These past couple weeks represent the biggest shift in my understanding of personal finance in many years, maybe even decades. Things that never made much sense to me (and which I dismissed as foolish) now make a lot of sense, and my own plan for how I manage my finances has changed drastically. I also have a much greater understanding of what is happening in the economy (for example, why the stock market is so high when things are going so poorly).
It all started with Mark Zuckerberg. I read online somewhere that he bought a 6 million dollar house and got a mortgage for it. Why would you get a mortgage for a house when you’re a billionaire?
This led me down a rabbit hole and made me realize that extremely rich people treat personal finance in a fundamentally different way than you and I do, and that their approach can be scaled down and used by normal people like you and me (if you’re a billionaire and I have offended you by calling you a normal person: sorry).
Why would Mark Zuckerberg get a mortgage? Because his rate was about 1%, and he can earn more than 1% on his money. There’s more than that, though. Mark may not have 6 million sitting around in a bank account, so he would have to sell Facebook stock. That’s a hassle, but it also creates a taxable event. He has to pay taxes on the stock, assuming it has gone up. Now his house is more expensive. Instead he can just pay 1.05%, which is just barely over the inflation rate (and probably under the average inflation rate during the term of his mortgage), he can write off some of that interest, and he saves a bunch of money.
It turns out that ultra-rich people use credit like this all the time. The main mechanism is by taking loans out against their stock portfolios (or other liquid assets). If you want to get a loan with no collateral, you’ll pay a huge interest rate (like a credit card). If you have okay collateral, like a depreciating car, you’ll get a better interest rate. A safe fixed asset like a house gets you an even better rate. But the best rate of all? Portfolio loans. Even for normal people like you and I, it’s possible to get rates in the 1.5-2% range (more on this later). And you can write off the interest, which means that wealthy people get about half of that money back. On really large loans the rates are under 1%, and when taking taxes into account they come in at well under the inflation rate.
Banks will do this because there’s no risk of default. If your stocks start to go down and you have too much borrowed, they can liquidate your stocks and pay themselves back. That’s a lot easier than repossessing a house. Banks can now borrow at just over 0%, so why not make a few fractions of a percent on a loan that can’t possibly default?
It makes sense. Banks put out the loans because there’s no risk to do so, and people take them because the loans make it nearly free to access money.
Of course, if their stock portfolio tanks, they’re in trouble…
I have never invested any significant portion of my money in the stock market until very recently. There were a few reasons for this.
First, a quick primer on something I just learned. There are two types of gains in the market: alpha and beta. Alpha is essentially the capitalization on unpriced knowledge. If you count the trucks outside a chicken farm and realize there aren’t as many as usual, you have discovered knowledge that isn’t reflected in the stock price. You can trade on that knowledge and capture some alpha, which will then adjust the global stock price (in reality you probably wouldn’t move the needle much, but that also means you didn’t actually capture all that much alpha. A hedge fund could take all of it).
Also, there’s beta. Beta is much less glamorous, but it’s essentially the rising tide of the economy. Our capital markets generally work to move money from inefficient places (sitting in a bank account) to efficient places (being invested in a business which can turn it into products and services). This cycle creates value and some of that value is captured in stocks. Beta is the reason that the stock market really can keep going up forever.
Alpha is a zero sum game. If I earn $1000, someone loses $1000. Beta is not a zero sum game. Anyone can capture beta.
Everyone you know is trying to capture alpha, and they are all failing. Unless you are a very sophisticated professional investor, you are not capturing alpha. When people say “XYZ company is so much better than their competitors, so I’m investing in them”, they are making a mistake. The market knows exactly how good they are, what their advantages are, and what their disadvantages are. That’s why that company’s stock is at whatever price it’s at.
When people “win” by trying to capture alpha, what has happened is they’ve actually captured beta AND have exposed themselves to volatility by choosing an individual stock. That means that they will appear to have beaten the market, but if they do it long enough they will regress to the mean.
If you don’t believe me, you can read more about this elsewhere.
I knew that people trying to capture alpha were largely misguided, but I didn’t fully understand beta.
Common wisdom says to invest in index funds, which is a method of capturing beta. This is certainly a much better idea than choosing individual stocks, but it still didn’t make sense to me. An index fund averages 9% over the long term, but sometimes exposes you to 30% or larger downswings. I have enough ways to make around 9% with less volatility, so I wasn’t interested.
I had heard people talk about bonds, but I knew that they returned less than stocks on average, so I was even less interested in them.
Then I heard about something called the All Weather Portfolio by Ray Dalio. He’s the manager of the biggest hedge fund in the world and is a writer who is best known for the excellent “Principles”. Ray Dalio can chase alpha (he has a fund called Pure Alpha) because he is actually the best in the business and is the one finding real alpha. But he is also interested in beta, and that’s what the All Weather Portfolio is for.
Beta comes from different sectors at different times. Sometimes stocks deliver all of the beta, but other times bonds do. By mixing stocks and bonds (and other uncorrelated assets), you can average out and get a steady drip of beta.
This process creates a much smoother “up and to the right” graph than just investing in stocks. Even though the mix doesn’t return the same 9% per year, it may return 6% with only 1/3 of the volatility. The risk/reward is much better. What Dalio then did was apply leverage to the portfolio. Imagine if you could double everything (either through 2X ETFs, futures, or margin). You would then have roughly a 12% return with only 2/3 of the volatility of stocks along. Genius.
This post was getting really long and I still want to research a couple things, so I will continue next week with practical steps to implement this strategy. If you think I’m wrong about anything, please let me know on twitter or by email.
I will probably share at least a rough outline of my portfolio here and will share the exact portfolio as well as updates on my Patreon for inner circle members.
Photo is the Austin skyline. Sorry the post was late this week… I wanted to research as much as possible.
In other news, I think I’m selling the (still unrepaired) Bentley on Monday. Hate to let her go, but I got an offer I couldn’t say no to.