Ben Carlson: Risk, Reward, and the Future of Investing

Risk just means different things to different people at different times, right? For people who are in the industry, I think one of the biggest risks for us is, you know, ego and overconfidence. And it's like we've got this all figured out. And I've seen, you know, some of the smartest people I've ever met in my life are terrible investors because of that.

Well, there's all this private equity stuff too, right? There's constant takeovers of private equity with RIAs and consolidation there. And I think what it tells me, I mean, if you wanted to look on the cynical side of things, you would go, "Man, this feels like a late-stage behavior, doesn't it?" Like all this M&A activity, it's much easier during a bull market. But I think what the big realization has been for a lot of these pools of capital, especially in the last 10 or 15 years, is just, you know, asset management is a really great business because, you know, and the reason there's consolidation is because organic growth is not that easy. But if you have the market growing, you have this built-in growth engine, right? Especially because of the bull market we've been on, where U.S. stocks have been, you know, on this like 17-year charge higher of mid-double-digit returns, right? And so I think that there's been a lot of that.

It is interesting to think about because at my firm, we spend a lot of time talking and thinking about culture. So like, yes, you're buying these good businesses and you're getting this organic growth and that's great, but what does it mean for the end client? Like, what say do they have in all of this? And I think that's the thing that kind of gets lost when you're just looking at the numbers of, oh yeah, this is a great business. It's got a built-in growth engine and if we can consolidate enough of them and grow that way, we can keep this train going. But what happens to the client at the end of the day, right? And as you know, asset management firms have a lot of, we'll say, personalities. There's a lot of culture, a lot of quirkiness, and that's a feature, not a bug. But when you combine them, it can create a lot of political issues and new organizational changes that might distract professionals from ultimately helping the client, which is what we're trying to do. So I think some of the pitch has been that we're going to combine firms and we're going to combine back office, which will save money, but we'll also be able to offer our clients new services that they didn't have before.

I'd be a little worried that I'm just kind of a cog in the machine, just a number for people. And most people with financial advisors, they don't care as much about the name on the door as like the personal advisor they're working with and that relationship. So I think for a lot of people, they'd want to ensure that the personal relationship is staying the same. But yeah, it's also, is the customer service going to be worse, right? Are there going to be cutbacks and am I going to be talking to the same people and working in the same process? So I think that would always worry me, that these companies are probably looking for redundancies and that sort of thing. And I do think the end client is probably the last thing people are worried about in these situations. And frankly, I've talked to a number of advisors who are really concerned about what AI means for the business. And they're saying, you know, I'm going to retire in five or 10 years anyway. I might as well just sell and get a good price now. And if they're thinking that way, then of course they're not really thinking about the client. So yeah, I'd be asking a lot of questions about how this relationship is going to change, what my fees are going to be, what kind of services I'm going to get, how the customer service is going to evolve. I'd be concerned if I was seeing this constant consolidation on top of consolidation.

Well, it does seem like another thing where this is a great time to do it because, you know, all the flows have been going into passive products, right? Even though there's been kind of a, I feel like a comeback for active management, like thematic funds especially in recent years because of retail investors and their affinity for the markets now. But that's another side of the business where even though the flows are all going into passive products for the most part, the fact that markets are up has meant that it hasn't really hurt actively managed businesses in many ways, right? Because the market has gone higher. So I think maybe part of it is planning for retrenching for what happens if there is ever a downturn and maybe the flows get worse and the AUM goes down and then it's a business problem. So to me, the consolidation there does make a lot of sense. I think it's also probably thinking in terms of what if the headcount we need isn't going to be as large anymore because we have these tools and technology. I've heard from a number of young people already that said, "Hey, I had this analyst position and they're kind of doing away with it now because of AI and the research capabilities." And I wonder if that's a piece of it too, is that they realize the headcount doesn't need to be as large for these places anymore. They can have some synergies.

I do think there's going to be a lot of give and take on this, where there's going to be like an overreaction of people saying, "Yeah, we don't need any of this." And then in a number of years down the line going, "Oh my gosh, we didn't have anyone to train and who's going to be the next one to step up and be that middle manager role or whatever it is." And so I think you're going to see firms like overreact in both directions on this stuff, right? Like cut down to the bone and then realize, "Oh man, we don't have that next class of people ready to come up." Maybe that, yes, we're paying more money, but that's an investment in people and it's not necessarily like just about the cost savings and the cost benefit. But I'm sure there are plenty of quantitatively based firms that are looking at it and going, our headcount would be far, far lower now because of this. Then you have to think, well, at what point does the technology become a commodity too? And like, how much are we really getting ahead of other firms using the same technology and LLMs that they are, and how are we interacting with it? And so I think there's going to be give and take. But I do, again, I've heard from a number of young people who are very concerned about this and wondering, like, where is my initial training going to come from in this business? And I sympathize with people because that's, I started out as an analyst, right, with no experience and no real knowledge and kind of had to learn and got a good training program. And I think that's really helpful for people. And I think it's helpful for people who are kind of teaching the next crop of people as well because I think that helps keep them sharp. And certainly the trend from the hiring trends that I work with my finance majors, it's shifted even in the past three years since I've started teaching at the college level. There's been very little interest in going into equity research or to active management.

I've thought about this a lot and there's a million definitions of risk, I think. And the way that I've really kind of changed my mind about this over time is just thinking that like one definition of risk counts for everyone, but really your capacity to take risk changes depending on where you are in your life cycle, right? If you have a more mature portfolio and you're not putting as much money in and you're approaching retirement versus a young person versus sort of a middle-aged person, right? Like a gigantic bear market is going to be way more impactful to someone who has a mature portfolio who's retiring and has to worry about spending down their portfolio versus someone who's young who has many years ahead of them and has the ability to with their human capital to save and keep contributing to the market and adding funds. And so I think risk just means different things to different people at different times, right? For people who are in the industry, I think one of the biggest risks for us is, you know, ego and overconfidence. And it's like we've got, I've got this all figured out. And I've seen, you know, some of the smartest people I've ever met in my life are terrible investors because of that, right? On the other end, you have newer retail investors coming in who really don't know anything. And their biggest risk is like being naive and not knowing the whole Buffett, like your biggest risk is not knowing what you're doing. And so I think that there's different risks for different people. And like, you know, we've, there's been all this research and the big leap forward I think for financial professionals in the last 20, 25 years is like all this focus on behavioral psychology. And it's like, what's the biggest bias that, you know, that the biggest risk? And it's like, well, it's the, it's whatever one you're blinded to, whatever your blind spot is, that's, that's the risk. And so I think it really depends on like the person in the situation.

Yeah, if you think about like risk in terms of uncertainty, the reason stocks have a risk premium over other asset classes is because there is more uncertainty involved, right? And there is more chance for something really bad to happen, and that's why you get those higher expected returns. But it's not like a one-to-one thing where I'll just pick the most highly volatile asset and that's going to give me for sure the highest returns. So obviously there's like diminishing returns at some point, but I do think that is part of it. You're right that the academic part of, man, one year stocks could be up 30%, the next year they're down 15%. And just having that wide range of outcomes that you don't get in cash, you don't get in fixed income or some of those asset classes. I do think that's one of the reasons that, you know, that's why stocks offer a higher long-run return.

And the big thing there is that it's the overall portfolio that matters, not just the individual part. So you could take a very highly volatile asset, could be a really good thing in the context of a broader portfolio that doesn't have as many volatile assets, right? Because you could use it to rebalance the portfolio, right? When it's doing really well, you take some off the table and rebalance into other stuff. And when it's doing really poorly, you shovel money back into it. And so it's really the whole portfolio construct that matters. And for us, we always start with, you know, we can't offer you investment advice on your portfolio without understanding what your goals are, right? We can't offer blanket advice to everyone because we need to know when you're going to spend the money, what your relationship is like with risk, right? How you think about risk. And you can take all the inputs you want. Like we learn this in level three of the CFA exam, right? It's your willingness, ability, and need to take risk and your time horizon and all these things. And you could put that into a computer and it'll spit out here's what your portfolio should be based on your age and all these things. But you could have had an experience in the past that totally changed the way you think about it. Like we have a portfolio manager for a fixed income hedge fund right now who makes very good money, has a high net worth, but he worked for Lehman Brothers in 2008 and lost something like 90% of his net worth because it was all in the stock of the company. And he admits, listen, I know I should be taking more risk based on my age and based on how much money I have and how much money I make, but I can't force myself to take more risk because I've experienced this thing in the past. And so that's where I think being a wealth manager takes into account the qualitative aspects of this and understanding that you're not just trying to force-feed a portfolio down someone because the spreadsheet tells you that's what they should be invested in. You also have to understand like what they're willing to give up or what the trade-offs are going to be for them in terms of their appetite for risk based on their history. And sometimes too, it comes down to telling someone, no, just because you had this bad experience in the past doesn't mean that you can all of a sudden invest from a fetal position, right? Or just because you've done so well in the past doesn't mean that you can try to shoot the moon all the time and go crazy. So part of it is too like setting reasonable expectations and telling people, you know, sometimes the way that you feel about this is wrong. We need to actually right-size this.

The hard part for people just starting out is that like there's a huge difference between a paper portfolio and real life losing money, right? And so some things you have to experience for yourself and you don't know how you're going to react to a 20% decline in your stock price in a matter of weeks or something, right? And some people have the ability to sit through it and add more money and they're fine and they don't do anything, and other people know that they will freak out. And so I think there probably is a little bit of give and take right when you're starting out to kind of go through some experience and learn and maybe even pay some tuition to the market gods occasionally. And I think there could be some trial and error for people, right? It's interesting. I think a lot of the young people who got involved in crypto early on, I think experiencing like the bone-crushing volatility that you did in that class will probably serve them well going forward in a more traditional portfolio because they've lived through these huge painful cycles, right, with like 70, 80% crashes. And I think if you've done that before, like we have clients come to us and we'll say, "Hey, we have these risk management techniques we can use for your portfolio in case there is this really nasty 40, 50% bear market." And they'll say, "Listen, I sat through the dot-com bubble. I sat through the Great Financial Crisis. Like, I know myself, I know I'll be okay." One of the best predictors of future behavior is past behavior. And then you have other people who come to you and go, "Man, in March of 2020 when the COVID pandemic was really and the stock market was down 30%, I sold half of my portfolio and it took me five years to get back in." And so I think there is something to the fact of like knowing yourself and understanding yourself and better understanding the clients in terms of like what they're potentially going to do in those situations.

So, you're right. I mentioned some things you have to just experience for yourself. When I was a young investor just getting started in this business, I realized very quickly like I've never experienced these things before. Like what is it going to be like for me? And so I thought if I can't wait 20 years to go through a full cycle or whatever, I have to start learning and I have to start reading about the South Sea Bubble and the Great Depression and all these different things that have happened in the past and learn about the 1970s. And so I dove headlong into reading about market history. And it was very helpful to me to understand like what are the similarities and differences of these huge crashes and these huge booms and busts. And it was very instructive for me. And I didn't come away from it thinking, man, now I know I can predict the future, right? It actually made me more humble about the investing business because you realize like, you know, there's been some really smart people in the past who've gotten totally taken by these things, right? And so I do think studying market history is helpful just to give you an idea of the range of outcomes. And one of the reasons I really wanted to harp on a lot of the bad stuff is just as a reminder to people that like this, despite everything that's happened, all the recessions, all the war, all the depressions and inflation and deflation and all these bad things, like that's kind of baked into the pie of the past whatever hundred years of really good returns in the stock market. It's not like the stock returns have given you that because you sidestepped all that stuff, right? You sidestepped it.

That's inclusive, and you kind of have to learn how to deal with that stuff. And, you know, everyone in their life cycle is going to have to deal with, you know, one or two or three or like big financial crises at some point. And that's why I wanted to just remind people of those. And it's not like the ones in the past are going to happen exactly again in the future. But it again, it was really helpful for me to just study these periods. And I thought the best books that I've read were the ones that really like were happening kind of in that time, right? And you hear what actually people thought at the time, not just because it's always easy to look back and go, "Oh, yeah, massive buying opportunity. Of course, I would have done that, right?" But without understanding what it's like to live through that period. And so I wanted to help better understand like how crazy the boom times can get and how just like gnarly the, you know, the bust times can be for people and try to really paint a picture of some of those really crazy periods in the market.

And when you look back at Warren Buffett's op-ed, and I think it was the New York Times, the "Buy American, I Am" — people look back and see, you know, look, he was telling people to buy when the market was panicking. The market went down another, I think, 30% after he wrote that. And there's an article that I've saved, and it was in the Los Angeles Times, and the date was, I think it was March 6th or March 9th, whatever the bottom of the market was. And there was another op-ed. And looking back, you have to kind of wonder, was it sarcasm or parody? But it was a person just kind of putting their heart and soul out there saying, you know, now is the time to panic, you know, I didn't sell early enough. And people, and, you know, I have nothing against that author. He was just saying what was on his mind at that time. And a lot of people felt that. And I think especially since we haven't really had a crisis, an extended crisis like that since the financial crisis, it's really hard for people to understand if they just started investing even 10 years ago the pain and mental anguish that came along with that. I mean, especially since it was a housing-related crisis. A lot of people had housing tied up in this, you know, they had mortgages to pay and now their house was underwater. And it was a very stressful period. And to be able to be confident enough that, you know, I have the capital that I can part with now, right, rather than just hoard it because who knows what's coming next. I'm going to part with that and say I'm going to invest. That's a major leap of faith that you have to do in...