574. Why Size Matters w/ Victor Haghani
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This is Victor hagi, and i'm on the vern and invest podcast.

I love math. I always have IT was one of the things I inherit from my mother and even her father, and math served me throughout my academic career. In fact, I was instrumental in the training of practice of becoming a physician.

Math IT can be argued, is central to almost everything. Yet when IT comes to investing, most of my decisions have been based on exact opposite. My god, how many months of an emergency fund should I have? Six months? Sounds good.

One percent of my portfolio should be banned. About ten percent, one percent of my acid allocation should be international. I like thirty. I got so caught up. And what I was investing in that I spent little time delving into the math of what my guess today might say is even more important. How much.

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Vict gandhi spent four decades actively involved markets in financial innovation. He started his career one thousand nine hundred eighty four at salmon brothers in bond research in nineteen ninety three, Victor's cofounded partner of long term capital management, his participation, the failure of L T C M, was a life changing experience that let him to question and revise much of the way he thought about the economy, markets and investing.

He founded on wealth in two thousand and eleven to help investors manage their savings in a disciplined, research based, cost effective manner and to capture the long term returns they ought to earn. His recent book is titled the missing billionaires, a guide to Better financial decisions vitor haghars. I welcomes to earn an investment to read you a quote here from your amazon page ads of twenty twenty two. Forbes estimated there were just over seven hundred billion aires in the united states, and you'll struggle to find a single one who traces his or her wealth back to a millionaire ancestor from one hundred. This begs the question, what's more difficult making billions or holding onto them?

My dad used to say to me that it's harder to hold on to money than to make IT. And somehow I just never thought that. But, you know, just seemed incredible and impossible that that was the case.

But I have to say with them, you know with a as I get older and i'm in my early sixties now, uh, I see that my dad and that a dog was is probably right IT is incredibly hard to hold on to uh wealth or to keep your wealth growing with cost of living is probably Better than you thinking about the nominal terms. And I think one of the really big chAllenges is that the decisions around wealth happen over decades, years and years and decades. And it's so hard to do anything consistently over that long time. Like time really poses big chAllenges on our discipline.

I wanna talk about you and how you ended up getting into the financial world. But before I do, you know, I can help you thinking about that quote and thinking about asem tric risk IT seems to me what allows you to become a billionaire.

Is that actually being really good at assets? Tric risk? Where's what helps you keep the billions, especially when we're talking about and after generation is the exact opposite, is baLanced risk of risk mitigation. There are kind of different skill sets are .

not they they, they really are. And uh, you know that that, uh, to become super wealthy, uh, you're gonna running at some long belong people time where you're taking what most people would view as excessive risk A A huge amount of risk, and then IT pays off. And and and and to maintain your wealth, we really have to take the right amount of risk.

And you know and that we need to understand that risk eats return. Risk eats compound return. More specifically, you know, the higher the risk that you are taking, the more is eating into your compound return.

Now of course, at the same time, the more risk you take, the more you are expected return is but your compound return eventually starts going down, the more risk you take. Um and you're you're right. I think those are two different skill sets.

I remember meeting a very wealthy uh french uh uh industrial alist back in the early nineties. And uh h we we were talking to him about investing with us to L T C M. And we are having this great conversation. But um in the room was a man who just SAT there I kind of scale at us but didn't didn't say anything. He didn't ask any questions, didn't say anything and later we learned that um that the the industrial alist had hired this man to be there and to keep telling him know and to keep and to like keep him and check because this billionaire french industrial is just IT was had just had a pretty low risk tolerance when left to his own devices or well, I I should say I think that took more risk and was even consistent with what his own stated preferences on risk would be. But but just had a tough time are saying no to things that sounds of good.

I like this concept that risk eats in the compound returns. You experience this. You experience this in a very real way. I was about long term capital and what happened with IT because I feel like for you, that was really a turning point in how you looked your investment strategy.

yes. Well, that was the beginning. I was I was really a beginning of a process. You know, I took me a long time between one thousand ninety eight, and you probably wasn't until you two thousand and five that some of those lessons really started to become cleared to me. And and i've been thinking about IT and learning ever since.

So even this year, I think that I would say different things, that I would have said five years ago about the whole experience in what I learned. But for your listeners, you know, maybe some of them are Young and and and don't remember these events. But L T C M was a uh, a pretty successful hedged fund, started in one thousand nine hundred and ninety three.

Uh the main players and IT were uh senior trader is that it'd been trading at Solomon brothers with Solomon n brothers own a uh capital quit successfully over a period time and then we wound up spinning out into a standalone vehicle called C M. Long term capital management and and we had a we had spectacular returns for four, five years. No averaging like forty percent a year.

And then in uh uh by october of one thousand ninety eight, we lost ninety two percent of of of our capital in one thousand nine hundred ninety eight uh through losses in our leverage positions and eventually fourteen banks bought our whole bought the whole portfolio from all of our existing investors, put in additional four billion of capital and then uh and then had us liquidate that over the course of about a year uh or so, just liquidate the positions to kind of move on and return their capital. And they made uh, a low double digit return over that year of one thousand eight ninety nine. So yeah, it's interesting.

I like if you think about uh, if you take each years return of uh of long term capital, right and you say, okay, i'm going to take the return of year one, the return year to the return of year three, four, five and you average them all together, right? The average annual return of uh long term capital was like twenty percent or something, even with the mind as ninety two percent. But uh, but you can see that if you put a dollar in at the beginning and you didn't take any money out, this average return is kind of irrelevant to you.

I mean, let's say that instead of losing sixty two percent, we lost one hundred percent at the end. Well, if we lost one hundred percent at the end, the annual average return would have been like a twenty percent, right? But the compound return was what I was, mine as one hundred percent, because all that matter as you lost all your money in one of those years. And so it's it's a great example of this difference between average annual returns and compound returns and how and how risk uh know how how risk just really eats into these compound returns.

We could see IT in a in a simple or example of just somebody who says, well, I made fifty percent and the next year I lost fifty percent is like, okay, well, your average annual return was zero in that case uh or you know maybe we should take an example as a positive return, but we can just take that one but your compound return is minus, uh uh well minus twenty five percent over the two years, you know because he went up to one fifty and then down to seventy five. So that's like, you know it's it's a little bit more subtle than that when the risk is lower as we get with investing in the stock market. But that's what that work in terms of a how risk is eating compound return.

And you took quite a sizeable personal hit, right? You are heavily investing in L, T, C, M.

solo. Yeah, yeah. No, I was. Um I mean, obviously um you know any investment would have been too much given how things turned out but a you know in our book we talk about like what what could I reasonably have a thought about at the time you not knowing that we were going to lose ninety two percent in one hundred ninety eight and and I think that the way that I think about the world uh today um and what i've learned, let me back to.

To have come to a logical conclusion, to have had uh, quite a bit less invested in my business. You know I mean this this general idea, don't invest in your own business and you know too much or more than you need to is a pretty good lesson, right? I mean, the people at iron, for instance, you are always know, we always bring up these these poor people at and on that we're working there and they had their their pension and four one k all invested in iron stock or the same at lemon or many other places.

And IT just is like, your career is there, your work is there. Why would you want to also have most of your wealth in the company stock? There's a huge cost to that.

And I think that you more and more people are realizing that the know doesn't know it's not it's not the right to do in in general. You I mean, sometimes a founder or sometimes there is no choice and sometimes you have to show people that you believe in what you're doing and that you eat your own cooking. But there you know there's limits to that. You I think that you know IT shows prudence if you see an investment manager and he has or SHE has fifty percent of her wealth and her fund a rather than one hundred percent you know to me that shows print IT doesn't show a lack of conviction.

So what we're talking about here resizing, right? And so we know that there's an investment in front of us, and you could have looked at this investment, want to fight the risk of this investment, and then you use that information to help you decide how to size your bet.

In other words, how much of my personal wealth should I put into this business and how much should I withhold? And i'm going to make up some numbers here because I don't know the exact numbers in your book, but let's say you are eighty hundred and ninety percent invested in this company that eventually went to almost zero, went down ninety two percent. Now using a framework you've developed with expected utility, which will talk about a lot more later, you might be able to look back and say, you know what? I should have been fifty percent invested of my personal wealth into this.

I should have sized this bet much smaller based on what I knew of the risk. Let's compare that, what I was talking about in my intro, the gut factor, right? So I could look at you and say, okay, there's some complex math here and there's some equations and you've gone back and you've looked at the mathematics behind these things and you say, uh, I can set up a formula to help me make decisions on sizing how much of my own personal wealth I should have put in to L, T, C.

M. But then I would shoot back, that your gut should have told you that maybe eighty or ninety percent wasn't appropriate, that fifty percent made more sense, maybe not as analytical and mathematical, but still true. Is there got such a bad thing? And if not, why looked towards these mathematical models that admittedly dly, but people don't necessarily understand?

Well, I think that there's nothing Better than than having a model in your gun being a sensible framework. Uh, and then have that agree with your god. You know, once you've thought thought IT through is really useful, sometimes our gut can really go wrong though. And in financial decisions in general, very often our gut, uh, you know, I mean, think of our gut as being, you know, sort of a, you know our fast thinking. You in the conomo appropriate you know our god is our is is sort of our h our quick intuition about things.

Well, we have books and books and articles and articles that tell us you know that when IT comes to financial decisions were easily kind of food uh or let the strain by our gut um now you know I think that when you're using a model to think about things you know you want at the end of IT to be able to make a total sense of what it's saying, what is suggesting and then that should feel good to you intuitively and good to your god. You know, once you've reflected on that. But you know but I think that is really helpful to have some kind of framework.

And you know sometimes people can get to the wrong framework, right? So like let's say that you're framework, you know your Young, whatever you're like. Well, i'm going to make all of my financial decisions to uh to try to maximize my expected wealth, you know, the expected amount of money that I have.

And then they started thinking about the stock market and they are like, you know, gosh, the stock market tends tends to go up over time. So IT has a positive expected return relative to say, facets. So actually, you know, the more I invest in the stock market, the higher the expected return is of my portfolio right of stock market, uh, has a five percent excess return over, uh, margin interest rates.

Then it's like, well, you know, every time I leverage get up on getting an extra five percent expected turn and you might say, well, I should just try to do as much of that as I can do. Well, you know, in that case, you sort of really got and then it's like, well, okay, that kind of make sense, i'm trying know, but you have the wrong framework and that's not as we talk about in the book, that's a bad framework. You know you want this framework where you're maximizing your risk, adjust as well through your expected utility.

And so yeah, I think I think the model you know having a model and thinking is through is really, really valuable. And you it's like once you have the insights from that, you know know once you have this basic inside trying to maximize, you are risk adJusting well for your risk adJusting return. You know, then you don't even need the model anymore, you know then you can really start to make you you can see the right answer to things, uh, you know just more clearly by having that simple framework.

And um yeah we have a few equations and in the book and so on. But but really you finance and investing is is is really pretty simple. It's not rockets science.

And you know that that you know we had to throw a few greek symbols into the into the book just to make IT clear for some readers. But uh, yeah, it's, you know, hopefully all of the concept is super simple in there. Uh, no. Once once they are given some consideration.

if we posit this idea that expected return can be calculated on a various asset types, do we spend too much time worrying about what the assets are versus the size of the bets were making? In other words, I feel like for a big part of the book, not all, but for the big part, the book, you really separate investments into two major asset types, right? There's a safe outset and a high risk asset, right? So so we're not getting into the you know and I A stock picker in my an index person and my ecru pto person and my alternative investments.

We're not talking about all those, although you do go into that a different parts of the book. But for a lot of the modeling, you're really talking about two different asset types, a safe one and a high risk one. Do we spend too much time worrying about what we're investing in and not enough time thinking about the size of each of those investments?

It's hard to know at every how much time everybody is is spending on on you know, different things. But just by judging from what is published, you know, just judging from what the financial press throws at us, the newspapers, the wall street journal, financial times and said, you know what we see when we turn on the T V. To any of the business channels to bloomberg or C N D, C N D C?

You know it's it's ninety nine percent, ninety nine percent. Is this, uh, what to invest in? What's hot? What's not? What should we do? Should be cypher, should be this, should be that that's a bad idea. Should be index funds. And and and almost no a discussion happens on, uh, asset allocation over time.

And h so yeah, I do think that uh, if that's a signal of what as individuals are thinking about because it's what we're seeing in reading and then for sure, we're spending way too much time on on that. Um and uh, you know not for everybody though. I mean, you know there's I think there are just you know, we were both the h bog had bog head conferences recently.

And you know I thought that you like had this feeling that people are trying to achieve financial freedom by finding away where they don't need to spend that much time on either of the decisions they sort to make their decisions. Like i'm going to invest in index funds for the bogle heads, right? They're like one decision is, uh, i'm going to do IT myself.

I'm going to be a DIY investor. I'm going to invest in low cost index funds, mostly from vann garden ets. And then i'm going to think about asset allocation and i'm going make my decision. And once I do all of that, i'm going to put all my focus onto um you know these other things that i'm going to refresh myself and keep myself up today by coming to conference and you being part of this community. But i'm you know but i'm gonna have my financial freedom by not having to think about and manage and monitor what i'm invested in all that over time.

IT does still hit me that these sizing decisions still even affect those of us D I wires who don't want to spend as much time doing IT. And I mentioned to feel those in the introduction, right, like how much to my emergency fund d versus how much is. So that's right.

That's that's low risk versus high risk, which how much going to put in equity? What's my safe withdraw IT? How much is going to be allocated to bonds versus regular equities? Again, low risk versus high risk or safe versus high risk, these sizing decisions are very prevalent even if we're trying to know, use the kiss method right, keep its simple, stupid, right? These sizing decisions, they are boys there yeah they're .

really important and we have to think about them and have a framework and decide on them. But once you decided on them, they write your sort of your um you know you're in good shape, then you can keep thinking about them know you don't need to thinking about them.

You know it's not like reading the newspaper every day to see what the videos earnings were or you or what's happening in A I you know you're making these decisions you know commonly and the others think about these decisions is that these decisions are you know what I would call a positive some decisions or their their decisions that you are not competing against anybody. To get right, you don't you need to just make these decisions for yourself. And there is nobody that you have to do IT Better than you just have to do.

You just have to do IT. If you're gna pick stocks, you have to beat somebody. You have to beat in a city deal or whatever you know, you have to beat.

You have to beat golden sex when you're picking stocks is zero sum. You're you're engaged in the most competitive zero summer activity out there when you're deciding on what to invest in if if you're going to try to be an active investor. But the sizing decisions are for you to make and you make them in you and they're not that difficult.

And then uh, and you're not competing against anybody, they're positive. Some you get IT right and that's good for you and that and that you're not a you don't need your good decision. Your good decision is not relative to somebody else making a bad decision. We can all make good decisions, uh, and we're all Better off.

You know I think I think about your bet with L T. C. M. And so I know for you that change the way you looked at some of these investing decisions. But I could also say that, you know, vict was a Young guy, and he was looking maybe to get to the a billion air class. And one of the quickest ways to get there is to take asem, tric risk, right, knowing that there's a big downside. And so I guess the question becomes what our goals, which brings us to a concept of expected utility, and you talk about this throughout the book, explain to us in simple terms what expected utility is and what what is the outcome that were hope, hoping to get from doing an expected utility analysis.

Well is means to an end. So wealth is there to, uh, so that we can spend IT on ourselves, so that we can spend IT on others and so we can give IT away. Those are the things that we can do with our wealth. You know that counting IT doesn't doesn't qualify as as uh as as a use.

Um no uh so what's our objective? Is our objective to have as much wealth as we can get? Or you know should our objective be to maximize this uh this happiness that we're getting from the spending of IT and the giving of IT away IT makes sense, I think you know, to be focused on the end.

The end is that the the happiness or welfare that we get from the use of our wealth, and that's what we want to be maximizing. Now what we think about maximizing that, what we have to realize is that the more that we spend on ourselves, the more in general that we give to others. You especially giving to other family members generationally, but even giving to charity, uh, there's a there's a decreasing uh marginal uh, benefit that we're getting as we do that, we can see that.

No, that you know in our book we talk about eating gummy bears. You know that the the first one is great. The second one is still, you know two is Better than than one and h but but to a lesser extent and eventually you're like, okay, i'll have another one but you know it's really not bringing me much, much joy me maybe the gum bears you know that when IT comes to eating things, you know eventually starts going your welfare starts going down when you've had too many.

But with wealth, the each extra dollar of wealth has a decreasing uh, impact on our happiness. IT made more wealth is Better than less wealth. No, I don't think that we ever get to a point where more wealth is worse than less wealth and know because we can always give IT away and get ourselves back if that we're the case.

But IT has this decreasing marginal uh, impact on our welfare and happiness. And so because this uh the because the relationship be between wealth and uh and happiness or utility is economists call IT is not linear but rather it's um it's it's that the slope of IT is decreasing over time, are over over higher wealth. We know when that makes us risk avers because now if somebody comes to us and as here, flip a coin and you could make more wealth or lose some wealth and is the same amount, you're like, well, I don't want to do that.

Why would I want to do that? Because the extra wealth is not as good as the pain from the wealth that I you. Yes, exactly.

So so that leads us to just be naturally risk covers. This is an idea that goes back, you know, hundreds of years not to do with behavioral economics. It's to do with rational economics. And and so you know that's why we want to be focused on maximizing our risk adjusted a wealth, our risk adjusted return in our in our financial decisions.

To put in another way, the goal is not to make as much wealth as possible, but to make enough wealth to get the best utility out of IT without taking as much risk.

Yeah, I think that's reasonable. Yeah yeah.

We are talking to Victor ha ghani. He has spent four decades actively involved in markets and financial innovation. He started clear in one hundred and eighty four, and now he found at alm wealth in two thousand eleven to help investors, managers, their savings in a discipline, research based, cost effective manner.

And we are discussing a framer to decide how best to invest, not just what to invest in, but also the sizing of those bets. We're discussing something called expected utility. We're onna. Take a short break. I'm dog.

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I hate most business podcasts. It's all blow, blow, blow. Tell me your background now. Nobody has time for that. I'm Jason fiver, editor and chief of entrepreneurs gazing and host of the podcast problem solves.

So I know you are busy running a business and you just need answers, and I find them want to increase trust as a leader. I talk to whole foods cofounder john maki. Want to manage your time Better.

I talk to google in house productivity expert, straight to the point, thirty minutes or less just searched for problem solves. We are back with vitor hagan's. His most recent book is titled the missing billionaires, a guide to Better financial decisions.

And we are talking about expected utility. This idea of how do we get the most joy, pleasure, happiness, the best use of our dollars, while still taking the least amount of risk people in my community, Victor, talk a lot about safety. Dw, right? There's a to talk about how much can I spend after I retire to get the most out of IT, to spend the most dollars and yet still be safe. Talk about how an expected utility framework could help you look at such things as a safe way.

So look in the late one hundred and sixty, a couple of M I T economists, uh paul, sam melson and a student Robert Martin tried to uh saw what economists called the lifetime consumption and portfolio choice problem and what and basically this is uh all tied up with how do we take our wealth, whether IT be our financial wealth or our human capital, that we're converting into financial wealth and ah how do we invest in and then how do we cumuli and spend IT and invested, you know, later in our lives and uh and so the framing of the problem, uh that they solved was basically saying, okay, what i'm interested in is maximizing the lifetime utility, which is the utility that I get, let's say, break IT down year by year, the utility I get each year in spending my money, right? So we have this this relationship between spending and how much utility i'm getting, how much happiness on getting from that spending.

And the more we spend, the more, uh, happiness we get, but at a decreasing rate. And so the problem was set up as I want to find my policy choices between spending, I A spending choice to make and in investing choice to make in my investing choice is how much to put into stocks and how much to have in safe assets. And I want to come up with a joint policy spending and investing that maximizes the some of my expected utility of spending over the rest of my life.

You know, you can also put in a request function at the end where you're getting utility from whatever you leave to future generations or to charity. And that's the problem they set up and they solved IT in a close form solution. No kind of based on some simple assumptions. They may they didn't build into an actual longevity or mortality tables. You know they kind of assume that you knew how long you are going to live, but you can stick in a mortality tables and still solve the problem in the same way.

Um you know I should say also there's a discounting factor that you might want to use in there in the sense that like maybe you know what we how how much we enjoy things in the future, uh, that we have a preference for enjoying things today verses enjoying them in the future kind of natural but you know doesn't change the problem too much by having a little bit of A A time preference discount rate in there. You know the basic thing that they found, I think that the most profound thing that they pointed out, which makes so much sense intuitively afterwards, is that your spending policy in your investment policy are connected to to each other in a way that you cannot break. They're incapably connected to do each other.

So you can't say i'm going to be seventy percent invested in equities, uh, thirty percent in in fixed income and then follow a spending policy of of just spending a fixed amount of your of money each year, maybe adjusted for inflation. You can't have a fixed spending policy in in money terms, but have this risky variable portfolio on the other side that I mean, you can do that. sure.

No, but but that is not uh that's not an optimal um sensible approach. And and and h you know so you can h think through whether IT is that uh, you are comfortable with your spending being somewhat variable if your portfolio is variable and and if not, then not like if you really just cannot uh see your spending varying at all from you know IT doesn't to be from year to year can be kind of on a rolling basis. But if you're not going to spend more money, if you have more wealth, uh, and if you're not going to cut back, you know, then why take any risk if you're not going to cut back on your spending?

If you lose money, then you know you might be headed to bankrupcy before you die. I mean, this is all under the assumption that you're not getting a lot of value from leaving money for others. You know once you have enough money where you're leaving IT for future generations or for charity, then your own spending just is becomes less relevant because it's the small part of your wealth.

Um so that kind of the major insight from their work, which makes a lot of sense to to us. So we talk about a lot in the book. Um you know the other thing is that um you really need to base the new artizan, so to speak, of your wealth on uh the risk adjust that after tax expected uh real return on your portfolio that was a mouthful.

But um you know you don't want to look gage to your portfolio and say, well, you know I think the expected return is eight percent and and then kind of use that in your spending decision, you need to adjust IT for risk. You need to adjust IT for uh, cost of living increase and you need to adjust that for taxes and and then that number that comes out at the end of all that risk, adjust that after tax cost of living adJusting. That's the number you want to kind of think about when you say I have this much wealth, I I want to make sure I can live to one hundred and spend a certain amount and your budgeting IT and that's the number that you want to think about you know for the um document lation of your wealth. So now you know I know that there's all this focus on the four percent rule, the three percent rule, the five percent rule. And you know, are they too simple?

Sic, I mean, what what you're saying really matches very well with what at some Christian bends over morning starts been talking about a lot about variable withdraw rates, about bucketing systems, about guard rail systems. Basically what I think she's saying in a less mathematical way is we need to adjust to what's happening while it's happening in order to create the most utility right to get the most spending at the safest way possible. Are are those kind of more simply list c rules like they quote and quote for percents for joy? Are they just too simple?

I but you think simple and their misleading because they're kind of letting you think that you look like um I can be seventy percent in equity, thirty percent and fixed didn't come and somehow um i'm going to be OK if I just keep spending fifty thousand dollars a year justice for inflation and and then you know people will say, well, of course, you know like after two or three years of your portfolios has gone down a lot, you know maybe you should start over again, you know apply four percent and now apply four percent to your diminished portfolio.

Well, okay, yeah I agree with that, you know but that that is you know you might as well have the right framework and rules in place to begin with. So um yes, I think that you know there um I think they kind of get people off a little bit on the wrong foot, you know with just the way that they're thinking about IT and you know having this this framework uh that we've been talking about this lifetime expected utility maximization framework really helps you with these other really complicated decisions like should I buy a fixed rate annuity? Well, it's really hard to think about that because you know if you're buying an annuity from an insurance company that the insurance company is building in a profit margin that the insurance company, Michael, bankrupt, you are scary, you know, but but hopefully, you feel that they're some kind of protection there.

But you're taking some of an you know it's it's Better to have the money yourself than to give IT to an insurance company as an annuity, right? But we need a way to analyze whether that annuity is Better than than a just managing our own longevity risk. And know as we've written about you know, we find that for people who uh are in good health uh and who don't have a big request desire, you know who are not really looking to leave a lot of money, are not getting a lot of satisfaction from the fact that they're going to leave money behind for others when they pass away.

That for those people, it's very often in the case that some annuity is just a straight and newdick a variable in newly, not a unity with whistle, ls and bell and all that stuff, but just a straight up a newly can be a really great solution for them. You know even though unfortunately ah you know new IT these these days don't come with inflation protection in the united states, other places they do um but even so, I think that inflation risk is tolerable up to uh a degree. You deferred annuity are pretty can be pretty attractive as listen, I just want to make sure that if I live past eighty, I want to be covered from eighty on out and your sixty.

Like you don't need to pay the insurance company to give you an annual I payment from age sixty to eighty. But from eighty on, you want to get those unity payments and you can there know and thereby you can spend a lot less money paying the insurance company for that deferred nudity. And you know strAngely enough, when we've looked at the unity, they seem you know like when IT just comes down to a straight you know cash flow annuity um that that does seem like h there's some reasonably, fairly pressed products out there um that we see and you know you can go to van guard and other places to get multiple quotes on just the strait straight opportunities. Know you just what you don't want to get anything.

you don't want any. Uh no yeah but but again, then you are also still stuck with the sizing issue. It's like, okay, annuity can help and can add to my life and much, but how much what this all leads me to his after reading your book, I definite got the idea so I can go to m wealth and hire vict horgan.

I and he can mathematically work out some of these difficult questions for me, right? He can help me decide what would really increase my lifetime expected utility, right? So not just the most money, but that I actually get the best use out of that money towards happiness are request or what I want, but not everyone's gonna to Victor horgan, ian and higher alm wealth.

Is this a framework individuals can use? So there are lots of DIY res out there who are listening to this, lots of people who like to keep IT as simple as possible but are realizing that maybe there are some more complicated factors that they haven't included. Is this something in individual and mother out on their own?

Well, the concepts don't necessarily require any math at all. And so yes, you know that that orient your decisions to uh um to risk adJusting everything, you know to make everything risk and to read to read and think about some of the different less applications in areas where you can apply this thinking. I think all of that is is is definitely accessible and valuable for uh for every D I Y investor out there of all shapes and forms and sizes.

You know sometimes you get into this, you I think that doesn't a nuwan make sense that should I be buying in annuity? You know you you've got a sort of have a spread sheet. You've got ta play around with the you know but um should I look at in the city and what's in the unity doing for me and and everything that I do uh that involves uncertainty.

I have to realize that that there is a value to reducing risk, reducing uncertainty in a cost to increasing IT. And we don't need to mathematically model that, right? So if you said so, here's so. Let me give you an example where I say we don't need to do any mathematical modeling of of of a basic core. So an investor, a DIY investor, has fought long and hard about how much they want have in stocks and how much they want to have in in treasuries.

And they've decided that for them, the optimal is at this at a moment in time, or whatever, that the optimal and seventy percent stocks, thirty percent bonds and this will ignore taxes and stuff for the moment. And uh they think that the stocks are gonna them, uh you know say an extra um six percent return above safe assets. So they have seventy five percent in stocks. They are going to get an extra percent. So they're like, okay, this is nice.

I'm going to know i'm going to my portfolio overall is going to give me four and a half percent above, say, fast because I have seventy five percent in the think of me the six percent and then we say, okay, can you calculate the risk, adjust the return of your portfolio and uh and and uh well, we could say, okay ah you know here's a little math formula ford is equal to 哒 哒哒 哒哒 and that gives you the answer but but I can ask the question in a way requires no math at all I say to you OK uh okay Jordan， you ve got this portfolio. It's got this four and a half percent excess expected return above safe assets um what if I told you you are not allowed um to own any equities at all? You have to have all your money in the safe asset, okay? And and you say, no, no, no, but but I want to own these equity, you know and I say, I know that I know you want to the act is not going to compensate you.

How much do I need to pay you as a as a fixed extra return each year to compensate you for not owning that portfolio? And you say, oh, I get IT well, i'm getting an extra four and a half percent return from owning equities but um but that's risky. Now vick is offering me a risk free alternative portfolio.

How much do I want from that? And you would say, well, listen, I, I, I definitely want more than zero, and I and all accept less than four and a half percent. And you might say, you know what?

Give me a, you know, give me two and a half percent, and i'll be just as happy as I was. Give me two and a half percent for sure, and i'll be just as happy as I was. Well, that two and a half percent is the risk adjusted return of your portfolio.

And you know bingo, you know we didn't need to bring in any of the math that's in the book. You know there's a formula which rockers say, but that there's your answer. You've answered the question without any, you know and and that kind of thinking about just trying to think about uh, in a world of no uncertainty, what do I what am I willing to accept?

What am I willing to pay for insurance and a um you know you can get you can get really far with a lot of the stuff um and and just you just need to know the places to try to ask these questions. You know like you're insuring your home, you should kind of think a little bit well, it's hard, unfortunately with insurance, it's a little bit hard to say how much insurance should I buy. We should be able to say that we should be able to say, I want to ensure my home, but you know, I just want to ensure eighty percent of IT.

I don't want to ensure the whole thing against fire. You know, i'm willing to lose the first hundred grand or whatever and get lower and save money on my insurance. With health insurance, we do get to choose effectively. We get to choose how much health insurance we buy by setting are deductable.

And should we be going for the lowest deductable possible, the highest deducted, you know, I think there's a lot of uh stuff out there that would suggested for many people, they should be going for the highest deductable possible. Um and that's an expected utility calculation. That's a risk.

That's a risk and return calculation. I'm going to save money. I'm going take there's a risk of losing money, but how much money I Williams to lose each year?

You know that's that's there. I mean, you know a lot more about that than I do. But these are the kinds of decisions you know we are expected, uh, utility, where risk adJusting things really can materially help people uh, to be financially independent.

Victory, I wanted to thank you for coming on the show today. When I think about what we talked about, I realized that two things come to mind. One is that often we can figure out what we think the a risk adjustment should be because we have an idea what an investment should return.

But ultimately, it's the sizing of that investment that really will affect our happiness with the outcome are expected utility. So that's the first point. This second point is, again, the goal is not necessarily to make the most money because as you are talking about, the more money you make, the less utility you get out of those last dollars. And so what we really want to do is figure out how to get the most utility out of each dollar at the least risk. And when I end this episode way and every episode by asking if people have you questions, I would want to know more about your framework or your practice, what is the easiest way for them to get .

touch with you but they can email me, uh A A Victor and al wealth stock com also they can go to our website and wealth that com and there's lots of places there to contact us and ask ask ask questions or more information uh, but I just feel free to email me is, uh is totally fine the .

book is titled the missing billionaire, a guide to Better financial decisions. Victor hag ani, thank you so much for coming on, earn and invest today.

Thanks so much. Jordan really enjoyed IT, and I was a pleasure.

That's a rap.

N an invest is now part of the air wave media podcast network. Visit airwave media. Dt, come to listening. Subscribe to this show as well. Other find by.

I first met Victor hagi at the bogo heads conference a few months ago, and I was taken by his presentation specifically because he talked about the sizing of our asset allocation and not just the assets themselves. So clearly, when we are talking about asset allocation, we went to hold a series of assets that are uncorrelated, right? This is the whole idea behind diversification.

We want assets that behave differently during different market environments. Therefore, when one goes up, we want the other to go down. And when one stays the same, we want one to go up.

And this idea, though less related, our assets are the safer IT, is for us because we are Better diversified and we are less likely to take a huge hit in our portfolio. But we spend a lot of time talking about what we invest in is that stocks is IT bonds, that alternatives is a gold or silver. And even when we're talking about just equities, is that an index fun? Is that separate stocks, which index fun is a small cap or large cap or make cap?

All of these things are important, especially towards diversification, but I never spent as much time thinking about sizing. So let me put in this way, you can make the worst to bet and invest in the worst asset. Let's talk crypto, because a lot of people are suspicious of crypto.

You can invest in crypto as long as you size IT appropriately. You can invest in all sorts of assets. And if you size them appropriately, the likelihood that you're gonna end up with true danger, having a portfolio that's a dangerous that's gonna leave you barren is very, very small. So we don't talk much about sizing of our asset allocation, but maybe we should I think we get confused because modern porfolio theory is always told us that we should shoot for something like us, sixty forty asset allocation, sixty percent equities, forty percent bonds.

Maybe nowadays that looks like seventy thirty, but it's interesting because if you start thinking about sizing and we look at equities is the high risk asset, right? We're not talking about specific stacks at the moment, but let's just say we're looking at the S M P five hundred index. That's the high risk asset.

Where is the low risk asset? Is our bonds right? The likelihood is that those are not going to have as much volatility. They are safer.

So why do we want to put sixty percent of our money in a high risk that and only forty percent in the lowest asset that would suggest that maybe we are having way too much volatility. We are putting ourselves at much higher risk. When you start thinking about sizing, you start looking at things very differently.

And you know, recently I was talking actually to Frank vcs, we're doing an episode that's coming out later about risk parity. But IT made me think even further about sizing when we're talking about having different asset classes like treasuries and equities and throwing things in like gold. The idea is you're trying to find a risk parity, but if you size the assets correctly, you can basically decrease your risk and yet not really change your returns that much.

So you're gonna moderate returns. You're not going to get a high returns if you're just one hundred percent equity, but you still get pretty down good returns, but you could do so at much less risk. So I think it's an important aspect. I think we have to think more about the sizing of our bets as well as what we bet on and how much. And so it's not only whether your equities or treasuries or commodities or alternatives or crypto or whatever, it's in the sizing of those bets there.

You really can decide whether you're creating a portfolio that's uncorrelated and safe, a portfolio that i'll hopefully whether the different seasons as the different market environments manipulate your holdings, right? So you'll be able to deal with high inflation and low inflation, you'll be able to deal with high equity Prices and low equity places, uh, you'll be able to deal with high interest rates and low interest rates. And isn't that the goal? I mean, the goal is that we create a portfolio that helps us risk manage, so we save and invest enough money that continues to grow but protects us against the worst market conditions. I think we have to think more about sizing. What do you think.

right? I leave things running just for a few minutes to catch whatever we talk about after the show. Any big idea or mean thing you think we left out? Obviously, we can cover the whole, but there's so much good information in there. But anything you wish we would have touched done .

being just one thing which you might want to work into your comments that was thinking about right at the end, which is, you know this idea that there's these two decisions that how much on the what and the how much question is easier to answer than the what question, first of all but also it's more critical because if you get the how much decision wrong, but the what decision right, yes, you you're screwed and I would I think would have been nice to if there is a way to just build that comment and on your side would be great.

Yeah, I really I definitely took that from the book. You can almost make any mistake as long as you get to how much .

question right? Yeah, exactly exactly. I think that's also value.

Well, not that it's you know it's like the type I, type I, type I and type to air kinds thing but yeah I think it's like, oh wow, you know that's interesting. Get that wrong and you're gone. But you can survive almost any and .

the other simplistic look, again, completely not mathematical and more. God, generally, the answer to how much is probably fifty percent less than you think. I don't know that right or wrong, but I think IT generally comes out. We generally over estimate our real rist tolerance, especially when we're Young.

And what I seem to take a lot of time is that we're too black or White at either zero one hundred percent, but a lot of times we'd be served Better by being somewhere closer to fifty percent. Now is that fifty percent total? No, it's fifty percent of maybe what you thought with your god, right?

If your god is, tell you I should be eighty percent my business. Maybe I should be forty percent of my business. And again, that's a kind of slappy way of looking at IT. Uh, but IT is one of the kind of more simplistic takeaway I felt like I took from your book is that we're often we often should size things Better and probably what that means as we should be unless as opposed to more yeah yeah.

I just doesn't heard us to be in somewhat less than the optimal. And you know the shape of those curves is kind of flat, flat near the optimal, but then really IT sharply declines above the optimal, yes, and declines less dramatically below the optimal engine, which again gets too .

expected utility, right? So again, we're back to this idea that you know the utility just doesn't increase as much on the upside um but IT decreases quite a bit on the downside, which again gets back to over time about IT feels really good to be productive. But a lot of the time it's easier said than done, especially when you need to make time to learn about productivity so you can actually be productive.

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