034 - The Stock Series Part 2

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Time Speaker Text Tags
0 - 9 Jonathan Mendonsa OK so we have JL Collins here with us in the studio today and we're going to be doing part two of the stock series. We're back in the studio. How you doing today.
9 - 12 JL Collins I'm doing great and I am I am really honored to be here.
12 - 63 Jonathan Mendonsa Well we are thoroughly excited to have you. I know this is a conversation that we've been wanting to have for a long time. We did part one of the stock series several months ago and it's actually been one of our most downloaded episodes. It's been downloaded literally tens of thousands of times at this point. I should point out that you do not need to pay for part 3 in part four if you're just joining this conversation. JL just released his audio book It's now available I believe for download on Audible dot com. And you should definitely go check it out. You can hear the entire simple path. to wealth as explained by the author I can't imagine a better person to read that but if you want to have a conversation about the stock series that's hopefully what we're going to accomplish today. And we're going to be hitting on a couple different things we thought we'd talk about. What if this is 1929. We're going to talk about portfolio ideas and really just kind of have some fun with that pull at some threads and see where this conversation leads us. So Jim just a big thank you for being willing to have this conversation today.
63 - 88 JL Collins Well let me start by saying I am thrilled to hear that it's the most downloaded one that you've done particularly because it puts me in such a rarefied company I have been listening to your podcast. I am thoroughly impressed with the caliber of guests you get and the quality of interviewing that you do. And so if I'm anywhere near the top of that pack that's that it makes my heart soar.
88 - 100 Jonathan Mendonsa Awesome. We'll be forced a mike on you this time and we know you can be doing some geo arbitrage soon so hopefully we found one small enough that you'll be willing to put it in the bag and carry it along with your very limited personal belongings on this trip.
geoarbitrage
100 - 103 JL Collins And I think you just should send me a new one each time.
103 - 108 Jonathan Mendonsa That will be our frugal fail of the week.
108 - 110 Brad Barrett Hey we're happy to do so, for Part 3 and 4 that's a small price to pay.
110 - 151 Jonathan Mendonsa So today what we'd like to start with is if I were going to tie this to one of the articles that you did this it would be Part 4 of the stock series. The big ugly event deflation and also a bit on inflation. But to put this in context as we're having this conversation it's 2017 and there are a lot of people that feel that maybe the market is headed for a downturn now it doesn't matter whether or not that actually happens we're not professional prognosticators. If you want that you can look on TV and get 50 people with 75 opinions. That's fine we'll leave that alone but let's say that we're looking backwards and this ends up being 1929. What happened during the Great Depression and in the FI community with the information that we have access to. How do we approach a situation like that.
151 - 163 JL Collins Well the lead up to the Great Depression the crash of 1929 was of course the roaring 20s and it was a very robust time there had actually been as I recall and I'm not a historian on this show.
163 - 165 Jonathan Mendonsa Nor did you experience it personally.
165 - 420 JL Collins Nor did I experience personally I just missed it. But there had been as I recall a crash around 1920 something like that and of course the country would just come off a world war one at that point and then you had what we're all familiar with the Roaring 20s and those were boom times for a lot of reasons. And in good times people get exuberant and sometimes they push the envelope a little bit too far and towards the end of the 20s the stock market started to have a very nice rise during this period and people got greedy. Fear and greed are what drives the market right and people got greedy and at the time it was very easy to buy stocks on margin it is still fairly easy to buy stocks on margin. And buying stocks on margin simply means that you are borrowing money from your stockbroker to buy stocks and the power of that like any leverage like the leverage when you borrow money to buy a house is that if it goes up you make more money. So let's take the house example just real quickly because that's what everybody is familiar with and say you're going to buy a house for $100000 Jonathan and I'm going to buy a very similar house for $100000. Maybe the two houses are next to each other and you buy your house for all cash you plunk down $100000 and you just buy that house for cash. I go out and I get a mortgage for 90 percent of it so I just put down $10000. That's leverage. That's the same thing as buying stocks on margin. Now let's suppose that a year from now we've we've bought well and the right neighbourhood and a year later our houses have both gone up 10 percent. Well you have made $10000 which is 10 percent of the $100000 you put in the game. I have made the same $10000 bet because I use leverage. I only have $10000 in that game so my gain is a hundred percent. So I have magnified using leverage my gain on the same price increase we both enjoyed. That's great. And that's one of the reasons by the way that people are so enamored of houses is because leverage magnifies the gains when they go up. That's also the thing that made it so terribly ugly when housing prices crashed and 2008 and that's the problem because leverage is a double edged sword. It cuts both ways. So let's take that same scenario. You buy your house for $100000. I buy my house for a hundred thousand dollars you put cash I put down just 10000 10 percent and a year later it's gone down 10 percent. Well you have taken a 10 percent loss on your hundred thousand dollars you got $90000 left. I've been wiped out. I've taken a 100 percent loss. So now let's go to the stock market and back to the 1920s. People are buying stocks on margin and they're bidding up the price of those stocks to irrational levels because everybody is making money hand over fist because when you buy on margin that puts more and more money into the game and it extends things more and more. And as always happens then surely the music stops and everybody is scrambling for a chair. And when the music stops and the market starts dropping if you are not buying on margin just like with your house the most you can lose is a hundred percent. If it goes completely to zero which the market's never done but if you've margined yourself by say 50 percent which is common on one stock margins if the market drops 50 percent which of course it did not just in the Great Depression but just a decade ago in 2007 2008 you were wiped out. And if your broker is calling you for margin calls which means the stock is going down and they want to make sure it doesn't go down so far that they're holding the bag for what you know you are forced to sell. And that creates an even greater selling pressure on the market than the natural ebb and flow would ordinarily have. And so when you have a lot of margin built into the market and the market starts to drop and markets are very volatile they're always going up and down. So there's always times are going to drop. If you add margin into that suddenly that drop gets accelerated and it gets faster and faster and deeper and deeper. And in 1929 you had the stock market crash.
housing, stocks
420 - 463 Jonathan Mendonsa And I want to pause on that for a second because it's that margin call that makes the comparison so much more dangerous for doing this with stocks as opposed to getting a mortgage on your home because you don't see that many people worried about using leverage to purchase their primary residence. Right. The fundamental difference there is that if your house does go down in value 40 percent the mortgage company is not coming to you and asking you to cough up the balance as long as you can afford to make the payments. That's the difference. And I guess if you were to go back to 2008 the problem was because of the massive scale and that horrific lending practices they were not insuring that the people that were getting these homes could make the payments. And ultimately you know not to go down that rabbit hole but that's why the whole system crashed in 2008.
463 - 492 Brad Barrett So Jim in this article part 4 of the stock series you have four lessons here and the first one which we've talked about is never buy stocks on margin. Second if you don't mind me reading it I love the writing here. If a time comes and you're reading and hearing about people routinely making fortunes in and aggressively rising market using margin something very very bad is around the corner and you say Joseph Kennedy is said to have known it was time to exit the market in early 1929 when he started getting stock tips from shoeshine boys. And I just love that.
492 - 495 JL Collins Yeah that's that's as far as I know is a true story.
495 - 510 Brad Barrett And I want you to comment on lesson Four but let me just quickly read lesson three if you see lesson number two forming. It is a good time to take your chips off the table which is very tough to do when everybody is making quote unquote easy money. And lesson for once the crash comes it is too late.
510 - 626 JL Collins Well let me first comment on the lessons two and three because they are kind of linked together. I am somewhat famous for saying that the market is volatile and we can't predict when it's going to plunge and therefore we ignore the volatility, we're buying for the long term. And if anything we make the volatility work in our favor when either we are building our wealth and adding money to the market weekly or monthly or as earned income comes in and we're we're saving a portion of that. We're adding it in. So when the market dips we get to buy at those lower prices and that smooths the ride or once we're living on our portfolio Bonds play that role and we adjust the allocation which takes advantage of those market dips. So in less than two and less than three though you hear me saying something that begins to sound a lot like market timing which I mostly preach against. So those two are things that are really out on the far edges of the market when things really get out of whack is the only time that I would say begin to take your chips off the table. And of course whenever you have a a long bull run like we have now people start to get antsy and say Is Now the time to take the chips off is now the time and those times are very very rare and probably unpredictable. And then the lesson four is that once the crash comes then it's too late. So typically investor behavior is the market goes up for a number of years and it begins to feel normal and the money feels easy and they start investing and then all of a sudden it crashes or it or maybe it doesn't even crash maybe it has a correction which is a 10 percent decline or a bear market which is a 20 percent decline. Crashes are like 30 plus percent and then people get all nervous and after the decline they they sell well that's the classic closing the barn door after the horses have run away.
savings
626 - 674 Jonathan Mendonsa That is the most painful thing. And I think when it comes back to if our community is latching on to this idea of the beer and the foam and especially when we're following your general advice and we're falling more or less the advice of the Fi community and we're latching onto index funds we own a very small piece of the United States economy. And what you're asking yourself is Do I think that at some point in the five or ten year future or whatever it may be it's going to come back. And if you sell at the bottom because you say I don't want to lose any more you're contributing to a fire sale that you can never recover from. And I think having the confidence and just stepping away and saying what does this volatility represent what does this crash represent. Is there a actual change or do I still own at the end of the day a piece of the U.S. economy. You've got to be able to make peace with it in your mind and then hopefully make a decision based on that I think.
indexfunds
674 - 801 JL Collins I agree Jonathan I think you're absolutely right because the fundamental investing choice you're making. First of all we should say that their index funds these days there's a huge range of index funds and there are index funds for very small sectors of the market and that's not what we're talking about we're talking about broad based index funds index funds track the S&P 500 or my personal preference that track the entire stock market the total stock market index fund like the VTSAX. SO if you buy something like the VTSAX total stock market index fund or even an S&P 500 fund you are basically betting on the economy of the United States. And to do that you have to believe that the United States is going to for the foreseeable future remain a dynamic successful economy. It's always going to be volatile, it's the nature of economies. But unless you believe that the United States is in a permanent long term decline or it's about to collapse as an economy. You know I'm famous for a post in this series where I say the market always goes up, well as long as the U.S. economy is remaining strong and robust overall and has a future, that will always be true. If the United States goes into a tailspin that's non recoverable then eventually that, and someday it will. By the way, I mean nothing lasts forever. Then obviously the VTSAX and the U.S. stock market by extension won't won't be going up at that point. But I don't see that happening in the near future. I think the United States is good for at least another hundred years as is a dynamic volatile economy. It's not going to be the same as the last hundred years is not going to be the same as it was today. But I don't think we're going away anytime soon. And if you believe that then the way I recommend you invest makes sense if you don't believe that, and not everybody does. If you believe the U.S. is on the verge of collapse then obviously you don't want to be investing in the stock market of of the U.S. Just like if you believed in any country if you thought it was on the verge of collapse you wouldn't be investing in the stock market.
indexfunds, stocks
801 - 823 Jonathan Mendonsa I think that definitely simplifies it from all the other variables that maybe you have to look at if you're an active investor. Simplifies it down into a much more easy to comprehend almost binary choice which then will allow you to dictate the decisions you make. So I get that that makes sense to me. I think it would be interesting just for the sake of conversation to dial it back and talk just for a second about that person to be that investor in 1929.
823 - 901 JL Collins That's a great question. So let's start out by saying that there's no way around it. The stock market crash in 1929 and the ensuing Great Depression was as I say the title of that post a big ugly event. I mean there's just no way around that. Stocks went down from their peak to their bottom something on the order of 90 percent. So if you had a million dollars in the stock market in 1929 before the crash by the time it hit its bottom. Assuming that you didn't sell you'd be $100000. So there's no question that's ugly. And it did eventually recover. But you know it took a fair amount of time to recover with that in mind. It pays to step back and say well OK are there any mitigating factors. Well if you'd stayed the course you would have eventually recovered. That's number one. It would have taken a while if you had been one of the 75 percent who kept their jobs. So the unemployment rate during the Great Depression reached 25 percent. The implication of that of course is as bad as that is. Seventy five percent of the people were still working if you were one of the fortunate seventy five percent and the odds of course were in your favor and you kept investing in that stock market if you kept the faith you would have been buying stocks. At extremely advantageous prices.
stocks
901 - 907 Jonathan Mendonsa So I guess the takeaway point there is may the odds forever be in your favor. It's almost like a tagline for a movie. I wish I.
907 - 1041 JL Collins Yeah. The point is I've said that if you were a young investor the very just starting out or just even a few years in the very best thing that could happen to you is a stock market crash assuming that it doesn't scare you away. And assuming that you keep working and you and you keep investing because you are buying stocks at lower prices you're buying them on sale at bargain rates. So anybody who's listening to this who's young and just and just starting you know you should be rooting for the market to take a plunge. I get on the blog Periodically I get a lot of comments from actually from investors of all stages but I have a fair number of young beginning investors and the typical comment that concerns them is they'll say you know I've put together $10000 or $20000 and you know it's sitting in my bank account and I want to put it in the market but I'm just afraid I'm just afraid that if I put it in the market today that it's going to drop dramatically tomorrow and Oh and I'll lose my money. And that's an understandable fear. But if you take the longer horizon and you're working towards financial independence that 10 or 20 thousand dollars is not a lot of money. You're going to look back on it and a couple of decades and it's going to be pocket change to you. So as hard as it is to believe if you put that $10000 which probably took a lot of blood sweat and tears for you to pull together you put it in the market. And tomorrow the market chooses to plunge 50 percent and you get cut in half. Celebrate because you are going to continue to invest in the market and you're going to be buying at better and better prices. So in a sense that's why volatility doesn't concern me as long as you don't panic and sell. It's going to recover. If you're continuing to put money in it's going to work to your advantage. If you're at the stage of your life where you no longer earning money and so you don't have cash flow to continue investing at that point if you're following my advice you diversified into bonds. And so when the market plunges you will be selling some of your bonds to buy those stocks at that lower price and by the same corollary when the market recovers and goes up you'll be selling some of that to go back into bonds to maintain whatever asset allocation you have chosen. So does that makes some sense.
stocks
1041 - 1087 Brad Barrett Yes. My big takeaways are the psychology of it which is don't get freaked out. Even if you do see your money in your hypothetical go from 10K down to all the way down to 5000. And really the bedrock foundational principle of the fi community is live below your means right. And have a savings rate. Hopefully it's 30 50 70 percent something like that. And you are continually pumping money into your stock investments and to your point you're buying it at a huge discount. So that's why you're saying you should celebrate if that happens to you if that timing is exactly right. Now obviously in a perfect world this person isn't losing the $5000 but you're saying that's completely immaterial over the long run and then getting to buy at discount prices potentially for years.
savings
1087 - 1188 JL Collins You know. Brad you're you're absolutely right you. You hit the nail on the head in fact I might even go so far as to say let's suppose I had a magic wand and I could make things work and somebody in their 20s comes to me and I want them to be as successful as possible. And they have $10000 and they put the $10000 in the market. I'm going to use my magic wand and immediately have it go down 90 percent go down to $1000 just because the power of that savings rate that you talked about and the new money coming in will so vastly eclipse the $9000 they lost. They will be better off by taking that hit early. That's why I can't emphasize enough that unless you think the United States of America is swirling down the drain. I can't emphasize enough how important it is not only to stay the course and not panic and sell but to take advantage of the drops and keep adding money is as you go along. By the same token you don't want to stop adding money when the market goes up because the market can go up for long periods of time to heights that at the beginning you wouldn't have thought were possible. And you don't want to lose that just keep putting the money and keep putting it in and truly I told my daughter don't pay any attention to it. The ideal thing is put money in the savings rate is key. Put as much money in as you can whenever you can and otherwise ignore it. Jack Bogle says something similar and he said he says now and then in a few decades when you decide to finally look at your statement he said don't even look at your statements for decades and then in a couple of three decades when you finally decide to look at your statements see where you are. Make sure you have a cardiologist next to you because you're going to have a heart attack. at how Well you've done.
savings
1188 - 1224 Jonathan Mendonsa And the reflexive thing that I want to point out here is that nobody in this room wants a recession to happen. There's a lot of pain and heartache that comes when the market crashes and that's recognized. But when you're talking about your mental game when you're talking about well in the FI community how to handle that and how to handle the own personal fear that you have about whether or not you should put money in and what to do if a crash is for you to recognize that if it does crash if the market does go down there is a play for you there. And by being empowered with this information you will financially benefit from this in a very big way that that's going to be big for you. So if you're armed with information you are going to do very well.
1224 - 1298 JL Collins Well I would also say Jonathan that whether we want the recession or we don't want a recession whether we want a market crash or don't want a market crash, Mr. Market doesn't care even one little tiny wit. The market is and the economy are going to do what. Markets and economies do regardless of what we want. So that's part of adjusting the psychology. That's part of and one of my earlier posts in the stock series where I say toughen up cupcake because you can't. Recessions are never going to go away. We're always going to have recessions whether we like them or we don't like them it just doesn't matter. They're a fact of economic life in our economic system. The market is always going to be volatile. It's always going to have bull runs like we're having at the moment and it's always going to have bear markets like we will at some point. I have no idea when. Let me say I'm not predicting a bear market tomorrow or the next week or. But it could happen. And I will say absolutely that we will see bear markets again. But yeah the markets don't go don't care what we want or what we don't want. And so we have to toughen up and just just accept that this is the way it is. Once you understand that's the way it is then you can begin to think about OK how do I deal with this reality how do we deal with it when it goes up and how do I deal with it when it goes down.
1298 - 1305 Jonathan Mendonsa I'm adopting that tagline toughen up buttercup. That's definitely a tax cupcake.
tax
1305 - 1309 JL Collins You can change it to Buttercup if you want my blog cupcake.
1309 - 1334 Jonathan Mendonsa Perfect You know you made this great comment on the article and you said none of this is to say that big ugly events are not very scary and destructive things but they are rare. And in the context of our overriding approach spend less than you earn. Invest the surplus and avoid debt. They are survivable. That ties in so perfectly with what I would say is the overall theme of your article series and it's that simple is good. Simple is easier and simple is more profitable.
debt
1334 - 1369 JL Collins And it's it's more powerful Absolutely and it does. It does tie in with that theme. And you know it's not to say that we will never see another great depression again. We have seen stock market crashes I mean we just imagine most of the people listening to this lived through the crash in 0 7 0 8 0 9. I mean that was the second ugliest in our in our country's history. So it's not like these things are never going to happen again. But they are exceedingly rare events. There a book I forget the author's name but the guy wrote the book about black swans.
stocks
1369 - 1372 Brad Barrett Nasseem Nicholas Taleb.
1372 - 1694 JL Collins Yeah so. So he wrote this book The Black Swan which is which is a great book I highly recommend it. And just real quickly a black swan is a very rare but very traumatic event that happens and it can be in the economy like a depression. The Great Crash of 29. It can be war it can be any guy any number of different kinds of traumatic earth shaking things but by definition it's important to remember that they are very rare. So if we look at it in terms of the stock market and the economy black swans like the Great Depression the crash of 29 even the one in 0 8 0 9 are very rare events. And so as an investor you have to ask yourself OK. I know black swans exist. I know they can happen. What do what what should I do about that. And the problem is that if you fall prey to fear of a potential black swan and you start adjusting your investment strategies expecting one or against the time it might come you are going to leave a lot of money on the table because they are so rare. Most often they don't happen. So let me illustrate this. Let's suppose that the three of us are sitting around in 1975 and I picked 1975 because in my book I talk about the stock market period from 1975 to 2015 which is when I was I was finishing the manuscript and writing this and that's a nice 40 year period. I chose 1975 because that happens to be the year I personally began investing it happens to be the year that Jack Bogle created the first index fund and it happens to be a nice four decade chunk of time. So let's suppose that three of us and maybe our audience were all sitting around having a cup of coffee and it's 1975 and I say guys I got some I got some news I have a time machine and I just came back from 2015 and I looked back at the next 40 years that are coming from 1975 here where we're sitting. And let me just tell you what's going to happen. Because I've I've seen it. This is come back from the future. So here's what's going to happen you know we're 1975 and inflation is ramping up and it's kind of ugly that's going to get a lot worse. Mean By 1980 by the early 80s we're going to see mortgage rates at over 15 percent. And there's going to be this thing called stag inflation because not only we're going to have this outrageous inflation but it's going to be tied to a stagnant stagnant economy and it's going to be so bad that in the late 70s BusinessWeek this highly regarded magazine that everybody thinks is on top of things they're going to run a cover story called The Death of equities. That's how bad it's going to be for stocks. And then in 1982 we had the beginning of a bull market that was really nice. There was this bull market and it went all the way up to 1987 and then in the fall in 1970. Nineteen eighty seven we had Black Monday and Black Monday. The market dropped the biggest percentage in history. I mean right up until 2015 it had never dropped that far in one day. It dropped 25 percent in one day it never happened in history before. And that triggered this nasty recession that lasted into the early 90s. But then there was all this cool technology I won't tell you about it because you wouldn't begin to believe me sitting here in 1975 some of the cool technology that's coming. But there was this cool technology and there were companies around and they started going public and there was this big tech boom and people started making money again and it really looked great. And then you know around the year 2000 that all collapsed actually in 1989 that all collapsed. And we had that what was called the tech crash and then shortly thereafter there was the biggest attack on U.S. soil since Pearl Harbor. So we got attacked by foreign actors on our own soil. The biggest attack since Pearl Harbor and that dragged us into two wars that were very much like Vietnam that lasted for years. In fact when I left in 2015 they were both still going on and we were really making no progress just like in Vietnam and that dragged this out. But anyway in spite of that the good news is that that after 9/11 and the tech crash everything things started to get better and better again and we had this other little bull run and then these lenders started lending out money without any consideration to people's ability to pay it back to buy houses and the housing market explode that housing prices were going up. It became this great bubble and it burst and collapsed and that created the greatest economic depression or drop since the Great Depression. I mean the only one we were had in the history of the country was the great depression back in 1929 in the 30s. That's how bad that was and that lasted for two years. I think the good news is you know beginning in 2009 that seemed to have bottomed out and as I got my time machine to come back here to 1975 and 2015 you know the market was had recovered nicely it was back on one of those Bull things. So that's for the next 40 years holds fellows. Now the other thing that's just happened here in 1975 is this guy Jack Bogle just created this index fund where we can invest in the stock market in the U.S. who wants to put all their money in the stock market now.
housing, indexfunds, stocks
1694 - 1695 Jonathan Mendonsa Pick me pick me.
1695 - 1733 JL Collins Yeah. Well you know I think most people will look at that litany of disasters and would have said no bloody way. Yeah right. The last the last thing in the world I want to do is pick the stock. If you're if you're right that that's what our future holds all that angst and disaster and war and collapses the stock markets the last place I want to be are you out of your mind. Don't know this guy Jack Bogle is know what an index fund is but I do know I don't want anything to do with stocks. Well of course the rest of the story is that over that 40 year period stocks returned just under 12 percent a year.
indexfunds, stocks
1733 - 1735 Jonathan Mendonsa 11 Point five seven right.
1735 - 1740 JL Collins 11 I think it was eleven point nine actually. But by that I'll take 11 point 7.
1740 - 1741 Jonathan Mendonsa Right. That's amazing.
1741 - 1813 JL Collins Yeah. So the point is the market, there's a saying on Wall Street the market climbs a wall of worry. The market in the last 40 years has been incredibly volatile. It's had more than one crash and yet it still has returned just shy of 12 percent a year. It's a little bit stunning. Now I have no idea what the next 40 years are going to be like and I'm not suggesting that in the next 40 years are you going to return 12 percent. I make this point in my book and I've gotten some criticism because I use the figure from the last 40 years because that's what actually happened in that period of time. You can take any period of time by the way and get different numbers if you took the period of time from 1980 to even to 2000 the market increased much more. They give us like 18 percent a year on average. By the same token if you took the period of time from 2000 to 2009 you know it was nowhere near 12 percent. So a lot of this is depends on what particular period of time you take. You look at different. But in 1975 which was the year I started investing to 2015 that 40 year period was filled with all kinds of challenges and problems. And it still posted incredible returns.
1813 - 1847 Brad Barrett Yeah Jim that's remarkable. I mean a 12 percent annual return compounded over 40 years I mean just using the what is it the rule of 72. I mean your money would double every six years approximately. Slightly more since we're saying it's slightly under 12 percent but I mean that's. That's amazing. Your money would double 6.6 seven times in that 40 year period and that's even counting all those absurd catastrophes that you listed. I mean like you said you would probably run for the hills if you came back in that time machine and told that all that but it would have been the best thing you could have ever done to invest in that money.
1847 - 1905 JL Collins Right. And this is by the way nobody knows what the next 40 years will will hold. I would imagine the next 40 years will will be equally traumatic because we live in traumatic times. But we also have a very dynamic economy and there is a lot of things happening in the world in the world of technology and advancements and breakthroughs on the scientific front. I mean I don't know what the market's going to do the next 40 years and nobody else does either. Who knows it could be an unmitigated disaster and we could have the zombie plague and civilization collapses. But it could make the next 40 years look like they was standing still. We just don't. We just don't know. But the point is that it's incredibly powerful. Even though even through some really really challenging times and I imagine the next 40. My guess is the next 40 years will be every bit as challenging and every bit as rewarding.
1906 - 1931 Jonathan Mendonsa So our community has basically more or less agreed on at least using index funds for the basis of the brunt of our investment vehicle certainly it's what Brad and I preach in large part due to your article series. And one of the things that now that we've boiled it down or distill it down to it's most simple level what we would like to do next is maybe talk about the different tools you have in your in your bag and talking a little bit about the different things that you should be considering.
indexfunds
1931 - 1932 JL Collins Let's go for it.
1932 - 1939 Jonathan Mendonsa In your article here you post three things three considerations and the first one is what stage of investing life are you.
1939 - 2033 JL Collins Let me start by saying that the classic way of looking at what stage of investment life you are is based on your age and that in the old days or even Even today from most people that kind of makes sense because most people lead fairly traditional lives and that means that they go to school they come out they either go to college or they don't go to college they get a degree they don't get a degree. They go to work and they work for 40 years and hopefully in that 40 years they accumulate some assets and then they and then they retire that sort of defines your stage of stage of investing and you accumulate your wealth over that 40 years and then hopefully you've done well and you retire on it in the FI community of course we're striving to reach financial independence much faster our savings rates are are much larger. People typically hit FI or they get close to it maybe they change careers or maybe they stop working for a while and they travel and then they find something interesting to do and income starts coming back in. So your stage in life for the people listening to this in the FI community isn't just defined by your age it's defined on one when you happen to be doing you know there'll be periods of time where you're working you get FI or maybe even mostly to FI and then you're doing other things travelling or whatever that are bringing in income and so you're living off your investments then maybe suddenly you're doing something that brings in income again and it's going to go back and forth. So how you are invested is how you want to be invested is going to shift based on what stage you're in. And.
college, savings, traditional, travel
2033 - 2050 Jonathan Mendonsa So you've essentially painted a different picture and instead of us just talking about what you need to be doing when you're 65 and what you need to be doing when you're 35 it instead comes to your to your mental game to where you are at this point in your life. Do you want. Are you trying to build your wealth or you try to preserve it. Am I on the right track here. Yeah
2050 - 2108 JL Collins absolutely. And the point that I would make is that you can go in and out of those stages so you might presumably at the beginning of your career you're definitely going to be in the wealth building stage you're going to be working. And if you're pursuing F-I you're going to be saving a very large amount of your income upwards of 50 percent ideally and that's your wealth building stage. and then you're going to get to the point where your investments can begin to support you and you might stop working and that becomes your wealth preservation stage. And when you stop working maybe you're traveling around or doing whatever it is that you want to do that it's not paid work. Maybe you stumble upon something that begins to generate income again so you go back into the wealth building stage. So you might because we're talking about people who are going to be hitting financial independence fairly early. You could go into your wealth building stage to your wealth preservation stage and back again a couple of times in your life.
career, savings
2108 - 2116 Jonathan Mendonsa Yeah. And this goes back to something that I was calling the rotating swivel door. If you want to use that in your articles I give you permission.
2116 - 2120 JL Collins Thank you. Yeah. I'll have to know how much you're going to charge me.
2120 - 2123 Jonathan Mendonsa exactly what you're charging me. I want it all back.
2123 - 2125 JL Collins There you go.
2125 - 2145 Brad Barrett Hey Jim talk us through what you would advise people in these different stages as far as like the percentage that they would put in equities bonds ETC talk us through as they're going through this swivel door or whatever it may be or you know hopefully it's a it's a one way. But what do you generally advise on the blog and with people that you speak with.
2145 - 2201 JL Collins So great. Great question Brad. So in the wealth building stage I'm fairly aggressive and I recommend that people be 100 percent in stocks and very specifically if possible in VTSAX which is the total stock market index fund done by Vanguard. Now I say if possible because when people are working they're frequently funding 401k plans or 403 B plans and they're restricted to what investments those plans offer. But basically you want a broad based stock index fund or maybe a couple of them. If you have one with your 401K or another in your your personal investments but you want to be 100 percent in stocks because your savings rate is high and that constant flow of new money coming in from your 50% let's say ideally 50 percent savings rate. That tends to smooth the ride.
401k, 403b, indexfunds, savings, stocks
2201 - 2245 JL Collins So that's when the stock market plunges as it does periodically unexpectedly you can celebrate that because that money you're putting in is buying more shares of your VTSAX and so you just keep putting money in you don't care what the market's doing. You're just putting in as much money as you can whenever you can. That's the wealth building stage. And because stocks are the most powerful wealth building tool available to us we want to be 100 percent in stocks. That means of course we have to be willing to accept the volatility. The best way to accept it is to just ignore it. And don't worry about it. if anything Celebrate when the market drops because each dollar you put in then buys some more shares than it would have otherwise.
indexfunds, stocks
2245 - 2281 Jonathan Mendonsa And I want to pause and highlight that because that's the critical part when you're in this and you've identified yourself as being in the wealth building stage so mentally you say I am in the wealth building stage I want to accumulate wealth that is you have to have your psyche right for that too. Any time the stock market goes down you don't care. Except that now you almost want to get more in there than any time you see the stock market go down. You don't say oh man son of a gun. This is hurting my returns. No you're saying it's a fire sale. It's on sale. I'm purchasing more of the U.S. economy for the same price as I was last week.
2281 - 2419 JL Collins That's exactly right. It is a different psychology than the vast the psychology of the vast majority of investors. I continually get comments on my blog from people who are young and new to investing and they've saved up say $10000 which is a lot of money to them. And I appreciate that and they're about to put it in the market and this money didn't come easily. They work hard for this money. And the idea that they could put it in the stock market and see some of it disappear maybe even get cut in half or worse. That's that's terrifying. But if you're using the approach that we're talking about you should turn that psychology on its head and celebrate those drops because it means that you're getting to buy things on sale. I have frequently said if you could make the market do anything you wanted it to do what you would want it to do with your magic wand is the moment you start investing you would want to see a major stock market crash and then you would want to see the market just bump along that bottom for the next 40 years while you invest it and then you'd want to see it skyrocket. Now of course is not going to do that. But the point is that if you're investing if you're working and you're saving your money at a 50 plus percent savings rate and you're investing dips in the stock market allow you to buy things on sale. They are your friend. The volatility shouldn't bother you. No . by the same token some people say well gee that means I shouldn't buy when the market's going up. And unfortunately that doesn't work because right now for instance the market is very near its all time highs and that has a lot of people nervous and they say well you know maybe I shouldn't invest now especially if they're doing what we're talking about where they're working and They're saving and investing 50 plus percent of their money. Say maybe I should stop. Well the problem is nobody knows what the future holds. Tomorrow the market might plunge 50 percent or today might be the lowest we will ever see the market in our lifetimes. We don't know that. So you never know exactly where the market is which is why you have to keep investing all the time because while it's great when the market drops and psychologically you need to say to yourself you get to buy some stocks cheaper than I did the day before. There's no guarantee that you're going to get that drop from this point and,you can't time it is what I'm guess I'm trying to say.
savings, stocks
2419 - 2426 Brad Barrett Yeah that makes perfect sense. And so you're saying 100 percent equities in the wealth building. And then what about wealth preservation.
2426 - 2439 JL Collins So the wealth building stage just real quickly is when you are working and you have an income flowing in and you are saving a percentage of that hopefully 50 plus percent and you're building your wealth. So that's a 100 percent stocks.
stocks
2439 - 2570 JL Collins Now at some point the whole reason that we want to do this is that we can be independent of paid work and jobs. Doesn't mean we're never going to work again because work is satisfying and worth doing and we may even work for money again. But we no longer have to work for money. So that becomes the wealth preservation stage. So when you stop working for money whether you stop working for money at age 30 and you wind up working for money again at age 35 or you stop working for money at age 65 and you never worked for money again. Whenever you stop working for money, trading your labor for money you've entered the wealth preservation stage. So when you're the wealth building stage that constant flow of your earned income that you're diverting to your investments is what smoothes the ride because you're investing all the time and that tends to even out the peaks and valleys. So that is that ongoing flow of money is smoothing the ride. When you don't have that ongoing flow of money because you're no longer earning money you need a different strategy and that's the wealth preservation stage and what you do to bring balance into your portfolio now that you don't have your own earned income to do it is you start allocating some of your portfolio to bonds because bonds tend to be more stable than stocks. They tend to stay stable when stocks are dropping and they help balance the ride for you. And so you will pick a stock allocation or you'll pick an allocation rather between stock and bonds and then you will adjust to that allocation maybe once a year you don't have to do this very often to keep it in balance. And that has the effect of when stocks are down and bonds are up your percentage of bonds will have gone up and you will be buying more stocks at the low price to bring them back into balance with where your bonds are. By the same token if if stocks continue to go up the percentage of bonds will continue to go down and you want to start selling some stocks and adding bonds to bring them back into balance. And that's how you preserve your wealth. Now the question that of course everybody is probably asking themselves as well. What percentage do I keep in stocks and what percentage do I keep in bonds.
stocks
2570 - 2571 Jonathan Mendonsa You're stealing my question from me.
2571 - 2574 JL Collins I'm sorry I will back off and let you ask that question.
2574 - 2576 Jonathan Mendonsa You just pause right there.
2576 - 2577 JL Collins I'll pause right there.
2577 - 2583 Jonathan Mendonsa Jim. What percentage should I have in stocks and what percentage should I have in bonds. See now you can have it back.
stocks
2583 - 2599 JL Collins That's that's a wonderful question. I wish I'd thought of that. You are one astute interviewer. Think we could just take a nap here. So you're so good at that.
2599 - 2623 Jonathan Mendonsa So my understanding of this is that we have a couple of different tools in our bag when we're talking about these allocation models and essentially just fo you to be able to draw this out of your toolbag We have stocks bonds and then we have cash. And those are the three different things that work really well together when you're when you're coming up with a model and you're essentially basing it on your riskier investment horizon. All of these different factors they will determine the ratio of those three things right.
2623 - 2645 JL Collins Exactly. So when you're in the wealth preservation stage you are going to be owning primarily a stock fund and a bond fund the total stock market fund a total bond market fund as is ideal. You are going to have some cash because you have ongoing expenses and operational needs and you don't want to have to be forced to sell things at an inopportune time.
stocks
2645 - 2795 JL Collins But the question then becomes well how much in stocks and how much in bonds and that really speaks to your personal risk tolerance. So the more you have in bonds the smoother your ride will be but the lower over time your returns will be because the return on Bonds is very low compared to stocks if you graph VTSAX which is the total stock market fund against the total bond market fund over a 10 20 year period of time you will see a very volatile line for the stock fund. But that winds up much higher at the end of the period a much smoother line that that doesn't rise very far. So when you buy bonds you are trading volatility. You are sparing yourself volatility at the expense of long term returns. So you have to ask yourself how much am I willing to give up to smooth my right to reduce the volatility when stocks plunge. Bonds tend to hold up and then you're going to be glad that you have bonds even if you're very aggressive as you can tolerate the swings of stocks you might want to have bonds just so you have this rebalancing tool We were talking about that you can bring that you can bring to bear. Personally I do because I am in the wealth preservation stage I do 75 percent stocks 25 percent in bonds. That's considered pretty aggressive. And I want to be on the on the fairly aggressive side. So if you went more than than 75 percent stocks you would be choosing to become still more aggressive. And if that suits your own tolerance for volatility that's fine. I even there are some people that I respect who even say I can tolerate even in the wealth preservation stage I can tolerate 100 percent stocks because I have enough money and I have enough tolerance for volatility. By the same token if the volatility prevents you from sleeping at night then 75 percent stocks is probably too high for you and you have to make a choice not just based on the numbers because the numbers would suggest you don't want to be always 100 percent stocks because over time they outperform everything else but you also have to have to think in terms of your comfort level. And again I like some bonds just because I like to take advantage of I like to have something else when I don't have that. That inflow from earned income to take advantage of the stock market volatility. I like to have the rebalancing between stocks and bonds to do it for me.
indexfunds, stocks
2795 - 2822 Brad Barrett And Jim that's kind of what I was going to ask next which was you know let's just say for argument's sake you know you you personally live a FI lifestyle your expenses aren't significant. Let's say you make some money from your web site you obviously have book sales and hopefully audio book sales at some point you're going to get Social Security and eccentric center. Has there ever been a thought that you would move back to 100 percent equities. Is that something that's ever crossed your mind or are you pretty comfortable with 75 now.
socialsecurity
2822 - 2974 JL Collins You know Brad that's a great question and a very pertinent one to me personally for all the reasons that you just outlined. So my working career was I didn't retire early because during my career there just wasn't a concept I even had in my head. I did step away from my jobs for various lengths of time anywhere from three months to five years but I always did it with the intention that I was going to go back to work at some point. I never thought of it as retirement. The last job that I quit that I figured I wasn't going to work again was back in 2011 very coincidentally that's the same time I happened to start my blog and the two are not at all related surprisingly. So at that point in 2011 I went to this 75 25 percent stock bond mix that I was just talking about more recently and I never intended to make money from the blog but the blog has grown in ways that I never anticipated and and effective actually last year it started making money a couple of years ago but it was really just sort of breaking even with its expenses so I wasn't showing any any great income from it. But last year the expenses have stayed fairly stable within the income is growing rather nicely. So suddenly as of 2016 I didn't come for the blog. And then also in 2016 is when I publish my book the simple path to wealth. And that's been much more successful than I could have hoped. So I have income coming in from that so suddenly I have I have money coming in again in a way that I never anticipated. So I am still sitting on this asset allocation and I am debating what I want to do if I want to move back towards a 100 percent stocks. My hesitation is that the book has been selling very well it's been out for a little over a year but I have to assume at some point it will saturate the market and those sales will begin to drop down. I just put out the audio version of the book and that's doing very well and so far it is not pirated sales from the Kindle or the print version but I can't sit here and comfortably say Well it'll be the same next year or five years or ten years from now the same thing with the blog. The blog is coming along nicely. But you know I don't know how much longer I want to keep working on it and I may stop putting up new posts and then it'll still have a momentum of its own. So anyway a long way of saying I do have current income coming in that I never anticipated. I just don't know how long it's going to last. And so I am debating with myself whether to move to 100 percent stocks or not. And I just haven't pulled the trigger and they haven't made the decision on that.
career, stocks
2974 - 2999 Jonathan Mendonsa So will there ever be a case for someone to do. I'm just trying to put myself in the situation of someone coming to you asking for an allocation that would suit their particular lifestyle and what the criteria would be for you to say a 60 40 or 50 50 or similar to what you're doing to 75 25. I'm just trying what would be the what would be the different factors that will be crossing your radar before you would that would be the scenario that you would lay out.
2999 - 3127 JL Collins Well that's a that's a great question Jonathan and I think there are two factors to it. Right there is the mathematical factor let's call it. And there is the emotional factor mathematic. You are always better off being in stocks because stocks over time outperform everything else. If we go back to the conversation we had about the last 40 years and that litany of disasters that I was able to put out in front of you and yet in spite of all that the stocks returned almost 12 percent a year. So stocks are a very powerful wealth building tool. So just looking at the numbers you can make an argument that you should always be in stocks. My friend Jeremy who writes at go Curry cracker. He's a big believer in being 100 percent in stocks for exactly that reason. And he has a very high tolerance for the volatility. The only downside to being in all these stocks is that incredible volatility. And again we're assuming that the U.S. as a country and the economy is going to continue to do well over the next 100 years. If you don't buy that then everything I said doesn't make any sense. But there's the emotional side of it. And most people want something that smoothes that volatility because the volatility can be very ugly. Now in the last decade since found that quite a decade but the last seven eight years the market's pretty much done nothing but go up. And that tends to make people complacent and especially new investors and it's hard to overemphasize how ugly it is. When you have a 1987 and in one day the market suddenly goes down 25 percent or you have a 2008 2009 where the market gets cut by more than 50 percent. And it just never seems like you're going to get to the bottom. So don't underestimate how difficult that is to deal with emotionally and how hard it is if you're 100 percent in stocks to stay the course through that it's easy to do it when the market's going up. It's most profitable to do it when the market is going down. But it's also very very difficult to do it. So that's when you enter in when you add bonds because it's smoothes that right when the stocks take their next inevitable plunge.
stocks
3127 - 3157 Jonathan Mendonsa So Someone comes to you and they know that you have spent a lot of time researching this topic and they are very comfortable talking about it and they say my parent is I'm trying to help them with their finances and they have $400000 that are in investment vehicle that they told me they'd like for me to help them put it somewhere they don't have any additional income coming in. They're not in the fi community they don't have the flexibility and we want to give them advice but we don't want to put them in an overly risky scenario. What are the questions they come to your mind when someone presents you with that scenario.
3157 - 3250 JL Collins Well the first question that would come to my mind is how comfortable are they with volatility. So there are a lot of people who are very uncomfortable with the stock market and very uncomfortable with the volatility of the stock market and that volatility is never going to go away. So the first thing I would say is if Jonathan if your parents are fearful about the stock market if volatility makes them uncomfortable. And if there is any chance at all that when the market plunges as inevitably it will at some point that they're going to panic and sell at the bottom then keep them out of the stock market in the stock market has a wonderful long potential to build wealth. But you have to have a long term horizon. And if you don't stay the course. Everything I've said doesn't matter if the market goes down and you or your parents panic and sell then nothing I've said works anymore. It's all predicated on the fact that you're going to ignore the volatility. If anything you're going to add to it either by selling some of your bonds or by your oncoming cash flow. So I guess the first question becomes is the philosopher once said. Know thyself. And unless you are absolutely sure. Or your parents if you're advising them are absolutely sure that they can tolerate the volatility and will stay the course. Then you don't want to be around stocks. Now as to what your allocation ought to be if you say well you know I mean my parents are you know they're they're not stocks make them nervous. I think they'll stay the course. But boy they're sure not a hundred percent they're not go Curry cracker. They're not Jeremy they're not.
stocks
3250 - 3252 Jonathan Mendonsa There's not very many go Curry crackers out there.
3252 - 3338 JL Collins Exactly. There are not very many Go-Curry crackers and one of the things that I'm afraid of. By the way is I hear on my blog from commenters more and more people young people especially sort of cavalierly saying yeah I'm going to be 100 percent stocks and I don't care if the market drops. Well unless you've lived through a market drop Don't be so sure it is. It's breathtakingly scary. I mean it's breathtakingly scary. In 1987 when the market plunged. I panicked and sold. I sold at the bottom. Now that was an expensive lesson as I watched it march back up and I bought in after it had passed my Hi-Point before it had crashed. When the market when the market plunged in 0 8 and 0 9 I didn't sell. And part of the reason I didn't sell is because I had that 1987 experience under my belt but I was still nervous. I mean it is breathtakingly ugly when the market plunges the way it can plunge. And so nobody listening to this unless they've lived through it you got to look long and hard in the mirror. And you can't assume without a lot of soul searching that you're not going to panic and when it happens you just have to remind yourself that it will end if it doesn't recover then nothing matters anyway, it won't matter what you do. So you have to just stay the course. But I can't emphasize enough that it's easy to say in the middle of a bull market like we're enjoying now, very hard to execute. When you see your nest egg go from a million dollars to half a million dollars.
3338 - 3345 Jonathan Mendonsa But it almost sounds like you're saying that Bonds at least for you are really merely a crutch to keep you from selling at the bottom.
3345 - 3387 JL Collins Bonds Smooth the ride you know Bonds the function the bonds have especially in this day and age where interest rates are so low and you know in the old days when Bonds paid higher interest rates they were much more attractive investments to having a portfolio anyway. So if you had a bond that was paying seven or eight percent and you had stocks that maybe had with more volatility a historic return of 10 12 percent well Bonds suddenly became much more attractive. Interest rates are so low now that Bonds really in my mind are just ballast to keep you balanced and to smooth the ride. And so how much you hold and bonds depends on how comfortable you are with volatility.
3387 - 3419 Jonathan Mendonsa So for that 60 year old or 70 year old example that we were just talking about even if they are 100 percent go curry cracker they're core. They've they've they've bought into it hook line and sinker but they're not earning income. You could make the case that they should still be considering this. I don't know 25 percent or 50 percent or 40 percent whatever that number is just because they keep the volatility is more dangerous for them especially if they have to have that income and they don't have the flexibility that maybe we talk about building into your life when you've grabbed this concept of a younger age.
3419 - 3508 JL Collins Well you've covered a couple of different things there so. So let's let's take the last last one. First the flexibility. So if if you have a situation let's say you have a million dollars and using the 4 percent rule which is a rule of thumb as to how much you can safely withdraw from a portfolio that throws off $40000 a year if you need every penny of that $40000 to pay your bills then you are in a much more precarious position than somebody who has a million and a half dollars and can pull sixty thousand but their core spending is really at 40000 and the other 20000 is when they do travel or whatever additional things they do. So it does depend a little bit on your personal situation. And as I said a moment ago the problem with the bonds today is that interest rates are so low. So in the old days you know bonds when they were paying 6 7 8 percent coupons then that was a pretty nice return in of itself. Now the total bond market index fund pays something on the order of two and a half two and three quarter percent VTSAX the total stock market index fund pays dividends of just under 2 percent. So bonds today. No. No longer have that they're no longer have much of an additional income boost from interest as opposed to dividends on stocks. So they're you mostly have them today in your portfolio to provide that stabilizing effect against the volatility of stocks.
indexfunds, stocks, travel
3508 - 3595 Jonathan Mendonsa Yeah that's perfect. Thanks for I know I've been harping on that. Thanks for kind of helping me piece says the other frankly I think sometimes it comes down to the fact that it almost just seems too simple. Right. You want you want a more complex answer but frankly again it goes back to the idea that simplicity is power and being a little bit contrarian with some of these questions I think will help me personally but also our audience latch onto these concepts and understand that they stand up to inspection. I think that after we work through all these individual pieces like allocation the one thing that kind of stands out that I'd like to see discussed and I believe this is actually going to set us up for a question from Amber from our Facebook group was this idea of fixed income people talk about things like annuities and all these other fancy vehicles maybe even reverse mortgages to provide fixed income and the value of just having set income. But we haven't really talked about that in the context of saying that just index fund and I'm just wondering in your mind as a financial planning tool and as an alternate vehicle do those fit inside the fi universe at all is there any place for them is they are they something that you consider or that you've talked about in your blog at all. Dum dum dum. And if you want the answer to this controversial question as well as others from our Facebook group we will be featuring in an episode that will be released in two weeks same bat time same bat station. We'll see you next time. As we continue to go down the road less traveled.
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