Masters in Business: OSAM Patrick O’Shaughnessy (Audio)

We had Jeff Glenlock, Jim Chainos, Mark Cuban, and now we're starting with a whole new run of new shows beginning uh this weekend, which is January. Before I tell you the details about this week's guest, let me just tell you a little bit about what we have in store for you some fantastic shows. Recording next weekend is some guy named William Gross, formally of Pimco. Now with Janice, we spoke, or we by the time you hear this, we will have spoken for a couple of hours. We've

been going back and forth about this show. A lot of really interesting stuff, enough material that it might even end up being a two hour show. So that's fascinating stuff. Check out that next week I'm heading out to Seattle to interview Howard Marks of oak Tree Capital, really a super value investor, and another phenomenal fixed income investor. Uh Cliff Fastness of a q R is on our schedule, as is Jim McCann of eight hundred Flowers, which in

response to a lot of requests. Hey, I love the interviews and I'm learning a lot about finance and investing, but what about things in non financial business. So Jim is somebody we've known for a couple of years, and he's a really fascinating character who essentially took a single flowers shop and turn them into this fantastic, successful, publicly traded company. We have a lot of other people queued

up from outside the world of finance. I think that's going to be really interesting, including people from the arts and and that could be a really intriguing conversation. Before I babbled too long, let me tell you about this week's guest. It's a special youth edition of Masters in Business. Patrick O'Shaughnessy, author of Millennial Money, all about how young people can make a fortune courtesy of their fifty year investment horizon. You know, we tend to think of the

youth today as being really disadvantaged. They came of age in the midst of a horrible financial crisis that burdened with lots of student loans and and college debt. There aren't that many great job opportunities. Patrick takes a very contrarian position, which is the youth have the single greatest advantage on their side, and that's time you get to compound returns for fourty or fifty years. Most people don't really start investing seriously into their forties or fifties, or

at least that's what Patrick says. And by that time, you've given up so many decades of compounding, you've missed out on so much that you're actually at a disadvantage. Even if you're making very little money and putting very little aside, you should still do it, says Patrick in his book Millennial Investing, because of the miracle of of compounding,

and one it does two your returns. Essentially, you can start later and put more money away, and you'll end up with about as half as much as someone who starts early, someone who starts in their twenties. So be sure and check that out. Uh, with no further ado, let me introduce Patrick O'schalnessy, principal at O'Shaughnessy Asset Management and author of the book Millennial Money. This is Masters in Business with Barry Ridholts on Bloomberg Radio. This week.

I have a special guest who is unique in two ways. First, his name is Patrick O'Shaughnessy. He's the author of Millennial Money, How Young Investors Can Build a Fortune. So this is a special youth oriented version of Masters in Business. But we have a couple of first with Patrick uh Patrick is you're born in eighty five, right I was. You're thirty yet almost thirty, just about to turn thirty in April, so by far you are our youngest guest ever on

the show. And second, you're the first guest who is the offspring of a previous guests co We we had um Yale Hirsch and his son Jeff, but they were on together, So you're the first um, first official progeny of a prior prior guest, so that that makes you unique. A little background about pat Rick um obviously born in n five, not quite thirty, undergraduate at Notre Dame, surprisingly degree in philosophy, not finance, but you ended up becoming

a chartered financial analyst. How did you find your way to finance? So my interest in markets in general, and finance even more generally really comes through human psychology. I studied philosophy with sort of an unofficial minor in psychology, just because I'm interested in how people act and how people think. And I think that the stock market represents probably the most interesting intersection of all the most interesting disciplines. So I sort of backed into it through psychology. UM,

and that's what got me interested. And then from there I went to, you know, the more traditional route studying accounting through the c FA, etcetera. But it's people that got me interested in marketing. And it certainly doesn't hurt that your father is James O'shawna See, who wrote a highly regarded book What Works on Wall Street and runs the firm um Oceana Csset Management where or a principle,

I've been extremely fortunate UM. And I say that not so much because I have a father who is a well known investor, but more because of how he encouraged me as a young person really just to love learning. UM. It was never about this ratio or that ratio is really just about loving to read, loving to investigate. So that's the reason I'm so lucky, but lucky for a

lot of reasons. So let's talk about you as a young person, because the theme today is going to be the advantages of youth, the things that young people have that they may not even realize that works so strongly in their benefit. And who better to discuss it than it's someone who is a not quite thirty and b wrote a book about what millennials should be doing with their money. And the funny thing about that is when people think about this generation, the thought processes, they're living

in their parents basement. They don't have a lot of economic opportunity. Jobs aren't plentiful, it's tough to get by. And you took an extremely contrarian position and you basically said, hey, you'll never have a better time to invest in your life than when you're in your twenties and thirties, and I'm going to write a book about it. Yeah. You know, this is true of young people in general, but even more so of the millennial generation, just because of what

they've witnessed. Three catastrophic collapses in the housing market, in the stock market, um and we are as people tend to be once burned, twice shy, and so we've got this very negative view of the stock market. My goal with the book was to sort of reverse how people think about risk and make them realize that if you've got forty years ahead of you, you have huge potential.

If you start very young, and dollar might turn into seventeen dollars, whereas if you wait till forty, like most people do, that same dollar on average turns into just about five dollars. So, so let's talk about those three crises. The dot com crisis, you have the housing collapse, then we have the financial crisis. How has that impacted the psychology of of your peer group, of the millennials. Well,

it's really part of our biological heritage. There's one of my favorite writers is the anthropologist Diamond, who spent a lot of time with indigenous people in Papua New Guinea. And when he was traveling with them, one night they were setting up camp and he wanted to set up a camp below a tree, and they said, absolutely not, we won't do it. And he was surprised because the tree was fine, it was alive, it hadn't begun to

rot or anything. But they wouldn't do it. And he realized that they take all sorts of extreme precautions against even very low probability events, and he called this tendency constructive paranoia. Human beings are very sensitive to even low probability losses because negative things have a big impact on our survival. Now that's great in a primitive setting, but

in the markets, the exact opposite is true. We say better safe than sorry, which is how we tend to act biologically, but in markets, typically the safer you feel, the sorry you will be in the future. So what works on the savannah doesn't work on the Wall Street. Absolutely,

and and that's just the way we're programming. We've seen three catastrophic things that signal to us danger when you look at markets, So that makes millennials more risk averse, and they tend to run very low stock expo oosure and absurd levels of cash in the portfolios they do. And some of the most recent surveys show fifty or more in cash for twenty five year olds, which is just insane because of the power of inflation, you know that the value that cash will slowly get stripped away

over time. Whereas they have very little in stocks, which over the long, over four decades, have always been you know, the most renuwerative successful asset class. Never never a negative UM twenty year rolling period of equities in the US. UM, you look at Japan. That's really the exception, isn't it. Yeah?

Internationally and there's some there's some extreme examples like Japan, Germany, some of the World War two countries, But equities over the longer term after inflation have been safer than the more traditional bonds. In cash compounding, use the famous example of the grain of rice on a chessboard. Describe the advantage that twenty five year old has if they're looking

at a forty or even fifty year investment horizon. Well, the thing about compounding that makes it hard to take advantage of is all the great benefit happens at the tail end of life, not in the beginning. So if you're investing a thousand dollars now, you might only make a few hundred dollars in returns, but the same rate of return way later in life represents much bigger sums. My favorite example of this is Warren Buffett. Everyone knows him as the most successful investor out there. Um, you

know sixty billion dollar net worth. He was not a billionaire until he turned sixty years old, and his superpower was that he started when he was eleven years old buying shares and the power of compounding. Now, he was a great investor, but the power of compounding was what led to his great results through time. The same is true for young people today. Small a bounds invested now

can result in huge sums in our fifties and sixties. Patrick, in the book, you discussed three factors that are required in order for any young investor to succeed, and those factors are be different, go global, and get out of your own way. Let's let's discuss those in reverse order. Let's start with get out of your own way. Sure, I think this is actually probably the most important of the three because strategy is one thing, but if you don't stick to your strategy, you will be in trouble

in the long term. Investors tend to be their own worst enemy, reacting emotionally at exactly the wrong times, both in times agreed and in times of panic. So the key, really, I think, is to get out of your own way by making your investing program as automatic as possible, meaning money from your paycheck or bank account is just automatically invested, whether it be in your four oh one K retirement account or just regular brokerage account, and invested for you

without you having to take action. Because the more opportunity we have to interceed in the portfolio, the worst our results are are likely to be. There's been a and may have even been your dad who on the show told the story that when Fidelity did a review of accounts, the accounts that had been the most successful, ones that people essentially had forgotten about, just left to the left them alone, and those were the highest returning portfolios in

their whole book of business. There's an amazing you can you can overcome all this by just making your investments automatic, and for most people that's the easy solution. So four O one K, it's really easy. Is there a way

to make it automatic with just a regular brokerage account? Sure, you can set up with almost every company with whom you might have an account, you can set up set up an automatic transfer from your bank checking account into your brokerage account pretty easily, and and that's probably the most basic and effective way to do it. So once the money hits how does that get disposed into a portfolio.

So there are certain services that do it for you. Um, this is kind of the cutting edge of the meeting of Silicon Valley and Wall Street where their software that they've built that just automatically handles it all for you. There's a number of companies that do it. The biggest of them is a company called wealth front Um. There there are a number of other great options that people can research, but they handle everything for you once the money is there, and then you don't have to do anything.

That's that's great. I know Bennements is a competitor. There's personal Capital. There's about a dozen of those. We have our own version of it. There. There's a lot of different monies that do that. By taking the human element out of it, you're removing the emotion, you're moving the people being in the way of their own interests. Yes, an emotionless investing process will always be better than one that involves too much people. So now let's go to

the second point, which is go global. Obviously referring to the home country bias that we see all all over the entire investing world. Yeah, I call it portfolio patriotism. It's this it's this tendency to prefer companies whose CEO as we know, whose products and services we use and so on. We just like the familiar, and we don't

like investing in companies that we've never heard of. Unfortunately, that ignores a wealth of opportunities abroad, and very often some of the best opportunities and the cheapest opportunities are outside of the US. So I encourage investors to build a very global diversified portfolio because there are countless examples

of individual country stock markets. Japan is probably the most current and extreme example, having law long periods of time where they do badly, but an equal weight to balance global portfolio has has really never had a twenty or thirty year run of negative performance, even after inflation. Um So, I think that a balanced global approach is better than just buying stocks in the country in which you live.

We're speaking with Patrick O'Shaughnessy, author of Millennial Money. Now, the third points, or really the first one in your list is probably the most challenging one, which is similar to the Apple slogan think different. You're saying be different, yes, and and this is really a point that is addressed specifically at those trying to outperform the market. It's a

hard task to do and for most investors. If I met one on the street, I would say that simple index funds are a very good option to get started for those that are interested in in owning individual stocks rather than just owning the entire market. I think that there are certain ways that if you are consistently different in these key ways, you can outperform the market over

the long term. These are things like buying stocks at very cheap valuations, buying higher quality companies that themselves earn strong returns on their investments, Buying companies that are definitely not meddling with the books, that have real cash earnings, not quality earnings, high quality earnings um. And it's also important to look at recent trends in the market over the last say, three to nine months. Companies that are

the falling daggers sometimes are best avoided. So if you can buy high quality, cheap companies that the market is just beginning to notice, and do that very consistently through time, that has been a strategy that historically speaking, has worked very well better than the overall market. The key is that you have to be different, and we're gonna come back to the checklist that you've created in order to

be different. But when you end up taking these three bullet points, um, get out of your own way, go global, and be different, what are those portfolios end up looking like? So depending on whether or not the investor is is choosing to be very different than the market, it'll end up looking quite distinct. You might have always global holding, because that's a key part of it. But typically if you're a young person the vast majority in equities, you

might have imbalances in terms of the market sectors. You might own a lot of consumer stocks but no energy stocks, something like that. You have to have a willingness to look very different and not care what's going on in the market. Only care what's going on obviously to the benchmark or the SMP five hundred exactly. And you know, two thousand fourteen it was a hard year. The SMP five beat everything else. Um, So you really have to have that intestinal fortitude to ignore when you're losing to

the overall market. But but the combinator, the combined portfolio will still be well diversified globally and within the US side of things. What sort of names we do you tend to look at I know they rotate on a regular basis, but you're really talking about high quality companies at a relatively low valuation. Yeah, one of I'll give one example that's pretty representative of these ideas, which is

Cgate Technology. It's a hard drive manufacturer. Um, we've owned it for about five years and it's been one of the best performing hold in our firm's history. It was a classic value story where everyone said it's going out of business. Hard drives is dinosaur technology, it's all moving to the cloud. Um, this industry is going out of business. Super cheap valuations, high quality earnings, they were aggressively repurchasing

their own shares, they were investing in themselves. Um. Those are all great things to look for in a company, and that would be a kind of a common profile the name that that we like. Let's talk about one of the biggest trends in investing today, the idea of active versus passive indexing. In the book, you start out by saying, you know, if nothing else, passive indexing is fine, but I think you could do better address that if

you would. Sure, I think that you know all the all the original arguments in the book trying to compel young investors to get going are all based on just owning the overall market simple passive indexes that you don't have to do anything, you just own a slice of global business. I think that that is a great way to get started, and for the average investor, that's probably

the best solution. They don't have to think about it much, they don't have to spend time researching companies anything like that. I do think that for the sort of the second level investor that wants to get deeper into the weeds, that there are ways to beat the market. You just have to do your research and do your work and stick to some really proven key principles. So my my opinion is kind of twofold. It depends on the individual investor. For most people I know that aren't in this business,

I advocate simple passive index funds because they're cheap. We know, they do very well over time, they have good tax friendly returns um and you don't have to know much about the markets to participate in their growth. You're just buying into the global business universe and letting it do

its thing and getting out of the way. Yeah, all of a sudden you've got millions of people working for you effectively, and that's that's kind of a powerful concept and not trying to pick which the winners will be, just participating in the entire thing. But there are some issues you have with passive investing, which is similar to issues that Rob are not has raised, and um your dad has raised and other people. And it has to do with the problem with selecting stocks based on market

cap waving. Yeah, so we we think of market cap as a factor like any others, like price to earnings or something simple like that. This is an interesting study if you broke the market into ten groups equal groups of names. So let's say there's three thousand stocks or so in the market, three names in each group, and the division was based solely on their size. So the number one group was the three d biggest stocks, Number ten the three hundred smallest, and you ran that simulation

over the last fifty years. The only really interesting thing you would find is that the biggest group, the three hundred largest stocks or so, have underperformed the rest of stocks by between two and three percent per year on an annualized basis. So names that have done the best over the long term go on to actually underperform. We would argue that the index based strategy is just to buy big cap stocks, and then that doesn't make much sense that you can do better from a strategy perspective.

Where indexes have it right is how disciplined and consistent are. Talk a little bit about this. Something in the book I found fascinating, which is only buy stocks with the letter C as an example of what one of the flaws in cap weighted indexes yees. So if all you did every year was by every name in the market that started with the letter C, honestly, you could do it just about any letter and the result would be

the same. You would outperform the market on paper. And the reason for that is that it excuse you away from just the biggest names and just create sort of a random sample of companies that that tended to actually do better than the biggest stocks overall. So kind of a funny exercise, it is, certainly wouldn't advocate anyone do that, but but it's it's powerful to show that just a random sampling will do better, an equal weighted random sampling

than than just a market index on paper. I suspect we're going to see an E T F in the not two different future called E T F B E D f C E t F D just just stocks of those letters because someone will someone will end up um buying it. So so now let's talk a little bit about when you're not buying indexes, when you're putting together a portfolio, how do you deal with the behavioral issues that you mentioned throughout the books throughout the book

in terms of how investors get in their own way. So, really, we think the solution is to make your approach completely model based, meaning you design a model that selects stocks for you based on proving key ideas, attributes the common stocks that have been successful share and then you stick to that model through thick and thin. And I can promise you because value stocks are a big component of what we do that very often you'll look at the names coming out of your model and say, wait a minute,

this can't be right. This stock is terrible. It's the cgate technology of five years ago. Uh, you know, it's the leisure stocks of five years ago when people said, no one's ever gonna do anything for fun again. They're just battening down the hatches. So it forces you to own some uncomfortable stocks, which is why we think you just need to take humans out of it, make it a model based approach. Only that's so funny. My my favorite war story about reaction to stocks when the first

Apple iPod came out. I've been a Mac fan boy for forever. I got my hands literally the first week the iPod came out, and oh, I get it. The Sony Walkman for the digital era. This is gonna be huge. Apple at the time was fifteen bucks, thirteen cash. I showed this to a dozen people. The reaction was uniformly, dude, what are you talking about? Things? Out of business? Ah?

And I learned that when you get that oh reaction, pay attention because it means all the worst part of the stock is out of the price, and all that's left is either out of business or a lot of upside. With Apple turned out to be a lot of upside. I love the phrase the cave you fear to enter holds the treasure you seek, and that is often true

in the stock market, as it was with Apple. In our earlier segment, we discussed a variety of different factors that go into approaching markets correctly as a young investor. But you took it a step further. What you said second level investing beyond indexing, and you created a checklist for identifying stocks that have five key characteristics that you think make for the best sort of portfolio that people

can in fact do themselves. Yes. Yes, So so we can go through each of the five, which I think I have very compelling reasons each. The first is that you want companies that are very oriented towards their shareholders. What I mean by that is they send lots of cash back to equity and debt stakeholders in the company there, So that means retiring debt, buying back shares, an issuing dividends, paying dividends. Yes, and so you want to favor those stocks.

And you want to avoid stocks that are just issuing a ton or raising a ton of new capital. So secondary equity offerings, you know a lot of new debt, those tend to be bad science historic. What about the companies that generate a lot of stock options and have to issue stocks to cover that. How does that fit into that? So you've got to make sure you look

at the net number. So you want to look at total buybacks and total issuance and net those numbers out against one of other to account for any sort of issuance that's for stock options, that would be a bad thing issuance for stock. So shareholder yields greater than five percent? Is uh? The first bullet point. Second bullet point return on invested capital. Yeah. So the key idea here is that this is sort of a measure of a company's quality. You want to invest in company whose own investments are

are yielding great returns. So if a company takes its cash that it's raised through equity and debt, makes investments in property, plan, equipment, whatever its investments are, depending on its business. You want businesses that are great at earning high returns because those filter through two investors. So a return on invested capital that's very high relative to competitors has historically been a good sign. So you want to

focus on companies with good return on capital. All right, And the third bullet point operating cash flow greater then reported profits. Yes. So the bottom line number that everyone still pays attention to is earnings EPs. That's the number that makes headlines. Far fewer investors are focused on real operating cash flows. We want real, not manipulated earnings, and there are a lot of ways to make earnings look

better than they are. Maybe it's growing your accounts receivables, or messing with your inventories, or just blowing up your asset base. There's lots of ways to do it. We want to focus on companies that have real, strong, consistent operating cash flows that are at least as high as their earnings, hopefully a lot higher. So how are you measuring that? How are you looking at actual cash flows? So it's very simple. On the statement of cash flows,

there's three different kinds. You just look at the operating ones, ones that are coming in on a net basis as a result of the company's normal business activities, and you compare that with the company's reported net income. A simple check is just to say we want companies cash flow

higher than their earnings. This would help you miss the endrons of the world, the adelphia's the world comes, all of which would have would not have passed this does It doesn't make sense to have earnings higher than cash flow. It doesn't make sense because that means it's coming from something like accounts receivable. You your earn engineered. It may not be fully engineered, but it means that the earnings are not coming from real cash. It's coming from cash

that you think you'll receive in the future. All right, So that was bullet point checklist number three. Number four enterprise value to free cash flow less than ten x. How does that work. Yeah, it's a fancy way of saying you want to buy cheap stocks. You want to buy companies trading at low multiples. I like free cash flow. You can use earnings, you can use book value, you can use sales. They all work. The important point is that the less you pay for stocks, the more you

will earn from them in the long term. Very easy to say, much harder to do in practice because it often points you towards some contrary bets places that the market is worried about. But value is key. If there's anyone lesson from this list that people take away is to focus on paying as little as possible for earnings, for cash flow, for sales, etcetera. Let's look at the last factor, which is really kind of interesting. You describe it as a momentum factor, but I'm gonna say it's

not a momentum factor. It's really a avoid dogs factor. Because what you your bullet point is your checklist point is s x month momentum that's in the top three quarters of the market, which is a polite way of saying, hey, avoid that bottom quarter. Yeah, there's there's honestly no special

magic to that particular cut off point. The real key is that we know from market history companies that have been doing the absolute worst over the last six months or so tend to continue to be dogs for the next year, and that by avoiding those companies you can avoid what people often call value traps um things like that wait for the wait for the trend to be established a little bit more before buying in. That can

be a nice addition to just about any strategy. We're speaking with Patrick O'Shaughnessy, author of Millennial Money, describing the checklist that young investors should use in order to put together their own active portfolios if they already have a passive portfolio and want to take it to the next level.

So let's let's go overall five of these shareholder yields greater than five, return on invested capital greater than operating cash, greater than earnings, enterprise value to cash flow as less than ten x um, and then six month momentum in the top three quarters. This is really a version of the great Warren Buffett quote, which is I'd rather buy a wonderful business at a fair price than a fair

business at a wonderful price. This isn't rocket science. These are common known, common sense investing principles just put into a rigorous model, and they work very well together. You're buying shareholder friendly companies, high quality earnings, very attractive prices in this case, and the market isn't selling them off, you know, in droves over the in the recent past. So let me push back a little bit of this.

So this sounds a little complicated, although you're saying, if if I subscribe to a AII, I could have most of this automated. What does this generate? What sort of output? How often do I have to change this? Is? This is not exactly a set and forget portfolio. How much work is involved in managing this? It is not set and forget And that's why really I highlight that it's for that second level investor that wants to do a

little more. You can still manage it with as little as one to two times per year touching the portfolio. So it's not going to require that you trade all that often. In fact, every stock you bi should be held for at least a year for tax purposes. So it's a slow moving strategy. If you want to just rebalance every December thirty one, you could do that quite effectively, and it wouldn't require all that much work, maybe half an hour at the computer with your with your brokerage

account open. So what do you get for all this work? What's the net long term returns of this sort of portfolio? So the returns have been outstanding in the past, and of course you know you can never expect the past to repeat itself exactly. But this sort of concentrated portfolio I recommend about twenty five stocks or so by these different measures, UM has yielded honestly crazy results. It's it's performed by about n outperformed the market by about nine

percent on an annualized basis over the last fifty years. Now, of course that doesn't include trading frictions or or taxes or anything like that, so you need to reduce that number in your mind. But this combination has been powerful. Now buffets out performed by significantly more than that on an on an annualized basis. But that that that number is a pretty good starting point a year for fifty years.

That's compounded obviously in an O eight oh nine. A portfolio like this is does this get shell act as bad as the market or are you buying cheap and it doesn't fall as much? It's it gets shell act. It's a long only portfolio. It's a stock portfolio, so you can expect it to be more volatile. It's not some magic bullet. It will have long it can have a five year period when it's underperforming the market. The

key is really sticking with it. Of course, we've had a pretty remarkable fifty year periods in US actually markets, and yeah, it's been it's been a great sample in which to test a strategy like this. Um So, my goal is not to anchor people on which is a tremendous return, but rather to show them that it's possible, through a rules based strategy to outperform a market based on some you know, well proven principles. And the advantage about performing isn't just a couple of percent a year.

It's it's talking about youth. We're talking about millennials who have a multi decade UH time horizon. How does that compound over thirty or forty If you get ten percent or nine percent, just out performing by three or four percent, what does that do for you over thirty years. I mean, if you're investing, let's say you're maxing out your four O one K or putting some similar amount dollars a year, which is hard, very hard for for many young people.

Let's say you're putting five thousand dollars a year away that the difference in two or even two or three percent out performance can literally mean millions of dollars by the time you're sixty five or seventy years years down the road, forty years down the road, because it's peanuts in any given year two or three percent, but that compounds, like the rice doubling on the chessboard that you mentioned earlier, to significant sums and big gaps over the term. So

it's it can be very renumerative. We've been speaking with Patrick O'Shaughnessy, author of Millennial Money and principle at O'Shaughnessy Asset Management. If you want to hear more of this conversation, be sure and check out our podcast extras there at Bloomberg dot com and at Apple iTunes. My regular daily column is at Bloomberg View. You can follow me on Twitter at Ridholts or check out my blogged at Ridholts dot com. I'm Barry Ridholts. You're listening to Masters in

Business on Bloomberg Radio. All right, welcome back to the podcast. This is the fun part of our show where we let our hairs down and have a little bit of a drink and discuss things that we can't talk about on the radio. Um for those of you who are joining us for some strange reason. Halfway through the podcast, I'm Barry Riholts. My guest is Patrick O'Shaughnessy. A little background about how Patrick and I know each other. I actually know Pat's dad for I don't know. It's got

to be like ten years true story. I don't know if he ever told you this. Our old office, I want to say ten years ago was like Park and fifty was right diagonally across from the Walldorf and I'm in a Starbucks on Park, right near the old bear Sterns building. And it was right as he was extricating himself from bear Sterns a few years before the clap. So I want to say that's like oh five, oh six, it was seven when it was all said and done. Okay,

it was the machinations had begun. So it was it was literally about nine or ten years ago, and we're saying, I'm having coffee with a friends and he's at the

next table having coffee. At that time, we had both been doing Bloomberg's c NBC, Fox whatever and had seen each other around and we just kind of looked at each other and he goes, you're and I go, you're And so we just started schmoozing, and we were very sympatical about a lot of things UM, evidence based, rule driven investing, looking at data, looking and so we just struck up a conversation and started emailing and stayed in touch over the years, and I've had him speak at

our conference. We've we actually have some UM money with with your dad, and so when you've came along and he introduced us, it was kind of interesting, was like, well, what's this young turk gonna do. This young punk having to follow a dad who wrote one of the most seminal books on quantitative investing. And I gotta tell you, you did a really nice job first book. This is

really you know, I have a blur full disclosure. I have a blurb on the book and I say, if someone gave me this book when I was in my twenties, I'd be a billionaire today. Yeah, maybe a little bit of hyperbole. Maybe not. Um, someone that starts very young might have might have those lucky results. But yeah, it's it's been. It's been a great relationship. And I'd say the other thing that we really share. What I've enjoyed about your writing is the psychology aspect of it of markets.

I think think that really at its base, that's what this is all about, is figuring out what incentivizes people, what motivates people, and in many cases, trying to do the opposite and do that consistently. So you know, it's funny because I began my career on Wall Street as a trader. I didn't go to business school and went to law school. Love law school, hated being a lawyer, and when the opportunity came in the early nineties to

jump into finance, I jumped at it. And the training essentially consisted of being shoved in the deep end of pool and being yelled yelled at all, right, swim and either you learned to swim or you drowned. It was that sort of training process. But I had a different background like you. Um, I had a philosophy background, but I also had a lot of math and science, and so I was always looking at wealth. Here's the hypothesis,

let's either validated or disprove it. And all the stuff you hear on trading desks, most of it is just nonsensical myths that don't end up to close scrutiny. Why is this stock going up more buyers and sellers? That's sort of nonsense, and you talk about a number of these, but that's what led me down that path of Uh, the explanations I'm being told make no sense whatsoever. There's got to be a better reason why humans behave this way. Yeah.

I think really the only persistent advantage in markets is understanding investor of psychology, because that's not going to change. That's kind of the one factor that just doesn't change through time. We always react the same way to similar stimuli, and if you understand that, you can do really well.

You can build a successful strategy. And so I think the background in psychology, like when we're interviewing people, my I always sit up a little taller when someone's got an interesting background like that, because it brings a unique perspective to markets that's evergreen, that will always work. UM. So I'm fascinated by the you know, million studies that show just how terrible we are, how we're just finding fake patterns all over the place all the time and

chasing them around. Um. You know, we're concer instantly foolish with our money. And the good news is that for some active investors that creates persistent opportunities to exploit UM. And you know, that's why, that's why we had that model based approach, because we can hope to consistently exploit

you know, behavioral misspricings. It's fascinating it It's almost gotten to the point where behavioral finance and and behavioral economics has become too accepted because when I first started exploring this, I want to say, twenty years ago, there wasn't a lot of writings that were out there. Dick Faler had a couple of books, Um, Thomas Gilgovich up in Cornell. You know, it was before the commons of the world and the Shillers of the world had won their nobels.

So early on you had a hunt for information that explains why people were irrational. And the funny part about that is the fundamental premise of economic I am loath to use the word science, is that humans are rational if it maximizing economic actors when they're not not even close. Right. And you mentioned Kenneman who who wrote my favorite, probably my favorite psychology book, Thinking Fast and Slow, which isn't just about investing, but it's a great investing book without

really meaning to be. He has a term called cognitive mirages, which means even though you might be aware of all these ways you're being irrational, that doesn't stop you from being irrational in the future. It's very, very hard to overcome our biological imperative. Anyone that thinks otherwise should try buying some value stocks because it's very hard to do so. So psychology is it's very hard to overcome. It's you know, if you understand that, you at least have a shot

of saying, hey, am I doing something wrong here? What what should I be doing? Instead of what I'm actually doing? Yeah? Sometimes, you know, I I often wonder if some sociopaths would be better investors in the average human. There's a studies that show that. Yeah. An awesome, awesome study called Lessons from the Brain Damaged Investor where a research or at Stanford by the name of but Shiv had two groups play a very similar the same investing game twenty rounds

single dollar bills. Every round was you can choose to invest your dollar, hand it over and I flip a coin that comes up heads, you get two dollars and fifty cents that comes up tails. I keep your dollar. The other option is you just hold on to your dollar and wait two fifty versus the Well, no, why wouldn't you give a dollar every round? Well, of course, right, so they explained to the participants, the math is basic. The expected value of each coin flip is a dollar

twenty five. You should play every single time. That would be the smartest strategy. So the two groups were these a normal group of everyday people and the second group who all had brain damage to a very specific part of their brain, the limbic system that controls emotions, specifically fear um, and so these people couldn't feel fear like the average person could. So they had them played this game and they tabulated the results, and here's what they found.

The brain damaged players played of the time. They weren't perfect, they didn't do the pent which would be the best strategy, but they played of the time. The normal brain patients only played fifty seven percent of the time, and the reason for that was just one thing after a loss, meaning after they invested their dollar, they lost the coin flip and lost their dollar the next round, which wasn't shouldn't be it's a coin flip, it's not influenced by

the previous round. They only played of the time. So after a loss again we talked about it on the earlier part of the show. After a loss is when we get extra sensitive, which is which is exactly backwards, right, classic risk aversion is that you feel losses twice as much as you feel the benefit of a game. And this is this is a this is a in you know, a study example showing exactly that that when you take the emotional part of our brain out, we don't make

these same mistakes. And there's countless ow there's examples, but I love that one because it's it's amazing that we make such a clearly irrational decision. The researcher told him, that's in irrational, wrong decision and they still they still did it, so pretty amazing stuff. That's fascinating. We talked a little bit about automated investing, well front benement, lift off, personal capital. There's so many of them. Uh, there's still

a teeny tiny percentage. They get a lot of press, but there are tiny percentage of of the investable assets. Do you think this is gonna expand into something more significant? Is this a millennial sort of thing or is this the sort of situation that um, it's gonna be a little niche and it's not gonna go anywhere beyond that. UM, I think that it will probably consolidate there. As you mentioned, there's a lot of them out there, and they do

different things and they have different strengths and weaknesses. But I think the core idea here, which is make investing automatic and extremely easy, and use software to do all the things that we say we should do but then don't actually do. Manage our taxes, make regular investments, don't monkey with our portfolios. It just does it all for you for for fairly affordable fees. I think that concept is here to stay UM and and some of these

companies will be wildly successful and their software companies. Uh, they've got a course strong financial people at the companies. But you know, I know Adam Nash, who's the CEO of Wealth One pretty well. I've I've spoken to him a number of times, and the guy is is a smart, shrewd software guy with a sort of finance as a secondary skill set. And it's They've built a pretty incredible product.

And I think that those sorts of automated solutions will stick around, and they will be very good for millennial investors because that solution is way better than you know, calling your broker looking for a tip um like you know, say my dad's generation did more commonly, That's just not a great way to invest. This is smarter and I think it will last makes a lot of sense. Let's

talk a little bit about bubbles and global investing. We hinted and alluded to the Japanese situation, but it seems that bubbles are a function of our post War War two era. We've had We've had the nifty fifty in the late sixties that ended a twenty year run from forty six to sixty six. We've had the dot com bubbles. We've obviously seen problems in Europe we've We've seen the Japanese bubble in eighty nine, then the housing boom and bust in the US. Is this just the nature of

capital markets? They go through these sorts of periods. It is, And again I think it's rooted in psychology. You've got these melt ups towards the end of these major bubbles, you know, the famous ones like the Tulips, the Dutch Tulips mania and south Sea crisis, etcetera. It happens over and over again, and the charts all look the same, right, and you can take away the stories and you've got

all identical charts. Japan is probably my favorite. I was a big Michael Crichton fan growing up, and he wrote a book about the Japanese corporate takeover of America, which, in hindsight sounds so silly Sun. What was the Land of the Rising Sun or something something like that, and Rising Sun maybe just maybe just that shorter title. And so when I dug into the history of the Japanese market, I was just fascinated. What was going on just blew

me away. In the whole markets trading at ninety times earnings, there were certain industries trading at two hundred and fifty times earnings. I love using the example that if you apply that multiple to you know, an enterprising youngster in your life who makes who has lemonade stand and makes fifty dollars a day every year, Well, by that math, that that little lemonade stand would be worth about six million dollars with a similar valuation. And so there was

just crazy stuff going on. Uh, and everyone was terrified that in America that the Japanese were going to take over. They bought Rockefeller Center, they were taking all the crown jewels of America back to Japan. And and and there was even one potentially apocryphal story of them overpaying by two hundred million for a big landmark. It might have been the Exxon Building or something like that, just to set

the record for the highest price paid. That's a good use of shareholds of money, is to say we set the record. We we overpaid the most for a building. Yeah, I think. I think the bottom line is that bubbles happened. Um, they happen in large part because of human psychology, which won't change. And then in the future, when something feels really enticing and you want to be a part of it, like you know you might have, or in real estate or whatever. The more recent examples are just stay out

of it. Yeah, you might miss out on some great short term gains, but we know how bubbles end. They all burst, So just ignore your emotions as much as you can. You know, when we started seeing chatter of China taking over the world, I'm old enough to recall the Japanese taking over the world, and like, geez, this sounds awfully familiar. That Chinese have been around for five thousand years there, they've perennially been a threat. Why would we think that this time they're gonna be any more

successful than they've previously been. It just felt so similar to the sort of oh, the Japanese were taking over. It really felt the same. My favorite history book Market history books a book called Devil Take the Hindmost, which chronicles kind of all these ones that we've mentioned. There's a great chapter on Japan. It goes through tool Mania,

tons of other examples. But it is amazing that it's just the same pattern over and over again, never learning from history, uh, always making the same mistakes as those before us, because we can't help ourselves. Well, some people can, and some people can but to be honest, the vast majority of people, when when the animal spirits are running, they're they're joining the herd. It's it's the example I

love to give and in a presentation is now. I don't know if you in your youth this was on television, but when I was a kid, Sunday Night's Channel seven, Mutual of Omaha's Wild Kingdom, I mean, that's today it's the Discovery Channel and Animal Planet. But back in the days of broadcast TV, when Marconi had just recently invented radio, that's all we had. Animal Planet didn't exist. Mutual of Omaha's Wild Kingdom was the closest thing, and every show

began the same way. It's a vast sea of of meat on the hoof over the Savannah's million you'd see these and they zoom in from the aerial shot and you'd go from the earth black with will to best I mean just and you'd eventually get to our heard of a small herd of a few thousand whatever it

was Zebras gazelles. So usually the gazelle and invariably one gazelle wanders off from the herd, and then they show you the picture of the lions and the tall grass, and who gets eaten but the gazelle that's not part of the herd. And I think that is the evolutionary basis for why there is safety in numbers, why there is comfort in doing what everybody else does, even when we know it's not right for us. There's good reason we're programming the way we are because it's it's we

survived right. And the unfortunate thing is that culture and cultural constructs like markets just evolve a lot faster than our biology. So we can't evolve to keep up um with the evolution in culture, and that puts us out a disadvantage. And so that my my suggestion is if you just remove yourself from the equation, all of those problems will go away. If you don't, you're gonna spot fake patterns, you're gonna see things that aren't really there,

and you're going to create all sorts of problems. So just get out of just get out of the way and remove yourself from the equation. You talk about the difference between human software and human hardware, and you alluded it to that, and that this last statement, the repeat

the quote that you actually had in the book about that. Yeah. So, so my point was that human hardware, our biology and all the reactions that we have because of our biology, evolves a lot slower than our software, which is our culture. Things like markets are are the best examples economies, things like that. Um you might have heard of the term meme, the cultural units of cultural evolution that can just move a lot faster because it doesn't require you wait from

generation to generation to make incremental changes. The problem is they're at an imbalance today. We're not designed to survive and thrive in our current environment. We're designed to We're kind of stuck in the Stone Age, if you will. We're optimized for that environment in most ways, and we did really well. Obviously you can see the result to that.

We just haven't changed much, even though the world has changed a great deal, and now often it does us a disservice because we make all these crazy, irrational decisions. You mentioned a book Devil Takes the Hindmost. The book I'm reading right now is called Last ape Standing, and it's about the evolutionary process. At one point in time.

Over the past let's call it four million years, there have been approximately at least that we have a fossil record of sixteen various species of humans, and why did we as a group of humans survive when others didn't make it? And had to do with our adaptability and our big brains and and our ability to walk up right, and a lot of other factors that are great for surviving in an ever changing world that requires adaptation on the fly, The ability to work with tools, the ability

to adapt to changing conditions. All those things are great. All those survival traits are great, but they have nothing to do with making you know, intelligent capital allocation decisions in a system like the capital markets and the big I think the biggest of those tendencies is this loss of version that we've we've referred to a few times

that were twice as sensitive to losses. If you think about the kinds of errors that we could make ten thousand years ago, Let's say we were walking we saw, you know, a russell at a russell in the grass or something. One type of error is we could get alarmed and and and overly defensive and it could turn out to be nothing. Call that a little insurance policy that you take heed you didn't need to, but you did. Anyway. The second mistake you can make is that you say, oh,

it's nothing and it's alliance. Right, And guess which one of those two people survived. Well, it's not who survived. It's of those two people, only one of them are passing their jeans along the risk aversion. Hey, they managed to be around long enough fifteen or twenty years back then to to actually have progeny. The people who ignored it, who didn't have that risk aversion, they were lunch, Yeah, and it makes perfect sense, and it just doesn't work,

and Mark it's and that's too bad. But if we know about it, at least we can adjust to it. So I would be remiss if I did not address something that you spend a long time talking about in the book, which is inflation and the erosion of purchasing power. We didn't get to it on the on the broadcast portion. Let's let's you had a quote that I really liked in the book. You know, when the Ford Model T first came out, it costs two hundred and sixty dollars

that today buys you a single tire. Yeah, a nice tire, but a single tire. And and that just shows the power over time. It's sort of like death by a thousand cuts. In any given year, Inflation is is hardly ever massive, other than say the nineties seventies when it got to double digits. But even if inflation is two percent per year or three percent per year, it's sort of a hidden tax acting on you behind the scenes that you never really realize until you look back over

a lifetime. We mentioned I'm twenty nine years old. Since I was born, the purchasing power of the dollar back then has about been cut in half. So inflation has slowly eroded the value of a dollar just in my

shorter lifetime, I will continue to do so. So the key is to position yourself in assets that do well on top of inflation, inflation plus inflation plus and And the problem is that all of the assets, especially for millennials, that we think of as the safest, that will take cash as bonds, sure T builds, whatever, whatever you want to look at, are in fact the most dangerous over the long term because inflation kills their return. So cash, let's take T bills net negative real return. Let's take

T bills for example. Once you get to ten twenty thirty year holding periods, and you look back over the last hundred years or so. About of those twenty or thirty year holding periods, cash actually has a negative real return, meaning after you take inflation out of the equation, you lose purchasing power, and that's what people think of as

the safe asset. There was occasions when over those long term periods, long term bonds again some make people think of as safe on a real basis loss more than forty per cent over a thirty year period, and that's crazy, that is not that is not a safe place for your money because inflation was slowly working against it. Meanwhile, stocks, even after inflation, have never even had in the US

a twenty year period of negative real return. So even if you had invested on the eve of the crash in ninety nine and then done nothing and came back twenty years later, you still would have eked out a positive six percent return. It's not a great return, but it's positive, and the same cannot be The same cannot be said of cash and bonds over the longer term.

So inflation is key to pay attention to, and we're talking about the pernicious compounding effects of even something as low as two percent over the course of thirty or forty years. You know, we as kids, we used to make fun of my father and our parents, who always used to give us the story. Listen, when I was your age, for a nickel, we could go to the movies for a quarter, we could go to the beach. We could get two hot dogs, fries, a soda and still have money left over for a matten ae. And

today all that stuff is fill in the blank. And the joke is, as you hit a certain age and you're not there yet, and I'm just about there yet, you could look back twenty thirty years and say, I remember when you know movies were a dollar fifteen bucks from a movie. That's crazy, it's it's but this is really a pernicious drag on returns that are not achieving any sort of nominal I'm sorry, any sort of real return. Yeah. Most of the time you hear the stock marketing long

term returns ten percent, Well not really. Once you take inflation out of there, it's more like six and a half or seven percent, And that's a huge difference over the term. And and same thing with with cash or you hear maybe three percent, well not when inflation is four percent per year. For thirty years. Um, so it's it's behind the scenes, it's hidden, but you need to pay attention to how how does the fact that we're living in a deflationary era impact that? Or is this

merely a temporary phenomena. Um. I am certainly no expert on on, you know, the drivers of inflation, and a little suspect that that anyone is. I don't know that anyone has a complete picture of what drives inflation over the longer term. I do know that once once we've left the gold standards and has been kind of moved to a global fiat money system, inflation has been the norm over longer periods of time because there's no real control. And I'm not an advocate of a gold standard or

anything like that. Well, it made sense at one time. I can't imagine anyone really believing it makes sense to anyone without large gold holdings believing that going back to the gold standard makes any sense today. Right, But I think there's some compelling evidence that explosion in the supply of money can can lead to inflation over time. And I don't think we're going back to a gold standard. I don't think we should. But but with a fiat money system I think comes long term real inflation that

will will be important for millennials. It's something that you have to recognize his reality, even two percent as a drag and have to plan around. And that means having a substantial slug of your investment portfolio in a equities and be global equities that meet the characteristics that that you described earlier. And that's doubly true for young people who have a long time ahead of them. They don't

need this money anytime soon. That should be the goal as they're setting it aside and forgetting about it um and so that's doubly true for young people. Anything else you want to touch on that we haven't gotten to before I released you out into the Wild? This has been really great. I appreciate I appreciate the opportunity to come on the show. I love the show. I think we've covered good ground. I'm glad we had a the

opportunity to talk about things that apply to millennials. You know, a lot of what we do on this show seems to be geared to people who are either professionals or have been investing for a while, or fifty something or sixty something year old and you know that blurb was was heartfelt. It's the sort of thing that I wish I knew about in my twenties. My four oh one K would be substantially large, or my investment portfolio would be substantially larger had I started even ten years earlier.

This is the major bummer about investing is that everyone that's interested in it has squandered the advantage of youth typically, and that young people just aren't worried about it. They're not thinking about it. It's not in their minds. It's not a pressing concern. It's very hard to think a year ahead, let alone forty years ahead. Uh. The sad paradox is that the most potent time to start is when you're young. That's the time when people tend to

care the least. What one last psychological study which is really fascinating, So people have a real hard time understanding time understanding their own mortality, understanding you have a finite window.

They did a study I'm trying to remember the economists, last psychologist who did the study where they explained essential, here's what it's gonna cost to live, and here's your income, and they explained all these things logically and try to get people to say, hey, I'm willing to put this much money away every um month, and they ended up

getting a relatively small amount. Then they use the software where they took a picture of their face and digitally aged it to show here, by the way, here's what you're gonna look like when you're seventy to eighty years old. The photo vastly more effective than logically explaining, and they would get people to commit far more monthly savings because suddenly it becomes real, Oh, I'm gonna be old one day in that working and I need to have some income to live on and not rely on Social Security.

And it just goes to show you how easy we are to be fooled, manipulated, or nudged into doing the right thing. That was amazing. I had not encountered that study, and it's always fun to hear about a new one, and I think again highlights what we've been saying, which is appealed to emotion more than anything that you can get people to act. You know, show them a bunch

of abstractions and numbers and software. It's not all that compelling, but say hey, here's what you're gonna have to gonna look like this is what you're really going to be dealing with, and all of a sudden they act that's an amazing study. Well, Patrick, thank you so much for coming by. It's been a pleasure having you. UM. We'll

get this edited together and out on the weekend. For those of you, UM who want to check out the rest of the series, you can go to Apple iTunes all O. All previous Masters in Business are posted there. We have a great line up coming up with the rest of the year. I'm really excited about some of the names that that you'll see. Uh. In fact, coming up next week we have our interview with Bill Gross UH that will be posted in one or two parts starting I want to say January. UM. Check out my

daily column on Bloomberg View. The blog is at Ridholtz dot com. Follow me on Twitter at rid Halts. I'm Barry Ridhults. You've been listening to Masters in Business on Bloomberg Radio.