors is what types of stocks, what types of securities we buy, what type types we include in our portfolio. You know, knowing that you were a dimensional fund for about seven years and knowing that Dimensional funds believes that there is a value premium, that over a long period of time those value-oriented companies should produce a higher expected return than those growth-oriented companies, those growth stocks.

I’m just curious to hear a little bit from you that to explain to our listeners why does the value premium exist? Why should investors, long-term investors, why should we expect a higher return from value stocks than growth stocks over those long periods of time?

Rubin Miller: One of the reasons why I left Dimensional Fund Advisors, which is a fabulous fund company is because I’m not that interested in value versus growth debates, which is to say this is a part of Taylor and my industry that many advisors and researchers and analysts love talking about the war between value and growth and it’s like call something a war and everyone runs around like a warrior.

Like there’s so many heavy-headed opinions about why value stocks should be better growth stocks or why this year’s better for growth. And the truth that I believe is that prices are probably pretty fair out there as I described earlier, like I believe in passive investing in the sense that I don’t want to go out and spend my time, energy or resources trying to out and guess everyone else. So I’m generally indifferent between say one growth stock versus one value stock.

I don’t know what’s gonna happen but it is true that value stocks tend to be less exciting companies. Nobody wants to work at a value company, everybody wants to work at Amazon and Facebook and Tesla or at least they did until last year. But like these growth companies are the ones where you see all these really smart people flock to for careers.

And what happens is that’s because their futures are so bright on expectation that these companies, people love what they’re doing, it’s cutting edge, blah blah blah. And so they attract a lot of talent and in the stock market when you have heavy expectations into the future, you become a growth company, which means people buy up the price.

And so you might have a, this company that’s not earning a ton of revenue each year isn’t maybe super profitable but has a really high stock price cuz people love what it might be in 10 or 20 years.

And value stocks tend to be the other end of the spectrum, kind of steady Eddie companies or even struggling companies they call, you know, relatively low price companies cuz people don’t really wanna own ’em, they’re not that exciting and whatnot.

And the way investors just think about this is not to pull out the finance 101 book or with a bunch of equations, but just think about in a rational world if you have the option, I’ll use McDonald’s as a kind of established player and then a non established player.

So let’s use some, you know, the restaurant down the street, it doesn’t have to be a publicly company, just take a McDonald’s franchise and some restaurant down the street that you like and if I told you you’re gonna get 10% a year return, you already know that you’re gonna get 10% a year, which company are you more excited about holding that year?

You’re gonna have ownership in it. Which one do you wanna own? Most people would say, well I’m more comfortable with McDonald’s, it’s more robust, it knows how to make money, it’s more profitable, it’s got more resources and all that. And if I’m gonna get the same 10%, I’ll just take the easy way out, you know, the less risky one. And that’s how you should think about value in growth stocks, which is that people tend to wanna own these nice solid companies.

And so how is the market going to incentivize people to own less nice companies? And that’s the story which is that’s what the value companies are, they’re less nice companies but every stock has to be owned. And so the way that the market has traditionally done this is that there’s a premium to own value stocks, depending how you measure it, it’s about two to 3% a year.

But like stocks, it’s very volatile itself. Many years growth does better than value, but on average value does better than growth about 2 to 3% a year. And that’s why owning the kind of crappy companies in the market. But it has to be that way, it has to be that way because every stock has to be owned.

And so how do you incentivize people to buy less nice companies? You have to give them a slightly higher expect return and we’ve realized that higher expect to return in the last a hundred years, there’s no reason to think going forward that all of a sudden everyone’s gonna want to own crappy companies.

I don’t think that’s the case. I think people are always wanna own the nice companies that have cool outlooks and sound cool and have all smart people working there. And so that means the prices of these value stocks are essential, you wanna think about as being somewhat depressed for what they’re offering. And I have no reason to think value stocks wouldn’t do better than gross stocks going forward.

The caveat as asset allocators is, I don’t know when that’s gonna show up. So similar to the way you and United say, I don’t know what stocks gonna do next year, I have no idea if the value’s gonna be growth or growth’s gonna be value. I just expect over really long periods for value to do a little bit better. Because I just can’t imagine a world where people get to buy kind of the nicest shiniest companies and get the highest returns. That doesn’t make sense to me otherwise, no one’s gonna own the other stuff.

So I tend to tell people, you know, it wouldn’t surprise me if growth did better than value for 10 years. And we’ve seen periods where that happens, it’s kind of rare value tends to outperform definitely most even five-year periods and over 10 years it looks really, really pretty.

But just like in 2022 with stocks and bonds, we might face a period where a big part of a client’s investment experience with me might be a tenure, a decade where growth does better in value. So I have to manage around that. And the way you mitigate that tail risk is by diversifying across both types of stocks.

So you own the steady Eddie, maybe struggling companies because they come at low prices and you own the nice cutting edge high tech companies because they come at high prices. It is true that I believe investors should probably overweight value stocks a little bit given how compelling the research is. That’s some special research too that those sort of ideas we’re discussing what a Nobel prize in 2013.

So we’re not talking about anything that’s kind of unknown to professionals, but how you’re gonna implement with knowing this information is very different amongst how people kind of cut that up. But I take basically modest tilts to value. There’s a couple other premiums too that are economically intuitive and so I also overweight those. But for the most part, I tell people my client portfolios look very much like the market. I don’t want a manager to charge me high fees and hijack the market return. So I try not to deviate too much away from the market.

Taylor Schulte: Yeah, I really like the way you framed that and Rubin, I mean I could talk to you forever. We often have very long conversations and I appreciate those. I wanna be respectful of everybody’s time and before I give you a chance to share a little bit more about you, your firm, your blog and where you write, just any final thoughts here on the time horizon, reality verse expectations, any great chess stories you wanna share?

Just any final thoughts before we talk a little bit more about Rubin, your amazing blog that you started a couple of years ago, your firm and everything else.

Rubin Miller: Thanks Taylor. I did wanna say, I just wanna come back to, we were talking about sort of inputs in the financial plans and I think I went on a rant about stocks and how we basically, we have an idea of the historical return but it’s, it’s really noisy over time.

And I just wanna say with bonds what investors should know, and this also relates to active and passive, is with bonds, your expected return, if your bond portfolio looks like the market is your yield and the yield gets kind of quoted by companies that run ETFs and mutual funds. And so that’s a really good proxy for your expected return.

So if you have a market based portfolio like an index fund and a fees are low, your yield is very similar to what you should expect each year. And so that’s very helpful for financial planning.

And so the expected returns in a financial plan should mostly be related in my opinion to current yields that you’d see in the market. Timeline matters obviously if you have a 20-year time horizon as an investor, if you don’t want to use one-year yields for bonds.

But that’s a good kind of little nugget for people to think that’s different from stocks to bonds. And we don’t have a helpful yield in stocks. I see this error all the time. Stock funds do have a yield, but it’s a distribution yield. It’s what they pay out to you each year and then deduct basically from the price.

That’s how you wanna think about it. So those yields are not helpful. Bond yields are very helpful and that is your expected return if you decide to use active management, which I don’t encourage investors to do. The traditional active management where someone believes they have the expertise to pick individual bonds, that’s gonna come typically with a higher fee.

And each time you have a more concentrated portfolio or you move away or deviate from the market itself or like the index of the market that we’re discussing, then your ability to capture the market return moves further and further away. Which is to say you’re gonna look less and less like the market return. That might be good, that might be bad.

As I shared on average, if you use expensive active management, the expectation should be it’s gonna be negative to your returns. So it’s just important to know that with bonds, we have a lot of information with stocks we don’t. It’s also one of the reasons why bonds tend to be a little safer than stocks. And then I always hear this question about like, what about more exotic asset classes like cryptocurrencies or something like that or gold.

We have no idea, there’s no real mechanism to understand, expect returns and anyone who tells you otherwise is it’s kind of a garbage answer.

So I wouldn’t use expect returns if you ever take a big risk. I’m not saying don’t, people should never own Bitcoin or anything like that or crypto, but if you do, you just kinda wanna remove that away from your financial plan. It’s not a very helpful input because even if you did have like the utmost conviction that it’s gonna work someday, which I don’t, but even if you did, it’s so noisy as we’ve seen in recent years, it can go down 50% or more, whatever.

That’s not helpful for trying to paint a picture of your most likely outcomes leader in life. So if you’re someone who likes to take flyers like that, just kind of compartmentalize that and put it in a different bucket, it’s not very helpful for retirement planning.

Taylor Schulte: Yeah, maybe to summarize your comments about bonds and them being used in financial plans and setting expected returns, the starting yield of your bond or your bond fund is a pretty good predictor of its future return. The clarifying point that I wanna make, and I don’t wanna go down this rabbit hole right now, but I’ve done a whole series on bonds.

Again, I’ll link to it in the show notes, you can check it out. But the one clarifying point I just want to, I wanna make here is that there are different types of bonds and there are some bonds that are very, very risky and that’s starting yield starts to become kind of meaningless and trying to predict future returns. And there are bonds that are very, very safe. Your AAA-rated government bonds or high-quality corporate bonds.

So not all bonds are created equal. And when we talk about expected returns and using that yield to predict future returns, we are talking about those safer bonds because there are bonds that can be a little bit more volatile and more unpredictable.

Rubin Miller: That’s a really, really fabulous point. You know, all in investing is just one big risk and reward curve. And the further you go into risky bonds, the more they actually probably start to look like stocks. And the less clearer you have around your expectation match reality when it comes to using yield as a proxy for expected return. Yeah, great point.

Taylor Schulte: So Rubin, where can people find you, your firm, your blog, anything else I don’t know about?

Rubin Miller: You know everything. Thanks for having me on. I’m the founder and chief investment officer of Peltoma Capital Partners. We’re an RAA in Austin. I write a blog called Fortunes and Frictions and you can find that it’s just written out fortunesandfrictions.com. And then I’m on LinkedIn, you can connect with me there and I’m on Twitter, but I’m pretty bad at it. But it’s Rubin Jake Miller and you can find me there too.

Taylor Schulte: And we’ll link to everything in the show notes for this episode. Please, please, please do me a favor and go check out Rubin’s blog, Fortunes and Frictions, just some amazing writing, amazing articles. We’ll link to a few of them that we talked about today, but go check it out.

Rubin, thank you very, very much for this conversation. I really enjoyed it and I know we’ll have you back on the show soon. So, thank you very much for your time today.

Rubin Miller: Thanks, Taylor. Love you, man.

Once again, to grab the links and resources from today’s episode, just head over to youstaywealthy.com/185

Thank you, as always, for listening and I’ll see you back here next week.

Disclaimer

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.