Intro  0:29  

You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. we keep you informed and prepared for the unexpected.

Preston Pysh  0:50  

Hey everyone, welcome to The Investor’s Podcast. I’m your host Preston Pysh. And as always, I’m accompanied by my co-host, Stig Brodersen. As we said in the intro, we’ve got a bunch of really interesting clips from various self-made billionaires on the current state of the global economy. 

First up in the queue is billionaire Sam Zell. His net worth is almost $5 billion and he has made a fortune as the founder and chairman of the private investment firm equity group investments which specializes in real estate. That’s how he made all this money, through real estate. We found this audio clip from about a month ago where Sam is talking about the hospitality business and the hotel business. Give this a listen and then we’ll provide some comments afterward.

Sam Zell  1:35  

To go from 70% occupancy that’s 0% gets your attention. The answer is the hotels are going to slowly open and occupancy is slowly going to increase. One of the big issues that I have been focused on since the pandemic began, the shutdowns began, and that everybody’s talking about the cost of having your building closed down is that nobody’s talking about the cost of reopening. That is very significant. 

Even the best hotels across the United States are going to open at 5%. Then they’re going to go to 10% and then to 12%. It’s going to be in a tough environment. I don’t believe that this is going to end the “convention business” or the use of hotels to make deals. I heard a lot of people say “God, with the experience we’re having right now. I don’t know why we’ve ever put anybody on the road”. I would expect it as it starts and they will be reticence of people to go on the road. 

They’ll say we’ll just zoom it out and that’s what will happen. Until some young aggressive guy gets on a plane goes and gets the deal done while you’re sitting on zoom selling an idea. I don’t think we’ll have any significant change. Just like office space, we had an oversupply in the hotel business already in place before the pandemic. 

The result is there’s going to be a significant number of hotels that are not going to reopen. I would bet that they would have not reopened except maybe a year or two later than what’s going to happen now. The hospitality business is not going anywhere. People like Marriott, Hyatt, and Hilton are going to get home and more dominant and stronger as the world reopens. 

Stig Brodersen  3:39  

Wanted to play this clip because I found it very telling of the importance of understanding the competitive situation in any industry that you would enter. As an investor, the lack of competition is really what you’re after because less competition means higher margins and more pricing power. It’s hard to find an industry with as much competition as the hospitality industry. 

Partly, this is because the service they provide is highly commoditized. After all, you as a hotel guest have too many similar options and your switching costs are just low going from one hotel to another. Now, what some sellers are saying here is that the big hotel chains will start to consolidate coming out of the pandemic. One could just mention the recent rumor between Accor Hotels and IGG is one example. 

What could happen is what we’ve seen in a similar way in the airline industry, at least before the pandemic. That too was a commoditize sector untime relations allowed for them to be restructured and then to consolidate which in effect meant gaining more monopoly power and then indirectly allow for higher profit margin and higher prices for consumers. 

In reality, that is a little harder to do for the hospitality sector because you can add new capacity much easier than in the airline sector. Just take Airbnb as an example. In the past, you might even argue today, even though it’s very challenging during the pandemic they’ve been a major disruption. Anyone with an extra bed could now add more capacity to the market and even as a small-time investor or a small group of investors you could much easier open a new hotel than start an airline. 

We very often see this after a crisis: different sectors becoming more and more consolidated simply because it’s survival of the fittest. A lot of the weak companies that have less access to credit just go bankrupt. Then you see the bigger change which is also about stem cells getting out here and getting more and more dominant which means that they can push up prices. 

Preston Pysh  5:44  

The only comment that I would add to that Stig is that it’s going to be interesting to see what happens here in the coming quarter, the fourth quarter of the calendar year. To see how much the travel picks back up. I anticipate that you are going to see some of the tracks pick back up. You’re going to see some of the hotels have more traffic than what we’ve seen in the last two quarters, mostly because things appear to be getting a little bit more back to normal. 

I know that the schools are starting this startup in a lot of states here, at least in the United States. I suspect that some businesses are going to probably send more employees out there to travel. It’s going to be interesting to see. The way I’d be tracking this is watching the top line for all these companies looking at the revenue for the quarter that we’re currently in whenever it closes out. 

I’m curious to see how that top-line revenue will compare to the previous quarter. That’ll be something to watch closely. I don’t know how much more pain these types of businesses can endure. You can hear some of the numbers that Sam has thrown around which are crazy. Let’s go to one more clip from Sam. This is him talking about commercial mortgage-backed securities and he has some thoughts on this. We’re gonna play this clip and then we’ll have some more comments.

Sam Zell  7:00  

If you look at where the real focus of CMBS (Commercial Mortgage-Backed Securities) has been, it’s been in retail. There’s much more retail in CMBS than there is residential or anything else. It’s primarily retail, which, by the way, as far as I’m concerned, is still very much of a falling knife. 

When you package things together as CMBS does, you might end up with a good mall and four bad ones. That just drags down the whole scenario and sends capital fleeing and that’s basically what’s happened. I wouldn’t be very confident that those people who have stepped up and taken advantage of the CMBS market are likely to end up with very high positive results.

Preston Pysh  7:54  

In this clip, he’s talking about the malls and just that type of real estate. I can tell you my buying habits have just changed drastically from what they were 5 years ago. It’s almost like they’re in a completely different universe. The way I consume and the way I buy things. I think most people are similar to myself that if I want to buy something, I just pretty much go on Amazon and order it. 

The thing that has surprised so many people is you just don’t need something right now you can typically wait 2 days or even a week for something to arrive way more than what I think I would have suspected before this Amazon online shopping type craze. 

I honestly cannot even tell you. The last time I went to a mall and walked around the mall to go find something I didn’t even know was years ago. Maybe I’m a more extreme example of that scenario but whatever it is, I think that the main thing here is the buying habits COVID has warped buying habits in a major way. 

Probably one of the biggest victim areas of COVID is “the malls are not a place I want to go inside and walk around and look for things. I just want to be able to just go on my phone and place the order, while I’m sitting here on my couch” let alone getting up to a desktop computer to place the order. It’s that easy. 

I’m with him on this. This was interesting to hear how much of a falling knife he sees this area and I suspect this is going to continue to play out in a very abrupt way in the coming two to four quarters.

Stig Brodersen  9:51  

All right, the next clip we’re going to play is from billionaire Peter Thiel. Peter Thiel became famous for being the co-founder of PayPal. He made a fortune as Facebook’s first outside investor when he bought a 10.2% stake for only $500,000 back in August 2014. He later started Palantir and many other companies. Here’s a clip with Peter Thiel about technology investment and formal education.

Peter Thiel  10:21  

There is a lot that one can do online in all these forms. When I take my venture capitalist hat and look at these things as things to invest in, I always think it’s very important to break down the abstractions a little bit and to remember that education itself is always an abstraction. 

If we make it a little bit less abstract, let me suggest the 4 different things that education means in practice in our society. The 1st thing is the official meaning that it is all about learning. It’s about the information. It’s a positive-sum game. Variations of it are it’s an investment in your future. Going to college is an investment in a better future. 

Second, it’s a consumption decision. It’s a 4-year party and I used to think that it was this bad quantum superposition of investment and consumption where people in the housing bubble bought a large house with a swimming pool and it showed how frugal they were and how much they were saving for retirement. It was conflating investment and consumption which is always a mistake. 

Third and fourth are the most important. The third one is that it’s an insurance product and that it’s something you buy to avoid falling to the ever bigger cracks in our society. They can charge more and more for you because people are getting more scared about some of the things that have gone wrong in this country. The 4th one is it’s a 0 sum tournament where you have to think of Harvard and Stanford, Caltech, and other elite universities as a Studio 54 nightclub. 

The value comes from excluding people. There’s a Harvard or Stanford version of putting Harvard or Stanford classes online and letting people take them. These universities have done it. People can take those classes in many cases but they don’t get credit at Harvard or Stanford and taking those classes does not lead to a Harvard or Stanford degree. 

That tells you that a lot of the value of this very strange good that is called education comes not from the actual learning but more from things like status, selection, exclusion, things of that sort. I think that when we look at these different approaches we have to try to disentangle what they’re doing. Online education is great for learning but unfortunately, learning has almost nothing to do with the so-called educational system.

Stig Brodersen  12:42  

Okay, guys. I wanted to play this clip because Peter Thiel is voicing a concern that has troubled me for years, both as a student at Harvard University and later as a college professor at a local college. Thiel is talking about the elephant in the room that formal education has fundamentally changed for the worse. Education is increasingly decoupled from learning. 

For example, I don’t think the quality of education I got at Harvard was significantly different than formal education elsewhere. In reality, it wasn’t that different. It has opened a lot of doors to otherwise would have been closed, but I didn’t learn more. 

For business relationships and employers at the face of it, there is so much asymmetric information that we use as signaling whenever we enter a new working relationship. Formal education is just one but a very important example of that. 

It’s used very often as an irrelevant filter to exclude people. Again, there’s a decoupling between learning and education today where most of us losers are at best, we’re no better off. It’s not just a security issue from Ivy League schools. You see the same problem in the labor market given the oversupply of PhDs. 

What you’ve seen is that PhDs are taking jobs that had previously been held by those with a master’s degree and you’ve seen too many people with master’s degrees in return push down those with the bachelor degrees. And on it goes. 

When education and qualifications do not go hand in hand, education creates a deadweight loss in society. We all rake up more student debt and just as bad, we spend years in education that we don’t need instead of joining the labor market, creating value for society.

Preston Pysh  14:31  

I’m sure I sound like a broken record when I say some of these things but this is the result in my humble opinion of printing. This is the result of an incentive structure that’s based on spending and increasing, spending and increasing, and spending some more. People go out and they have to compete at an even higher level by spending more money obscenely that there’s no way you’re ever going to get that money back rates of return for the cost to get the next degree, to just remain competitive. 

To do the job that the person’s doing, they don’t even require the degree that they often have at masters or a Ph.D. level it’s learned on the job. I wanted to play this clip to Stig because I just find the whole education model to be insanely frustrating and recently there was some news that Google was coming out with some courses that you can take. 

If you take those and you don’t have a college degree or anything else, Google’s gonna wait. That is as far as being just as valuable in their hiring process but that’s what they say. I don’t know if that’s necessarily how it will play out in application but I think it’s a step in the right direction. 

When I talked about this on Twitter, I was surprised at the number of people that started kicking and screaming saying, “Well, they’re training you on how to program things the Google way that then creates a network effect that further amplifies their strength as a company and builds further dominance for them.” 

I just don’t know what the right answer is, but I do think that Peter Thiel’s comments about the exclusivity of this, separating people, and not everybody having a fair shake is completely accurate on the money. 

It needs to be said. It needs to be talked about more. I completely agree with him and it’s a big problem. Technology is coming for the education sector here in the coming 5 years. I also think it’s coming for the finance sector in the coming 5 years and it’s going to be interesting to see how this plays out. 

I hope that it transitions and allow more people opportunities at a much lower and substantially reduced cost and that employers will honor that and look at that as being the same in the eyes of performance in the way that they hire. We’ll see how things progress here in the coming 5 years. 

Okay, next up, we’re playing one of our favorite economist investors, Ray Dalio. This is Ray’s comments on the limitations that exist for policymakers and central bankers, dealing with this current situation that we all know we’re in as far as the printing and the universal basic income. All of those factors. 

Ray goes on a long discussion of this and this is something that he had talked about within the last month. This is an important clip as far as I’m concerned and I hope you guys enjoyed listening.

Ray Dalio  17:52  

The limiting factor has to do with the demand for that money in debt. In other words, debt is a bond, a promise to receive a lot of currency. When it gives no good return or a bad return, and there’s printing of a lot of currency it’s not desirable relative to other things for private investors. However, the central bank can buy it too so the limit has to do with the limit of demand. 

That limit of demand has to do with the central bank’s purchases of that because they could buy it and there’s no problem. You look at periods of where in history was the most of it that have ever taken place and to try to define the limits. The war years are an example. I think the most analogous period we’re in now was 1932-1945. I’ll explain the various ways it was analogous but more importantly, I’d like to deal with the question of the limits. 

You first had the depression. In that depression when you hit 0% interest rates you had the printing of money, the buying of financial assets, and then you had a lot of fiscal policy. Programs that produce large deficits which then were monetized by more of that. 

Then you went into the war years. The war years are very similar to now in terms of the need for a lot of money and credit. Produced an enormous amount of money and credit but it was managed by the Central Bank in a way where they were de facto taking that on. It was a good example of testing the limits of that. 

Now, we went into periods where: what is an alternative source of wealth? As I say, it could be stocks, gold, other assets but those became the boundaries. What would happen in terms of this limit is if something transpired where the dollar as a reserve currency, the holders outside made another better market? 

It could be gold, stocks, or an alternative currency. In the earlier session which I listened to, China has a reserve currency, there will need to be alternative assets. When that happens and I think it will happen then it looks like a currency defense. 

What I mean by currency defense is if money leaves that asset, if those who are holding bonds don’t want to hold the bonds because they have lousy returns and they are printing a lot of money and they want to go to something else and that starts to accelerate then what that does is as money leaves it puts the central bank in the position of having to decide whether it buys more bonds to fill in that gap or it lets interest rates rise. 

They can’t let interest rates rise, there’s too much debt. Interest rates rising means that the asset prices will go down and it’s too vulnerable. All currency defenses. What it means is that they then have to accommodate that. The act of accommodating that in and of itself is a big problem. Should that happen, that would be terrible for the United States. 

Earlier, I heard about the discussion of the privilege. That’s right. The United States dollar is a tremendous privilege and we are certainly pushing the limits of that. If we were to think that the dollar was to be any other currency because of us pushing the limits, if that were to happen it would be probably the biggest disrupter not only to the markets but to the whole world geopolitical system. 

We’re in a Fiat monetary system throughout most history but there was gold. Let’s say 1944 *inaudible*, the Bretton Woods system is linked to gold. The United States printed a lot of money and more claims on gold than there was gold. In 1971, which wasn’t very long ago, we couldn’t meet those claims on gold because we had too many IOUs. We had devaluation and the dollar as the world’s monetary system or currency is critical but very much depends on the United States’ competitiveness and so on. It’s a longer-term risk. 

One of the things that have been a prop for the dollar is the fact that there’s a lot of dollar-denominated debt. What that means is it creates a demand for dollars that debt will either be satisfied in some fashion or another because there’ll be the dollars to produce it or that dollar debt will be defaulted on in one way or another. 

That’s a whole other discussion we can get into if you want but at that point, it’ll reduce the desire, the short squeeze for dollars which was to weaken the dollar at the same time. As we look longer term, they squeeze the politicization of it and change the nature of the capital flows because we are in a situation where you can be squeezed. 

When you start to think of that, yes, if you’re China, you’re holding a trillion dollars of treasuries. Would you want to do that given the recurrence and all the conflict? So this China piece is important. Let’s say there are 3 things that we’re spending a lot of time discussing: the monetary and debt cycle, the wealth gap and values gap cycle, and China. If we look at those things in combination, that’s the best way to look at the whole picture.

Preston Pysh  23:52  

A lot is going on in this conversation and Ray is covering a lot of territories but if a person listens to this it sounds confusing. This would be the best way that I could simplify it for you: we’re at a point where interest rates have been pushed down to nothing. If the demand for newly issued debt in the United States goes down, central bankers are just going to step in and continue to keep the yields at 0%. 

They’re going to continue to be a buyer of pretty much anything that’s issued and as Ray said, they can’t allow for interest rates to go up. The main reason they cannot allow interest rates to go up is that the value of everything on the planet is based on those interest rates. When interest rates go up, the value of everything goes down. If they allow the fixed income market to have rates and to start going up it’s going to have an enormous impact on the stock market. Not in a good way but in a very bad way.

That’s going to have just rippling implications for the value in everyone’s buying power across the globe. You can see how we’re in a situation or an end game and that’s why you see some great macro thinkers like Grant Williams out there doing shows called the end game. This is what they’re getting at. Although Ray’s comments are really valuable to kind of hear him put them in perspective he doesn’t offer my humble opinion in this exchange. 

He doesn’t offer an example of what’s going to happen and how this plays out moving forward? What’s the most likely scenario of this playing out now? He does say that there has to be a weakness in the dollar but he doesn’t necessarily get into how much buying of the bond market the central bankers are going to have to do: how much liquidity and fiscal spending. 

He talked a little bit about how much they did back in World War II but I suspect this is way more profound and way bigger of a deal than your typical market participants might realize. Fascinating to always hear Ray’s thoughts. Recent clip. We wanted to play that for you guys and let you interpret it whatever way you want but that’s the way we were hearing it. 

The next clip that we have is billionaire Eric Schmidt. He’s known for being the CEO of Google from 2001 to 2011. Executive Chairman of Google from 2011 to 2015 and he’s holding a significant stake in the alphabet, the parent company of Google. 

Together with his other investments, he has an estimated net worth of $14 billion. In this clip, he’s talking about things like TikTok, the consolidation of technology, and this piece with China. It’s an interesting clip we’re gonna get and play this one for you.

Eric Schmidt  26:49  

20 years ago, the 1 big player was Microsoft but Microsoft has now been joined by 4 other very large companies. Each of which is run cleverly but in a different way. They have different ways in which they win and they lose. We benefit from that brutal competition. Look at what you have in a mobile phone, the competition between Android and iOS, Apple phones and Android ecosystem, has brought a supercomputer into your pocket that’s going to continue. 

The reason it’ll be different in 20 years is that artificial intelligence will create a whole bunch of new platform winners. Remember that the way these works are the U.S. establishes global platforms that everyone else uses. 

We are forgetting that it is U.S. leadership at the platform level, whether it’s Google or Apple or what have you. It has brought us to this point where we have multi-trillion-dollar corporations that are leading the market. I don’t know enough about their dispute. I left the board a decade ago. 

The important thing about the app stores is that they provide some level of security, branding, and protection for the user. In China, for example, Google does not have a single app store because of regulatory issues. There have always been issues of: “Is the app that you’re using certified,?” and so on. I would be careful about breaking up the App Store model as it does provide some security and protection. 

We can quibble about how they’re managed but the important thing is when you use an app store you can rely that what’s on it is represented to be what it really is. Just think of all those viruses that you’re not getting as a result of the App Store.

I don’t know what the confidential security concerns are about TikTok. The claimed reason for this action is data sovereignty. In other words, people would like to have data for TikTok to be held in the United States. 

If that is the goal, there is a much simpler way to do it which is to require TikTok and other companies like it to work with a cloud provider. Amazon, Google, or Microsoft, are examples of those who have the necessary security protections and are covered by U.S. law. What I worry about is that the U.S. taking a data sovereignty position which is what effectively sets the precedent that this will now be done against American firms that have a global presence. 

Essentially, every American tech firm has data that are stored in the U.S. subject to U.S. law that’s used by Europeans, for example, and they bristle at that. Now you’re setting the precedent that they can insist on this too. Be very careful about the multi-move scenario. The back and forth in these things seems appealing but then it sets in motion a whole bunch of things that can affect American dominance. 

We have benefited enormously by American values and American technology being used globally. I worry again, sorry, we have all these worries that what we’re doing is we’re splintering the internet, as you said. It’s so easy for a country to say we don’t like these other people. We are safer as a world because we’re using each other’s applications. We’re getting to understand each other better. 

You have to make accommodations for NASA security. In Wally’s case, there was some evidence that Huawei was busy doing things that are inappropriate and there are several ways of stopping that and detecting it but the best solution to Huawei is to have a strong competitor in the United States. That strong competitor should be able to wipe them out competitively. 

Again, we’re playing with TikTok and Huawei from a behind position. I’d rather have strategies where I’m quite sure the U.S. will win. We can win these battles with focus, great innovation, all the things that we do so well, and open borders and lots of people using it outside the country.

Stig Brodersen  30:18  

As you can tell, he is addressing a concern that all of the 3 major business regions: U.S., Europe, and China are facing right now. How to compete globally and the role of regulation. Schmidt is very smooth whenever he presents his arguments. 

What he’s really saying there between the lines is that the big tech companies are competing, which is good for consumers but they shouldn’t compete too much domestically and the U.S. government should protect them as much as possible for the benefit of the country. 

Of course, keep in mind that Eric Smith is speaking as a private citizen and not as a representative of baytech here like Google. We know what the big tech companies want but what do we want as private citizens? We want our national companies, of course, to be able to compete globally. That is tax revenues at least to some extent. You might say it’s a job. A lot of good things come from our companies being able to compete. We also want the privacy of our information and we want low prices for goods and services. 

The good news is that we can get at least 1 and perhaps we can even get 2 but you cannot have all 3. You cannot compete globally, you cannot have the privacy of information if you at the same time also want low prices for goods and services. The thought of having companies like Google, I’m just using it here’s an example because of Eric Schmidt’s background but you can just as well have said Apple, to protect the national interest of the U.S. is just not realistic. 

Just to give you one argument, both companies have more international revenue than domestic revenue. You have management and the board is hired to optimize shareholders’ profit. They’re not hired or incentivized to do anything for the greater good of America which is likely also why both companies have been giving up IP (Internet Protocol) and may consider concessions to compete abroad, most noticeable in China. They also try to evade tax in the U.S. 

Eric Schmidt is not using the curse word monopoly here and he’s also not saying that as private citizens we should trust big tech companies with our sensitive personal data but that is the implications of what he’s saying. You cannot have global dominance and privacy of citizen information and low prices in the new era that we are facing today. 

I don’t fault him for saying that. Please do not get me wrong. You hear the same arguments in all of the 3 major business regions but here in the West, we as voters and consumers have to make a choice.

Preston Pysh  32:53  

All right. Next up, we have another Ray Dalio clip. He’s talking about some of his ideas on what’s going to happen here in the near term once we get past this post-pandemic period.

Ray Dalio  33:05  

When we talk about a document, you have to start with who has what money to invest. That’s where it starts. That’s why you have to look at incomes and balance sheets of all of the pieces, okay? What’s happened is its damage. There are holes. When we look at that today, a lot will depend on who gets the support. There is an important redistribution of wealth that is happening today when checks go out and get sent to people to fill in those particular holes. 

The economy will then readapt and it’ll adapt. I want to encourage you to think of it as follows: There is a real economy that does it. Just imagine there’s no medium of exchange that there’s no money in credit that it’s just the real economy. The things you have around you and the ability to produce that. 

Then simultaneously this financial economy has a lot of IOUs people who have accumulated this buying power who have a claim on the goods and services purchases as the new producers. The amount of claims on these, the debt is a suck of vacuum cleaner, essentially. That on the network that’s a claim on net worth. How that’s filled in by the government and how well it is will be defining characteristics. 

I would imagine that what’s going to happen is that savings rates are going to rise. That’ll be individuals and companies because everybody wants to assure themselves of safety. It’s redefined financially and I imagine what the priorities are going to shift. In other words, their priorities will be into healthcare and building the basics. I imagine you’re going to see we’ll learn things about social distancing and so on. 

Regarding the last part point of the question, yes, we’re going from a world that was interconnected and worked in a way where the most efficient producers on a global basis would compete with each other to sell things. It would have originated wherever it was best. It was a highly interconnected world and a more efficient world because of that ability to specialize. 

That won’t be anywhere near the same. We’re now going to be moving to a self-sufficient world. Not only will individuals want to assure their self-sufficiency but countries are going to want to be self-sufficiency because they’re also vulnerable. It’s a different geopolitical world. 

For political reasons and various reasons right now merchandise is being shipped. From China to the United States for masks, ventilators, and so on. That’s a vulnerability. I imagine we’re going to then want to build those things and build self-sufficiency. When that self-sufficiency is built it’ll make things more inefficient in the process. The world will look different that way. 

Preston Pysh  36:22  

Even though Ray doesn’t get into anything too specific in this clip, I find it interesting because it covers this idea that so much of the things that used to be purchased overseas whatever those big chunk items are. If you’re somebody who’s trying to analyze “where do I want to invest in the future?” I would challenge a person to look into the things that we have imported the most. Then, of those things that we’ve imported the most, what strategically makes the most sense to keep organically or domestically inside the country. 

Those are the areas that I would probably take a really hard look at because what he’s getting at is that things are going to become more compartmentalized in the future. I agree with that. I don’t think that trend is going to change post-COVID. In the first part of this clip, Ray was talking about the difference between money and credit. The idea that when the credit is becoming impaired or blows up, that has to be replenished by the government that has to be put back into the system. 

How it gets put back into the system is such a key point to try to understand because where it gets inserted is going to have a huge impact as to where those specific markets bloom up. It’s going to be another area to investigate as we get this compartmentalization. As the government’s replenished these promises and agreements of credit that have become impaired, how they get replenished into the system, I suspect there’s going to be a lot more UBI (Universal Basic Income) that will be done in the future. 

How does that play out? If we’re putting money into the hands of the population? How are they going to? Ray suggests that there’s going to be a higher savings rate but for the part that isn’t saved, where is that going to go? Those are some of the things to think about.

Stig Brodersen  38:15  

Alright, guys. This part and time in the show, we’ll play a question from the audience. This question comes from Zach.

Zach  38:22  

Hey, Preston Stig. Zack here. The first thing I want to say is thanks so much for the podcast. It’s amazing and it’s taught me so much. I’m finally getting close to finishing all your episodes since I jumped on your guys’ journey a bit late. My question has to do with portfolio diversification. I’m starting to understand how to value stocks and the accounting side of things but I’m struggling with trying to figure out how to diversify my portfolio to minimize risk. 

My question to you guys is how do you feel about the Markowitz modern portfolio theory? Is that something that a newer investor such as myself could or should use to help me with diversifying my portfolio? Thanks for any help you can provide me with.

Stig Brodersen  39:03  

Zack that is a fantastic question and a very important question to ask. Before I do give you an answer please allow me to introduce to the audience what the modern portfolio theory is. Typically referred to as MPT. The general rule behind MPT is that you want to optimize your return for the least amount of risk which is a very nice idea. 

I also have to say that aside from the intention of the idea the theory and the corresponding marble are just so flawed that I would be doing you a great disservice not to tell you why before I start this recommendation. 

Keep in mind that the best advice I can give you is simply to ignore MPT. MPT is taught in business schools worldwide. One of the many issues with the model is that it meshes risk in terms of volatility. It doesn’t include any thinking in terms of intrinsic value or assessment of the underlying securities. 

There’s no such thing as intrinsic value in the model, because it assumes that both stocks and bonds are priced correctly at all times and that all asset returns are distributed through a bell-shaped curve around a fictitious assumed rate for the stock market. 

If you’re thinking, “what you said there Stig just makes no sense”, that’s completely fine. I couldn’t understand it either when my professor spent lecture after lecture in business school explaining why we shouldn’t think for ourselves. 

Just to give you an example of how absurd this theory is when the S&P 500 tanked in March this year and the S&P 500 went from 3,300 to 2,200. Academics want you to believe that the price you bought in that would matter, and that it was riskier to buy whenever the market quickly bottomed out of 2,200 than before it was trading at 3,300. 

You might as a stock investor be thinking, “if I can buy the same basket of stocks for 2,200 why would I buy them for 3,300?” Wouldn’t it be a better deal to just get them cheaper? You would be right. You might also be thinking, what is it that you really learned in all these finance classes? 

Whatever you’re taught that it doesn’t make any sense for you to think about what a stock is worth because the sum of all people who don’t think rationally should make the stock market rational. That is a story for another day. I will stop my rant about academia for now. 

What is risk? Let me borrow Warren Buffett’s definition. Buffet defines risk as to the permanent loss of capital. That’s one. The second would be, risk of an adequate return on capital. Keep in mind that both of those measures are at the time of the decision, a qualitative assessment. It’s not a fixed calculation. To sum up, please forget everything that has to do with the modern portfolio theory or MPT and use Buffett’s definition instead, if you want to be successful in investing. 

To answer the second part of your question, Zac. You might be thinking, “if I’m not going to use MPT then what should I do to diversify?” If you want to diversify you should identify and invest in uncorrelated assets. This of course comes from an investor who tends to be quite concentrated. More than diversification for the sake of diversification, look for investments that have very little risk. The less risk you incur the less you need to diversify in the first place. I’m curious to hear what your thoughts are about this Preston.

Preston Pysh  42:58  

Stig, the last point that you’re talking about which is the correlation is how Ray Dalio would describe that the holy grail of investing is finding uncorrelated things. Let me just take Zach through a thought experiment. A lot of the times you’ll hear professional investors say, “you’re too concentrated in that sector”. I absolutely hate when people say that because it goes against just the logic of digging a little bit deeper. 

Let’s say we’re in the energy sector. Chances are that most of the companies in the energy sector are correlated but that doesn’t mean that they are correlated. Let’s say you have Company A and you have Company B and the correlation between these 2 companies is 0. 

Those 2 companies are completely uncorrelated. You’re valuing these companies which is a completely separate process: you’re looking at how correlated they are and what you think the value is. Let’s say that for Company A and B, you find both to be of substantial value. 

If they’re completely uncorrelated your volatility risk becomes reduced. Imagine doing that for 4 companies or 5 companies or 10 companies. If the proportion of those 10 companies that you own are somewhat equally weighted and your correlation is at 0, you’re drastically reducing that volatility “risk.” 

That I would challenge people to think in terms of if you’re concerned about volatility, and you do buy into the academia definition that risk is equal to volatility, which I don’t see it that way. I see the volatility as my opportunity to capture something of value because of the volatility that the lower price offers me whenever it happens.

You just have to make sure if you’re buying 15 different stocks they’re all correlated at 1.0 and there’s a lot of volatility in those picks, you better be prepared for a wild ride. If there’s no correlation between the picks or they sum out to a correlation of zero and you have a lot of volatility in those, and you’re weighing them appropriately based on that volatility you can have all your picks in the same sector if the correlation on it is 0. I would just challenge that line of thinking. It’s usually a good rule of thumb but you got to dig deeper and you got to understand what the correlation is. 

Zack, I’m excited to be able to give you our TIP finance tool because this is something that the tool does for you just automatically. We have a portfolio tab where you can enter all your different stock picks that you have and then it pumps out a correlation table and it shows you for each pick how correlated they are to each other. 

Your goal is to try to 0 out your portfolio with respect to its correlation. I believe that’s how you reduce the risk in your portfolio and it’s not just me. It’s people like Warren Buffett and Ray Dalio. That’s how they look at these things. Excited to do that. 

If anybody else wants to get your question played on the show go to asktheinvestors.com. Get your question played on the show, you’ll get free access to our TIP finance tool. Zack, we’re excited to give that to you and we appreciate you asking such a fantastic question.

Stig Brodersen  46:23  

All right, guys. Preston, I hope you enjoyed this episode of The Investor’s Podcast. We will see each other again next week.

Outro 46:31  

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