Steve foerster perfect portfolio Steve foerster perfect portfolio
Podcast 327

327: The Pursuit of the Perfect Portfolio with Steve Foerster

My guest today is Steve Foerster. Steve is a Professor of Finance at Ivey Business School and holds a Ph.D. from the Wharton School and a CFA designation. He’s won numerous teaching and research awards, including the William F. Sharpe Award, written textbooks, and is a former director and chair of the investment committee of Western’s alumni endowment fund.

On top of all of that, he’s published over 50 articles in journals such as the Journal of Financial Economics, the Journal of Finance, and the Financial Analysts Journal. His list of accomplishments are incredible, and I’m thrilled to have him on the show today to dig into his wisdom.

In his latest book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, Steve and coauthor Andrew Lo tell the story of modern investing by profiling and interviewing some of the most prominent figures in the world of finance, including six Nobel Laureates and an innovator in the world of mutual funds. Through this work, he allows us to explore what the perfect portfolio might be–and shares fascinating information about how we invest today.

In our conversation, Steve and I discussed how he chose the 10 innovative investors who became the focus of his new book, how to take distinct investing approaches, and create a “super portfolio.” We’ll also dig into what goes wrong in so many conversations between investors of all ages and their financial advisors and much more.


Here's all you have to do...

  • Step 1.) Subscribe to the podcast and leave an honest rating & review over on iTunes.
  • Step 2.) Text BOOK, that’s B-O-O-K to 866-482-9559 for a link to our book request page, complete the form and we will ship you the book for free. It’s that simple!

In this podcast interview, you’ll learn:
  • How contrasting viewpoints, philosophies, and concepts shaped Modern Portfolio Theory as we still call it (even though it’s now almost 70 years old).
  • The seven principles behind Steve’s “perfect portfolio.”
  • How investors like Gene Fama’s concepts of investing have changed dramatically over the course of half a century.
  • Why “know your comfort zone” is such hard advice for most investors to follow, especially in bear markets.
  • How to understand your own behavioral patterns–and risks–in investing and everything else.
Inspiring Quote
  • "It’s human nature for us to want to find the right answer." - @CaseyWeade
  • "We all have our own perfect portfolio, and that perfect portfolio changes over time. It should change as our circumstances change. We are different individuals with different views, backgrounds, and tolerance for risk at different stages in our life. Our portfolios by definition have to be different." - @ProfSFoerster
Interview Resources
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Read the Transcript

Casey Weade: Steve, welcome to the podcast.

Steve Foerster: Hi, Casey. It’s great to be here.

Casey Weade: Well, I’m excited to have you on here, Steve. And before we came on, I always like to take copious notes and do tremendous amounts of research. And I had over three pages of notes before we went up to about half an hour ago and I was like, ah, I got to distill this down. I’ve never had three pages of notes before. I can’t have any more than two pages of notes. I knew that this conversation could just go in so many different directions with your wealth of knowledge and experience, what’s going on in the markets today. We have history.

And you’ve just done so much. You’ve had so many accomplishments. And I said, nope, we’ve got to pick one thing to focus on today. So, today, I want to focus our conversation and on your most recent book that was coauthored with Andrew Lo, which John Cochrane said was just an amazing academic effort. And that book is In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest. And I want to kick it off with that. I want to ask a little bit about the title itself, and that was how do we invest today? I mean, can you get that generalize to say, hey, this is how we invest today?

Steve Foerster: So, the title is meant to be this notion that the perfect portfolio is something that we’re always searching for and it’s this pursuit notion. And so, we can delve into this a lot more detail in terms of what it means, what it means to two individuals, but I want us to focus on this notion of a pursuit. And just like the pursuit of happiness, we can pursue what this perfect portfolio might be.

Casey Weade: But I’m thinking that that pursuit is ongoing and ever-evolving, even from some of the leading investors and those in the world of academic research. And it took you about a decade to complete the book, but 10 years to write the book on how we invest today. And as I was thinking about that, the investment landscape has shifted so much over the last 10 years, just the tools that we can use and dramatically so over the last 20 years. How do you keep up on the shifting landscape as you try to create a book like this over a decade-long period of time? And that kind of leads into my next question, which is, and maybe you tie these two things together, how long before something is no longer modern?

Steve Foerster: So, those are great questions. So, we view the book on a whole variety of different levels. I think on one level, it’s really a history book. It’s a history of what’s known as modern portfolio theory, which is kind of untitled because it really goes back seven decades to...

Casey Weade: The perfect segue of my next question, and this has always been one of my big frustrations, I say, how do we call modern portfolio theory when it’s 70 years old?

Steve Foerster: Yeah, there are challenges with that. Just to give another similar kind of example, I’ve been involved in helping out with a conference. It’s been around for a couple of decades that we used to call it the Alternative Investment Conference. And then we had to come up with a different title because things that 20 years ago we would think about as alternatives are now more common. So, open to suggestions. Casey, if you have a better title than modern portfolio theory, we can try to work that in.

But it is something that really is ever-evolving. So, on the one level, it’s a history book and really trying to capture this evolution of the thought that really shaped the industry that you and I are in right now. So, that’s one level. On another level is biographical. We had the great fortune of talking to 10 of my heroes, really, 10 of my investment heroes. So, that was just the process of writing the book was such a lot of fun and to get spending time with my coauthor, Andrew Lo, that was a blast as well.

On the third level, it’s really meant to try to synthesize what we heard in our various conversations with these luminaries to see if we could come up with a framework. And so, this really, I think, hopefully, addresses your question in terms of, well, we did these interviews over 10 years. Is it still relevant? What we hope to end with is a framework to think about how one puts together their portfolio, and so, some principles, a process of what we call a path to the perfect portfolio.

Casey Weade: So, you talk about your heroes in the world of finance, and for some, their heroes or in the world of NBA or MLS or golf, oh, I got to meet my hero, and it was so exciting to meet Jordan or Tiger. And I had Jeremy Siegel on the podcast here not long ago and I was so anxious and so nervous. I felt like I was meeting one of my heroes.

Steve Foerster: There you go.

Casey Weade: I guess we can find ourselves in the same realm of nerdism here.

Steve Foerster: Absolutely.

Casey Weade: And it’s something I get really excited to do. There’s just so much fun. And I want to learn more about these people and more about really the stories of you and your experience and meeting with these individuals. But even before we get there, I just wondered, how did you distill it down to these 10 pioneers? How do you just take all of that? I mean, there are so many individuals that have made such a huge impact in the world of investing and portfolio management and finance. How do you distill it down to just 10 people?

Steve Foerster: Yeah, that’s a great question. And clearly, what we wanted to do was we wanted to focus on living individuals that we could have this conversation. And what really tied the book together is we asked them all the same question, what’s your take on the perfect portfolio? So, that limited us people like the first American Nobel Prize winner in economics, Paul Samuelson. He would have been a great person to talk to if he was still alive.

So, it was really starting with Harry Markowitz and then trying to find a trail that led from Harry Markowitz to Bill Sharpe and others. That was sort of our thought process. We also wanted to, again, focus on those that were both in the academic world, six of our ten won Nobel Prizes in economics, but also in the practitioner world as well. People like the late Jack Bogle who made such a mark in terms of the investment industry. Well, I’m sure we’ll get into that as well. So, we wanted to have a combination of those who really made a mark in terms of this whole process of investing.

Casey Weade: Well, and you have some really big names in there, of course. We’ve got Shiller, Sharpe, Liebowitz, Siegel, Fama, Bogle, Merton. You have Markowitz, Scholes, Ellis. I mean, so many great big names. I’ve kept kind of curious who didn’t make the list. Who was number 11? And he said, it’s got to be an even number. We’re finance people. It has to be 10.

Steve Foerster: I’m trying to recall how we ended up at 10. You’re right. It’s a nice round number. I don’t think there was really a number 11 that we left off. It had been, as you mentioned, over a decade. So, it was time to wrap things up. There were other people that we might have wanted but declined for whatever personal reasons they might have had, but we were delighted with who we ended up with.

That being said, I must say that if we have a follow-up book, hopefully, it will have a more diverse group of individuals rather than what I would call, no disrespect, but old white men are a lot of the people who ended up in our book. And I think it is the next generation of academics and practitioners much more diverse that hopefully, we’ll be having this conversation 10 years from now in a follow-up.

Casey Weade: I’m curious about that. When you look at those individuals today, who’s the next Harry Markowitz? Who’s the next Jeremy Siegel? Who’s the next Warren Buffett? I mean, who stands out to you today that you’re keeping an eye on to say, that might be the person we write this book on 10, 20 years from now?

Steve Foerster: Yeah, that’s a good question. And no one person springs to mind. I’m on the academic side. What’s curious is that we can look back over the decades and we can pick out the five major research papers that really had an impact. Those are few and far between. If we get one major paper that really moves the dial in a decade, that’s really something, which says something given how many thousands of research papers are published every year. So, I’m not sure who’s out there.

The other thing, Casey, is that sometimes, there are so-called sleeping beauties. These are these nuggets of research that don’t have an initial impact. Harry Markowitz, this 1952 paper is a great example, really didn’t get cited by other academics, really didn’t get picked up by practitioners until the late 60s. So, there could be something that’s happening now, and the full impact of it won’t really be realized for a while.

Casey Weade: When you think about all those conversations you had, I’m sure there are some that maybe stand out more than others. Of all the conversations you had, is there one in particular that just pops into your mind when you think about all these individuals?

Steve Foerster: That’s a really tough one because they were all great conversations. And I think they all went in different directions, some where we expected and some where we didn’t. I think the most surprising one was with Myron Scholes, who we certainly know as the co-founder of the Black-Scholes option pricing model, who won a Nobel Prize along with Bob Merton, and unfortunately, Fischer Black had passed away and almost certainly would have won a Nobel Prize with them as well.

But what’s lesser known is, is that Myron Scholes was involved in the development of the first index fund. So, he wasn’t all just a derivatives person. But what was surprising about our conversation and it took me a lot of time to unpack it and really digested afterwards, but his starting point in terms of thinking about the perfect portfolio was very different than most of our other luminaries. We can think of, as investors, the two key factors in any investment, what’s my expected return and what’s my risk?

And what was fascinating was his focus was really on the risk side that that was really the starting point that we should try to look at what we want to have in so-called terminal wealth or the wealth that we want to have heading into retirement, and work backwards from that in terms of how much risk that you should be taking on to try to reach that particular goal. And the other surprising thing was that if we think of sort of a bill distribution, the sort of normal distribution of expected returns, oftentimes from a risk perspective, we just focus on worrying about how do I try to manage that downside risk. And yet, his approach was, yes, that’s important, but also think about that upside risk. When should you be prepared to take on more risk when the environment looks favorable? So, I think that was the most unexpected conversation that we had.

Casey Weade: And he had an unexpected conversation there, someone that maybe took the conversation in a different direction than others did off the top. But when you look at the different strategies or ultimately saying this is the perfect way to invest or manage money, this is the perfect portfolio, when you look at all these 10 individuals, who are the two that stand out as the starkest contrast?

Steve Foerster: So, I would say the starkest contrast would be Gene Fama and Bob Shiller. And I think the Nobel committee intentionally awarded Shiller and Fama the Nobel Prize in the same year. And yet, it raised a lot of eyebrows because their perspectives were so different. And really, what it centers on is this whole notion of what Fama describes as efficient markets, which simply stated, according to Fama, his classic definition, stock prices fully and immediately reflect all relevant information. In other words, what you see is what you get.

Whatever a stock price is selling for, according to the Efficient Market Hypothesis theory, that’s what its value is. And so, we can look at data on an individual stock level, we can look at it on a broader market level in terms of is the market fairly valued? One term that really irks Fama is this notion of a bubble. And it’s fascinating because I looked at one of his earliest papers in the 1960s. It mentions bubbles. I think it’s about 20 times. And each time, he puts bubbles in quotation marks, he doesn’t even want to speak about bubbles.

And we contrast that with Bob Shiller, who is known as a behavioral economist. And Bob Shiller’s pathbreaking research really questioned a lot of the fundamental financial models, including those of Markowitz and Sharpe, that have this underlying assumption that all investors are rational. And what Shiller was able to show is that he took a look at the overall US market, called the S&P 500, and looked at if investors had perfect information in terms of if they bought that portfolio of S&P 500 stocks and they knew what the dividends were going to be received over the next 30, 40, 50 years, how should they have priced the market on a day-by-day basis?

And what Shiller was able to show is, in theory, what the price of the market should have been, should have been much less volatile than what we actually saw. And so, his conclusion was that there’s something going on here that is not rational. And so, in Shiller’s world, bubbles can occur where we have prices that get overly inflated. A classic would be in the late 1990s, the so-called dot-com bubble. And so, things got so far out of whack, and then the bubble finally burst and we came back into the reality. And so, Shiller was famous for anticipating what might be happening in the late 1990s, and also just before the financial crisis, Shiller identified something was out of whack in terms of housing prices as well. So, what I would have to say that the two of them would be the greatest contrast in terms of the 10 luminaries.

Casey Weade: I think this is one thing that is challenging for your average investor to come to terms with, because it’s human nature for us to want to find the right answer, the best answer. There has to be one way, which is the best way to invest, right? I mean, this is the combination of efficient frontier. This is the best way to do it.

And I’ve got to say, this also reminds me the contrast between all these different 10 great minds. They were all great investors. They all had great track records. They all really produced fantastic results at the end of the day. They were all doing it in a different way. And this reminds me of retirement researchers, Dr. Wade Pfau, Bob French, Alex Murguia. All of those three individuals are academics that are deep into not the portfolio management world, but in the retirement income world. And they all three prefer a different retirement income strategy.

And I think that’s frustrating for a lot of investors and retirees going, yeah, but one of them’s the best. One of these different individuals, one of these top 10 individuals has it right. They know exactly the best way to invest. If someone’s trying to approach it in that way, what do you say to that individual?

Steve Foerster: That’s a great question. And I think this is really what we have to try to digest after we had these 10 interviews. How do you make sense of it? How do you make sense of Fama versus Shiller to take an extreme example? What we tried to do in the book is to, as best we could, despite our personal views and takes on the world, we tried to present different positions in an as agnostic way as we could. And what we hope the reader will do and what we hope every individual will do is to develop your own investment philosophy.

And again, to use the extremes, are you a Fama, or are you a Shiller? And I have my personal views in which I would be closer to a Fama or a Shiller, but even my personal views, Casey, I can’t say conclusively that I am right. I’m an empiricist. I look at data. Fama and Shiller are empiricists. They look at the same data. They don’t argue over are these data correct or are these data incorrect? They have different interpretations. They have different ways of looking at that.

And so, it’s the same then in terms of what our beliefs will be. Our beliefs should be evidence-based. That being said, there’s different evidence out there. What I’m getting at is that start with your investment beliefs and then you should invest consistent with those investment beliefs. And let me give you an example. So, passive versus active strategies. Very, very briefly, I’m sure your audience is aware a passive investment strategy would be something like buying and holding an index fund like the S&P 500 as it pertains to equities.

An active strategy, and so, that would be Fama buy and hold something like an index fund, although it’s a little more nuanced with Fama. Shiller, on the other hand, would look at ways of being an active investor, and the key dimensions there, I could be a security picker like a Warren Buffett or I could be a market timer, which Shiller admits to being, I think, a little bit of a bull.

So, I’m not going to say to you, Casey, you should be a passive investor, you should be an active investor, but what I would say is if you believe, like Fama does, that markets are efficient, then your strategy should be one of buy and hold an index fund. If you believe like Shiller, that markets are not efficient, then you should consider an active strategy. And I know that’s hard and perhaps unsatisfying, but I think that’s the only way we can square the circle.

Casey Weade: Well, there has to be another way. I mean, what do we want to do? I look at these guys like Power Rangers. How do we take all of these Power Rangers and combine their powers to create the super portfolio? It seems like there have to be some fundamental constants, or either we combine the fundamental constants across all of them to create the ideal portfolio or we have a portfolio that uses each strategy to a certain degree. Maybe it’s siloed.

Steve Foerster: Yes. So, I think there are commonalities. And so, let me give you one. I think all of our 10 luminaries would agree that diversification is important, and so, we should be diversified. And really, this goes back to Harry Markowitz, who was the first to really provide this framework. It seems very simple now, but as an investor, we should consider our two key dimensions. What’s the expected return of securities that I’m looking at? And what’s the risk associated with those securities? Simple as that.

And so, if you can imagine almost a two-dimensional drawing with our vertical axis is our expected return, our horizontal axis is our risk. We all want to be in the northwest corner. We all want to be, all else equal, having the highest expected return and the lowest amount of risk. And what Markowitz was able to show is that diversification is really, I would argue, our only true free lunch, our only way of getting to that northwest corner and moving to a situation where I could have a higher expected return for a given level of risk or a lower level of risk for a given level of expected return.

So, we get that by being diversified, diversified across our securities that we hold, diversified across the asset classes. So, I think if you’re looking for a universal principle, I would say diversification is the key. Another one is looking for ways to lower our costs and do our investing in an as efficient manner as we can, looking for ways to minimize the tax hit that we are going to have. So, whether it’s Fama or whether it’s Shiller, I think those principles would hold.

Casey Weade: That’s diversification, keeping our costs low, and minimizing our taxes.

Steve Foerster: Yeah.

Casey Weade: Right. I want to get into how we do this ourselves. You brought some things up earlier that I wanted to dive a little bit deeper into. In the book, you have a checklist of seven principles to begin constructing your perfect portfolio. And I think that’s really important, your perfect portfolio. Maybe we need to go there quick. How do you define if you were to define the perfect portfolio for you? And anyone, in general, is there a one or two-sentence phrase we can say this is what the definition of a perfect portfolio is?

Steve Foerster: It’s what makes sense for you as an individual at this particular time, given the various factors that you are facing in your life, your goals, your tolerance for risk, and so on.

Casey Weade: Yeah, well, that’s perfect. That’s a good segue because number one on this list is determine how much expertise you have in financial planning and how much time and energy you’re willing to devote to managing your perfect portfolio. Now, I question because I was actually consuming a podcast this morning by Michael Hyatt and going into some research around self-awareness, and some of that research shows that 80% of us believe that we are self-aware, only 10% to 15% of us actually are self-aware. How do you get self-aware enough to know what you don’t know and determine how much expertise I have? And how do I get self-aware enough to know how smart or how not smart I really am?

Steve Foerster: Perhaps the best starting point is let’s assume we’re all dumb when it comes to investing. I think that would be the best starting premise and you better have a convincing case that you are smarter than the average bear, that you have that expertise, be it credentials, be it educational background. So, I think my personal take would be you’ve got to make a very strong case to not have a financial advisor, not have somebody that you rely on. I feel that I have a lot of expertise in investing and I rely on a financial advisor. So, that’s sort of the premise.

There are some people and perhaps those who are heading into retirement, perhaps you’ve got more time on your hands. It takes a lot of time to devote to managing your finances. And so, if you are a surgeon, I would sure rather have you devote your time to the expertise of doing the surgery than to be mucking around with investments that you may or may not have expertise in.

Casey Weade: Well, I believe that some of the best surgeons in the world, I would hope that some of the best surgeons in the world would not believe they know everything, that they would say, I don’t know everything, I don’t have everything figured out. And they’re able to reduce that ego to become the best surgeon in the world. When you look at these 10 different individuals that you interviewed and these are some of the biggest names in finance, they’ve won Nobel Prizes. Did you find a constant there that they’re all curious and they don’t believe that they’re 100% right? Or are they all convinced I’m 100% right, all those other nine guys were completely wrong?

Steve Foerster: We didn’t ask that specifically. Some of them did share or have publicly stated in terms of what’s in their particular portfolio. I don’t know how many have financial advisors. Some, like Merton, are in the business of providing tools that will help financial advisors. Some, like Bill Sharpe, shared with us screenshots of his portfolio, and it was very simple. Here are four ETFs. I’m looking at a World Stock ETF, a US World Stock ETF, a World Bond ETF, a US Bond ETF. That’s it. Put them all together, combine it with a TIPS product, an inflation-protected bond. And there you have it. So, it’s really different perspective in terms of their approaches.

Casey Weade: But they have to maintain curiosity, right? I mean, I feel like that has what I was asked not long ago, what do you think’s led to your success? I say curiosity and humility. I don’t think I have it all figured out. And I want to continue to have conversations like this so that I can learn more.

Steve Foerster: So, I think a great example, Casey, would be Gene Fama. Gene Fama has been probably, arguably the most prolific finance researcher and has had major, major research papers in each of six successive decades. And so, what’s fascinating is the transformation that Fama has made in terms of what his perfect portfolio has been.

In the early 70s, he was one of the first researchers, part of a team that tested Bill Sharpe’s famous capital asset pricing model. And his early tests were supportive of the capital asset pricing model. And so, Fama’s conclusion, and he admitted that if you asked him in the 70s into the 80s, what was his perfect portfolio? It was a portfolio that mimicked something like the S&P 500.

Fast forward to the early 1990s with his now famous coauthor, Ken French, in a series of papers, they took another look at the capital asset pricing model and critiqued it and found it lacking. And very, very briefly, not to get too much into the weeds, but the capital asset pricing model says that the only factor that drives prices of individual securities is the market portfolio, something like the S&P 500. So, all that matters is how risky your individual stock is relative to that market portfolio.

Fama and French said, wait a second, there are other factors out there. We don’t know exactly what’s driving them, but one of the factors tries to capture the difference between returns on so-called value and growth stocks. Another factor tries to capture the difference returns between small stocks and large stocks. So, they came up with what’s been known as a Fama-French three-factor model, which has this value versus growth component, which has this small cap versus large cap component, and then has the market portfolio as another factor.

What they found was in their research was that when you add in these to other this value growth and the small cap, large cap factors, the market portfolio factor goes away. And so, famously, as Fama shared to a New York Times reporter, their study showed that beta, the risk measure that we grew up with in terms of the capital asset price, beta is dead. So, what is Fama’s perfect portfolio post that research that he and French uncovered, it’s one that is diversified, and the market portfolio is a big part of it, but it tilts toward value stock. It tilts toward small stocks. So, there’s a classic case of someone whose beliefs, whose thinking have evolved over time based on evidence. And so, that’s where I think we have to keep an open mind and be aware of what the newest evidence is.

Casey Weade: Yeah, whatever it is. I think that’s one of the keys to success in an area of life is simply curiosity, talking a little bit more about risk, and jumping down to number three and your seven principles to begin constructing that perfect portfolio. It’s find your comfort zone regarding financial gains and losses. That’s one that takes some issue with. Yeah, I’m not sure investors really know their comfort zone and I think great examples of that and happen during bear markets. I mean 2022 is a perfect example of that.

We have individuals that a year ago told us that they were on a scale of 1 to 10, they were 8. And now, they go, yeah, I think I was wrong. You don’t really know what your comfort zone is until you experience the downside of that comfort zone. How does someone really understand what their comfort zone is? Or do they have to experience some loss and really learn what that comfort zone is through not-so-good circumstances? I mean, can we get ahead of that?

Steve Foerster: That’s a super question, and really, a critique of what’s a common practice, know your client. You have to try to through discovery get some kind of sense in terms of whether your client what kind of appetite they have for risk and what tolerance they have for risk, more importantly. So, let’s suppose...

Casey Weade: One that changes. If we’ve got 2013, they go from being a moderate investor to go, oh, I’m actually aggressive. If it’s 2022, they go, I’m aggressive, actually, I’m moderate.

Steve Foerster: So, that’s my point as well. So, imagine, Casey, it’s a nice summer day. We’re sitting outside and we’re having a cup of coffee. You present me with a bunch of questions in terms of what my risk tolerance might be, a 7-point scale. What if I lost 10%, even 20% of the portfolio? I’m feeling pretty good today. And so, I check off, oh, yeah, I could handle that.

But when something like that happens, when 2020 happens, when 2007, 2008, 2009 happen, and to give some more of a historical perspective, I would argue that one of the most infamous days in investing history, a bit of a history lesson is back to October 19, 1987, probably before you were even born. But what happened on that day, Black Monday, is that on average, US stocks drop by more than 20%. And that was just unheard of. Up to that point, the worst day had been during the 1929 crash, where stocks had dropped by 12%.

So, even if we were trying to get some kind of sense of my risk tolerance pre-October 19, 1987, I might be trying to have a scenario of stocks going down by 12%. I wouldn’t have even thought of stocks going down by 20% in a day. So, I think to your point, yeah, we always have to reframe this and we have to really think about it. And perhaps, as you point out, maybe you have to experience this, maybe you have to really feel in your gut what that feels like to have those kind of losses.

Casey Weade: Yeah, I was reading a Reddit post this morning on WallStreetBets. And I just love spending time in there. And there was an individual that posted and said that they were very upset with their financial advisor. They hadn’t been performing well, underperforming the markets. They’re losing money this year. And he goes on to say, my advisor is down 12% this year and firing it and there are a lot of responses. That means it’s doing pretty well. The market’s down 25%, you’re only down 12%.

But I think many, not most maybe, but many individuals go to a portfolio manager, investment manager, a financial advisor, and their expectation is you’re going to get all the upside and none of the downside. You should have seen this coming and you need to make changes. What do you say to those individuals?

Steve Foerster: So, first of all, I say something was lacking in that initial conversation with a financial advisor that that expectations need to be set. And I think you see this is where it comes back to investment beliefs. And so, what the advisor should be doing through the discovery process is to find out what that individual’s investment belief is and to provide them with a portfolio that’s consistent with that investment belief.

And so, the story you provided, there seems like there was some kind of disconnect. What was that individual’s horizon that they shared with the financial advisor? Because if it was a long-term horizon, I would argue the last thing you should do is have an app that tracks your investments because who cares on a day-to-day basis what your investments are worth? If you look at your investments, I would argue personally, if you look at it more than twice a year, then that’s too many times. So, something doesn’t add up with that story in terms of there has clearly been a gap in expectations.

Casey Weade: And I think that leads right into the fourth on our checklist, and that is think about your investment philosophy and what you believe about markets. And my question to that would be, yeah, I mean it’s really important to find out what we believe, but what we believe is probably wrong, right? I mean, how important is it to uncover what we believe if it’s most likely incorrect? And maybe that’s just a personal bias of mine, like, yes, I think it’s good to understand what I believe, but it’s also important to understand that I don’t know what I don’t know. And whatever I believe is probably at least a little wrong.

Steve Foerster: So, I would challenge you, Casey, in terms of what do we mean by right and wrong. As investors, we might have a really narrow answer to that. We each have one life to live. We each have one roll of the dice in terms of our investments over time. And we can look back on it to say, oh, gosh, I did quite well over the last 20 years, or I’m disappointed with how I did. And so, it’s really hard to tell with one observation, whether I’m right or wrong. Even with a century of data, it’s really hard to tell.

And so, I think I might reframe this to say what is it we’re trying to do with all of this? We’re trying to achieve our goals. And those goals, what are those life goals are need to be translated into financial goals, and then our portfolio is formed to try to achieve those financial goals. So, whether I am “right or wrong,” whether I take in, for example, an active strategy or a passive strategy, perhaps in both of those cases, I can achieve my goals. And so, that’s another way to think about what we mean by right or wrong.

Casey Weade: So, it’s not that we’re trying to discern what the right answer is, and buy and hold index fund versus an active strategy, passive or active, but do I believe whatever strategy that I have chosen can help me reach my goals? That’s really what we’re trying to say here.

Steve Foerster: Absolutely. That’s how I’d like to reframe it. Exactly.

Casey Weade: That’s great. And I also want to talk about the next one on your list there, which is list all the assets that you have, most importantly, and the assets you are willing to hold, such as mutual funds, ETFs, stocks, bonds, real estate, so on. And one of the questions I had around there is, just because you don’t want to hold it, does that mean that you shouldn’t hold it? You go, well, I don’t want to hold equities, but does that mean that you shouldn’t hold it?

Steve Foerster: So, I think this is all part of the whole process. So, that should be your starting point as we then move from what we call the principles to the process to the path and where you end up, which is your actual asset mix, which is what we are talking about in terms of the so-called perfect portfolio. If that portfolio, let’s suppose in an extreme, you don’t want to hold equities, as long as you can still meet your financial goals without holding equities, all the power to you, I think all of that, that’s great.

I think it’s always this evolutionary process. I’m sure many of your clients, many of your listeners are very intrigued about crypto. And should that be part of one’s portfolio? Or should that be something that you exclude as part of your portfolio? And this is where I’ve thought about that, and I’m an evidence-based person so I was curious, and in one of the blogs that I write, I put together as much data as I could on Bitcoin just to really understand the risk in return, historically, Bitcoin. And my conclusion was that looking at Bitcoin compared to even a diversified portfolio of stocks from a risk perspective, we’re talking 10 times the risk. And so, today, at this point, I made a personal decision that crypto, it doesn’t make sense for me in terms of my portfolio. So, that’s the kind of process I would like individuals to go through to come to the conclusion that any investment is part of or is not part of your potential set.

Casey Weade: This makes me think of Buffett’s invest in what you know, which to me, that seems to be pretty dangerous advice, especially if you have a very narrow scope of expertise. If I really only understand car mechanics, should I only be investing in car mechanics? What do you have to say about that old adage?

Steve Foerster: So, Buffett’s a great example. In the late 1990s, Buffett avoided the whole dot-com “to use Fama” and just to use Shiller’s term the dot-com bubble. Fast forward, and Berkshire Hathaway is now investing in tech stocks, correct me if I’m wrong, I believe, they have a big stake in Apple, for example.

Casey Weade: He recently ventured into crypto as well.

Steve Foerster: And there you go. So, I think that’s an evolutionary process. And I think the process, I don’t know for sure, but the process that Buffett went through as a very thoughtful individual is looking at these things more deeply, looking at the evidence, and looking at what made sense. Another example, what Jack Bogle shared with Andrew, my coauthor, interviewing for the book, surprisingly in his portfolio, he had a small portion of gold that he held. He wasn’t all just low-cost index funds. So, it’s really trying to be open but really give a lot of thought in terms of what you’re prepared to invest in.

Casey Weade: So, if you’re going to venture into something that is new to you, that you’re not that familiar with, then educate yourself on it before you pull the trigger.

Steve Foerster: Absolutely.

Casey Weade: And I want to touch on the last one of your seven here before we move on, and that is avoid obvious mistakes and anything that always makes it, well, if they’re obvious, I would have made a mistake. You think about this on the golf course, like, yeah, I know I shouldn’t hit out of bounds, but I didn’t know that I was over here and that was going to lead to this. How do we avoid obvious mistakes? Again, if they were obvious, we wouldn’t have made them in the first place.

Steve Foerster: So, the biggest category of what I would put under obvious mistakes are behavioral mistakes, the biases that we have. And this is kudos to Shiller, to Dick Thaler, another Nobel Prize winner, to Daniel Kahneman, another Nobel Prize winner, who really brought us to understand more about ourselves. One of the biggest biases that we have as individuals, and in particular, as investors, is overconfidence.

There have been classic surveys, rate yourself as a driver. Are your abilities above average, average, or below average? And 80% of respondents claimed to be above average. And the same goes for investing as well. I’ve done some of these surveys and I’m as guilty as the majority in terms of having overconfidence. What studies have shown is that the way this translates, by the way, there are gender differences. Males tend to be more overconfident than females.

What that translates to as individuals and investing is overconfident individuals tend to trade more. The result of excess trading is underperformance. So, there’s this clear path from overconfidence to excessive trading to underperformance. So, that’s a clear bias. And if we can get our heads around that, then we can manage these biases or try to manage these biases. And it’s not individuals only. Studies have shown that professionals have these biases, too.

Casey Weade: So, one of the best things that we can do, and I mean, I love this. One of the best things that we can do as individual investors is understand obvious mistakes, but that really comes down to understanding our behavior, having a better understanding of behavioral finance, of which, we’ve had many great conversations around behavioral finance. There’s a lot of great books and resources. If someone does come to you and say, hey, I want to avoid obvious mistakes, I want to get better at understanding my own behavioral risks. What direction do you point them in? Do you recommend any specific books or resources?

Steve Foerster: I think the one that comes to mind is Daniel Kahneman’s Thinking, Fast and Slow. Another one is Thaler’s, a book coauthored called Nudge, where they focus on a lot of behavioral examples and experiments that really uncover the biases that we have. And I think there’s a bit of prescriptive nature to these books in terms of what we can do. I think the first step in anything is self-awareness, is to realize that we’ve got these biases. I’m Steve and I have these biases, and let’s start there, and then we can try to overcome.

Casey Weade: Yeah, well, we’ll make sure that we put links to those books in the show notes of Let’s get to you personally. And I was curious, you and Andrew went into this research project, took a decade. You had to learn a lot. I mean, you already knew a lot, but you still had to learn a lot from these conversations. And I’m curious, anything specific that you or Andrew, maybe both of you, changed about the way you invest after completing the project?

Steve Foerster: I think it’s just the revelation and spoiler alert, there isn’t just one perfect portfolio, that we all have our own perfect portfolio, and that perfect portfolio changes over time. It should be changing over time as our circumstances change. So, just how important all of the personal factors are when it comes to investing, and Charley Ellis, I think, really, really unpacked this well and he’s a big proponent of low-cost index funds and was actually one of the first individuals to publicly come out against a totally active approach.

But he really said that you and I, Casey, we are different individuals and we have different backgrounds, we have different views, we have different tolerance for risk. We’re at different stages in our life. And so, our portfolios by definition, have to be different. We’re looking for different things. So, I think what really struck us is this really comes down to a personal pursuit with assistance. I don’t mean to do it on your own, but where we’re going to end up is going to be different for each of us.

And back to some of our parts of our conversation, is your approach right? Is my approach right? Maybe we’re both wrong. And I think that’s okay as long as we can both be approximately right. If we’re approximately right, then really, I hope that we’ll both be able to obtain the financial goals and the financial freedom that comes with achieving those financial goals.

Casey Weade: And I’m curious, when you look at these 10 individuals, is there one philosophy that is as close to Steve as we can get? And the same goes for Andrew. Do you two follow different philosophies? Do you two prefer one of these individuals’ philosophies over another? And if so, who?

Steve Foerster: So, I would say for me, my philosophy would be closer to Bill Sharpe. He came up with this capital asset pricing model that really the conclusion was all that matters is this market portfolio, so buy and hold this market portfolio. And I’ve shared with you his simple approach for ETFs plus TIPS. There it is. They share your portfolio, and it’s very straightforward.

Another great book I’ll give a plug for my coauthor, Andrew Lo, and how his philosophy differs. Years ago, he came up with what he called the adaptive market hypothesis. And he has this great book that I highly recommend called Adaptive Markets. And so, his take on the Efficient Market Hypothesis that it’s not really wrong, but it’s incomplete, incomplete in the sense that we have to take into account all kinds of evolutionary type of things.

And so, this efficient market really is always evolving. And so, I think Andrew would have this premise of starting with efficient markets, but making sure we are more adaptable as scenarios change, as our view of risks might change as well given different scenarios. So, I don’t want to speak for Andrew, but I think that would be something that would be more distinctive for his approach.

Casey Weade: So, it’s always something that just continues to hammer home. Any time we interview two amazing experts, they always have a slightly different approach. And so, I can really appreciate that. So, the question of the day, given today’s market climate, economic climate, are there any particular lessons that you think we should be focusing in on or pulling from these 10 academics that might be especially timely today?

Steve Foerster: Sure. I would say three things. One, I would say don’t panic. We’re speaking in October 2022 and it’s been a terrible year, not only for equities, but for bonds as well. Don’t let your emotions take over. Don’t be that person that you just described in the Reddit forum that wanted to fire their financial advisor because their portfolio was down 12%, which I think you and I agree is a pretty good result so far this year. So, that’s one thing.

The second thing I would say, and in particular, for your listeners who perhaps like myself, where we’re getting close to that magic typical retirement age, despite that, think long term. I hope that when I soon hit 65, I hope that my investing horizon is still going to be 20-plus years. And so, there’s going to be a lot of ups and downs in the next 20 years. So, as long as I have a long-term focus, as long as I’m aware of what might happen if there’s a really bad year and stocks and bonds are down by 20%, do I still feel okay by keeping that steady course?

The third thing that I would say, and this is where Martin Leibowitz has made a lot of contribution is we’re transitioning now from a really low-interest rate environment to a high-interest rate environment. And in the short term, there’s a lot of pain. It often seems counterintuitive to investors, but when interest rates go up, bond prices go down. And so, that’s where we’ve seen bond prices go down in 2022, coincidentally, as interest rates are going up. So, we’re all feeling that pain. But eventually, there are going to be some benefits in particular for those who are relying on a fixed, steady income for savers. That’s going to be a good thing in a higher interest rate environment. So, hang in there.

Casey Weade: Well, I appreciate the glass-half-full thoughts there. Well, as we come to a close, I want to make sure we TF your book for our listeners and we want to give it away. We partnered up with Steve. We got a bunch of copies of his book here and we want to give them away until they’re all gone. So, if you’d like to get a copy of In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, all you have to do is shoot us an email after you subscribe to the podcast and write an honest rating and review over on iTunes. Shoot us an email, [email protected] with your iTunes username. We’ll shoot it out to you for free. Stephen, thank you so much. It’s been a true pleasure.

Steve Foerster: Likewise, Casey. Glad to chat to you.