Robert Leonard  2:01

It’s funny that I live in the Boston area. Where I work is where we source all of our co-ops from Northeastern. Awesome. Well, we’ll dive into your YouTube and your side hustle, things of that nature. But before we do, I know the audience is big into stock investing. So let’s talk about your day to day responsibilities as a portfolio manager, what does that look like?

Ben Felix  2:25

When you talk about people being interested in stock investing, what I do as a portfolio manager is super not interesting from that perspective. The reason is that in PWL, our investment philosophy is that you cannot beat the market. So all of the security analysis that the CFA program teaches, we’re not doing that. We build portfolios using low cost index funds for our clients. We focus a lot more on the wealth management financial planning side.

We consider investing to be one of the many inputs, but we’ve got model portfolios that we’ve put a lot of time into building. So we’re not spending a whole lot of time researching specific securities or anything like that.

In terms of the breakdown of my time, a good chunk of it is spent meeting with clients, keeping in mind that we’re not a fun company. We’re not just managing assets, we’re doing Wealth Management, which is a lot more involved.

At the client level, I spent a fair amount of time doing research. But again, it’s not research on stocks, it’s research on financial planning, minimizing tax and efficient retirement, drawdown and things like that. So that’s client research.

I know we’re going to talk about YouTube as a side hustle, but it’s actually not. So I do spend a chunk of my time at my job writing content for my YouTube channel as well.

Robert Leonard  3:35

That’s interesting. So you mentioned you have an MBA, you’re a CFA, CFP and CIM, and you’re a successful Portfolio Manager. So what made you want to start a YouTube channel?

Ben Felix  3:48

You got to understand in Canada, our financial services landscape is really dominated by five big banks. We know that from a marketing perspective, we cannot differentiate ourselves. That’s not the right description. We can’t compete on marketing spend with these big banks that we have here.

And so, our strategy has always been content, which I think as a firm we’ve been pretty good at for quite a long time. A few years ago, based on the data on video consumption, we decided that it made sense to try and get into video as part of our overall content strategy. So we did that. That’s really how my channel started. It was a decision at the corporate level for the firm that I worked for, to pursue video and just happened by luck or whatever you want to call it that my channel has done fairly well. It’s kind of become a thing of its own now.

Robert Leonard  4:35

So you don’t consider it a side hustle?

Ben Felix  4:38

I mean, it’s tricky. It blurs the lines because I mentioned that I spend some time at work working on that project. But the majority of the time that goes into the YouTube channel is usually on the weekend, which is kind of tough because I have three young kids and a wife who also demands my time. So it’s not completely a side hustle because it’s fully supported by my work, but most of the time is my own time. So is it a side hustle or not? I don’t know how to answer the question.

Robert Leonard  5:07

Would you have it if your corporate job were to change? Would you continue it now?

Ben Felix  5:12

Yeah mean, it’s at a point where I think it’s got quite a bit of momentum. As a standalone business now, if I stopped putting anything into it, it’s not huge. I think I’ve got just under 100,000 subscribers. So it’s producing some, not insignificant revenue, nothing that I can live off of and support my family off of. But yeah, I will keep it going for sure.

Part of the tricky thing is, I don’t do all of the animations and things like that. So there’s a cost to that. If I factor that in plus my time, the *inaudible* is losing money. So it’s not a great business in that sense. But like I said, I could start making new content, and it would still do something as a business. Anyway, yes, separate from my corporate job, I would definitely continue with the YouTube channel.

Robert Leonard  5:53

A lot of people are wondering who can create those animations for them? So are you just outsourcing them to a freelancer or is it something that your corporate job is handling?

Ben Felix  6:02

The corporate job handles it. I don’t do any of that coordination myself. We do have a video editor and an animator, so they’re two separate contractors. I wish I could do that myself, but I guess I wouldn’t have time to do that, even if I had the skills.

Robert Leonard  6:16

It’s very cool that your corporate job allows you to be able to do something that a lot of people would consider a side hustle and even help you support that with the different animations and different freelance opportunities that they provide.

Ben Felix  6:29

I think from the perspective of the company, it’s been really powerful in terms of reaching people that might be interested in becoming clients of our wealth management service, but also communicating ideas, what we’re thinking about and how we’re thinking about things to our clients.

That’s been one of the most impactful things from our perspective is the feedback that we get from clients of our firm, just saying how much they appreciate the content, or even just whenever we meet with people, they’ve already got so much context for how we’re thinking about things because they’ve been keeping up to date with our YouTube videos.

Robert Leonard  6:57

So you found it to be a good lead generator?

Ben Felix  7:01

It’s been really, really good. We do a podcast too but it’s like through the comments that I get from people who’ve reached out based on watching the videos or listening to the podcast that they feel like they already know me. They already know exactly how we’re thinking about all these different financial planning and investing issues. So it’s very different from a billboard where you might get someone curious about the fact that you exist, then you’ve got to sell them on your services.

If somebody contacts us, based on watching YouTube videos, or listening to the podcast, there’s no real sales process. It’s like they’ve contacted us because they know exactly what we do and they know that they want that. So I guess it is good for generating leads, but it’s good for generating extremely qualified leads.

Robert Leonard  7:44

And so, for someone listening who may not be in the exact position you are where provides leads for their day job, I wanted to talk about that because if they have, maybe the YouTube channel isn’t making a ton of money, but maybe it’s providing leads for something else that they’re doing, maybe they have a book, maybe they have a course maybe they have consulting services, or just maybe they have something else that they’re selling on the side. Then maybe they need to start a YouTube channel just to get that content out there to add as a sales funnel or a lead generation tool for them for whatever they’re looking to do outside of YouTube.

Ben Felix  8:13

A friend of mine also has a YouTube channel. He’s starting to more recently, it’s not 10,000 subscribers kind of thing but he’s in music production. We’re just chatting about YouTube and he said he’s not making any money with 10,000 subscribers, you’re not making much of anything.

However, he said that the lead generation for his music production has been massive. He’s getting clients from that that are much more meaningful to him in terms of revenue. So yeah, I think if you can do video well, it can be extremely powerful. Like I said before, when you’ve got people contacting you and they feel like they already know you, that’s extremely powerful, f you’re looking to generate business.

Robert Leonard  8:47

When you’re creating these courses, are you providing a sales pitch in the video? Or is it just more of an organic thing, just by listening to your content, watching your videos, they kind of go down the funnel, if you will? Then they end up finding what else you’re doing and it leads that way. Are you providing pitches in the video?

Ben Felix  9:04

There’s never a pitch in the video. I think occasionally I’ll say this is how we’re doing. This is how I do this at my firm very occasionally. But most of the time, I don’t even mention it. I say at the beginning of the videos that I’m a portfolio manager at PWL Capital. But for the most part, I barely talk about what I do or anything like that.

Robert Leonard  9:22

tHow do you balance your career as well as”side hustles”: not necessarily a side hustle like we’ve talked about but you said you work on it on the weekends you have kids and a family so how are you balancing this dynamic?

I think you’re somewhat fortunate that you’re able to do the YouTube channel in combination with your day job but for someone who isn’t, how are they able to balance these two dynamics and work on them both at the same time and make them both high quality?

Ben Felix  9:45

It’s a really hard question to answer. It’s no joke, having my job. Yes, like I can work on the YouTube channel and the podcast at work but I’m also really busy at work with clients and research like we’ve talked about. Dude, most of this is on the weekend. So maybe from that perspective, it’s not that much different from having a true side hustle.

It’s called a hustle for a reason, I guess. I don’t use that word much to describe what I’m doing, but it’s a commitment. There are definitely times on the weekend where I don’t feel like or in the evening, where I don’t feel like doing stuff, or I’m not in the mood to really think deeply about something, but to kind of have to do it. I mean, you get it with a podcast, too, like these things don’t stop, especially if you want it to do well. If you want to communicate well with the audience and build a good audience and a good community, it’s got to be consistent.

But consistency is really, really hard. Yeah, so I don’t know. If someone wants to have a side hustle, you’ve got to understand its commitment. Think in terms of content, you’ve got to understand that consistency is huge. Quality is also really important. That’s one of the reasons that it’s so hard to do this stuff.

If I was doing YouTube videos, where I just got in front of the camera and talked about whatever, that’d be easy. That’s why I only do one every two weeks. Yeah, it’s a commitment and it’s hard, but I guess that’s why it pays off.

Robert Leonard  11:08

I don’t know about you. You’re probably a numbers guy as if you were an engineer. Just like me, I’m in accounting. That’s my type of thing. I’m not really super creative. So I kind of underestimated the level of effort that it was going to take to do something like this. It is a very creative project.

You mentioned the podcast. When I first started, I didn’t realize how hard it was to consistently every single week put out a podcast, but not just any podcast, it has to be high quality with great guests. It’s something you have to do every single week.

Consistency in the high quality is what’s key so it’s extremely difficult. Just like you said, it just takes time, hard work and commitment, really. Is there anything that you’re doing with your channel to try and make it stand out? It seems there are a lot of finance and investing related channels. So are you really focused on trying to make it stand out? Are you just trying to put out the best content possible?

Ben Felix  12:01

If you look at my old videos, they’re all there. I think they were worse than the newer ones. I think I’ve gotten a lot better in front of the camera. But when I started, I was really trying to appeal to an audience that was looking for…

Now I don’t like necessarily using the word evidence-based when it comes to financial markets and investing because it’s hard to refer to that as a science. It’s a social science, if anything, but I wanted to take an approach that was much more data driven, and had peer reviewed academic research backing up the things that I was saying.

I agree there are tons of financial channels and investing channels on YouTube and podcasts just the same, where you’ve got people talking about stuff based on their opinions or based on other people’s opinions, that’s easy to find. It’s also relatively easy to do, but the way that my firm thinks about things, and the way that I’ve always thought about things personally as well is that I really feel like I need to be able to back up anything that I’m saying. I need to be able to go back to the root and say, “Well, it’s true because of this.” That might be data, it might be theory.

So that was the basis of the channel from the beginning to communicate that type of information. That’s what I’m continuing to do and that’s what I plan to continue doing.

However, as far as I know, there aren’t a whole lot of other channels that are doing things the same way. So I guess that ends up being the differentiator, that wasn’t necessarily the plan from the beginning, but as it’s turned out, that’s been what differentiates my channel from the many others that are out there.

Robert Leonard  13:26

Your channel is called Common Sense investing. What does that mean? What is common sense investing?

Ben Felix  13:32

The way that I’m thinking about it in the way that I try to communicate what I think is smart investing through the YouTube videos is that you can’t consistently beat the market trying to do, so is probably going to make you worse off as opposed to better off.

Therefore, this is obviously an oversimplification, but therefore, it makes sense for most people to invest in low cost index funds. Now, I’ve talked about a lot more than investing on the YouTube channel, like I talk about different financial decisions in different financial products and concepts.

Though in broad general terms, what I’m telling people is that capturing the returns of the market is probably the smartest thing to do. So what is common sense investing, I would summarize it very broadly as using low cost index funds.

Robert Leonard  14:11

You have a video that asks the question, “Are index funds over diversified?” Modern Portfolio Theory would tell us that more diversification is always good. Can you describe why an investor may not want more diversification and in what circumstances?

Ben Felix  14:27

I thought a lot about this. I probably don’t know. Three months ago, I spent a lot of time thinking about this. There’s a firm that makes indexes and ETFs in the States called Alpha Architect, their CEO. I think his name is Wes Gray. He graduated from the University of Chicago, with Eugene Fama, the guy that sort of coined the term market efficiency, which is what makes… if markets are efficient index investing makes sense.

Anyway, Wes Gray studied under Eugene Fama, and he’s got this firm now called Alpha Architect and the whole basis of their products is optimizing for concentration in the right types of stocks.

So I spent a lot of time talking to Wes about this and a lot of time thinking about it on my own. But the reason that you would not want to diversify if you would want to be concentrated in a portfolio is that when you diversify, you lose exposure to characteristics.

As an example, if you want to be a value investor, if you invest in 1000 value stocks, you won’t have extreme value exposure. But if you instead invest in the 50 cheapest stocks that exist in the market, you’ll have deep value exposure.

So that’s two different portfolios. One’s much more concentrated, one’s much more diversified. But you could argue, and you should argue, that the more concentrated portfolio has a higher expected return, so you can be more diversified and you’ll have a lower expected return in my example, or you can be more concentrated and have a higher expected return.

The other big difference between those two examples, though, is in the concentrated portfolio, you’re also going to have more company specific risk or more idiosyncratic risks, unpriced risks, random risks, another way of describing it. So another way of thinking about that is that in the more diversified portfolio, you’ve got a more reliable outcome.

Now , we’ve got these trade offs, where in the diversified portfolio that say, like an index fund, you’ve got a reliable outcome, you’re probably going to get something fairly close to what you expect, on average.

Whereas the more concentrated portfolio, you’ve got a higher expected average return. But you’re also going to have more random errors around that expectation in the outcome that you get.

Now, the next step in that thinking is okay, well, if you want the higher expected return, theoretically, the most sound approach would be to take the diversified portfolio and use leverage to get your expected return where you want it to be.

Now, this is one of the things I talked to Wes Gray a lot about. He basically says leverage is messy and painful, which is true.

So to answer your question, I know this is a long way of answering it. But if you want to have higher expected returns, but don’t want to use leverage, that’s a much cleaner way of explaining this with my rambling just now. If you want higher expected returns, and don’t want to use leverage, having a more concentrated portfolio is another way to approach higher expected returns.

Robert Leonard  16:57

So who wouldn’t want to run that concentrated portfolio because I’m sure that’s not great for everyone?

Ben Felix  17:02

You get a couple things. You get the idiosyncratic risk that I mentioned, where yes, you’ve got higher expected returns on average, but you’ve also got a much higher expected dispersion of outcomes. On average, keeping in mind that people don’t get the average return, people get one outcome, on average, you get a higher expected return, but you will probably get something much higher or much lower than the average expected return.

That can be scary and it can even be challenging. From a financial planning perspective, if you’ve got a wide dispersion of outcomes planning around that can be really hard.

But the other piece, and this probably speaks to your question better, you’re going to have more volatility. If you take the 50 cheapest stocks in the market, that thing is going to be crazy volatile.

It’s not just going to be volatile. It’s going to have a ton of tracking errors. So if value stocks are down, the 50 cheapest value stocks are probably going to be down more.

And so, now we have volatility, which hurts anybody. But we’ve also got tracking errors, where the market might be down a bit… Well, your portfolio is down a ton, or the market might even be up and your portfolio is down a ton. So anybody that can’t deal with that type of pain, or that doesn’t want to have the potential for idiosyncratic risks that affect their outcome, those people would not want to invest in a concentrated portfolio.

Robert Leonard  18:09

That type of concentrated portfolio probably isn’t good for someone that’s closer to retirement, but someone who’s listening to the show, that’s a millennial investor that’s young, early 20s and early 30s, who has a long time and can weather that volatility, that might be a good type of portfolio for them, assuming that risk matches their risk profile, their personality, and they’re able to weather those swings in the market up and down.

However, assuming that’s the case, then the optimal portfolio for them is probably the concentrated portfolio.

Ben Felix  18:36

Yeah, I don’t generally advocate for concentrated portfolios, just because you do get that unpriced risk, the volatility is less of a concern. I think the other thing that we’ve spent a lot of time thinking about recently, and it stemmed off of this concentration versus diversification discussion, but the other thing I’ve been thinking a lot about is leverage.

Again, leverage is risky, genuinely.You can lose all of your money as a leverage investor is volatile and it can be scary. So again, the theoretically sound and probably more reliable approach for a young investor wanting higher expected returns is to use leverage.

I’ve got a YouTube video on that if people want to watch it. It is called investing with leverage. Yeah. So if we’re thinking that we’ve got a young investor with a super high risk tolerance, what’s the best way for them to get higher expected returns? There are a lot of trade offs.

However, it’s not an easy decision to have a more concentrated portfolio or to use leverage. I don’t think that the answer between those two choices is obvious.

Robert Leonard  19:29

You gave two options there. Why is or why isn’t picking individual stocks a third option? Why isn’t that a good choice for a millennial investor?

Ben Felix  19:39

When we start talking about picking individual stocks, that idiosyncratic risk component that I keep bringing up, it gets bigger, and it potentially gets even bigger than the overall expected return of the portfolio.

If we’re picking instead of the 50 highest expected returning stocks, if instead we’re picking the three or the five highest expected returning stocks, a lot I guess depends how you’re defining highest expected returning to, but you’re going to have a very wide dispersion of outcomes, which might not be a bad thing.

You’re not always going to lose, you might win. But you’re going to have a wide dispersion of outcomes where you’re going to get a potentially very positive or potentially very negative outcome.

I guess you could get an average outcome too, but the potential dispersion is a lot wider.

One of the big issues with individual stocks is that we know empirically that most of the market’s return in excess of T-bills comes from a relatively small subset of stocks. There’s a paper that looked at US stocks in 1926, 2015, and other 26,000 stocks that appeared in the CRSP database, the Center for Research and Security prices. 26,000 stocks appeared in that database for the full time period from 1926 to 2015, and 1000 of those 26,000 stocks, explain all of the markets’ return in excess of T-bills. It’s really like finding a needle in a haystack to find those companies that do end up beating the market.

Another way to think about that is if you are picking stocks, your chances of underperforming statistically not including things like being a skilled manager, which is a whole other conversation. But statistically, picking stocks, you’re much more likely to pick a loser than you are to pick a winner.

That also speaks to the concept of idiosyncratic risk where if you’re not diversified, the chances of missing out on the stocks that do explain the market’s returns are much higher.

Robert Leonard  21:19

You’ve also talked about avoiding index funds. Why would an investor listening to the show today want to avoid index funds?

Ben Felix  21:28

The title of that video is maybe misleading, because in it I talk about the reasons that someone might give you to avoid index funds. Then I talk about why those reasons don’t make any sense.

But the common ones that I hear from people who say that index funds are a bad investment, or that index funds are risky, and the line of thinking there usually goes that, well, if the market drops, the index fund is going to drop the same amount as the market, which is true.

However, for that to be a bad thing, we have to make the assumption that there’s some alternative that’s better. What could that better alternative be? Maybe you can pick the right stocks and aren’t going to drop with the market. But for the similar reasons that I was just talking about, that’s pretty unlikely. Maybe you can have an active fund manager that’s going to be able to protect the downside when the market drops.

Again, when we look at the data on actively managed funds in bear markets, they don’t do better than index funds. They drop just just as much, or they miss out on the recovery and end up doing worse overall.

So that’s one of the big ones, one of the other ones maybe speaks what we’re just talking about with picking stocks. With index funds, you get no control over your holdings. So you’re getting all these bad stocks and all these good stocks are good companies and bad companies.

However, I think that the flaw in the thinking there and this comes right back to the foundational theories of asset pricing is that there’s a big difference between a good company and a stock that’s going to have positive returns.

Now, if the markets are efficient, then information is included in prices. If that’s true, then stock returns are going to be based on new information as new information develops. So the idea that buying an index fund gives you exposure to all of these bad companies, that might be true.

However, the tricky thing is that bad companies can end up having really good stock returns. In the video that you mentioned, I had an example of from 2010 to 2017, Google, Apple and Amazon and Netflix all had crazy returns, like everybody knows that.

But over that same time period, you know which company outperformed all of them? Domino’s Pizza, which is crazy. You wouldn’t necessarily expect that. But it speaks to that idea that it’s kind of what I was saying with picking stocks, you can’t pick the good stocks. Even if you say that a stock is bad, or a company is bad, or that it’s not a fundamentally strong company, that doesn’t mean that it’s not going to have good stock returns, anyway.

So why would you want to avoid index funds? I don’t know if they really want a concentrated portfolio. But even then, there are some index funds like Alpha Architect that I mentioned. They do give you a concentrated portfolio. If you want control over your holdings, I get that.

Though that’s a bias in my opinion. It’s an illusion of control, you cannot control your outcome with stocks. The idea that you’re losing control by buying an index fund. Again, I think that’s that’s flawed thinking you can’t control your outcome. Regardless, the best thing that you can do for the reliability of your outcome is diversify.

Robert Leonard  24:08

I believe one of those other companies that outperformed those three major companies that you mentioned is Monster Beverages similar to Domino’s Pizza. I think those are maybe two of the only companies that did it over that time.

And to your point, very few people guessed that, or had the intuition or thesis behind that. Not only did they have the thesis right, but also the wherewithal to hold that from the time period where it was undervalued to today, in order to capture all of those gains right.

Just getting the thesis right is one small piece of it, and then having the fortitude to be able to hold it from then to now through all of the market swings and volatility. That’s a whole nother piece of it.

Also, you talk about how just because the fundamentals aren’t there for a business, either good or bad. That doesn’t mean the stock is going to follow. That’s so true. I mean, good business results usually lead to a stock price falling out but it isn’t always right.

I mean, we can look at Tesla as an example, the fundamentals a lot of people argue that they’re horrible. Others love it, and the stock does what it wants to do. There’s no real underlying fundamental data that shows why the company is doing what it’s doing. It’s more irrational, at least I would argue that.

Ben Felix  25:14

Yeah, you’ve got to recognize when you’re buying a stock, you’re buying expected future earnings discounted at some discount rate. And so, if you’re buying a company that other people think is or that everything’s is bad, maybe it really is a bad company. It means that you’re probably paying a low price for it. It means that the discount rates are probably high even if the expected future cash flows are bad.

If you can buy future cash flows at a really, really high discount rate, you’re paying very little for the future cash flows, that could give you great investment returns. I guess that kind of speaks to the idea of having a concentrated portfolio of the stocks with the highest discount rates, the highest expected returns at the lowest prices, however you want to say.

Robert Leonard  25:48

We have talked a bit about the efficient market hypothesis, you and I both studied finance, we both have MBAs in finance. So we’ve spent years studying this material. But for someone listening to the show, who didn’t study that or just doesn’t have a background in finance, explained to us what the efficient market hypothesis is in very simple terms.

Ben Felix  26:09

The way that Eugene Fama defined it when he wrote a paper on it in 1970, he said an efficient market is a market in which prices always fully reflect available information.

Now, Fama also says in the same paper, I think, or maybe in a later one, probably the same paper that the market cannot be perfectly efficient. That’s one of the things that I think people get wrong about thinking about market efficiency.

Market efficiency is a model for reality but it’s not reality and you shouldn’t expect it to be. Nobody’s saying that it is. The market cannot be perfectly efficient because of frictions and because of the the Grossman Stiglitz paradox concept, where if the market were perfectly efficient than everybody would index and the market would cease to be efficient, it cannot be perfectly efficient. If it was, it couldn’t stay that way for very long.

Market efficiency just means that information is in prices. If information is in prices, most of the time it doesn’t have to be perfectly efficient. But as long as information is in prices, most of the time, to the extent where prices are usually right, it’s really, really hard to beat the market.

The reason it’s hard to beat the market if prices contain accurate information is that prices will change based on new information. And so, to consistently beat the market, you have to either be willing to take more risk, which we’ve talked about with the idea of concentrating in the cheapest securities, or you have to be able to predict new information consistently. That’s been proven pretty consistently to be really hard to do.

You think about how we know the market is efficient? We don’t. But why do we think that it might be? Or why do we think market efficiency is a pretty good model? Well, how do you test market efficiency? You’d expect stock prices to be mostly random in an efficient market while they are, you’d expect active managers to be unable to beat the market, on average, while they don’t beat the market on average.

You’d expect fund managers that have done well in the past to not be able to do well in the future, while for the most part, they don’t. So yeah, market efficiency is a model, it happens to be a pretty good model for reality.

And so, I think that that’s a really good way for investors to think about how they should approach financial markets is to approach them from the perspective of the markets being efficient, which means you can’t beat the market, which again means it probably makes sense to just invest in low cost index funds, or if you want higher expected returns, picking stocks probably isn’t the way to do it. It’s at least not a reliable way to do it.

If you want higher expected returns, concentrating in stocks with higher expected returns because they’re riskier, probably makes a lot of sense. There’s a ton of good research on that like stocks with robust profitability and low prices mean it sounds like something Warren Buffett would say, but there’s a ton of good academic research backing this up. Those types of stocks have higher expected returns. You don’t need to pick individual stocks. So you can buy index funds that have exposure to value stocks with robust profitability.

Robert Leonard  28:44

So can the market be both efficient and irrational at the same time?

Ben Felix  28:50

There’s been a ton of research starting really in, I guess, the mid 70s or 80s on asset pricing, and differences in expected returns between stocks. One of the first observations was that smaller companies seem to have higher returns.

Now, this is from the perspective of the capital asset pricing model, which is a single factor model that relates the expected returns of a stock to their risky debt to its riskiness relative to the market. That’s where you hear about a high beta stock that’s got high exposure to market beta.

From that capital asset pricing model view, small cap stocks were delivering consistently higher average returns than their level of exposure to market risk would predict at the time appeared to be evidence that the market was not efficient. It was mispricing small cap stocks.

Then similar research came out not long afterward on value stocks against stocks with low prices that looked like they had these higher average returns than would be predicted based on their exposure to market risks that looked like a risk free profit. It’s like the markets mispricing value stocks.

Therefore, you can get this risk free profit by investing in value stocks and Ken French, Eugene Fama’s I guess, research partner, they came up with a paper in 1990 where they said that the capital asset pricing model is flawed. It’s more than just market risks that investors are capitalizing on.

They introduced the Fama-French three factor model, which started and has continued to revolutionize the whole field of asset pricing. I mean, factor research is a massive field now, and there are hundreds of thousands of documented factors in the academic literature. But the original ones were the market risk factor, small size and value.

Now, the reason that I’m going down this tangent to answer your question about the markets as being rational or irrational. Fama and French said small cap value stocks have higher expected returns because they’re riskier than the market? Everyone’s like, okay, cool.

Then this thing called behavioral economics or behavioral finance developed into an actual field of research with real theories backed by empirical data. That field of research has shown that there are there there could be behavioral or or irrational explanations for these differences in in pricing, like value stocks is a is a great example where they might have higher expected returns because they’re riskier, but they might have higher expected returns because or they might have higher demonstrated returns because investors systematically misprice the. They systematically overvalued growth stocks and undervalue value stocks, which results in higher expected returns for value stocks.

That’s an irrational pricing story to explain the empirical data.

Everybody agrees on the empirical data. You ask Eugene Fama, Nobel Prize in Economics for the rational markets, or Richard Thaler, Nobel Prize in Economics for behavioral errors, you ask them about the empirical data? Do we observe that value stocks outperform the market? Yes. Nobody is going to disagree on that.

But there’s a lot of academic debate on why we observe that, is it because prices are rational and risk based? Or is it because investors are irrational? They make these consistent pricing errors that result in differences in expected returns? So can the market be both efficient and irrational? I guess it depends how you want to view it.

Robert Leonard  31:56

How would you explain all of these concepts that we’re talking about in these different dynamics? How would you explain what happens with and we’re recording this early March 2020, how would you explain different things, like what recently happened with Tesla skyrocketing or beyond me, or different IPOs that have just had what some would consider absurd returns very early on, and even stocks that have been beaten down for no great reason…

How would you explain those different dynamics?

Ben Felix  32:25

When you see a story like Tesla, it’s really hard to discount the irrational behavioral mispricing story where investors bid up the price because they had irrationally high expectations, or they were enticed by the momentum of the stock or whatever.

It’s really hard to discount that when you see an anecdote like Tesla, but if you ask Eugene Fama for the Efficient Markets explanation, he would just say that investors’ expectations change.

You can argue whether that’s rational or not, but he would say, “Well, they’re expectations for future cash flows or perceived risk or both changed”  Those things can both change rapidly.

People sometimes say, “Well, the markets can’t be efficient, because it swings so violently.” But again, what would Fama say? I mean, the investor’s perception of risk can change very quickly, and that can cause market prices to swing very quickly, that doesn’t make the market inefficient or even irrational.

Robert Leonard  33:18

Do you think the increase in technology in the financial markets has led to a more efficient market overall?

Ben Felix  33:26

Probably. I spoke with Greg Zuckerman, who just wrote the book “The Man who Solved the Market” about Jim Simons and Renaissance technologies, which is a fantastic book.

Greg is a Wall Street journalist and he covers all the big hedge fund managers and covers all sorts of big trades, but he mentioned when we were speaking that 31% of trades are done by quant shops today. You think about Renaissance technologies specifically, like, I don’t know how well you know the story, but it’s a collection of literally the smartest people in the world, managed by one of the smartest mathematicians in history.

Through some combination of their own genius, and maybe a little bit of luck, they’re able to build this algorithmic quantitative trading model that has been able to produce 66% per year returns for the last 30 years, which is crazy.

But you could argue that people that are smart finding little inefficiencies in the market that they can exploit is just making the market more efficient for everybody else. I mean, you think about Renaissance technologies, their medallion fund is this specific fund that’s done so well. They’ve capped the size of the fund. It’s $10 billion, and they won’t take any more than any new money. They kicked out all of the external investors, it’s only employees of the fund that are able to invest in it. They distribute all of the games every year to keep the fund at 10 billion.

The reason is there are only so many of these trades to exploit. If you take that view, then it would suggest to the market that if there are consistent inefficiencies in the market, there’s a little limit to how many there are and Renaissance technologies are already mopping them up.

In general, I think high frequency trading, algorithmic trading quant shops, like you look at AQR or Alpha Architect that I mentioned earlier, they’re using quantitative models to really invest the way that what used to be the greatest investors used to invest.

Like, how does Warren Buffett invest? Well, there’s a paper from AQR in 2015 titled, “Buffett’s Alpha.” They looked at based on what we know today about asset pricing. Could we take that information and explain Buffett’s returns?

The answer is yes. The next step in that question is, can we use this information to systematically recreate Buffett’s performance? Historically, of course, this is using perfect foresight, because we have all the information now.

But they were able to do that with a systematic approach to investing, not Buffett’s genius, but systematically recreated.

If people are able to create models that can explain what if any market inefficiencies exist, then yes, I would say that that type of investing is definitely making markets more efficient.

Robert Leonard  36:02

Now, I want to shift gears a little bit. This is a topic that we generally talk about over on our real estate investing show. But it’s one that a lot of people in the stock investing community. We also talked about personal finance here on the show as well. I am often interested in and I often get asked about the cost of renting a home versus buying a home. I know you’ve discussed this specific topic, and you’ve called it the 5% rule.

So what are the pros and cons of renting or buying a home? How should we be calculating the financial payoffs or risks of owning a home?

Ben Felix  36:33

Well, I think that there are two very different questions in there, the benefits of home ownership. I am probably feeling good about it, maybe stability, but I would probably  argue against that. Feeling good

is the best phrase that I can get for owning a home. Maybe if you can buy an off market before it takes off in price, but I mean, that’s just like anything that’s really hard to do, especially consistently.

In Canada, we have two markets, Vancouver and Toronto, that have become I want to say overvalued, but that wouldn’t be an efficient market approach. They’ve become very expensive relative to incomes in those cities. If you bought there 10 years ago, you made a ton of money. That’s an argument for buying. But that’s also lucky. You can’t repeat that outcome, at least not consistently. When you buy you also take on risk, like I just mentioned, prices going up.

In another Canadian example, we’ve had cities in Western Canada, like in the province of Alberta. The cities there have had massive price declines. If you happen to have bought a home there five years ago, or something like that, you’ve lost a ton of value.

So just as much as there’s upside to buying there’s there’s also potential downside, and that’s obviously amplified by leverage, which most people are using when they buy a home.

Now, another benefit of buying a home though, is access to cheap debt, cheap leverage. Leverage, statistically, is a really good thing for young investors to use. Most people don’t use it to invest in stocks, if they’re going to use it to invest in a home that alone might make buying a home or worthwhile, worthwhile decision.

On the renting side, you get flexibility. You don’t have to worry about home maintenance, you don’t take on price risk, which might be a good thing or a bad thing.

Like in the two examples we just talked about, I personally rent. I really like not having to worry about anything. I’ll make a list once a quarter of stuff that needs to be fixed and it gets fixed like a week later. I have a good landlord. I know some people say that you can have bad landlords renting, which is true.

One of the things people talk about with renting and it’s something I’ve been thinking about a lot lately is stability, like you can get kicked out in Canada.

The province that I live in Toronto specifically, there have been all these situations where landlords use the landlord tenant laws to kick people out. So they can get higher rents, because prices and rents have gone up so much. Renters get worried about that.

I personally have addressed that problem by signing longer term leases, which puts a little bit more risk on me, but it also gives me my family stability where we can rent, we don’t have to worry about anything, including being kicked out because in Ontario specifically.

This is important to know the tenancy laws in your state or province. But for me, I cannot be kicked out while I’m in a lease. It’s only at the end of the lease.

So anyway, that would be what some people would say as a downside of renting instability, but I think that there are ways that you can work around that.

Now, in making this decision, people always say, “Well, it’s an emotional decision, and you shouldn’t make it based on the finances.” I don’t think that’s true and that YouTube’s madness that you mentioned.

I look at pretty much all the comments that I get on my YouTube channel. I don’t respond to them, because they’re too many, but I read them all. It’s so divisive on the rent versus buy channel. It’s like roughly 50% of people think it’s the stupidest thing ever that I’m saying renting is a reasonable financial decision And roughly 50% of people are saying how terrible their experience was owning a home and how they’re never buying again. It’s kind of fine.

However, I think that the first step, and I think this is true with any financial decision, is understanding from and maybe this is the engineer and me, but understanding from a quantitative perspective, what the trade offs are and making the decision like it purely in terms of the effect on your wealth. What is the impact of choosing to rent versus buy?

This is where I came up with that 5% rule that you mentioned whereI said that when you own a home… Well, I’ll back up when you rent, rent is an unrecoverable cost. You pay money for rent, and you get a place to live, and you get nothing else in return.  That’s really obvious.

And so, people feel sad about that when they read that they’re throwing money away. They’re paying their landlord’s mortgage, which is a total fallacy. I mean, it’s not because you probably are, but that being a bad thing, I think, is a fallacy.

So the reason that that’s a fallacy is that when you look at an owner, they similarly have unrecoverable costs, just people don’t tend to think about them as much for whatever reason.

But as an owner, even if you paid off your mortgage, so you’ve got no debt, you bought the house in cash, which would diminish the value of buying a home, because cheap leverage is one of the benefits.

Anyway, say you bought the house in cash, you still have property taxes, you still have maintenance costs. Again, these are going to vary by city and state and province in whatever country, even probably property taxes, you’ve got maintenance costs. And then the big one that people don’t think about is that you’ve got the cost of capital, if you buy a house cash, or if you put a down payment on a house, that’s money that you can no longer invest in stocks. Me as a renter, I pay my rent, but I’ve got all my capital available to invest in, in stocks. I can use margin to borrow to invest if I want to. I don’t do that, though.

Based on that, when you do the math, which I’ve done in a spreadsheet, it’s in a Google Doc, you can share it with your listeners if you want to. But it comes out to be that if you can, if you’re looking at potential homes, if you can rent for 5% or less of the value of a home that you would otherwise buy.

So if it’s a $500,000 home, for example, and the 5% comes from 1% property tax, and this is for Ontario, but it’s funny, it’s a pretty good estimate overall 1% for property taxes, 1% for maintenance costs, and I use 3% for the cost of capital. That’s based on the historical real estate returns globally, which had been about 1% above inflation versus the returns for stocks, ignoring taxes on the assumption that people have room in their tax free accounts to use, which again, if that’s not true, the 5% rule is not a rule. Really, it’s a model.

You might have to make adjustments anyway. So if you can rent for 5% of the value or less, renting is an equivalent financial decision. That’s important because knowing that, you can overlay the financial portion on the emotional preference, but at least you have the knowledge of the financial piece of it.

I think in so many cases, people make the decision to buy just because they think buying is a good idea in general, or because they don’t want to pay the landlord’s mortgage, which again, is flawed thinking, but if people start on the footing of renting and owning can be equivalent financial decisions.

The 5% rule is an approximation that you can use to figure out where that break point is. I think that puts people on much stronger ground to make an informed decision about how to pay for their housing.

Robert Leonard  42:39

It’s definitely a very polarizing topic, you have a lot of people on one side that feel very strongly about it, then you have a lot of people on the other side that feel very strongly about it. As you mentioned, I’m not sure if you’re familiar with a personal finance writer by name of roommate safety, but he falls on the same side of the coin as you in terms of he’s been a lifelong renter, and he thinks that purchasing a home is a terrible idea, terrible investment.

Then on the other side of the coin, I also had on my other podcast, Mark Ferguson, and he swears that buying a home is a fantastic investment. So it’s a really interesting bill to see both sides of the coin.

Quite frankly, you both have very good arguments. I think it really depends on the person and you should allow them to make the best decision for them.

Now, all of what you just said, does that mean you’re not a real estate investor and you just stick strictly to the stock market?

Ben Felix  43:27

I did a video a while ago on real estate investing, I should probably refresh it. I think with real estate investing, and I know you’ve got a real estate investing podcast. So I’d be curious to hear your thoughts, but we talked about concentration. We talked about idiosyncratic risk with stocks. I think that you have the same issue with real estate, the difference is that it’s a lot harder to diversify away.

If someone wants to pick five stocks and hope for a good outcome, fine. I don’t think that’s a good idea. But the trick was that you can very easily choose not to do that and diversify not just in your own country, but also globally.

With real estate, that’s really, really hard to do. If you are able to do it,  there’s a paper I read a while ago showing that to get by I guess it’s obvious now I’m thinking about it. But to get the returns of the real estate asset class, you have to own real estate, at least on every continent to eliminate the or at least reduce the idiosyncratic risk of the country specific risks.

Now, if you have enough capital to do that, great, but you’re probably paying property managers at that point, which are taking whatever 10% of your gross off the top. And so, it makes it a lot less attractive. The biggest downside of my opinion with investing in real estate is that you end up with and you can’t really get rid of that idiosyncratic risk.

Real estate as an asset class, I won’t deny and I can’t deny has had good returns as a whole. When we talk about global real estate, it’s beating the stocks with less volatility going back as far as we have data, but you can get global stock returns easily. You can’t get global real estate returns, private real estate returns with the same ease.

I think it ends up being a speculative investment with an unreliable outcome, but because of using leverage, if you get returns that are okay, it can still work out really, really well.

Robert Leonard  44:59

There’s a couple of things that want to dive into there And the first thing is the cheap capital. You’re absolutely right, I just locked in a 30 year fixed mortgage yesterday for under 3%. That’s insane. It’s incredible. It’s literally free money. And so, when it comes to real estate, just the cost of capital is very, very low, which obviously, like you said, can help with the returns.

Now, when you talk about this idea of real estate investing, and how it may or may not be a great strategy, are you thinking about it mainly from the aspect of real estate appreciation? Or are you also considering the cash flow?

The reason I asked that is because a lot of investors and specifically myself, and a lot of people that I talked to, we’re doing it so that the cash flow from the property acts as a source of passive income and can replace other sources of income, such as W2 income, rather than the property doubling in value over the next two years, like you’ve seen in Toronto or San Francisco or things of that nature.

So rather, we’re more conservative in our approach, and we’re looking for income replacement, rather than, you know, an appreciation play. So does that change your philosophy?

Ben Felix  46:04

I think, to invest in real estate, you have to expect the net rental yield to be the income return. I mentioned that historically, real estate has been better than stocks on average, and it has, but that’s been roughly 3% capital return and 5% net rental yield. So if you’re not getting that if you’re not getting the net rental yield, then it’s not even an asset class worth pursuing for the capital return alone.

I do think that a lot of real estate investors don’t necessarily get that. We see that in Canada here, where there’s been news articles written about landlords that are taking cash flow losses, consistently, basically betting on price appreciation. That’s a tough game to win.

However, if we tie this back to the idea of the 5% rule, and deciding to rent or buy, if you can find a landlord that’s renting their properties out at a cash flow loss, I mean, you might end up finding a really, really good deal as a renter on the passive income idea.

I can see the benefits of having passive income from any source. I know dividend investing is different from real estate investing but I’ve covered in a few videos, just the separation of income and capital, which, from a rational perspective, from an irrational perspective or a behavioral perspective, I totally get the attraction.

From a rational perspective, there aren’t a whole lot of good reasons to separate capital and income returns. But again, on the behavioral side, I totally get. It’s a lot easier to be disciplined when you have passive income, most people probably aren’t going to sell capital to invest in other stuff, because it’s really hard to think about that. I get the attraction of real estate. I don’t think that makes it a rational investment, though.

Robert Leonard  47:43

It’s also hard to kind of conceptualize or even just the utility of the capital returns. If your stock appreciates in value, that’s great. Maybe that is equal to the cash flow you’re receiving. But it’s not. It’s the utility piece. You can’t use that or you could sell the stock, cash that out, and then use that to pay for your groceries if you want.

Whereas the cash flow, it’s something that hits your bank account, and you’re actually using that for your day to day life. So it’s really that utility piece.

I think that going back to what you said about behavioral and just the psychology piece of it is what makes it really interesting. I think that’s really what makes all of finance. So interesting these days is the psychology and just the behavioral finance piece of everything, whether it’s real estate, the stock market, even personal finance. It’s a really interesting dynamic these days.

Ben Felix  48:25

That’s the best argument for like I buy through dividend investing into this discussion, but that dividend investing is not rationally bleed. So an under diversified portfolio, it really doesn’t make any sense. There’s no expected benefit to doing it. But if it keeps you invested, and allows you to enjoy your retirement or whatever, how does someone argue with that same kind of thing with real estate?

Robert Leonard  48:44

Yeah, it’s a tough argument to have. As we round off the show, Ben, I’d love to get the number one piece of advice that you give to a millennial listening to this show. It could be personal finance, it could be stock investing, it could be real estate, anything that’s going to help a millennial invest their time or money better.

Ben Felix  49:01

I think on investing, one of the most important things that you can do is have an investment philosophy, it might even make sense to write it down. When we start talking about these different types of investments. We just talked about real estate investing. We’ve talked about picking individual stocks, I’ve mentioned value investing index funds, there’s all these different things out there.

The reality is over the long run, I can say and I think it’s true that index funds are going to give you the most reliable outcome. But if you invest in a reasonably diversified way, in any risky asset, you’re probably going to get an OK outcome, probably a pretty good outcome. Like investing in stocks, even dividend stocks I mentioned are under diversified, you’re still going to get a pretty good outcome where people get into trouble when they start flip flopping between different types of investing.

If you’re a dividend investor because dividend stocks are doing well and then you get you know, you get knocked down 20% and decide that now it’s real estate and you’re chasing returns like that after taxes, transaction costs, losses that you don’t recover. I think that can be very detrimental very quickly and very slowly over the long term.

So if you want to be a real estate investor, great, but stick to it. Likewise, if you want to be an index investor, great, but stick to it. So I think that that idea of having a philosophy, knowing why you have that philosophy, knowing why you’ve made that decision, and again, maybe documenting it, maybe keeping a decision journal, so that you can always look back on why you’re doing this, that’s probably one of the most powerful things that any investor can do.

Robert Leonard  50:22

I recently talked to the leader of the Bogleheads investing community. AJ said the exact same thing. If you pick a strategy, you need to stick with it for almost life. It’s one of those things, you make a decision and you just stick with it. That’s a hard thing, I think for a lot of people to accept, especially in today’s world.

I think like you said, just the most important thing is getting started, get invested and stick to a strategy that has historically worked, and you’ll likely do very well over the long term.

Ben Felix  51:11

At PWL Capital, we do index investing with a tilt toward small cap and value stocks. That’s a strategy that’s been really painful for over a decade now, like value stocks have not done well, relative to growth stocks. Again, it’s FOMO and it’s painful.

So there’s the agency piece where we have clients asking why we are doing this, but we know exactly why we’re investing in value stocks. It’s statistically reliable in the data, it’s theoretically sound, whether we take the behavioral or the risk based approach. There’s a good theoretical reason for value stocks to outperform over the long term. But yes, it takes a lot of conviction to stick through this in the times like we’re living through like value stocks have done relative to growth, stock real bad, but we’re sticking to it.

Robert Leonard  51:56

I’d say a lot of people listening to the show today are relatively new, even if you’re on the higher end of the millennial spectrum, if you will, you probably missed out on most of the last crash. I mean, all you’ve done is invest in the last bull market. So you don’t really know what it’s like to invest in an environment like that, where you lose 30-40% of your portfolio in a pretty short period of time.

Again, as we’re recording this in early March of 2020, the Coronavirus is a huge thing right now the markets are getting beat down. And quite frankly, a lot of the things that I’m reading on Twitter or Facebook, things like that, you can tell they’re from investors that have not experienced a market downturn like this.

It’s a little worrisome as to what’s going to happen when the next recession does come when the Fed can’t pull those levers to drop interest rates and increase the economy and increase GDP and things of that nature.

So it’s one of those skills that you just kind of have to learn, you just need to focus on the psychological aspect of it, get invested, stay invested and research the historical data behind it and understand that as long as you do the right things over the long term, you’re going to turn out okay.

Ben Felix  52:59

That’s exactly that conviction piece comes from doing your research, you will be a confident investor. If you know exactly why you’re making decisions, if you do things because you’re following the crowd, or you’re listening to your brother in law or whatever, then it’s really hard to stick to the decision. But yes, like you said, if you do your research, and you know exactly why you’re doing the thing that you’re doing, it’s a lot harder to get derailed.

Robert Leonard  53:20

Yeah, I agree. That conviction piece is so important. That’s why you can’t just go out and invest blindly in a different strategy or something that you don’t know you need to understand what you’re investing in, so you can have the conviction and stick with it, then I’ve really enjoyed our conversation. We touched on a lot of really great topics, we challenged a lot of norms that I think a lot of people think about, and I think it turned out to be a great episode. I’m excited for the audience to hear it. Where can the audience go to connect with you further?

Ben Felix  53:45

Yeah, so I’ve got my youtube channel Common Sense Investing. I’ve also got a podcast called “The Rational Reminder Podcast.” We put episodes out every week, and that’s on iTunes, and whatever else podcasts are on. Yeah, those are the two main platforms that I’m pushing out content on.

Robert Leonard  53:59

Awesome, I’ll be sure to put a link to those different resources in the show notes. I’ll also get the Google sheet from Ben so that we can include that in the show notes so you guys can go play around with that as well. As always, I’ll put some books in the show notes about the different topics that we talked about. Go ahead and read those dive into the topics more.

Ben, thanks so much for coming on the show. I really appreciate it.

Ben Felix  54:18

Thanks a lot, Robert. I really enjoyed our discussion.

Robert Leonard  54:21

Alright guys, that’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.

Outro  54:27

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