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Investing Basics and Common Questions | Rational Reminder With Benjamin Felix and Cameron Passmore Ep. 231 (Part 1)

Check out the Episode Page and Show Notes 

Key Takeaways

  • If people only saved the money they earned, then they would lose purchasing power over time due to inflation 
  • Buying bonds is investing in a company’s debt and is relatively safe because the company is obligated to make its interest payments 
  • Bond investors have fixed returns and equity investors have uncertain returns to the upside and downside
  • The discount rate that investors apply to the expected cash flows of an asset is the way that differences in risk are expressed in asset pricing
  • A higher discount rate implies a riskier asset; it costs less to buy the future cash flows of riskier assets  
  • No single investor can have access to all the information that will affect the price of a stock or bond, but the aggregate of all investors – the market price – is a pretty good representation of all information
  • Unexpected returns are generated from new information that was not previously reflected in the price of the stock
  • The vast majority of active traders on Wall Street fail to outperform the market
  • Understand what your investing objective are; different objectives will have different levels of priority in your life and they will have different optimal portfolios to fund them  
  • By the time you are worried about something, it has already been reflected in market prices
  • Owning too much of your employer’s stock may overexpose you and your portfolio to one centralized entity, given it is the source of your human capital and now a sizeable percentage of your investment portfolio  
  • Having an emergency fund all the time is one way to prepare for a recession
  • Direct exposure to real estate doesn’t offer anything special over publicly-traded REITs once adjusted for sector exposure and the valuation lag in private markets
  • Financially fragile households have lower financial, emotional, and physical well-being; they have less satisfaction at work; and they report less social connection   

Intro 

  • In this conversation, Ben Felix and Cameron Passmore cover the fundamental basics of rational investing, which includes why people invest in the first place, risk and return, discount rates, pricing, the different types of risk, expected vs unexpected returns, the optimal portfolio, sticking to the plan, whether or not you should own your employers stock, emergency funds, preparing for a recession, direct real estate exposure vs REITs, and financial fragility  
  • Check out these Podcast Notes on Ben and Cameron’s Analysis of Alternative Assets
  • Ben Felix (@benjaminwfelix) is a portfolio manager with PWL Capital Inc. and co-host of the Rational Reminder podcast 
  • Cameron Passmore (@CameronPassmore) is the Executive Chairman and a portfolio manager at PWL Capital, and also a co-host of the Rational Reminder podcast

Main Topic: Investing Basics  

  • It can be challenging to find good investing guidance because the popular personal finance books are often at odds with the academic research 

Why Invest?

  • Investors invest to earn a positive real return on their investment 
  • If people only saved the money they earned, then they would lose purchasing power over time due to inflation 
  • Inflation erodes the purchasing power of cash
  • Rather than watching their purchasing power dissolve over time, investors may choose to take risk and invest in companies that ideally appreciate it value over time 

Risk and Return 

  • Buying bonds is investing in a company’s debt and is relatively safe because the company is obligated to make its interest payments 
  • If a company is unable to make its interest payments, then bond investors typically have a claim on the company’s assets 
  • Bond investors do not benefit from a company doing very well, though, like equity holders of the company do  
  • Bond investors do not have exposure to a company’s rise, but a company doing well increases the likelihood that it continues to make its interest payments on its debt
  • Investing in equities is riskier than investing in bonds
  • Buying an equity represents ownership in a given company 
  • The value of a stock fluctuates day to day as the market’s assessment of its expected cash flows and the riskiness of those cash flow changes 
  • Bond prices can fluctuate too when market discount rates change or when the solvency of a company or country changes  
  • Unlike bond investors, equity investors are unlikely to be compensated in the event of a corporate failure 
  • Equity investors can and will lose all their investment if a company is unsuccessful 
  • Equity investors can also experience real returns in their investment if a company is successful 
  • Bond investors have fixed returns and equity investors have uncertain returns to the upside and downside 
  • In the long run, equity investors expect to earn higher returns than bond investors
    • This expectation must be true because equity investors need an incentive to speculate and invest in the riskier asset 
    • The expectation must be true, not the actual outcome 

Discount Rates

  • The discount rate that investors apply to the expected cash flows of an asset is the way that differences in risk are expressed in asset pricing 
  • A higher discount rate implies a riskier asset; it costs less to buy the future cash flows of riskier assets 
    • If an investor actually receives those future cash flows, then they generated a higher return because they paid less for them sometime in the past 
  • Investors expect to earn a return equal to the rate at which they are discounting future cash flows 
  • No public market investor interacts with companies in a vacuum; there is a highly competitive market for financial assets where investors compete with each other to earn the best possible return relative to the risk that they’re taking 

Pricing 

  • No single investor can have access to all the information that will affect the price of a stock or bond, but the aggregate of all investors – the market price – is a pretty good representation of all information 
  • Financial markets bring together traders who disagree on the price of a financial asset
  • Market prices are what results from buyers and sellers disagreeing on the price of a financial asset 
  • Discount rates to future cash flows can be inferred from the market price of a financial asset 
  • An investor investing in an asset with a relatively higher discount rate expects to earn a higher return; but there is no free lunch, just because he expects to does not mean that he will 

Diversifiable Risk and Non-Diversifiable Risk 

  • Systematic risk is the type of financial risk where an investor earns a positive return for purchasing discounted future risky cash flows 
  • Systematic risk is also known as priced risk and non-diversifiable risk 
  • An investor cannot make systematic risk go away, which is why systematic risk is also referred to as non-diversifiable risk 
  • Diversifiable risk is the type of risk that is unpriced, and is also known as idiosyncratic risk
    • This risk is associated with a specific type of company
    • Example: A company executive tweets something inappropriate and the price of the stock falls
  • Generally, more diversification is better than less diversification  

Unexpected Returns

  • Total Return = Expected Return + Unexpected Return 
  • Expected returns can be calculated with discount rates and future cash flows 
  • Unexpected returns are from new information that was not previously reflected in the price of the stock 
  • Predicting unexpected returns is difficult because by definition, the information has not happened yet 

Optimal Portfolio 

  • Stock and bond index funds that provide exposure to the entire market are good starting points for the average investor 
  • The vast majority of active traders on Wall Street fail to outperform the market 
  • Some individuals have different characteristics than the average investor and therefore choose something other than the market portfolio
    • They are more comfortable with risk, they have above average human capital, their time horizon is significantly longer, etc. 
  • Understand what your investing objective are; different objectives will have different levels of priority in your life and they will have different optimal portfolios to fund them 

Sticking to the Plan 

  • The last investing basic is sticking to the plan
  • There is also doom and gloom about financial markets
  • There is always something that makes people think that something bad will happen in the next few months 
  • By the time you are worried about something, it has already been reflected in market prices
  • Investors are forced to take on some amount of risk to beat inflation 

Should I Own My Employer’s Stock?

  • Employees tend to allocate more to their company’s stock when it has a history of strong performance, and vice versa 
  • Owning too much of your employer’s stock may overexpose you and your portfolio to one centralized entity, given it is the source of your human capital and now a sizeable percentage of your investment portfolio
  • Generally, it is not optimal to be overweight your company’s stock 
  • Forty-two percent of Russell 3000 stocks had negative returns in absolute returns for the period 1980 through 2020
  • Sixty-six percent of individual stocks in the Russell 3000 trailed the index itself  
  • Forty-four percent of the time a stock drops 70% or more and doesn’t recover 

How Should I Prepare My Portfolio For A Recession?

  • Portfolio management cannot be reactionary 
  • By the time you have information that makes you want to change your portfolio, that information is already likely in market prices 
  • Having an emergency fund all the time is one way to prepare for a recession 
  • Ensure that you have marketable skills if you’re worried about losing your job 
  • Increase your financial resiliency by managing your expenses and increasing your savings 

How Does Real Estate Compare To The Stock Market, And How Does Direct Ownership Compare To REITs?

  •  

Do I Need An Emergency Fund? 

Episode 93 of the Rational Reminder Podcast Recapped In 60 Seconds

  • Add in small, value, momentum, and international stocks and bonds to the traditional 60/40 portfolio to improve it 
  • If something is kicking the hell out of everyone for a long time, it also makes it expensive 
  • Work with people that help you remain calm when the inevitable volatility shows up
Rational Reminder Podcast : , ,
Notes By Stan Rizzo

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