00:00:00
Welcome to personal finance for
00:00:02
long-term investors, where we believe
00:00:04
Benjamin Franklin's advice that an
00:00:06
investment in knowledge pays the best
00:00:08
interest both in finances and in your
00:00:10
life. Every episode teaches you personal
00:00:13
finance and long-term investing in
00:00:15
simple terms. Now, here's your host,
00:00:18
Jesse Kramer. Welcome to Personal
00:00:20
Finance for long-term investors, episode
00:00:22
118. I'm Jesse Kramer. By day, I work at
00:00:24
a fiduciary wealth management firm
00:00:26
helping clients nationwide. You can
00:00:27
learn more at bestinterest.blog.
00:00:29
blog/work.
00:00:31
The link is in the show notes. And by
00:00:33
night, I write at the best interest
00:00:34
blog. And I host this podcast, personal
00:00:36
finance for long-term investors. I help
00:00:38
busy professionals and retirees avoid
00:00:40
mistakes and grow their wealth by
00:00:41
simplifying their investing, taxes, and
00:00:43
retirement. Today is our ninth AMA
00:00:46
episode. Yes, an ask me anything episode
00:00:48
where we dive deep on your questions in
00:00:50
the world of financial planning,
00:00:52
investment management, retirement
00:00:53
planning, all those kind of juicy
00:00:55
topics. But first, we have a review of
00:00:57
the week from Bike Guy. Bike guy says,
00:00:59
"Solid and clear advice. I'm glad I came
00:01:01
across this podcast. The information is
00:01:03
always spot-on, clear, and concise, and
00:01:06
helps me make better personal finance
00:01:07
decisions. It may not be the most
00:01:09
entertaining thing to listen to all the
00:01:11
time, but I don't think I've come across
00:01:12
a finance podcast that so consistently
00:01:15
delivers accurate and helpful
00:01:16
information. Keep up the great work. I'm
00:01:18
definitely going to keep listening." I
00:01:20
think that's actually a good thing. I'm
00:01:21
not sure I want this podcast to be the
00:01:23
most entertaining thing to listen to all
00:01:25
the time. you know, I don't have the the
00:01:26
Jim Kramer sound effects going on,
00:01:31
>> but uh the fact that Bike Guy says, "I'm
00:01:33
consistently delivering accurate and
00:01:35
helpful information." That right, that's
00:01:36
the name of the game. That's it, right?
00:01:38
That is the name of the game. So, Bike
00:01:39
Guy, thank you for those kind words. I'd
00:01:41
be happy to send you a super soft
00:01:42
podcast t-shirt. Please drop me an email
00:01:44
to jesse at bestinterest.blog. And
00:01:47
listeners, if you have a question or a
00:01:48
concern or feedback that I can answer,
00:01:50
especially for a future Ask Me Anything
00:01:52
AMA episode, please send those questions
00:01:54
to my email address, jesseb
00:01:57
bestinterest.blog.
00:01:58
So, the first question is from Jim and
00:02:01
and really it's a it's more of a comment
00:02:02
than a question. Uh, but we're going to
00:02:04
use it as a springboard to start today's
00:02:05
episode. I wrote an article uh about a
00:02:08
month ago and I can link it in the show
00:02:09
notes. It's called Stocks for Growth,
00:02:11
Bonds for Sanity. And Jim commented on
00:02:14
that article and he said, "As all you
00:02:16
quote unquote advisers do, you never
00:02:19
understand time. At age 30 or age 40,
00:02:22
you go allin. At age 73, diversification
00:02:26
rules. Preservation, not growth, is more
00:02:28
important. Time is the variable that no
00:02:31
advisers seem to get." Well, I kind of
00:02:34
laugh at Jim because I'd argue that time
00:02:36
and timelines is probably one of the
00:02:38
foundational considerations in in all my
00:02:40
financial planning work. And uh if
00:02:42
there's any topics that listeners and
00:02:44
readers might be sick of me talking
00:02:45
about, it could be time and timelines.
00:02:48
Diversification a huge factor too and
00:02:49
and something I think I do a pretty good
00:02:51
job talking about. Then Jim's comment
00:02:53
might out him as a bit of a newcomer to
00:02:55
my content. But even then, I think Jim's
00:02:57
comment needs a little bit of massaging.
00:02:59
And I think we can all all learn
00:03:00
something from Jim's comment. So for
00:03:02
example, he says at age 30 or age 40,
00:03:04
you go allin, meaning your investments
00:03:06
should be allin kind of aggressive, high
00:03:09
octane. And I say not not necessarily,
00:03:12
Jim. You know, if a 30 or 40year-old if
00:03:14
they're saving for um a housing upgrade
00:03:17
or or a new house they want to move, if
00:03:19
they're saving for their kids' college,
00:03:21
well, those are probably short or
00:03:23
medium-term expenses that they're saving
00:03:25
and investing for, but not in an all-in
00:03:28
fashion. And then Jim goes on to say, he
00:03:30
says, "At age 73, diversification rules
00:03:32
because preservation, not growth, is
00:03:34
more important." Again, I would disagree
00:03:36
here, Jim. It might be true for Jim
00:03:38
himself, but not for all 73 year olds. I
00:03:41
know plenty of mid70s folks who ought to
00:03:43
be thinking uh of part of their family
00:03:45
wealth as being short-term, medium-term
00:03:48
so that they can fund the remainder of
00:03:49
their life, but then part of their
00:03:51
family wealth as being long-term for
00:03:53
their kids, for their grandkids, for a
00:03:55
charity after they pass away or
00:03:57
something along those lines. And for
00:03:58
those people and for those purposes, for
00:04:00
those reasons, for those goals and those
00:04:02
timelines, growth is actually more
00:04:05
important than preservation. even at age
00:04:08
73. Again, I'm being a little facicious
00:04:10
here. It's almost as if the individual
00:04:12
investors or the family's goals are the
00:04:14
most important thing, Jim. Those goals
00:04:16
come with specific timelines and dollar
00:04:18
amounts needed. Those timelines and
00:04:20
those needs inform the appropriate
00:04:22
amount of risk one can take and the
00:04:24
reward that one should seek from their
00:04:25
investing, which of course informs which
00:04:27
types of assets, which asset classes are
00:04:30
appropriate for that goal. And maybe
00:04:32
some adviserss don't understand that
00:04:34
idea, Jim, or prefer to invest in some
00:04:36
way that doesn't account for their
00:04:38
clients unique goals or timelines, and
00:04:39
that's their prerogative, their
00:04:41
business, and it's up to them to explain
00:04:42
that to their clients. But personally,
00:04:44
my financial planning and investment
00:04:46
approach, and that which I encourage any
00:04:48
DIYer out there to follow, is highly
00:04:50
dependent on time and timelines.
00:04:52
Diversification, of course, is important
00:04:54
at all ages. In my opinion,
00:04:56
diversification might be the only free
00:04:58
lunch in investing. And I think it's
00:05:00
always worth revisiting that that basic
00:05:01
tenant of investing, that relationship
00:05:03
between risk and reward. And it really
00:05:05
does start with the basics. High reward
00:05:07
comes from taking risks. Small risks
00:05:10
though or no risk lead to small rewards.
00:05:12
You can control your risk preference,
00:05:14
your time horizon, and your financial
00:05:16
goals. But if you demand satisfaction
00:05:18
from all three, you might be
00:05:19
disappointed. And really what I mean
00:05:21
there, we can dig into some more details
00:05:22
in a minute, but if you demand a
00:05:24
low-risk investment that over a short
00:05:27
period of time is going to fund lofty
00:05:30
financial goals, you're going to be
00:05:31
disappointed. You kind of have to pick
00:05:33
and choose. And people searching for
00:05:35
that lowrisk but highreward investment,
00:05:37
they're kind of seeking some sort of
00:05:39
mythical free lunch. And there's no such
00:05:41
thing as a free lunch. Although
00:05:43
diversification which we just talked
00:05:44
about diversification might be that free
00:05:47
lunch and the one and only free lunch in
00:05:49
the world of investing. So again risk
00:05:51
and reward are correlated. All
00:05:52
investments come with risk. Now what
00:05:54
does that mean? How do we define risk?
00:05:55
It varies but the popular definitions
00:05:57
are that risk is the probability of
00:06:00
permanent harm or injury. That risk is
00:06:02
relative to time horizons. A choice can
00:06:04
be risky in the short term but less
00:06:06
risky in the long term or vice versa.
00:06:09
Right? Stocks might be risky in the
00:06:10
short term, but most people would say
00:06:13
they become less risky. A diversified
00:06:14
stock portfolio becomes less risky over
00:06:16
the long run. Whereas holding a
00:06:18
portfolio of say short duration bonds,
00:06:20
not risky at all in the short run, but
00:06:22
if all you do is invest your money,
00:06:24
invest your money in cash and bonds,
00:06:26
that probably is risky or riskier in the
00:06:28
long run. So anyway, risk can change
00:06:30
over time. And risk another part of the
00:06:33
the definition of risk is that it is
00:06:34
related to volatility in some way.
00:06:37
Although many investors, for example,
00:06:39
Warren Buffett would probably disagree
00:06:41
with that idea. The whole point is that
00:06:42
risk is scary in some way, right? We
00:06:44
don't want to lose our money. And risk
00:06:46
implies that we might do just that.
00:06:48
Might just lose our money. So, when
00:06:50
we're faced with any sort of risky
00:06:52
investment, the intelligent investor
00:06:53
says, well, I'm going to demand a bigger
00:06:56
reward. If I'm going to take this big
00:06:58
risk, I need to earn a bigger return.
00:07:00
And what that ultimately looks like is,
00:07:02
hey, if the return isn't juicy enough,
00:07:05
I'm not going to pay that price. I'm not
00:07:07
going to pay the price that's being
00:07:08
offered to me. There's no demand at that
00:07:11
current price. And the lack of demand in
00:07:13
this capitalist supply and demand
00:07:15
economy, the lack of demand is going to
00:07:17
push the price down. And when we pay
00:07:19
less for the same investment that we
00:07:21
otherwise would have, well, that means
00:07:22
that the return on that investment is
00:07:24
naturally going to go up. And that leads
00:07:26
to this essential relationship both in
00:07:27
investing and in other parts of the
00:07:29
economy. But today we're going to focus
00:07:30
just on investing. This essential
00:07:32
relationship between risk and reward and
00:07:34
price. Risk is built into the investment
00:07:36
itself. Reward is something that
00:07:38
investors must demand and they make
00:07:40
these demands via the price that they're
00:07:42
willing to pay. Rental reward
00:07:44
overcompensates for the risk.
00:07:46
Intelligent investors are going to pour
00:07:47
their money into that investment. And
00:07:49
rental reward doesn't really justify the
00:07:52
risk. Intelligent investors are just
00:07:53
going to sit on the sidelines. That
00:07:55
demand or the lack thereof will push the
00:07:57
price of the investment up or down. In
00:07:59
other words, price acts as an
00:08:01
equilibrium mechanism between perceived
00:08:03
risk and expected reward. Some of you
00:08:05
might have seen a chart before, a very
00:08:07
simple chart that shows uh risk on the
00:08:10
xaxis and returns on the y ais. And it
00:08:13
shows this nice gently increasing slope.
00:08:16
As risk goes up, returns also go up. And
00:08:19
then along that slope are different
00:08:20
asset classes. You know, uh bonds are
00:08:23
relatively low or further left on the
00:08:25
slope because they're lower risk and
00:08:27
lower reward. And as we move up and we
00:08:29
move to the right, we hit things like
00:08:31
real estate and large cap stocks and
00:08:34
small cap stocks and private equity.
00:08:36
More risk, more reward. You can almost
00:08:38
think of it as a bell curve or a series
00:08:40
of bell curves onto this chart. And at
00:08:42
the furthest left, again, at the lowest
00:08:44
end of the spectrum, at the lowest risk
00:08:46
end of the spectrum, the bell curve is
00:08:48
very small because the range of expected
00:08:50
outcomes is very small with with lowrisk
00:08:52
assets. But as we move further right,
00:08:55
that bell curve grows. It grows in
00:08:57
width, it grows in height because the
00:09:00
range of expected outcomes becomes quite
00:09:02
large. And in fact, we eventually hit
00:09:04
many types of investments where the
00:09:06
range of expected outcomes is so large
00:09:07
that we might lose most of our money. So
00:09:11
anyway, in the show notes, I'll link
00:09:12
this article bestinterest.blog/risisk
00:09:15
andreward and you can see both of these
00:09:17
charts for yourself. But that leads me
00:09:19
to a question. What can you control in
00:09:21
this risk versus reward relationship?
00:09:23
Right? Some things are not in our
00:09:24
control as investors, but some things
00:09:26
are in our control. And what is in our
00:09:28
control is that we have financial goals.
00:09:30
We have a preferred time horizon to meet
00:09:32
those goals. And ideally, we can adopt
00:09:34
some particular risk preference to do
00:09:36
just that, to meet our goals on time.
00:09:38
But many people, including some of us,
00:09:41
run into trouble when either our goals
00:09:43
are too lofty, our time horizon is too
00:09:45
short, or our risk preference is too
00:09:48
conservative. Right? Everybody wants a
00:09:50
high return for no risk. They want that
00:09:52
proverbial free lunch, but it really
00:09:53
doesn't exist. And if you need high
00:09:55
returns due to either your lofty goals
00:09:57
or your short time horizon, then you're
00:10:00
going to need to take a lot of risk. And
00:10:01
if you can't stomach that risk, well,
00:10:03
then you're going to need to either
00:10:04
soften your goals or lengthen your time
00:10:07
horizon. You can almost imagine this
00:10:09
little triangle diagram where the three
00:10:11
points on the triangle are low risk,
00:10:14
short time horizon, and large financial
00:10:16
goals. Again, the three points on the
00:10:18
triangle, low risk, short time horizon,
00:10:20
and large financial goals. And as you, a
00:10:23
person, kind of move around this
00:10:25
triangle, as you move towards one of
00:10:27
those three points, you're naturally
00:10:29
going to be moving away from the other
00:10:30
two, right? So, if you demand lower risk
00:10:33
investments because you just can't
00:10:34
stomach the risk. If that's the point of
00:10:36
the triangle that you're moving toward
00:10:37
is low risk, well then you're moving
00:10:39
away from short time horizons and you're
00:10:42
moving away from large financial goals
00:10:44
because in order to reach whatever goals
00:10:46
you want with low-risk investments,
00:10:48
you're going to need a long time for
00:10:50
those investments to compound. If you're
00:10:52
moving towards the corner of the
00:10:53
triangle that say large financial goals,
00:10:55
right? If you have these big lofty
00:10:57
financial goals, well then you're moving
00:10:59
away from low risk. you're going to need
00:11:01
to start taking some some bigger risks
00:11:02
and you're also moving away from short
00:11:04
time horizons. If you have large goals,
00:11:06
it's going to take you some time to be
00:11:07
there. So again, there's this natural
00:11:09
trade-off. There's no free lunch except
00:11:11
for maybe one. Diversification might be
00:11:14
the one free lunch out there. And this
00:11:15
comes back to uh Harry Marowitz who who
00:11:18
won a Nobel Prize for modern portfolio
00:11:20
theory and and he was the one who first
00:11:22
said diversification is the only free
00:11:24
lunch. And what he meant was
00:11:25
diversification is the only way to
00:11:28
reduce portfolio risk to reduce risk
00:11:31
while maintaining returns to get out the
00:11:34
same reward that you otherwise would
00:11:36
while also reducing risk at the same
00:11:37
time. That's the whole reason why people
00:11:39
harp on the idea of diversification.
00:11:41
They're saying that a well- diversified
00:11:42
a well- constructed portfolio is less
00:11:45
risky than the sum of its parts. That's
00:11:47
the essence of modern portfolio theory
00:11:49
that won Marowitz that Nobel Prize in
00:11:51
economics. The idea is to create a
00:11:53
portfolio of risky assets. For sure,
00:11:54
they're risky assets on their own, but
00:11:56
to ensure that those assets are not
00:11:58
correlated with one another to ensure
00:12:00
that their behaviors, their return
00:12:02
profiles don't move in tandem with one
00:12:04
another, that they don't rise and fall
00:12:06
at the same time as each other. Marowitz
00:12:09
proved that a diverse portfolio in this
00:12:10
way has the same expected returns as a
00:12:12
non-diversified portfolio, but at
00:12:14
significantly less risk, less chance of
00:12:16
going to zero, less volatility along the
00:12:18
way. It can be measured using things
00:12:20
like the sharp ratio. That's the most
00:12:21
widely accepted measure of risk and
00:12:23
reward in investing. Portfolios that
00:12:25
exist on the so-called efficient
00:12:27
frontier, they represent the best
00:12:29
possible expected returns for a given
00:12:31
level of risk. Now, this idea, modern
00:12:34
portfolio theory and diversification as
00:12:36
a free lunch, it's not without
00:12:38
detractors. First, there's the math
00:12:40
versus reality argument. Modern
00:12:42
portfolio theory looks great on paper in
00:12:44
the world of pure math. But critics
00:12:45
would argue that uh it's not as
00:12:47
effective in the real world where the
00:12:49
psychological irrationality of Mr.
00:12:51
Market, all of us in the markets, our
00:12:53
irrational exuberance and our panic when
00:12:56
that is at play too. Beyond just the
00:12:58
math, it's also investor psychology.
00:13:00
Well, all of a sudden, modern portfolio
00:13:01
theory breaks down a little bit. Next,
00:13:03
some people would claim that
00:13:04
diversification simply isn't enough.
00:13:06
Nobel Prize winners Eugene FMA and Ken
00:13:08
French. They're proponents for example
00:13:10
of factor investing. In short, factor
00:13:12
investing says rather than looking
00:13:13
purely at risk, there are other
00:13:15
variables that lead to extra investment
00:13:17
reward. For example, size. They would
00:13:20
say that small caps tend to outperform
00:13:21
large cap stocks. Uh relative price,
00:13:24
value stocks tend to outperform growth
00:13:26
stocks. There are few other factors too.
00:13:28
Quality momentum and and a few that I'm
00:13:30
not going to talk about here. And modern
00:13:31
portfolio theory, the diversification
00:13:33
theory, if you will, ignores that idea.
00:13:35
that might not be a smart thing to do.
00:13:37
And then even there's criticism from
00:13:38
legends like Warren Buffett and Charlie
00:13:40
Munger who would claim that modern
00:13:42
portfolio theory is simply an invitation
00:13:44
to buy to own suboptimal stocks and
00:13:47
suboptimal companies in the pursuit of
00:13:49
diversification. Charlie Mer and Warren
00:13:51
Buffett were pretty famous for having
00:13:53
concentrated positions in their
00:13:55
portfolio. Rather than owning 50
00:13:56
companies, they'd say just own the best
00:13:59
three and ignore the 47 bad ones. Now,
00:14:02
how do we identify which three are the
00:14:04
best? That's what makes Warren Buffett
00:14:06
and and when Charlie Munger was alive,
00:14:08
that's what made them the legendary
00:14:09
investors they are. Their consistent
00:14:11
ability to identify those three needles
00:14:14
from the haystack of 50 stocks. You and
00:14:16
I, it's probably harder for us to do and
00:14:17
maybe that's why diversification makes a
00:14:19
lot more sense on the kind of individual
00:14:22
family level as opposed to the giant
00:14:24
institutional level, but that's a
00:14:26
conversation for another day. Getting
00:14:27
back to the point, risk and reward, they
00:14:29
are intrinsically connected. As risk
00:14:31
increases, investors must demand more
00:14:33
reward. And in your investing life, you
00:14:36
can control your risks, you can control
00:14:37
your goals, you can control your time
00:14:39
horizons, but it's impossible to control
00:14:41
to optimize all three. You're going to
00:14:43
have to sacrifice at least one in
00:14:45
pursuit of another. And while there's no
00:14:47
free lunch, diversification does come
00:14:49
close. A well- constructed portfolio of
00:14:51
diversified assets can provide
00:14:53
investment returns at reduced levels of
00:14:55
risk and reduced levels of volatility.
00:14:58
So Jim, thank you for the comment and
00:15:00
for the jumping off point. And now we're
00:15:01
going to go on to question two from
00:15:02
David. David is almost 47. He would love
00:15:05
to retire early. He's got some years of
00:15:08
service in the New York State retirement
00:15:10
system as well as in the federal
00:15:11
government retirement system. So he's
00:15:12
got some some pensions looming out
00:15:14
there. And he recently inherited about a
00:15:16
million dollars from his mom. Uh his net
00:15:18
worth alone is 1.5 million if you
00:15:20
include his house. He says uh he and his
00:15:22
wife have uh no mortgage. They have a
00:15:24
14-year-old son. And the problem that
00:15:25
David is facing is that he wants to make
00:15:27
sure that he, in his words, that he
00:15:29
leverages or that he uses the $1 million
00:15:32
inheritance now that he's at age 47 in
00:15:34
the smartest way possible to build
00:15:35
wealth over the long term with the hope
00:15:37
of retiring early. So, I think it's a
00:15:39
very interesting question. Thank you for
00:15:40
submitting that, David. Any good
00:15:42
financial planning conversation starts
00:15:44
with identifying all the puzzle pieces
00:15:46
with as much detail as possible. So, if
00:15:49
we were talking, David, I would want to
00:15:50
know more about say your pension or
00:15:52
pensions, the current ones that you've
00:15:53
earned or the future pension benefits
00:15:55
that you might earn over coming years. I
00:15:57
would want to confirm again just from
00:15:59
your question that the million-doll
00:16:01
inheritance, is that part of your $ 1.5
00:16:03
million net worth or is it in addition
00:16:05
to the $ 1.5 million, so really it'd be
00:16:07
more like $2.5 million of net worth now.
00:16:09
And beside getting all those puzzle
00:16:11
pieces out in the open, I'd want to
00:16:12
think about your overall situation to
00:16:15
get you retired early. So whenever you
00:16:17
choose to retire, David, I see three
00:16:19
main sources of income for you. The
00:16:20
first would be pension payments. The
00:16:23
second would be drawing down on your
00:16:24
portfolio assets, and that's where
00:16:26
things like, you know, the 4% rule or
00:16:28
smart safe withdrawal rates and
00:16:30
withdrawal strategies. That's where that
00:16:31
comes into play. And then the third
00:16:33
income source would eventually at a
00:16:35
particular age be social security. Maybe
00:16:37
there are other income sources that I'm
00:16:39
not aware of. That's really important to
00:16:40
get out on the table. But the
00:16:42
interesting thing for David's situation
00:16:45
and for a lot of people listening right
00:16:46
now, the interesting thing for a lot of
00:16:48
retirement situations is that those
00:16:50
three factors, in this case it was
00:16:52
pension payments, portfolio assets, and
00:16:54
social security that they're all subject
00:16:56
to change depending on when you choose
00:16:58
to pull the retirement trigger. Every
00:17:00
year you delay is most likely another
00:17:02
year that your pension benefit will
00:17:04
grow. Every year you delay is on average
00:17:07
another year for your investments to
00:17:08
grow and another year to get you closer
00:17:10
to social security age. One less year,
00:17:13
another way of putting it would be one
00:17:15
less year of retirement without social
00:17:17
security. But and here's the hardest
00:17:19
part. Every year you delay is also one
00:17:22
less year of life. One less year of
00:17:24
retirement. One less year that you'll
00:17:26
even need the money at all. It's like a
00:17:27
child, I suppose, who's given more and
00:17:29
more toys but is running out of daylight
00:17:31
to play with all the toys. Many
00:17:33
pre-retirees who really struggle with
00:17:34
this because we'll only know the right
00:17:36
answer in hindsight. Every year we wait
00:17:39
is another year of acrewing more assets
00:17:41
and acrewing more fixed income sources
00:17:43
and acrewing more of a safety net to
00:17:45
retire. But then every year is also
00:17:48
going to be one less year that we're
00:17:49
alive. Should David retire right now at
00:17:51
47? Should he wait till 50? Should he
00:17:53
wait till 52? Or will we eventually find
00:17:56
out that actually retiring back at age
00:17:58
45 was the right answer for David? So,
00:18:01
here's what I'd do. If if I were David,
00:18:03
I would start with a 20-year cash flow
00:18:05
projection. That exercise, it estimates
00:18:07
all the future money that you'll earn
00:18:09
and all the future money that you'll
00:18:11
spend over the next 20 years. It'll
00:18:13
include your portfolio, deposits, and
00:18:15
withdrawals and annual growth. It'll
00:18:17
have cash inflows, whether they're
00:18:18
coming from your salary or your pension
00:18:21
or social security. It'll have cash
00:18:23
outflows, of course, lifestyle expenses,
00:18:25
taxes, travel, college payments for your
00:18:28
now 14-year-old child, home updates,
00:18:30
whatever it may be. So, it has all the
00:18:32
puts and takes. And from that, you'll
00:18:34
get a net cash flow, inflows minus
00:18:36
outflows. Then, you'll calculate your
00:18:38
total portfolio value at the end of each
00:18:40
year. And you'll be able to see your uh
00:18:42
projected portfolio withdrawal rates
00:18:44
over time. You can do this in a simple
00:18:46
Excel spreadsheet, right? 20 columns,
00:18:49
one column for each year. And each row
00:18:52
represents a different inflow or outflow
00:18:54
or portfolio balance in your life. And
00:18:57
if I were David, I would make maybe
00:18:59
three or five or 10 different versions
00:19:00
of the spreadsheet, depending on how
00:19:02
ambitious you want to be, where the only
00:19:04
difference between each version of the
00:19:06
spreadsheet is going to be the
00:19:07
retirement date or retirement age, which
00:19:10
logistically really means you'll be
00:19:11
changing things like what year will your
00:19:13
salary inflow go to zero? What year will
00:19:16
that particular row go from your current
00:19:18
salary down to zero in lock step with
00:19:19
that? In what year will your pension
00:19:21
inflow start? And also, because we're
00:19:24
varying the retirement age, how big will
00:19:26
that pension inflow actually be?
00:19:28
Usually, they grow the longer you wait.
00:19:30
What year will you start withdrawing
00:19:32
from your portfolio? And how big will
00:19:34
those withdrawals need to be in order to
00:19:36
fully fund your lifestyle? Each
00:19:38
iteration of that spreadsheet will lead
00:19:39
to different portfolio sizes and
00:19:42
different withdrawal rates. And you'll
00:19:43
see that certain iterations, maybe if
00:19:45
you pull the trigger today, David, you
00:19:47
might see years of 5%, 6%, 7% withdrawal
00:19:51
rates. But then another iteration, if
00:19:53
you wait 5 years from now or 10 years
00:19:54
from now to retire, you might see most
00:19:56
of your years have a 3% or a 3 and 1/2%
00:19:59
or a 2 and 12% lower withdrawal rates.
00:20:02
You're creating this range of potential
00:20:04
outcomes for yourself. And if you choose
00:20:06
to do deeper analysis, say like a Monte
00:20:08
Carlo retirement projection, those cash
00:20:10
flow analyses will help inform where you
00:20:12
should spend your time inside the Monte
00:20:14
Carlo for example. What I mean is if one
00:20:16
of your cash flow spreadsheets shows you
00:20:18
withdrawing 2% of your assets per year
00:20:21
throughout most of retirement, I
00:20:23
wouldn't waste your time to do a Monte
00:20:24
Carlo analysis. You pretty much know in
00:20:26
that particular scenario, you're going
00:20:29
to be fine. your withdrawal rate of 2%
00:20:31
is so low compared to the the
00:20:33
conservative 4% rule. It's already
00:20:35
conservative and 2% is so much lower
00:20:37
than that. Why waste your time doing a
00:20:39
Monte Carlo analysis? Whereas, if you
00:20:41
really do want to retire at age 50 and
00:20:43
the cash flow spreadsheet shows you
00:20:44
withdrawing 4.5% of your assets per
00:20:47
year, I would encourage you to run that
00:20:49
scenario through a Monte Carlo analysis
00:20:50
to see what your worst case retirement
00:20:52
scenarios might look like. More than
00:20:54
anything else, I see Monte Carlo
00:20:55
analyses not as a how likely is your
00:20:58
retirement to fail analysis, but instead
00:21:01
how likely will you have to be flexible
00:21:03
in retirement analysis. You know, how
00:21:05
likely will you have to tighten the belt
00:21:07
during down years in the market? How
00:21:09
likely will you have to postpone the big
00:21:10
trip because of a bad market? Those kind
00:21:12
of things. That's really helpful to
00:21:14
understand and a Monte Carlo analysis
00:21:16
helps provide some color to that type of
00:21:18
question. Now, as far as specific advice
00:21:20
about leveraging your inheritance,
00:21:22
David, here's my two cents. I'm sorry
00:21:24
your mom passed away, and I'd ask you if
00:21:26
you feel any particular emotional
00:21:28
connection to the money that she left
00:21:30
behind for you. Now, if I'm just being
00:21:32
this callous robot, I would tell you all
00:21:34
money is funible. From a strict planning
00:21:37
perspective, treat this money as if you
00:21:39
had just gotten a million-doll bonus at
00:21:40
work. It's money that can be applied to
00:21:42
your goals and your timelines. It should
00:21:43
be invested through the same exact
00:21:45
framework as we'd invest any other money
00:21:47
in your family's financial ecosystem.
00:21:49
But because we are all human, I
00:21:52
understand that this money might have
00:21:53
some strings attached to it. Either
00:21:55
explicitly because of something your mom
00:21:56
told you or simply because of something
00:21:58
you feel inside. In that case, I would
00:22:00
encourage you to find a balance. You
00:22:02
know, make sure that you are honoring
00:22:04
your mom's wishes. Make sure that you're
00:22:05
feeling good about however you're you're
00:22:07
spending this million dollars or however
00:22:09
you're allocating earmarking this
00:22:11
million dollars. but also try to take
00:22:13
prudent steps toward advancing your and
00:22:15
your family's financial plan. So, thank
00:22:17
you David. I thought that was a great
00:22:19
question. And next on to question three
00:22:21
from Karen. Speaking of risk and risk
00:22:23
capacity, risk tolerance, those kind of
00:22:25
things. Karen says, "One subject I'd be
00:22:27
interested in is the subject of risk
00:22:29
capacity. I hear financial podcasts talk
00:22:31
all the time about risk tolerance, which
00:22:33
is how much you can stomach the swings
00:22:35
in the market without panicking and
00:22:36
going to cash. They also talk about risk
00:22:39
capacity, how much risk you can afford
00:22:41
to take without blowing up your
00:22:42
retirement. But I don't think I have a
00:22:44
good handle on how to figure out what
00:22:46
your risk capacity is. So, excellent
00:22:48
question, Karen. The way you're defining
00:22:50
these terms in your question, you're
00:22:51
differentiating between the subjective
00:22:54
feeling of risk and losing money versus
00:22:56
the objective math of recovering from
00:22:58
losing money. One thing I will say that
00:23:01
is, you know, admittedly confusing is a
00:23:04
lot of these terms get interchanged all
00:23:06
the time. risk capacity, risk tolerance,
00:23:08
risk difference, whatever it might be.
00:23:10
And so it can get confusing because you
00:23:12
can say, well, don't those all kind of
00:23:13
sort of mean the same thing. The words
00:23:15
that I've started using over time that I
00:23:18
found to be really helpful are
00:23:19
willingness, ability, and need. So, I
00:23:22
might use the word willingness to
00:23:23
describe the first part of your
00:23:25
question, Karen. Someone's willingness
00:23:27
to take risk has to do with their mental
00:23:28
fortitude, and it's a subjective
00:23:30
understanding of downside risk.
00:23:32
Willingness is subjective. where I would
00:23:34
use the word ability to describe the
00:23:36
second part of your question, Karen. An
00:23:38
investor's ability to take risk is based
00:23:40
on their capacity to withstand or
00:23:42
recover from losses, either temporary or
00:23:44
permanent. In general, the more assets
00:23:46
you have, the greater your capacity to
00:23:48
recover from losses, right? So, more
00:23:50
assets equals more ability to take risk.
00:23:53
And that's why certain high-risk
00:23:55
concentrated illquid assets, illlquid
00:23:58
investments, they're only appropriate
00:24:00
for investors with excess capital, with
00:24:02
a lot of money. Those investors are the
00:24:04
only ones with the ability to take on
00:24:06
that illquid high concentrated risk. But
00:24:09
also for younger or newer investors, the
00:24:12
ability to take on risk is directly
00:24:15
proportional to their income and their
00:24:16
savings rates. They have long timelines
00:24:18
in front of them. They're younger
00:24:19
investors. They're dollar cost averaging
00:24:22
into their portfolios most likely. So
00:24:24
even when investments are performing
00:24:25
poorly, they're most likely buying in,
00:24:28
right? Buying more as the markets
00:24:29
dropped. So they have decades to make up
00:24:31
for any losses. I would argue that that
00:24:33
investor, that younger or newer
00:24:35
investor, they also have a high ability
00:24:38
for risk. Ability is about recovering
00:24:40
from loss either through excess current
00:24:43
assets or through a healthy stream of
00:24:45
future saving. So here's a soft example
00:24:47
for you, Karen. I'm 35 years old as I
00:24:50
talk into this microphone. And let's say
00:24:52
we're about to kick off another uh lost
00:24:54
decade in the US stock market, just like
00:24:56
the stock market had a lost decade from
00:24:58
2000 to 2010. A crash or maybe two
00:25:01
crashes, some decent recovery, but
00:25:02
essentially a 10-year period without any
00:25:04
true growth from the market. Now, my
00:25:07
current assets on my balance sheet will
00:25:08
suffer some losses and some gains during
00:25:10
that period. Technically, will be no
00:25:12
worse for it, but also won't grow at
00:25:14
all. But also during that 10-year
00:25:15
period, my plan would be to continue to
00:25:18
dollarc cost averaging into my various
00:25:20
investment accounts. I'll keep buying,
00:25:22
including during the crashes, which will
00:25:24
certainly be to my advantage in the long
00:25:25
run. And by the time I do start tapping
00:25:27
into all these assets, which might be at
00:25:29
age 50 or 55 or 60, I believe all my
00:25:32
assets will have had time to recover and
00:25:34
grow beyond this hypothetical loss
00:25:36
decade that I'm proposing. In other
00:25:38
words, my 15, 20, 25 year timeline and
00:25:42
also my desire to buy more investments
00:25:44
over the coming years means that my
00:25:46
ability to take on risk is quite high.
00:25:48
But let me compare that or contrast that
00:25:50
to a 57year-old with aspirations to
00:25:52
retire at age 60 in 3 years. Now imagine
00:25:55
if that person went through a lost
00:25:57
decade of lows and minimal highs. What's
00:26:00
different between them and me? Well,
00:26:02
first, their current assets might suffer
00:26:04
losses that also happen to coincide with
00:26:07
their desire to withdraw money from
00:26:08
their accounts. This is exposure to the
00:26:11
so-called sequence of returns risk that
00:26:13
we've discussed on this podcast in
00:26:14
detail before. And second, for this
00:26:17
hypothetical 57year-old, they will not
00:26:20
be dollar cost averaging into their
00:26:22
accounts throughout this whole period of
00:26:23
time in over the next 10 years. They
00:26:26
won't be buying assets while low. they
00:26:28
don't get any of that long-term benefit
00:26:30
from the lost decade period like I'm
00:26:32
going to get. But it is worth asking,
00:26:35
you know, I've just kind of outlined a
00:26:36
bit of a pessimistic lens. Should we
00:26:38
apply that pessimistic lens to all of
00:26:40
their portfolio, to all of their assets
00:26:42
or just to some? And this is where the
00:26:44
goalsbased investing time and timelines,
00:26:47
asset liability matching frameworks,
00:26:49
this is where they all come into play.
00:26:51
All various ways of saying the same the
00:26:53
similar thing. I would argue that this
00:26:55
57year-old has a significant portfolio
00:26:57
of investment assets that they plan to
00:26:59
withdraw over multiple decades of their
00:27:01
retirement. Now, some of those assets
00:27:04
are going to be withdrawn in the next 5
00:27:06
and 10 years, precisely coinciding with
00:27:08
my hypothetical loss decade, but other
00:27:11
assets of theirs will be withdrawn in 15
00:27:14
years or 20 years or 25 years, maybe
00:27:16
even more. And that part of their
00:27:18
portfolio, those assets will be able to
00:27:20
ride out and eventually recover from the
00:27:22
lost decade. participating in whatever
00:27:25
growth might occur on the far side of
00:27:26
that event. So that person, this
00:27:28
hypothetical 57year-old, their ability
00:27:31
to take risk is less than mine. It's
00:27:34
much less than mine, but it's also not
00:27:36
zero. For a portion of their assets,
00:27:38
little to zero risk should be taken, but
00:27:41
for another portion of their assets,
00:27:42
yeah, plenty of risk can be taken. They
00:27:45
do have some ability to take risk. Not
00:27:47
as much as me, but some. And that might
00:27:49
beg a question, kind of an interesting
00:27:51
thought experiment. Are there people
00:27:53
with zero ability to take risk? I would
00:27:56
say yes. And it's not something I would
00:27:57
wish upon any of you listening right
00:27:59
now. Here's a hypothetical. Imagine an
00:28:01
85-year-old retiree. They need $30,000 a
00:28:04
year to live off of on top of their
00:28:06
social security payments. And between
00:28:08
their bank account and their IRA, they
00:28:10
have $150,000 in assets or approximately
00:28:13
5 years worth of annual spending.
00:28:16
They're in a bit of a pickle. They have
00:28:17
no real ability to take on any risk.
00:28:20
Now, what's interesting in kind of a a
00:28:22
morbid curiosity way is that they're
00:28:25
between this rock and a hard place. If
00:28:26
they take no risk at all, they're
00:28:28
essentially guaranteeing they will run
00:28:30
out of money at age 90. Whereas, if they
00:28:32
take some risk or maybe even a ton of
00:28:34
risk, they would now run the risk of
00:28:36
running out of money at age 88 or age
00:28:38
89, but yet they also open the
00:28:41
possibility of their money lasting some
00:28:43
extra years to 90 or 91. And then you
00:28:47
mix in the uncertainty of when they'll
00:28:48
actually pass away, right? If if they
00:28:50
pass away next year, this whole
00:28:51
conversation is a moot point. If they
00:28:53
end up living till 95, there's probably
00:28:56
nothing that anyone can do to prevent
00:28:57
the inevitable that they'll run out of
00:28:59
money. But the point is that this
00:29:00
person, it's almost like game theory.
00:29:02
It's like, do you take the giant bet
00:29:04
because it's the only way to get out of
00:29:06
your situation or do you take no bet at
00:29:09
all because you really can't afford to
00:29:10
lose any of that money. I would argue
00:29:12
they can't afford to lose any of that
00:29:14
money and they have no ability to take
00:29:15
on risk. So Karen, your ability to take
00:29:18
risk, recover from losses, it has to do
00:29:20
with your age, sure it has to do your
00:29:21
timelines, yes, but it also has to do
00:29:23
with if you're actively contributing to
00:29:25
your accounts. I also might add that if
00:29:27
you're accelerating more and more money
00:29:29
into your accounts over time, if you're
00:29:31
a younger professional with kind of a
00:29:33
high earning potential in front of you
00:29:35
and you plan on not only putting in more
00:29:37
money, but accelerating the rate at
00:29:39
which you're putting in money, that adds
00:29:41
even more ability to take on risk. Uh I
00:29:43
think that is something that many mid
00:29:45
and late career professionals do find
00:29:47
themselves in. earning more than ever,
00:29:49
making catch-up contributions to their
00:29:51
IAS, 401ks, maybe the kids are out of
00:29:53
the house, college payments are done,
00:29:55
and you've got this extra money on hand
00:29:57
to dump into the market to dump into
00:29:59
your investments. So, that's another
00:30:00
interesting uh wrinkle when it comes to
00:30:02
the ability to take on risk. Here's a
00:30:04
quick ad and then we'll get back to the
00:30:06
show. You probably know that I love
00:30:08
listener inspired content, but this is
00:30:09
my first listener inspired
00:30:11
advertisement. Frank asked me in short,
00:30:13
Jesse, is there a best time to start
00:30:15
working with you as a client? And the
00:30:16
short answer is yes. There are two ideal
00:30:19
times. One is at the beginning of a new
00:30:20
year for probably some pretty obvious
00:30:22
reasons, but the second one is right
00:30:24
about now, September and October. It's
00:30:26
the perfect time for year-end tax
00:30:27
planning to ensure you find the correct
00:30:29
balance of Roth conversions, tax gain or
00:30:32
tax loss harvesting, making charitable
00:30:33
gifts, spreading out any portfolio
00:30:35
changes over multiple tax years, or
00:30:37
whatever other tax dials we can turn for
00:30:39
you. working backward from the December
00:30:42
31st tax deadline. The time to start
00:30:44
those initial conversations is right
00:30:46
now, August, September, maybe into early
00:30:48
October, you want to give yourself and
00:30:50
us enough runway to make sure we get
00:30:52
this right for you. So, if you're
00:30:54
interested in starting a conversation
00:30:55
with me and my colleagues, you can go to
00:30:57
bestinterest.blog/work
00:30:59
and fill out the form there. Again,
00:31:01
that's on my blog on the workwithjesse
00:31:03
page. The address is
00:31:05
bestinterest.blog/work
00:31:07
and fill out the form. And now on to
00:31:10
question four from James. James says,
00:31:11
"Thanks for all the amazing content. I
00:31:13
discovered your podcast in the last year
00:31:14
and have become an enthusiastic regular
00:31:16
listener. I'm cautiously optimistic that
00:31:19
I'm on track to look very much like your
00:31:20
winning the game article." And I'll link
00:31:22
that in the show notes so you know what
00:31:23
we're talking about. As long as the
00:31:24
market doesn't throw any crazy
00:31:26
curveballs at us in the next few years,
00:31:28
my question is that after we all watched
00:31:30
our bond funds take a beating during the
00:31:32
last downturn, and that's 2022. We'll
00:31:34
get into that when with some of the
00:31:36
interest rate some of the interest rate
00:31:37
chaos that happened then. James says,
00:31:39
"I'm rattled with that being my safety
00:31:41
money. What are your thoughts? Are you
00:31:43
recommending more individual bonds for
00:31:44
the fixed income portion of portfolios?"
00:31:47
So, James, thanks very much for reaching
00:31:49
out. Congrats on almost winning the
00:31:50
game, as it were. Phenomenal and common
00:31:53
question about bond funds versus
00:31:55
individual bonds, especially for someone
00:31:57
gliding into retirement. So, let me see
00:31:59
if I can explain this succinctly. We
00:32:01
need to start with the term duration.
00:32:03
Duration is a term used in the bond
00:32:05
world, in the fixed income world. And
00:32:07
duration, you know, just the name the
00:32:08
the word itself, right, in the
00:32:10
dictionary implies time in some way. It
00:32:12
implies a length of time. And duration
00:32:14
in the bond world is partly related to
00:32:16
the maturity date or the term of a bond.
00:32:19
You know, a one year, a 5year, a 10-year
00:32:20
bond. But it al also takes some some
00:32:22
other things into account. And in short,
00:32:25
the duration of a bond is a measure of
00:32:27
that bond's sensitivity to interest rate
00:32:30
changes. Again, duration is a measure of
00:32:32
a bond's sensitivity to interest rate
00:32:34
changes. So a low duration bond is not
00:32:37
very sensitive to interest rate changes.
00:32:39
A high duration bond though is very
00:32:42
sensitive to interest rate changes. And
00:32:44
hopefully that idea makes a little bit
00:32:46
of sense. Now why? So let's imagine a
00:32:48
one-year bond that yields 5%. A one-year
00:32:52
Treasury that yields 5%. Then we can
00:32:54
compare that to a 10-year Treasury
00:32:56
that's also yielding 5%. Now, if we look
00:32:58
at the one-year bond, over that one
00:33:00
year, I would expect to put in $1,000
00:33:02
today. And a year from now, I'm going to
00:33:04
get $1,000.50 back. So, of the,50 that I
00:33:09
eventually get back, about 5% of that
00:33:11
eventual return of capital, about 5% of
00:33:14
it is going to be a function of interest
00:33:16
and interest rates. But if I look at the
00:33:18
10-year bond, the math is going to be
00:33:20
importantly different. I would expect to
00:33:22
put in $1,000 and then over the 10
00:33:24
years, I'm going to get 1,500 back. In
00:33:27
the first bond, I got uh $1,50 back over
00:33:30
one year. But in the second bond, I'm
00:33:32
going to get $1,500 back over 10 years.
00:33:35
So, if I look at that $1,500 I'm getting
00:33:38
back, 500 of that is interest. So, 33% a
00:33:42
full third of that eventual return of
00:33:44
capital is a function of interest and
00:33:46
interest rates. So, we can clearly see
00:33:48
that the total return of the 10-year
00:33:50
bond is more reliant on interest and
00:33:52
interest rates than the return of the
00:33:54
one-year bond. For that reason, it
00:33:57
should make sense that the 10-year bond
00:33:59
is more sensitive to changes in interest
00:34:01
rates. So, now with that out of the way,
00:34:03
we can pivot. And one thing I did to
00:34:04
help James in a little email I wrote to
00:34:06
him, I listed out four common reasonable
00:34:08
Vanguard bond funds to him. Maybe some
00:34:11
of you have heard of them. BND is the
00:34:13
Total Bond Market Index Fund, BND. And
00:34:16
then BLV, a long-term fund. BSV, a
00:34:20
short-term fund. So, L for long, S for
00:34:22
short, BLV, BSV. And then the ultrashort
00:34:26
bond fund, VUSB, US for ultra short.
00:34:30
What I did is I I listed out the
00:34:32
duration for these six funds. So BND,
00:34:34
the total bond market index fund, has a
00:34:36
duration of about six on it. The
00:34:39
long-term fund 13, the short-term fund
00:34:41
about 2 and a half, and the ultrashort
00:34:44
fund about 1. So if interest rates went
00:34:46
up by 1% tomorrow, I would expect in
00:34:50
pretty close approximation that the
00:34:52
following would happened. BND would lose
00:34:54
about 6% of its value because its
00:34:56
duration is six. BLV would lose about
00:34:58
13% of its value. The short-term fund
00:35:01
BSV would go down about two and a half%
00:35:03
and the ultrashort fund would go down
00:35:05
about 1%. And that occurs for very
00:35:08
similar reasons as I described uh
00:35:10
before. For the long-term fund BLV, a
00:35:13
very large amount of the future expected
00:35:15
return of that fund is coming from
00:35:16
interest payments. And for the ultrasort
00:35:19
VUSB for the ultrashort fund, a very
00:35:21
small amount of the future expected
00:35:23
return for that fund is coming from
00:35:25
interest payments. To finish that logic,
00:35:27
to take it one little step further, the
00:35:29
point is that if I'm owning a bond or if
00:35:31
I own a bond fund that is paying me out
00:35:34
say 4% per year and then tomorrow
00:35:37
interest rates go up 1%. So now all the
00:35:39
new bonds are paying 5%. Here I am over
00:35:42
here. I own a bucket of bonds that are
00:35:44
paying 4% and now all the new ones are
00:35:47
paying 5%. Who wants my 4% bonds if they
00:35:50
could go out to the the Fed and buy new
00:35:52
ones at 5%. So what's essentially
00:35:55
happened is that my bonds have lost
00:35:57
value because their printed interest
00:35:59
rate is lower than what all the new
00:36:01
bonds are selling for. And that's why
00:36:02
when interest rates go up on a kind of a
00:36:05
grand economic scale, when the interest
00:36:07
rates go up, the price of currently
00:36:10
owned bonds goes down. Now, going back
00:36:12
to the bond funds versus individual
00:36:14
bonds, owning individual bonds doesn't
00:36:17
really fix this issue. Owning individual
00:36:19
one-year treasuries would be very
00:36:21
similar to owning that ultrashort bond
00:36:23
fund that I just described. And you
00:36:25
would see very similar interest rate
00:36:27
sensitivity. Owning 10-year treasuries
00:36:30
would be very similar to owning a 50/50
00:36:32
mix of BND, which was the six-year the
00:36:35
duration of six, and BLV, which had the
00:36:37
duration of 13. So, if I kind of own a
00:36:39
50/50 mix of that, I'm going to have a
00:36:41
similar interest rate sensitivity to
00:36:43
owning 10-year treasuries. There there's
00:36:45
no benefit to owning individual bonds in
00:36:47
this case. And I've read here on the
00:36:49
podcast before, there's a pretty funny
00:36:51
tearown of this idea from investor and
00:36:53
kind of infamous crank cliff as
00:36:56
basically says if you open up the hood
00:36:58
of a bond fund, all that's in there are
00:37:01
a bunch of individual bonds. And so the
00:37:03
idea that you could somehow own those
00:37:06
individual bonds and get something
00:37:08
better or get something different than
00:37:10
the behavior of the bond fund itself
00:37:12
doesn't really make sense, right? It's
00:37:14
like saying instead of having a shopping
00:37:16
cart of food, I'm just going to go out
00:37:18
and buy bananas and buy beans and buy
00:37:21
crackers. And you look in the shopping
00:37:23
cart and what's in there? It's bananas
00:37:24
and beans and crackers. It's it's just
00:37:26
the same thing. So what what's an actual
00:37:28
recommendation instead of all this
00:37:29
esoteric definitions that I've been
00:37:31
giving you? What's my actual
00:37:32
recommendation to someone who's facing
00:37:34
this problem, who's maybe looking down
00:37:35
the barrel of retirement, trying to
00:37:37
figure out what they should do for their
00:37:38
bond allocation? I would build my
00:37:40
retirement portfolio such that the money
00:37:42
I need in year one of retirement is
00:37:44
probably going to be in some sort of
00:37:46
ultrashort bond fund with a one-year
00:37:48
duration. And the money I need in years,
00:37:50
say 2 through four of retirement might
00:37:52
be in a in a short-term bond fund with
00:37:53
two to four years of duration. And then
00:37:56
once you get out to say years four,
00:37:57
five, and six, depending on your ability
00:38:00
and willingness to take on risk that we
00:38:02
were talking about before, that's where
00:38:04
maybe some of those intermediate years,
00:38:06
maybe some of that money is uh going to
00:38:08
own something like BND, which was that
00:38:11
had that six-year duration on it. But
00:38:13
also, maybe that's where you start
00:38:14
sprinkling in some stocks. And then for
00:38:16
years 8, nine, 10 and beyond, if you're
00:38:19
pretty uh low on the risk spectrum,
00:38:22
maybe you still have some fixed income
00:38:23
in there for diversification, but also
00:38:26
largely that money for years 10 plus is
00:38:28
going to be invested in and just greater
00:38:30
greater risk, greater reward assets like
00:38:32
stocks. So you're building this
00:38:33
portfolio from the bottom up. And that
00:38:35
way if 2022 were to happen again, and
00:38:38
again in 2022, interest rates shot up
00:38:41
essentially faster than ever before in
00:38:42
history. I've got some some data in a
00:38:44
minute here where I talk about the way
00:38:46
that some funds still haven't recovered.
00:38:48
Some bond funds still haven't recovered
00:38:49
from 2022. But if 2022 were to happen
00:38:52
again in the solution I just described,
00:38:55
my short duration bond monies would be
00:38:57
very very minimally affected, right? The
00:38:59
money I need this year and next year and
00:39:01
the year after that would be very
00:39:03
minimally effective. Now, if I owned
00:39:05
some longer duration bonds, they would
00:39:07
have at least more time to recover from
00:39:10
for they'd have more time for interest
00:39:11
rates to come back down and the actual
00:39:13
value of the fund to go up and or I
00:39:16
would also own stocks in some of those
00:39:18
same buckets, for lack of a better term,
00:39:20
for some of those same timelines to help
00:39:22
diversify over that recovery period. In
00:39:24
other words, the problem that's
00:39:26
occurring very often behind the scenes
00:39:28
when these type of questions come up is
00:39:30
that someone owns, for example, they own
00:39:32
a bond fund with a long duration in
00:39:35
order to cover their near-term expenses.
00:39:37
They probably don't realize it, but the
00:39:38
way they're covering their near-term
00:39:40
expenses is by owning a longduration
00:39:41
bond fund. BND, for example, is a very
00:39:44
popular choice in the bond world because
00:39:46
it represents it's an index fund that
00:39:47
represents ownership of the entire US
00:39:49
bond market. But BND currently has a
00:39:52
duration of six years. BND lost 17% of
00:39:55
its value in 2022. As much as that at at
00:39:57
one point, that was peaked trough, 17%
00:39:59
down when those interest rates spiked as
00:40:02
part of kind of the COVID stimulus
00:40:03
recovery. And even including all of the
00:40:06
income that the fund that BND has
00:40:08
produced since then, BND is still down
00:40:11
4% from its 2021 highs. Now, if all you
00:40:14
look at is price alone, BND actually
00:40:17
looks like it's down 13% from 2021. And
00:40:21
that right there, as a little aside, is
00:40:22
why looking at bond price is simply not
00:40:24
good enough. So, here's a quick little
00:40:26
lesson, a quick little aside for you DIY
00:40:28
investors out there. Don't only look at
00:40:31
a bond or a bond fund's price. It's not
00:40:33
good enough, especially over longer
00:40:36
periods of time. The price of a bond or
00:40:38
the price of a bond fund does not
00:40:40
account for the interest payments that
00:40:41
that bond or bond fund has been paying
00:40:43
along the way. For example, in 2023, if
00:40:47
all you looked at was BND's price, you
00:40:50
would see that it was up 2.3%. But its
00:40:53
total return to investors was actually
00:40:55
5.7%.
00:40:56
So that difference between 2.3 and 5.7,
00:41:00
that 3.4% difference, that was the
00:41:02
interest payment that BND paid out back
00:41:05
to investors. So, I know a minute ago I
00:41:07
discussed why holding a bond fund is no
00:41:09
different than holding individual bonds,
00:41:11
but just to drive the point home. It can
00:41:13
be true and and some people might say,
00:41:14
well, if I hold my individual bonds to
00:41:16
maturity, I'll always get my money back.
00:41:19
And I don't know if I if I get that same
00:41:21
thing from a bond fund, but if a bond
00:41:23
fund is also holding its bonds to
00:41:25
maturity, then you'll always get your
00:41:27
money back there, too. The math is
00:41:29
exactly the same. And for that reason,
00:41:31
it can be worth understanding if any
00:41:33
bond funds that we're invested in that
00:41:34
you're invested in, you can ask
00:41:36
yourself, you can look at the bond fund
00:41:38
itself and and try to understand, is it
00:41:39
being passively managed or is it being
00:41:41
actively managed? Now, an actively
00:41:43
managed bond fund might actually choose
00:41:45
to sell bonds before their maturity
00:41:47
date. And perhaps they're doing so for
00:41:50
smart reasons, and that will actually
00:41:51
increase your return from the fund. Or
00:41:54
perhaps the active manager does so for
00:41:55
poor reasons, decreasing your return
00:41:58
from that fund. And that's true for any
00:41:59
type of active management. Whereas a
00:42:01
passively managed bond fund is very
00:42:03
likely to hold all their bonds to
00:42:05
maturity, ensuring the underlying
00:42:07
investors are receiving exactly the
00:42:09
promised nominal return that they signed
00:42:11
up for in the first place when
00:42:12
originally investing. So very
00:42:14
interesting question. I hope that helps
00:42:16
understand not only the mechanical
00:42:18
differences between individual bonds and
00:42:20
bond funds, but also that that little
00:42:21
definition about duration and why those
00:42:24
ideas are so important when it comes to
00:42:26
retirement planning, when it comes to
00:42:28
the timelines kind of inherent in our
00:42:30
retirement, and why just because you own
00:42:32
a diversified bond fund doesn't
00:42:34
necessarily mean that you are properly
00:42:36
planning for your early years of
00:42:38
retirement. And now on to question five,
00:42:40
which came from a listener AC. An AC
00:42:43
said increasing income is easier said
00:42:45
than done. A podcast episode on the
00:42:48
importance of increasing your income and
00:42:50
how to do it would be helpful. You work
00:42:51
with high net worth clients, Jesse. I'd
00:42:53
speculate that they have advice on how
00:42:55
to increase your income. Yeah. So, AC
00:42:57
the topic of savings rates, increased
00:43:00
earnings, decreased spending, a very
00:43:02
common topic here in the personal
00:43:03
finance world. My party line is that for
00:43:06
any of us, it's almost always going to
00:43:07
be easier in the short run. an emphasis
00:43:10
on the short run is going to be easier
00:43:11
in the short run to decrease your
00:43:13
spending. If that's the way that you
00:43:14
want to increase your savings rate in
00:43:16
the short run, you should focus on what
00:43:18
you're spending and what you can control
00:43:20
kind of easily that way. However, if
00:43:22
you're out there and maybe your uh your
00:43:24
little nephew is just discovering
00:43:26
personal finance for the first time and
00:43:27
he's trying to figure out what he can do
00:43:29
in the next month to improve his lot in
00:43:31
life, to improve his personal finances,
00:43:33
the answer is going to be for him to
00:43:34
start monitoring his spending and
00:43:36
ultimately decreasing his spending. But
00:43:38
over the kind of the mid to the long
00:43:40
run, as AC alluded to in the question,
00:43:42
we are far better off focusing on ways
00:43:44
to increase our income. It's just that
00:43:46
they're not easy. If it was super easy
00:43:48
to increase your income, then everyone
00:43:50
would be doing it. It's kind of like
00:43:51
that Kurt Vonagget quote from
00:43:53
Slaughterhouse 5 that, you know,
00:43:54
Americans, like human beings everywhere,
00:43:56
believe many things that are obviously
00:43:57
untrue. Their most destructive untruth
00:44:00
is that it is very easy for any American
00:44:02
to make money. It's a longer quote and
00:44:04
and worth looking up if you're not
00:44:05
familiar with it. But the fact of the
00:44:06
matter is that it's hard to find ways to
00:44:09
increase your income or at the very
00:44:10
least it takes time. It takes effort. It
00:44:12
takes some maybe some focused work. So
00:44:14
what are some tips? And that's what I'll
00:44:16
spend kind of the rest of this answer
00:44:17
talking about are some tips that we can
00:44:19
actually use to increase our income. The
00:44:22
first one that that I found personally
00:44:23
successful and seen a lot of stories
00:44:25
about is to simply talk to your your
00:44:28
manager or your boss. assuming you work
00:44:30
for a manager or a boss, that is,
00:44:31
assuming you aren't self-employed. You
00:44:33
know, the more time that I've spent
00:44:34
working here in America, both at a
00:44:36
really big corporation in my old
00:44:37
aerospace engineering job and now at a
00:44:39
much smaller company here in my wealth
00:44:41
management job, the more I realize how
00:44:42
much a good manager will value a good
00:44:45
employee. So, if you think you're a good
00:44:47
employee and you have a good manager, I
00:44:49
think you should go ask them what you
00:44:51
can do to earn more money. They might
00:44:52
not be able to snap their fingers like a
00:44:54
genie and just make it appear for you,
00:44:56
but they'll help you put a plan together
00:44:57
to get you there. Granted, I know there
00:44:59
are many jobs, especially probably like
00:45:01
public sector jobs, where it's simply
00:45:03
not possible. You know, they're going to
00:45:04
pay you based on your experience level,
00:45:06
the number of years you've worked there,
00:45:07
and that's it. My parents were both
00:45:09
school teachers. They couldn't just go
00:45:11
to their manager, their boss, and say,
00:45:13
"I want more money." I get it. But if
00:45:15
you do work at a job where that's
00:45:16
possible, I 100% encourage you to go
00:45:19
talk to your manager or your boss about
00:45:20
putting you on some sort of plan to
00:45:22
eventually get the raise you've been
00:45:23
looking for. That being said, my second
00:45:25
tip, again, especially in corporate
00:45:28
America, is to change jobs or change
00:45:30
employers. Job hopping, for better or
00:45:32
worse, often yields the fastest salary
00:45:34
bumps. One of my most popular blog posts
00:45:36
I've ever written, and I'll link it in
00:45:37
the show notes, tells the story of my
00:45:39
negotiations at my old aerospace
00:45:41
engineering firm, where tip one, my
00:45:44
first tip of talking to my manager, my
00:45:45
boss, didn't work. Now, my manager, she
00:45:48
did lobby on my behalf. She was very
00:45:50
helpful, but HR of human resources shot
00:45:54
down the idea. Shot down the idea of me
00:45:56
getting some sort of raise, which to
00:45:58
some extent forever turned me off to the
00:46:00
human resources profession. No offense
00:46:01
if you're listening as an HR
00:46:03
professional right now. It's not
00:46:04
personal. I get it. It's not personal
00:46:06
because HR has to deliver bad news all
00:46:08
the time and it's never personal.
00:46:09
Anyway, eventually I did get the raise I
00:46:12
was looking for because I had to spend
00:46:13
what I ended up doing was spending about
00:46:15
2 months and taking multiple trips
00:46:16
around the country interviewing with a
00:46:19
competitor firm and they gave me a great
00:46:21
offer to come work for them and only
00:46:23
then did my current firm match that
00:46:24
offer and give me the raise that I was
00:46:26
looking for. I find that whole game of,
00:46:28
you know, interviewing at other places
00:46:30
just to get an offer and then taking
00:46:31
that offer back to your current boss and
00:46:33
saying, "Now, will you pay me more?" I
00:46:34
find that game kind of lame, but the
00:46:36
fact of the matter is it's a real part
00:46:38
of corporate culture. And so if you're
00:46:40
looking for a raise, I think if you're
00:46:41
looking for more income, I think it's
00:46:43
worth understanding how that game gets
00:46:44
played. On to tip three, professional
00:46:46
certifications or licenses. So, you
00:46:48
know, here in my world, CFP, CFA, maybe
00:46:51
CPA as an accountant. I know for project
00:46:54
managers, the PMP certification, going
00:46:56
to a coding boot camp, getting a trade
00:46:58
license, something like that. The
00:46:59
payback can be really big. But again, I
00:47:02
would make sure you talk to your manager
00:47:03
or your boss first and you try to get
00:47:05
them to commit to some sort of quid
00:47:07
proquo. you know, if you go out and get
00:47:09
your PMP designation, then they'll give
00:47:12
you a raise of X. Talk to your boss
00:47:14
first. Go get the certification and go
00:47:16
get paid more. Tip four is to think
00:47:18
about growing something on your own. And
00:47:20
this one is a little hairy as I know
00:47:21
plenty of people who have tried or who
00:47:23
are trying to build a small side
00:47:25
business or grow some sort of online XYZ
00:47:28
business. Nothing seems to be happening
00:47:30
for them. When I look back at this very
00:47:32
project that you're listening to right
00:47:34
now, for three or four years, I wrote
00:47:36
and then started the podcast for no real
00:47:39
business reason. I wasn't earning any
00:47:41
income. I wasn't really looking to run a
00:47:43
business per se. It was just some side
00:47:45
hobby that didn't really have any sort
00:47:47
of business intent. But then I think of
00:47:49
one of my neighbors like in in my
00:47:51
neighborhood. He's got a great 9 to5,
00:47:52
but then on the side he runs a knife
00:47:54
sharpening business out of his garage.
00:47:56
It's a It's just a terrific small niche
00:47:58
business that he can do on nights and
00:48:00
weekends. My brother My brother dipped
00:48:02
his toe into entrepreneurial waters
00:48:04
first by doing handyman work for like
00:48:06
$75 an hour when he wasn't working his 9
00:48:08
to5. And eventually he realized he could
00:48:10
cobble together enough of those handyman
00:48:13
engagements to make it his full-time
00:48:14
job. And then he shifted to only saying
00:48:17
yes to the bigger jobs, you know, the
00:48:18
four-hour jobs, the full day jobs. And
00:48:20
now he's doing full-on kitchen remodels,
00:48:23
bathroom remodels, basement remodels.
00:48:24
It's taken him 5 years, but it's made a
00:48:26
massive impact in his life and in his
00:48:28
lifestyle to go from the 9 toive job
00:48:30
where he wasn't getting paid enough and
00:48:32
didn't really enjoy it to now literally
00:48:34
running his own business and only taking
00:48:36
big jobs and and getting paid a a much
00:48:38
fairer wage for it. So, that's tip four,
00:48:40
you know, trying to grow something on
00:48:41
your own. Tip five, thinking more long
00:48:44
term now. And this we're transitioning
00:48:46
as these tips go on into slightly more
00:48:48
long-term thinking. Tip five is to climb
00:48:50
the career ladder in some sort of
00:48:51
strategic way. Because climbing that
00:48:53
career ladder, it isn't just about
00:48:55
working hard. It's also about working
00:48:57
smart. Thinking about, you know,
00:48:59
clarifying where you want to go. Where
00:49:01
do you see yourself in leadership in
00:49:03
management? Do you see yourself becoming
00:49:04
a technical expert or maybe pivoting
00:49:07
into a new role entirely or a new
00:49:09
division, a different division in the
00:49:10
company that you're at? Because once you
00:49:12
know that destination of where you want
00:49:13
to end up, a great way of doing that is
00:49:15
by looking at the current leaders and
00:49:17
figuring out which one of them you most
00:49:18
want to emulate. But once you know that
00:49:20
destination, then you can map out the
00:49:22
skills or the relationships or the
00:49:24
experiences you'll need to get there.
00:49:26
Networking, for better or worse, it's
00:49:28
just as important as performance and
00:49:29
technical skills. Building strong
00:49:32
relationships with your mentors, with
00:49:33
your managers, with colleagues, the
00:49:35
people who could advocate for you maybe
00:49:36
when an opportunity arises. and then
00:49:39
having to track your accomplishments as
00:49:41
time goes on to connect them to
00:49:43
measurable outcomes that outcomes that
00:49:45
impact the bottom line of the company.
00:49:47
There's something there where managers
00:49:48
promote that kind of impact, not just
00:49:50
the effort that you put in, but really
00:49:52
the impact that you make to the bottom
00:49:53
line. And then the last tip here would
00:49:55
be to stay adaptable. Careers rarely
00:49:57
follow a straight line, but if you're
00:49:59
intentional about positioning yourself
00:50:01
for that next step, promotions and
00:50:03
raises often follow on quite naturally.
00:50:05
Again, thinking long term here. On to
00:50:07
tip six is to develop high value
00:50:09
expertise. The marketplace rewards
00:50:12
skills and not any skills but skills
00:50:13
that are rare, that are difficult to
00:50:15
replicate and that are in high demand.
00:50:17
It ultimately comes down to supply and
00:50:19
demand. And so developing one of those
00:50:20
highv value expertise skills is one of
00:50:23
the shest ways to grow your long-term
00:50:24
income. That's why specialist positions,
00:50:28
attorneys, uh senior engineers, seauite
00:50:30
leaders can command such strong
00:50:32
salaries. Getting there obviously isn't
00:50:34
quick. It often requires years of
00:50:36
education, credentiing, apprenticeship,
00:50:38
something like that. For example, one of
00:50:40
the highest earning people I personally
00:50:42
know fits into that description of a
00:50:44
specialist physician. Because of the way
00:50:45
medical school and specialization works,
00:50:48
he didn't start earning big money until
00:50:49
his mid to late 30s. Now, he's
00:50:52
approaching 50 and he's more than making
00:50:54
up for that. But I think one of the keys
00:50:56
there is to view the extra time and the
00:50:58
extra training. In his example, you
00:51:00
know, most of us started earning a real
00:51:01
paycheck at 22 or 24. He really didn't
00:51:04
start earning a quote unquote real
00:51:06
paycheck until 35 or 37. He put in 12
00:51:09
extra years of extra training time. And
00:51:12
I think it's important to view that as
00:51:13
an investment, right? Each exam passed,
00:51:15
each certification earned, each project
00:51:18
completed adds to your career equity, we
00:51:20
could call it. And over time, you become
00:51:22
not just another professional, but the
00:51:24
go-to expert. And that status carries
00:51:26
weight, which includes higher pay, more
00:51:29
job security, and and greater influence.
00:51:31
But the opposite side of the coin is
00:51:32
that the path that particular path also
00:51:34
demands persistence. The work can be
00:51:36
grueling. Progress isn't always obvious.
00:51:39
But sticking with it, that highv value
00:51:40
expertise creates leverage that lasts
00:51:42
for the rest of your career. And it's
00:51:44
that slow burn of career growth that can
00:51:46
be hard to start, but it it really does
00:51:49
compound and becomes very powerful once
00:51:50
the ball gets rolling. And then my last
00:51:52
tip on this one, tip seven, is equity
00:51:54
participation. Equity is when you earn
00:51:57
more than just a paycheck. You gain
00:51:59
ownership in the underlying company. the
00:52:01
underlying venture. So instead of
00:52:02
trading your hours solely for salary,
00:52:05
you're tying part of your income to the
00:52:06
growth of the business itself. And that
00:52:08
might come through stock options or
00:52:10
restricted stock units, RSUs, some sort
00:52:13
of profit sharing agreement, or directly
00:52:15
buying into the company. The upside, of
00:52:17
course, is that if the company grows, if
00:52:19
the business grows, your equity can
00:52:21
multiply in value far faster than a
00:52:23
steady raise ever could. But the equity
00:52:26
isn't necessarily free money, right? It
00:52:28
carries a lot of risk. Shares can lose
00:52:30
value. Options can expire worthless.
00:52:32
Private business ownership can be
00:52:34
illquid and uncertain. I mean, the
00:52:35
business can go out of business. And
00:52:37
that part of your balance sheet goes to
00:52:39
zero. But still, equity is how wealth is
00:52:42
often built at scale. It transforms you
00:52:44
from a simple employee into a partial
00:52:47
owner. And that aligns your personal
00:52:49
financial success with the company's
00:52:50
financial success. And for ambitious
00:52:53
professionals, that is a a gamecher
00:52:55
worth pursuing. So AC, thank you very
00:52:57
much for the question. And those are
00:52:58
some of my thoughts on how people can
00:53:00
practically and logically focus on
00:53:02
increasing their income over time.
00:53:05
Here's a quick ad and then we'll get
00:53:06
back to the show. I love getting your
00:53:08
questions and some of you ask me
00:53:09
questions about the wealth management
00:53:11
firm I work for in Rochester, New York.
00:53:13
Others ask about the best interest blog
00:53:14
and this podcast, Personal Finance for
00:53:16
Long-Term Investors, which operate
00:53:18
without advertising, without pushy
00:53:19
sales, and with no payw walls. How can
00:53:21
the blog and podcast stay afloat without
00:53:23
me dumping my own money into it? Well,
00:53:25
to answer both those questions, I want
00:53:26
to point you to episode 78 of Personal
00:53:28
Finance for long-term investors. I
00:53:30
intentionally recorded episode 78 to
00:53:32
shine light on those topics and inform
00:53:34
you how you are actually helping and can
00:53:36
continue helping these projects carry
00:53:38
forward. So, if you've ever been curious
00:53:39
about the business of my blog and
00:53:41
podcast, or if you're curious about my
00:53:43
day job in wealth management, please
00:53:44
check out episode 78 and let me know
00:53:46
what you think. Okay, and now on to
00:53:48
question six. This one's from Justin,
00:53:50
and this one's a two-parter. It's
00:53:52
probably going to be a long two-parter,
00:53:53
so I'm going to tackle part one here
00:53:55
today in this episode. If you're hungry
00:53:57
for more, please reach out to me and
00:53:59
I'll probably then tackle part two in a
00:54:01
future episode. But at the same time, if
00:54:04
this is something that you say to
00:54:05
yourself, you know what, I don't really
00:54:06
care about this topic, do me a favor and
00:54:08
skip part two. I'll listen to you on
00:54:10
that front, too. So, the question is
00:54:11
quite simple. Jesse, can you explain
00:54:13
cryptocurrency and stable coins? I'll
00:54:16
tackle cryptocurrency today from a very
00:54:18
high level. I'll tackle stable coins
00:54:20
potentially in a future AMA episode if
00:54:23
you guys find it interesting. And I want
00:54:24
to address this question not because I
00:54:26
believe in cryptocurrency uh
00:54:28
necessarily, but instead because the
00:54:30
total market cap of the cryptocurrency
00:54:32
world right now is about $4.4 trillion.
00:54:34
So if crypto as a whole was say a
00:54:37
company, it would be the biggest company
00:54:38
in the world, bigger than Nvidia, bigger
00:54:40
than Apple, bigger than Microsoft, etc.
00:54:43
And I think this conversation is kind of
00:54:44
like having an important talk about
00:54:46
drinking and drugs with your kids. You
00:54:48
might inform them that at college
00:54:50
they're going to see drinking, they're
00:54:51
going to see some weed. I remember
00:54:53
walking to a bathroom at SIOU fraternity
00:54:55
my sophomore year where there was some
00:54:57
sort of party going on and one of the
00:54:58
guys from the band, the band that was
00:55:00
playing downstairs, he was doing cocaine
00:55:02
on the sink. Now, that wasn't exactly my
00:55:04
type of partying, but I knew what it was
00:55:07
and I knew why personally I had no
00:55:09
desire to partake. And pretending like
00:55:11
it didn't exist wasn't really the right
00:55:13
answer, at least to me. like it it's
00:55:15
there and it's probably better to know
00:55:17
about it and then to choose not to do it
00:55:19
than uh to not even know what it is in
00:55:21
the first place. So, it's a funny
00:55:23
analogy, but similarly, I don't think
00:55:25
anyone needs cryptocurrency in their
00:55:27
portfolio. No one needs to own it, but
00:55:29
it is out there and it's really big and
00:55:31
it doesn't really seem to be going
00:55:33
anywhere. So, for that reason, I do
00:55:34
think it's worth at least understanding
00:55:36
what it is, how it works, why some
00:55:38
people see value in it, and why other
00:55:39
people think it's, you know, snake oil.
00:55:41
So, let's dive into that conversation
00:55:44
and specifically I'm going to read from
00:55:45
you from a a pretty long article I wrote
00:55:47
back in 2021 explaining Bitcoin in
00:55:50
simple terms. Now, I know that Bitcoin
00:55:52
is only one cryptocurrency and that
00:55:54
other cryptocurrencies have a different
00:55:55
quote unquote protocol, but I do think
00:55:57
that trying to explain this one clearly
00:56:00
and simply will at least open your eyes
00:56:02
to, you know, how the the greater
00:56:04
cryptocurrency world works. So, without
00:56:06
further ado, let's go first into the
00:56:08
highlights. Very highlights. a highle
00:56:10
review explaining Bitcoin in simple
00:56:12
terms. Everything that I'm about to say
00:56:14
over the next call it 2 minutes will be
00:56:16
explained deeper and further as as it
00:56:18
goes on. Bitcoin is software for lack of
00:56:21
a better term. It's a software that
00:56:22
tracks a digital only currency. There's
00:56:24
no physical currency. There's no coin
00:56:26
that you can hold in your hand like you
00:56:28
can hold a dollar or a quarter.
00:56:30
Individuals, people like you and me, we
00:56:32
use a what's called a digital wallet to
00:56:34
store to quote unquote store your
00:56:36
Bitcoin. Those wallets, they have a
00:56:38
unique Bitcoin address that makes them
00:56:41
unique to you. And they are very secure.
00:56:43
They are very private. They can only be
00:56:44
accessed via a unique password just like
00:56:47
logging into any other account with a
00:56:49
unique password. In the cryptocurrency
00:56:51
world, that password is called a key,
00:56:53
like the key to a door. So using their
00:56:55
private key, their private password, an
00:56:58
individual can authorize a transfer of
00:57:00
Bitcoin from their wallet, from their
00:57:02
private account to another person's
00:57:04
private account. Now, every transaction
00:57:07
that's ever occurred like that, any
00:57:08
transaction from a wallet from wallet A
00:57:10
to wallet B for any wallet in existence,
00:57:13
every transaction that's ever occurred
00:57:14
is recorded on this thing called the
00:57:16
blockchain. The blockchain, technically,
00:57:18
it's called a distributed ledger. I
00:57:21
recommend we think of it just like a
00:57:22
spreadsheet. It's a spreadsheet. That's
00:57:24
all that the blockchain is. And every
00:57:26
row on that spreadsheet says wallet A
00:57:29
just moved money to wallet B. And the
00:57:31
amount of money that was moved is X. the
00:57:34
amount of Bitcoin that was moved is Xed.
00:57:35
That's all it says. This wallet moved
00:57:38
this much Bitcoin to that wallet. That's
00:57:40
what each uh entry on the spreadsheet on
00:57:42
the blockchain says. Now, that
00:57:44
blockchain, that spreadsheet is
00:57:46
maintained and monitored. It's think of
00:57:48
it maybe as a Google sheet with a bunch
00:57:49
of different people having access to
00:57:51
that Google sheet. And people all over
00:57:54
the world are monitoring that
00:57:55
spreadsheet at all time. Those people
00:57:58
monitoring it. They're called nodes. And
00:58:00
the nodes record new entries on the
00:58:02
blockchain and then validate new entries
00:58:05
that are added to the blockchain. When
00:58:07
when new transactions occur, those have
00:58:09
to get validated. So again, what exactly
00:58:10
does that mean? We will talk about all
00:58:12
this in more detail. New transactions
00:58:14
are bundled into these things called
00:58:16
blocks and then a block is addended is
00:58:18
added to the end of the blockchain in
00:58:21
order to provide validity to new blocks.
00:58:24
And I know I I can hear myself saying
00:58:26
these words and I know you might not be
00:58:28
following me, but I I'll forge on. In
00:58:30
order to provide validity to the new
00:58:31
blocks, in order to confirm that all the
00:58:34
transactions there in the new blocks are
00:58:36
real, are legitimate, something called
00:58:38
proof of work must be submitted. And
00:58:40
that proof of work, I'll just tell you,
00:58:42
it solves a a difficult cryptographic
00:58:45
puzzle. And that puzzle solving process
00:58:47
is called mining. And the first node,
00:58:50
the first miner to solve that puzzle
00:58:53
that validates the new transactions is
00:58:56
actually rewarded with Bitcoin as their
00:58:58
prize. Thank you for solving this
00:58:59
puzzle. Thank you for validating these
00:59:01
transactions. Here's a little bit of
00:59:03
Bitcoin to reward you for that work. The
00:59:06
puzzle itself involves this specific
00:59:09
type of cryptographic puzzle. It's
00:59:11
called an input output code or a hash.
00:59:13
And the hash only works in one
00:59:15
direction. So you can easily verify that
00:59:18
a specific input to the puzzle led to a
00:59:21
specific output, but it's essentially
00:59:23
impossible to start with the output and
00:59:25
then find the input. The challenge in
00:59:27
the puzzle that the challenge that the
00:59:29
miners are given is that they're they're
00:59:31
given an output and then they have to
00:59:33
guess and check their way to finding the
00:59:35
correct input for that puzzle. The
00:59:37
puzzle itself, you can't really predict
00:59:39
that puzzle ahead of time because it's
00:59:40
based on all of the previous blocks. So
00:59:43
that the next puzzle is only created
00:59:45
once the previous block has been added
00:59:47
to the blockchain. So that's why you
00:59:49
can't predict or solve a puzzle ahead of
00:59:51
time. All the miners on planet Earth are
00:59:53
competing to solve this puzzle. Only one
00:59:55
minor actually wins. That minor provides
00:59:58
their solution or proof of work to the
01:00:00
puzzle. All the other nodes on the
01:00:02
network, all the other nodes in the
01:00:04
world verify that the proposed solution
01:00:07
is mathematically correct and then that
01:00:09
new block is added onto the blockchain
01:00:12
verifying all the transactions therein
01:00:14
and the winning minor gets a prize and
01:00:16
then the process starts all over again
01:00:17
for the next block. So that's it. That's
01:00:20
explaining Bitcoin in simple terms. So
01:00:22
so far we might be what 5 minutes into
01:00:24
this explanation and personally I
01:00:26
wouldn't blame any of you for saying
01:00:27
that. Jesse, what you just said doesn't
01:00:29
really describe anything to me and I get
01:00:31
it. So stick with me, trust me on this.
01:00:33
In order to understand how Bitcoin
01:00:34
works, we actually first need to
01:00:36
understand how traditional money works.
01:00:37
Once we agree on the basics of
01:00:39
traditional money, then explaining
01:00:41
Bitcoin becomes much easier. Money is
01:00:43
all about trust. It's based entirely on
01:00:45
a network of trust. There's no intrinsic
01:00:47
reason why a little green sheet of paper
01:00:49
with a former president on it can be
01:00:52
traded for a a week's worth of food or
01:00:54
for new shoes or I can take a stack of
01:00:57
these little green papers and trade them
01:00:59
for a car. Right? The ger, they accept
01:01:02
that little green paper because he
01:01:04
trusts it. He can use it to pay for his
01:01:06
store's expenses. The store employees
01:01:08
accept their salary in green papers
01:01:10
because they trust that the papers will
01:01:12
pay for their lifestyle. It's all about
01:01:13
trust. And you might say, "Well, doesn't
01:01:16
the government back up their money with
01:01:17
gold?" Yes, the US monetary system was
01:01:19
once backed up by gold, meaning that you
01:01:22
could go in at any time and trade your
01:01:24
green little dollars for a nugget of
01:01:26
gold. But that ended in 1933 when FDR
01:01:29
allowed the US Treasury to print money
01:01:31
without an equivalent gold backing. And
01:01:33
that fiscal stimulus got us out of the
01:01:35
Great Depression. And then in 1971,
01:01:36
Richard Nixon completely severed ties
01:01:38
with the gold standard by no longer
01:01:40
permitting foreign countries to exchange
01:01:42
US dollars for gold. Since 1971 when
01:01:45
Nixon did that, only trust has supported
01:01:47
the US monetary system. So, let's dig
01:01:50
into that trust network a little bit
01:01:51
deeper. Why do we need money in the
01:01:53
first place? I think it's important to
01:01:55
imagine a world without money. A
01:01:57
carpenter goes to the grocery store to
01:01:58
buy food. Without money, how does the
01:02:00
carpenter pay? Well, he can trade his
01:02:02
skills. But what if the ger doesn't need
01:02:04
any woodwork done? So, instead, the
01:02:06
carpenter would leave behind some sort
01:02:08
of IOU, a favor to be repaid later. The
01:02:10
shoemaker, they have a leaky roof. The
01:02:13
shoemaker hires the carpenter to come by
01:02:15
and they agree that the carpenter's fix
01:02:16
up is worth 20 pairs of shoes. But the
01:02:18
carpenter doesn't need 20 pairs of
01:02:20
shoes. So the shoemaker agrees that
01:02:22
he'll owe the carpenter in the future.
01:02:24
So we have another IOU. And the ger is
01:02:26
on his feet all day and he's worn
01:02:28
through his shoes. He goes to the
01:02:29
shoemaker to buy new ones, but the
01:02:30
shoemaker's garden is in full bloom and
01:02:32
he doesn't want to trade shoes for food.
01:02:34
At least not right now. So how does the
01:02:36
ger pay for new shoes with an IOU? It's
01:02:39
a simple example. The carpenter owes the
01:02:41
ger. The gcer owes the shoemaker, the
01:02:43
shoemaker owes the carpenter. We could
01:02:45
expand this example further to represent
01:02:47
the entire world's economy where
01:02:49
businessmen owe airlines and the
01:02:51
airlines owe the fuel company and the
01:02:53
fuel company owes the oil drillers and a
01:02:56
complicated web of IUS would ensue. And
01:02:59
how would we ever reconcile all these
01:03:00
different IUs? It's an accounting
01:03:02
nightmare with each individual tracking
01:03:04
their credits and their debits. But
01:03:07
universal trust in money completely
01:03:09
solves this problem. We convert each IOU
01:03:12
to a dollar amount and each person
01:03:14
measures their debts and their credits
01:03:16
in dollars rather than in unique
01:03:18
products like berries and fish. The
01:03:20
markets supply and demand will determine
01:03:22
where prices will eventually settle and
01:03:24
the economic activity would flourish
01:03:26
because concerns over payments would
01:03:28
basically disappear. That is why we need
01:03:30
money. But at least right now, who is in
01:03:32
charge of money? Well, in the US, we
01:03:34
have two institutions with the greatest
01:03:36
monetary responsibility. The Federal
01:03:38
Reserve and the Department of Treasury.
01:03:40
The Federal Reserve is part of the
01:03:41
government but operates with some
01:03:43
autonomy at least for now. It's the
01:03:45
largest country's largest bank. Uh the
01:03:47
Fed has three main mechanisms that it
01:03:48
can use to manipulate the amount of
01:03:50
money circulating in the economy. It can
01:03:52
buy or sell treasury securities, thus
01:03:54
adding or subtracting money from the
01:03:56
economy. It can adjust interest rates
01:03:58
just like it it did throughout the co 19
01:04:00
pandemic and recovery. And last, the Fed
01:04:02
can change requirements on how much
01:04:04
money a bank has to keep in reserve.
01:04:06
This is called the reserve requirement.
01:04:08
One of the terms often associated with
01:04:10
the Federal Reserve is quantitative
01:04:12
easing or QE. And that describes the
01:04:14
process where the Fed buys securities,
01:04:17
treasury bonds or other assets using
01:04:19
money that essentially the Fed creates
01:04:20
out of thin air. So quantitative easing
01:04:23
injects money into our economy, kind of
01:04:25
helping grease the wheels during hard
01:04:27
times. But this increased supply of
01:04:29
money without increasing the demand for
01:04:31
products will lead to inflation or the
01:04:33
increase in prices of goods and
01:04:35
services. Now, some people credit QE
01:04:37
with saving the economy after the 2008
01:04:40
financial crisis or saving the economy
01:04:41
during the CO9 pandemic, but many people
01:04:44
are concerned that QE is leading to
01:04:46
outofc control inflation that we will
01:04:49
eventually have to reap what we have
01:04:50
seown. And one of bitcoins and
01:04:52
cryptocurrency's ideal use cases takes
01:04:55
inflationary power away from
01:04:57
institutions like the Fed. I also
01:04:59
mentioned the Department of Treasury
01:05:00
before. The Treasury is in charge of
01:05:02
printing money that the Federal Reserve
01:05:04
requests. The Treasury distributes that
01:05:06
money to the public and to banks. They
01:05:08
send, for example, the COVID stimulus
01:05:10
checks. And the Treasury is also in
01:05:12
charge of the IRS. They collect your
01:05:13
taxes. Again, Bitcoin's ideal use case
01:05:16
removes power from the Treasury. You
01:05:18
can't just print more Bitcoin. And we'll
01:05:20
explain why that is later. So, the
01:05:22
question, I suppose, that the um
01:05:24
cryptocurrency maximalists would say is,
01:05:27
do we need big brother? Do we need the
01:05:28
government in charge of our money? So,
01:05:30
as we start to transition this
01:05:32
explanation into discussing
01:05:33
cryptocurrency more deeply, one of the
01:05:35
fundamental questions is, do we need the
01:05:37
government in control of our money? Do
01:05:39
we need banks to keep accounts organized
01:05:41
and to charge us fees in the process?
01:05:43
Can't the community just take care of
01:05:44
these responsibilities all on their own?
01:05:46
Since money is based on person-toperson
01:05:48
trust, why do we need the government
01:05:50
involved in the first place? And if free
01:05:52
markets solve all problems, why do we
01:05:54
need the government handcuffing our
01:05:55
monetary freedom? Those are some of the
01:05:58
questions that cryptocurrency purists
01:06:00
will ask and we'll keep them in mind as
01:06:01
we proceed. So, what makes some money
01:06:04
good and other money bad? If we look it
01:06:07
up, there are eight unique attributes
01:06:08
that economists or historians talk about
01:06:11
when it comes to good versus bad money.
01:06:13
The first one, general acceptability.
01:06:15
This is the trust that we've been
01:06:17
discussing. Money needs to be trusted
01:06:18
and accepted universally. Number two is
01:06:21
portability. Money needs to move, right?
01:06:23
Dollar bills, they're light. Credit
01:06:25
cards and bank account transactions and
01:06:26
PayPal and Venmo can occur
01:06:28
electronically. Gold, however, is fairly
01:06:31
challenging for an individual to move.
01:06:32
You literally need to be able to move or
01:06:34
port your money from place to place. The
01:06:36
third unique attribute of money is
01:06:38
indestructibility. Now, imagine if money
01:06:40
was made of tissue paper. You hand over
01:06:41
a $50 bill to a cashier and it just
01:06:43
ripped in half. Who's at fault? That's a
01:06:46
problem you want to avoid. The fourth
01:06:47
attribute is homogeneity or
01:06:49
fungeability. money needs to be the same
01:06:52
such that your $50 bill is identical to
01:06:54
my $50 bill. After all, they they have
01:06:56
to be worth the same amount. This
01:06:58
ability for one unit of money to
01:07:00
perfectly replace another one is called
01:07:02
fungeibility. Money is fungeible. Stocks
01:07:04
and gold are also fungeible. But
01:07:07
baseball cards or pairs of shoes are not
01:07:09
fungeible because once used or once
01:07:11
wrinkled or once made dirty, they have a
01:07:14
different value than what a new copy
01:07:15
would have. The fifth attribute is
01:07:17
divisibility. We need to be able to take
01:07:19
large amounts of money and break it down
01:07:21
into smaller amounts. If I have a $100
01:07:22
bill and I need a candy bar, I need a
01:07:24
choice other than buy 100 candy bars,
01:07:27
right? You need to be able to make
01:07:28
change for me. The sixth attribute is
01:07:30
malleability. This applies to physical
01:07:32
money mainly. You need to be able to
01:07:34
work with the material. Paper easy to
01:07:36
print on. Uh silver and gold were can be
01:07:39
easily melted and stamped and that's why
01:07:41
they were so often used as coins. Uh
01:07:43
glass, well glass would be tough to make
01:07:45
money with. Uh the seventh attribute is
01:07:47
recognizability. You've got to be able
01:07:48
to recognize money as money. Unique
01:07:50
coins, unique bills, unique credit card
01:07:53
designs. And then the last one, the
01:07:54
eighth one, stability. And this one is
01:07:56
huge. We need to rely on the fact that
01:07:58
the cost of goods today is relatively
01:08:00
stable to the cost of goods next week.
01:08:02
So now that we've covered a bunch of
01:08:04
basics about money in general, let's get
01:08:06
back to explaining Bitcoin. Bitcoin
01:08:08
again is a software. It tracks a digital
01:08:10
only currency. There's no physical
01:08:11
currency. There's no coin you can hold
01:08:13
in your hand. Bitcoin is decentralized.
01:08:16
That means that there's no Federal
01:08:17
Reserve. There's no Department of
01:08:18
Treasury involved. There's no higher
01:08:20
power that signifies trust or stability.
01:08:23
Then you might ask, how can we trust
01:08:25
Bitcoin? We'll get into that. The
01:08:26
Bitcoin network was started in 2008 by a
01:08:28
person, maybe a person uh named Satoshi
01:08:31
Nakamoto. Could be a real person, could
01:08:33
be a fake name, could be a group of
01:08:35
people using a fake name. We don't
01:08:36
really know. Uh and that mystery surely
01:08:38
adds some intrigue to the story of
01:08:40
Bitcoin. But Nakamoto's idea was to
01:08:42
create a currency that could be trusted
01:08:44
independently of government interaction
01:08:46
and independently of personal trust. The
01:08:48
algorithms and the codes used in the
01:08:50
Bitcoin network, they're all open
01:08:52
source. Anyone with a computer science
01:08:53
background can look at them and and
01:08:55
learn how it works. There's full
01:08:57
transparency. And the metaphor I'd like
01:08:58
to use here is why do you believe that
01:09:00
the sun will rise tomorrow? And the
01:09:02
answer is that the the natural world of
01:09:04
math and physics suggests that the sun
01:09:06
will rise tomorrow. So Nakamoto, he
01:09:08
wanted to use math similarly, just that
01:09:11
the world of math to create a similar
01:09:13
level of intrinsic trust for Bitcoin.
01:09:16
That brings us to the topic of wallets
01:09:17
and ledgers and blockchains. So if you
01:09:19
had Bitcoin, you would keep it using a
01:09:21
wallet. The problem is that the name
01:09:23
wallet kind of uh conotes this idea of
01:09:25
storage. You know, if Bitcoin is the
01:09:26
thing, then the wallet stores the thing.
01:09:28
But that's not really true. Instead, a
01:09:30
wallet is nothing more than an
01:09:32
identification number or an address and
01:09:34
a set of passwords or keys. It's really
01:09:36
similar to how your bank account ID
01:09:38
would work. Your bank account is not a
01:09:40
physical vault at the bank. It's just an
01:09:42
ID and a password. And the bank's
01:09:44
ledger, the bank's spreadsheet uses that
01:09:47
ID to track an account amount, right? To
01:09:50
track the number of dollars in your
01:09:51
account. That bank account is this
01:09:53
intangible storage. Again, it's not a
01:09:55
physical vault. It's really just a line
01:09:57
on a spreadsheet that your bank keeps.
01:09:59
Bitcoin wallets are very similar to
01:10:01
that. They're password protected using
01:10:03
one or more private keys, private
01:10:05
passwords that you, the wallet owner,
01:10:07
would have. Some wallets can be accessed
01:10:10
online, say through like a Coinbase type
01:10:12
website. And since they're online, they
01:10:14
can easily communicate with the rest of
01:10:16
the Bitcoin network. Other wallets,
01:10:18
though, exist on on local hardware, like
01:10:20
on a personal computer or on a USB
01:10:22
drive, they're more secure that way.
01:10:24
They're much harder to access that way.
01:10:25
And those kind of wallets require a
01:10:28
little bit of extra work like an
01:10:29
internet connection to then connect to
01:10:31
the larger Bitcoin network. So the
01:10:33
question, the next question I want to
01:10:34
tackle is how does another person know
01:10:36
how much money is in my Bitcoin wallet?
01:10:39
And that's answered by the blockchain,
01:10:41
also called the distributed ledger. And
01:10:43
when you see that word blockchain or
01:10:45
ledger, you should just think community
01:10:47
spreadsheet. That's it. So for
01:10:48
simplicity, just imagine that the
01:10:50
blockchain is a giant shared Google
01:10:52
sheet shared by thousands, if not
01:10:55
millions of people all over planet
01:10:56
Earth. That blockchain lists every
01:10:59
single transaction that has ever
01:11:01
occurred on the entire Bitcoin network,
01:11:03
just like you might use a spreadsheet to
01:11:05
list uh business payments or to operate
01:11:07
a budget. So if Bob paid Frank two
01:11:09
bitcoins in 2016 and if Jim paid Sally
01:11:12
five bitcoins in 2018 on and on and on,
01:11:15
all of those transactions are recorded
01:11:17
on the blockchain. Every single wallet
01:11:20
wallet transaction that has ever
01:11:21
occurred. So in that way by tracking all
01:11:24
of these transactions we know exactly
01:11:27
which wallets have Bitcoin in them and
01:11:29
exactly how much Bitcoin is in each one
01:11:31
of those wallets. However, what we don't
01:11:33
know is which human being on earth owns
01:11:36
which wallet. So in that way the system
01:11:37
is what we call pseudonmous. We know
01:11:40
where activity is occurring. We know
01:11:42
which wallets have how much Bitcoin. We
01:11:45
just don't necessarily know who as a
01:11:47
person is associated with which wallet
01:11:49
ID. Now, when I go to make a new
01:11:50
transaction, as long as I do so and I I
01:11:53
include my correct private key, my
01:11:56
password, then the network trusts that
01:11:58
the true owner, me, because I'm the one
01:12:00
who knows my own password, that I'm
01:12:02
actually making that transaction and and
01:12:04
the network will approve my transaction.
01:12:06
Now, in the current monetary system,
01:12:08
banks and governments control those
01:12:10
spreadsheets. You know, the bank gives
01:12:12
Jim permission to pay Sally, but why do
01:12:15
we need that central authority
01:12:16
intervention? The crypto community says
01:12:18
we don't. The goal of cryptocurrency is
01:12:20
to maintain this globally shared copy of
01:12:22
the spreadsheet so that people like you
01:12:24
and me can independently verify those
01:12:27
transactions and we'll get into more
01:12:29
detail here. So each person on the
01:12:31
network who's verifying those
01:12:33
transactions again they're called a
01:12:35
node. So now let's get into verification
01:12:38
and mining and that whole crypto prefix,
01:12:40
right? Why is it cryptocurrency? It
01:12:42
might feel like we're close to having a
01:12:44
complete system. So far we've covered
01:12:45
that Bitcoin is a virtual currency.
01:12:47
There's this giant shared spreadsheet
01:12:49
called the blockchain that tracks every
01:12:51
single account or wallet. It tracks
01:12:54
every single transaction uh the
01:12:56
quantities of those transactions. And if
01:12:58
all the nodes agree on the state of the
01:13:00
spreadsheet, then we're really happy. We
01:13:02
know who has money, who has Bitcoin, and
01:13:04
how much they have and it's all fine.
01:13:06
But what more do we need? What we need
01:13:08
is trust. We need a way to validate the
01:13:11
trustworthiness of the blockchain. Like,
01:13:13
how do I really know that Brian has five
01:13:16
Bitcoin in his wallet? What if someone
01:13:17
else's copy of the blockchain? What if
01:13:19
someone else's copy of the spreadsheet
01:13:21
says Brian only has three Bitcoin? How
01:13:23
do we all agree on a consistent uniform
01:13:26
version of the blockchain? The answer
01:13:28
lies in cryptography, in mining, and
01:13:30
proof of work. As a simple spreadsheet
01:13:32
might be really easy to alter or easy to
01:13:34
hack or easy to fake. So, Bitcoin uses
01:13:37
complicated cryptography or code solving
01:13:39
to verify new transactions. The act of
01:13:42
solving those codes is quote unquote
01:13:44
mining. Bitcoin mining provides
01:13:46
something called proof of work. We'll
01:13:48
break all this down. Proof of work. So,
01:13:50
how do you trust your trainer at the
01:13:52
gym? Well, is it because he's fat and
01:13:54
unathletic? Or is it because he's
01:13:56
muscular and knowledgeable? It's not a
01:13:58
trick question. You probably trust your
01:13:59
athletic trainer because his body and
01:14:01
knowledge act as some sort of proof of
01:14:03
work. He's put in the effort and he has
01:14:05
the results to prove it. That makes him
01:14:07
trustworthy. The same to some extent
01:14:08
works for Bitcoin. Whenever we append
01:14:11
some new transactions aka a new block to
01:14:14
the community spreadsheet, they come
01:14:16
those new transactions come with a very
01:14:18
difficult puzzle and proof of work that
01:14:20
the puzzle has been solved. All the
01:14:22
other nodes in the network can see the
01:14:24
solved puzzle and can test its proof of
01:14:26
work for themselves. It's called
01:14:28
consensus. The proof of work verifies
01:14:30
that the new transactions are in harmony
01:14:32
with the current iteration of the
01:14:33
blockchain. All the nodes can see that
01:14:35
the new transactions reconcile with the
01:14:37
current state of the spreadsheet. It's a
01:14:39
little bit like showing your work on
01:14:40
your math test. It proves your
01:14:42
authenticity to the teacher. You and I
01:14:45
can easily determine a physically fit
01:14:46
person. It's pretty obvious. We can also
01:14:48
determine that you know what's on the
01:14:50
math test. But how do all these nodes
01:14:52
agree that a new block of transactions
01:14:55
has been verified by a sufficiently
01:14:58
laborious proof of work? How much proof
01:15:00
do we need? And what exactly does that
01:15:02
look like? So here's where the crypto
01:15:04
bit comes in. The crypto prefix refers
01:15:06
to cryptography, the act of breaking
01:15:08
codes. And breaking a sufficiently
01:15:10
difficult code, which I called a puzzle
01:15:12
previously, acts as proof of work for
01:15:15
the Bitcoin network. Like many codes,
01:15:17
cryptocurrency codes are difficult to
01:15:19
decipher upfront, yet easy to understand
01:15:21
once you have the key, once you have the
01:15:23
secret. Good cryptocurrency codes
01:15:25
accomplish this via two distinct
01:15:27
character traits, if you will. The first
01:15:29
one is that these codes are typically
01:15:30
one way only. You can always and easily
01:15:33
trace an input to an output, but you can
01:15:36
never directly trace an output back to
01:15:38
an input. And I know that's kind of uh
01:15:40
confusing. It's kind of like a Play-Doh
01:15:42
squeezer. If you've ever played with a
01:15:43
child who has a Play-Doh squeezer, you
01:15:45
know, it's really easy to start with a
01:15:47
random lump and squeeze out a very
01:15:49
predictable pattern from the from the
01:15:51
squeezer. But it's basically impossible
01:15:53
to start with this pattern that came out
01:15:55
of the Play-Doh and then accurately
01:15:58
recreate the random lump. you know, was
01:16:00
the starting play-doh, was it kind of
01:16:01
lumpy? Or was it very lumpy? Did it look
01:16:03
like a goose? Did it look like a cookie?
01:16:05
We simply don't know. The squeezer,
01:16:07
which in this case represents the crypto
01:16:09
hash, creates an end pattern that simply
01:16:11
cannot be traced back to its origin.
01:16:13
It's only predictable in the one
01:16:15
direction, not in the other direction.
01:16:17
The end products might be slightly
01:16:19
different from one another. A little
01:16:21
more blue Play-Doh, a little more red
01:16:22
Play-Doh, but they are vastly different
01:16:24
from their respective input lumps. The
01:16:27
second important trait of a good crypto
01:16:30
code or crypto hash, is that it's
01:16:32
subject to what's called the avalanche
01:16:33
effect, which some people would call
01:16:35
chaos theory or the butterfly effect, in
01:16:37
short, a tiny change in the input
01:16:39
results in a massive change in the
01:16:41
output. A little extra red play-doh in
01:16:43
the starting lump might completely
01:16:45
change the appearance of the output. In
01:16:47
this article that I wrote, which we'll
01:16:49
link in the show notes, I put in a a
01:16:50
real example of how a simple small
01:16:52
change completely changes the output
01:16:55
from a crypto hash. You know, the
01:16:57
sentence, the quick brown fox jumps over
01:16:59
the lazy dog versus that same exact
01:17:02
sentence just with a period at the end.
01:17:03
The quick brown fox jumps over the lazy
01:17:05
dog with a period at the end. Those two
01:17:07
different inputs result in vastly
01:17:09
different outputs. And the puzzle in
01:17:12
cryptocurrency, the puzzle in Bitcoin is
01:17:14
to start with an output and then have to
01:17:17
go backwards and guess what input might
01:17:19
have created that output. It's to start
01:17:21
with that the patterned Play-Doh at the
01:17:23
end and then determine what the lumpy
01:17:26
Play-Doh at the beginning looked like.
01:17:27
How do we do that? We have to create a
01:17:29
billion billion billion different lumps
01:17:31
of Play-Doh, send them all through the
01:17:33
Play-Doh squeezer, and then compare them
01:17:36
to the target output that we were given.
01:17:38
A perfect match solves the puzzle. It
01:17:40
really is just a brute force game of
01:17:42
guess and check. So, how do we do that
01:17:44
in the crypto world? How do we determine
01:17:46
the quote unquote target pattern of
01:17:48
Plato and who does the solving? Mining
01:17:50
is the act of solving these puzzles. It
01:17:52
invokes images of physical labor and
01:17:54
hidden discovery. But you know, a puzzle
01:17:56
in the crypto world might be to discover
01:17:58
an input that creates a particular
01:18:00
output of X or less. So you're given
01:18:03
this this binary number and you have to
01:18:06
figure out you have to find an input
01:18:08
value that goes into this hash that goes
01:18:10
into this code to create an output value
01:18:13
less than the one that you were given.
01:18:15
And mining solves this process by
01:18:17
simultaneously completing two tasks.
01:18:20
First, the complexity of the puzzle
01:18:22
provides sufficient proof of work to all
01:18:24
the other Bitcoin nodes verifying all
01:18:26
the recent transactions. You know, new
01:18:28
blocks are assumed guilty until proven
01:18:31
innocent. Cuz remember, these new blocks
01:18:32
contain new transactions. Which wallets
01:18:35
are sending money to which other
01:18:36
wallets? And if you get that wrong and
01:18:38
you add it onto the blockchain, you've
01:18:40
kind of just uh blown up the entire
01:18:42
system of trust. So, the new blocks are
01:18:44
assumed guilty as if a random bad actor
01:18:47
is attempting to add fraudulent
01:18:49
transactions to the blockchain. So,
01:18:50
mining's proof of work does provide some
01:18:52
sort of evidence of authenticity. And
01:18:55
second, the miner who solves the puzzle
01:18:57
earns Bitcoin as a reward, and those
01:18:59
rewards have been decreasing over time
01:19:01
by design. So, approximately every 10
01:19:03
minutes, a puzzle is solved. A new block
01:19:05
of transactions is added onto the
01:19:07
blockchain. Importantly, the details of
01:19:10
the current puzzle and the details of
01:19:12
the current transactions are part of the
01:19:15
inputs for the next puzzle. So in that
01:19:16
way, the new puzzles are totally
01:19:18
unpredictable. You can't solve a new
01:19:20
puzzle ahead of time. The the newest
01:19:22
puzzle is based on the transactions that
01:19:24
we won't know about until the current
01:19:26
block is solved. And miners, they repeat
01:19:28
their guesses and checks, their guesses
01:19:30
and checks a million, a billion, a
01:19:32
trillion times or more until the current
01:19:34
puzzle is solved. The difficulty of the
01:19:36
current puzzle is automatically adjusted
01:19:38
based on the total number of miners
01:19:40
trying to solve the current puzzle. It's
01:19:42
a terrific example of some, you know,
01:19:44
harmonious economic incentives. Miners
01:19:46
are incentivized to compete to find
01:19:48
puzzle solutions. The winning minor gets
01:19:49
a prize. That's their incentive. The
01:19:51
Bitcoin network gets verifications that
01:19:53
the transactions that were added are
01:19:55
valid. And the more competitors, the
01:19:57
greater the integrity of the system. So,
01:19:59
we now know enough to explain the entire
01:20:01
cryptocurrency Bitcoin system. and we
01:20:04
can walk through the kind of block and
01:20:06
puzzle cycle again tying these ideas
01:20:07
together. Uh there's a bit of a chicken
01:20:09
and egg syndrome though because where
01:20:10
exactly do we start? So let's start at
01:20:12
the beginning of a new block. So all
01:20:14
over the world each node is updating its
01:20:17
version of the spreadsheet. The nodes
01:20:19
are aware that a solution was proposed
01:20:21
to the previous blocks puzzle. The nodes
01:20:24
are aware of all the specific wallet
01:20:26
towallet Bitcoin transactions that the
01:20:28
previous block verified. the ledger,
01:20:30
their copy of the spreadsheet is now up
01:20:32
to date, and we now know the current
01:20:34
status of every single Bitcoin wallet
01:20:36
all over the world. We know how much
01:20:38
Bitcoin is in every single wallet. So
01:20:40
now it's time to start the next block. A
01:20:42
new puzzle forms based on the previous
01:20:45
blocks puzzle solution and transactions.
01:20:48
The miners, they now know their their
01:20:50
next target output. They now know what
01:20:52
they're guessing and checking in order
01:20:54
to solve. So if we think back to Plato,
01:20:56
the the target output pattern has now
01:20:58
been made apparent to us. But who knows
01:21:00
what random lump input looked like to
01:21:03
create that output. We now need to start
01:21:04
guessing and checking to find that.
01:21:06
Every minor on the network is now racing
01:21:09
to find the solution. There's play-doh
01:21:11
everywhere, we'll say. And after a few
01:21:13
minutes, someone solves the problem.
01:21:15
Eureka. A correct input has been found
01:21:18
that solves the current puzzle. And
01:21:20
that's proof of work. It's sent to every
01:21:22
single other node on the network to all
01:21:24
of them to individually verify. like see
01:21:26
for yourself this particular input that
01:21:29
I just discovered solves the current
01:21:31
puzzle. You know, they then try out the
01:21:33
solution for themselves. Did the
01:21:35
proposed solution actually solve the
01:21:37
puzzle? Did this random number input
01:21:39
actually create the desired output? The
01:21:41
math doesn't lie. Verifying these proofs
01:21:43
of the work is a very objective
01:21:45
math-based process. And so a new block
01:21:48
is then appended to the blockchain. all
01:21:50
the nodes they they reach a consensus
01:21:52
that the solution that's been proposed
01:21:54
that the proof of work that's been
01:21:56
proposed is valid. Now, an interesting
01:21:58
thing that I I don't think I've touched
01:21:59
on yet is that when the new block is
01:22:00
appended to the end of the blockchain,
01:22:02
technically it doesn't have any
01:22:04
transactions in it yet because the
01:22:06
winning minor gets to do two things. The
01:22:09
first is that they get to pack the new
01:22:11
block with their choice of transactions
01:22:14
that are waiting to be added to the
01:22:16
blockchain. Cuz some transactions, they
01:22:18
come with little fees, little finders
01:22:20
fees in order to entice a minor to
01:22:22
include those transactions into the next
01:22:24
block. Those fees go to the winning
01:22:26
minor. And second, the winning minor
01:22:28
gets to claim a bounty of their own, a
01:22:30
bounty of Bitcoin by adding a pending
01:22:33
one extra transaction onto the end of
01:22:35
the block that specifically says, you
01:22:38
know, Jesse mine this block and now
01:22:40
Jesse's wallet gets one Bitcoin. Jesse's
01:22:43
wallet gets to claim the prize. So in
01:22:45
that way I guess all parties win. The
01:22:47
winning minor gets Bitcoin as a reward.
01:22:49
Cool. The network as a whole receives
01:22:52
some concurrence that the ledger is
01:22:54
accurate and up-to-date. Vital to
01:22:56
maintaining trust in the network.
01:22:58
Importantly, since many miners are
01:23:00
racing for the reward, the block gets
01:23:02
verified in a very timely manner, right?
01:23:04
So the individual wallet owners, they
01:23:06
don't need to fear that their
01:23:07
transactions might get stuck in limbo.
01:23:10
You know, every 10 minutes a new block
01:23:11
goes up and their transactions are
01:23:13
verified. So when one door closes,
01:23:16
another door opens. Now that the
01:23:17
previous block has been mined, has been
01:23:20
filled with transactions. That means
01:23:22
that all the data is there to start the
01:23:24
new puzzle for the new block and that
01:23:26
competition for the next block has been
01:23:28
started. So now all over the world, each
01:23:31
node updates its version of the
01:23:32
blockchain to include the most recent
01:23:34
block. The nodes are aware of the
01:23:36
solution to that block's puzzle. The
01:23:38
nodes are now aware of all the Bitcoin
01:23:40
transactions that have been packed into
01:23:42
that block and have been verified.
01:23:43
Ledger is now totally up to date. We
01:23:45
know the status of every Bitcoin wallet
01:23:47
in the world and it's time to go on to
01:23:49
the next block. We have a new puzzle to
01:23:50
solve. I know that many of you still
01:23:53
might have a bunch of questions and
01:23:54
answers. So, if you're interested, in
01:23:55
the show notes, I linked to this article
01:23:57
explaining Bitcoin in simple terms. At
01:23:59
the end of the article, I list out a
01:24:01
bunch of questions and answers like,
01:24:02
"Can Bitcoin really last? Will people
01:24:04
really use it? Why are the puzzles even
01:24:06
needed again? Uh, what if a node chooses
01:24:08
to stall? What if someone tries to
01:24:10
change an old transaction? Is Bitcoin
01:24:13
really unhackable? How would I even
01:24:15
spend Bitcoin? Here's a big one. What if
01:24:17
I need help with my Bitcoin? Right? I
01:24:19
can go to the bank if I need help with
01:24:20
my bank account. What if I need help
01:24:22
with my Bitcoin account? All really
01:24:24
interesting questions. Uh, can I become
01:24:25
a node? Can I become a minor? Is Bitcoin
01:24:28
a good investment in the first place?
01:24:30
What about all the other
01:24:30
cryptocurrencies? Right? There's
01:24:32
thousands of alternative cryptos called
01:24:34
altcoins. So, I provide some answers to
01:24:36
all those questions. I won't go into all
01:24:38
the answers right now because Lord knows
01:24:39
this uh episode has already been long
01:24:40
enough. For what it's worth, the last
01:24:42
thing I will say today is I really
01:24:43
appreciate the feedback I've been
01:24:45
getting. I I sent out a uh survey to my
01:24:47
newsletter audience over the last month
01:24:49
or so, and a few hundred of you
01:24:52
responded, which I'm really grateful
01:24:53
for. And I will say the two takeaways
01:24:55
that I will begin implementing, I
01:24:57
promise after uh in the coming episodes,
01:24:59
the two big takeaways are that slightly
01:25:01
more frequent episodes. You're asking
01:25:02
for slightly more frequent episodes. So,
01:25:04
we are about to adjust to three episodes
01:25:06
a month instead of an episode every
01:25:08
other week. So, that's exciting. And
01:25:10
then some of you said that you enjoy the
01:25:12
length of the episodes. Some of you said
01:25:13
that you wish the episodes were all a
01:25:15
little bit shorter. So, I'm going to
01:25:16
make a pretty conscious effort to keep
01:25:18
episodes to maybe between call it an
01:25:21
average of 40 minutes, 30 to 40 minutes
01:25:23
on average per episode. So, you'll see
01:25:24
these changes coming your way soon. As
01:25:26
always, thank you very much for
01:25:27
listening to Personal Finance for
01:25:28
Long-Term Investors. If you want to
01:25:30
contribute a question to a future AMA
01:25:32
episode, simply send me an email to
01:25:33
jessebinest.blog. Oh, and on that note,
01:25:35
I will say in the new uh episode format,
01:25:38
because we're doing episodes, three a
01:25:40
month every month. One of those three
01:25:42
episodes will be an AMA because I think
01:25:44
they're my most popular episodes. You
01:25:46
guys really seem to enjoy them and enjoy
01:25:48
submitting your questions. So, we'll now
01:25:49
have monthly AMA episodes instead of one
01:25:51
every other month. So, stay tuned for
01:25:53
that. Talk to you soon. Bye-bye for now.
01:25:55
Thanks for tuning in to this episode of
01:25:57
Personal Finance for Long-Term
01:25:59
Investors. If you have a question for
01:26:01
Jesse to answer on a future episode,
01:26:03
send him an email over at his blog, The
01:26:05
Best Interest. His email address is
01:26:07
01:26:10
Again, that's jessevestinterest.blog.
01:26:13
Did you enjoy the show? Subscribe, rate,
01:26:16
and review the podcast wherever you
01:26:17
listen. This helps others find the show
01:26:20
and invest in knowledge themselves, and
01:26:22
we really appreciate it. We'll catch you
01:26:24
on the next episode of Personal Finance
01:26:26
for Long-Term Investors. Personal
01:26:29
Finance for Long-Term Investors is a
01:26:31
personal podcast meant for education and
01:26:33
entertainment. It should not be taken as
01:26:35
financial advice and it's not
01:26:37
prescriptive of your financial
01:26:38
situation.
