June 29, 2022

Is Now a Good Time to Pick Stocks? The Pros & Cons of Active Investing with Jack Raines

Is Now a Good Time to Pick Stocks? The Pros & Cons of Active Investing with Jack Raines

Think you can beat -22%?

Given current market conditions, it seemed like a good time to revisit the age-old temptation for investors: Should I…try to stop the bleeding and make more active investment choices? Surely I could do better than -22%!

In most personal finance circles, this question is heresy—but lucky for you, I like to rock the boat. We’re digging into the case against active, some oddly compelling arguments for it, and everything in between in this week’s episode. Don’t call the FI/RE department on me! (See what I did there?)

I'm joined by Jack Raines of the blog Young Money today to discuss 'the true cost of alpha.' (Alpha = an investment's ability to beat the market.)

This is also our first episode with a listener Q&A. Today’s is about commission income: How it’s taxed, how to budget for it, and how to invest it. Got a question you want answered? Make sure you’re following Money with Katie on Instagram, where you’ll see our call for questions!

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This episode is sponsored by Betterment.


Welcome back, #RichGirls and Boys, to The Money with Katie Show. I'm your host, Katie Gatti Tassin. And today we are going to talk about something that's practically financial independence heresy: individual stock investing, and more broadly, active management strategies. So one thing I noticed when I first immersed myself in the personal finance world was that the devotion to passive investing, like the Bogleheads theory, if you will, was strong. So strong. In fact, that active investing really isn't even entertained as a conversation in the financial independence communities. It's practically a given in those circles that buying the total stock market, like VTSAX, and calling it a day, is the undisputed best path forward. And I think it's probably a strategy that owes its popularization to JL Collins, who published the book, The Simple Path to Wealth, and I myself mostly subscribe to that dogma with a few tweaks, but it always interested me that we totally ignored active investing as a viable strategy altogether. To be fair, the data is there to mostly disprove active management’s viability by over the long term. So it's treated as a “case closed” for retail investors, with mostly good reason. 

That said, I can't help myself. Anytime anything is treated as a given, that's not even worth exploring or talking about, I just want to get in there and mess it up. And I realized this might be a relatively frustrating episode as a listener, because I'm not providing a clear conclusion or answer, but that's kind of the point. I want to encourage you to come to that conclusion on your own, and give you some new things to think about that might not be what you're hearing in 99% of my content or anyone else's. So here's a brief overview of where I'm hoping to take our conversation today.

Number one, we will start by attempting to define what “active” even means. This is a slipperier slope than you'd think, though: Active and passive are kind of treated like distinct binaries in conversation, but the lines are actually pretty blurred. In some ways, there's really no such thing as passive, which we discussed in the last episode too, with Eric Balchunas. So we'll get into that in a little bit. The second thing: Broadly speaking, I'd also love to cover the general case against active, which I'm sure you're pretty familiar with by now. And finally, I want to dive into the potential case for active, and some of the most compelling stuff that I've heard. 

Have you ever seen that bell curve meme, where the people who are the dumbest—that feels mean to say, but that's the implication in the meme, so don't come for me—and the people who are the most enlightened and intelligent are on either side of the bell curve and believe the same thing, but for different reasons. And then the height of the bell curve in the middle is the majority of people, somewhere in between, who all believe something different. Sometimes the whole active world feels like that. Like the 19-year-olds with eTrade accounts are all about active. The vast majority of wealthy normal people are team passive indexing. And then the outlier geniuses at the far end of the bell curve, like think Michael Burry who called the great financial crisis and shorted the US economy, also believe that active makes more sense. I'm also really excited about my guest today, Jack Raines, who wrote a fantastic piece called “A New Definition of Alpha” that we will talk about in a little while. 

So anyway, you may be wondering, are you changing your point of view on the best way to invest? To be honest, I don't have a staunch perspective that I would bet my life on here. I have the one that I follow—passive—because it fits my lifestyle and my experience most fittingly. But if you asked me to bet my life on passive always being the best thing for absolutely everybody, and active being something that should never, ever, ever be attempted, I wouldn't. Remember how I said it's a bit of a blurry line between the two anyway? That is partially why, which is a perfect segue to my first intention today: defining what active management even means, and why it's a blurred line. 

Generally speaking, passive management is a label that we use kind of synonymously with index fund investing. And to even back up a step further, index fund investing is basically investing in something that tracks an index. So the most popular one in the US, we've got the S&P 500, but there are indices that track pretty much every conceivable concept, like thematic ETFs that only include certain sectors and industries like semiconductors, for example. Active management is typically a label that is used for anything wherein a manager is picking which stocks or funds are going to be included in the portfolio. And usually with the intention of outperforming some benchmark, like the S&P 500. This is why you'll see headlines about hedge funds being unable to beat the S&P 500. It's a benchmark that most will compare an active strategy to, in order to determine whether or not the active strategy is working. But honestly, the benchmark is kind of arbitrary, because a year where the S&P 500 tanks, but some other random index fund like emerging markets does really well, people would probably compare their hedge fund performance to that instead, not the S&P 500, but most active funds will cite their benchmark. They will tell you what benchmark they are trying to outperform. And it isn't always the S&P 500. Now here's where things are going to get a little bit blurry. 

Henah, senior editor: Katie, can you hear me?

Katie: Henah? Yeah, I can. I'm actually in the middle of a show right now. 

Henah: Katie, listen. I'm on a rocket ship and I'm flying to the moon.

Katie: Uh, what?

Henah: I did my due diligence and I YOLOed my entire savings into stocks. And now I am diamond-handing this rocket to the literal moon. 

Katie: That sounds like a… 

Henah: Wow! It is so beautiful out here. I wish you could see it. Oh my God, something is wrong. 

Katie: Henah, what is it? What's wrong? 

Henah: Oh my God. Katie! Katie! 

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Okay, well, the show must go on. So we will keep checking in on Henah and pass along any updates. Okay. So to some extent, a lot of index funds have an active component. Someone has to decide what's included in the index. Index funds aren't USDA choice, organic, naturally occurring phenomena that grow from the ground. They are man-made creations. To extend our S&P 500 example—and I think Eric touched on this a little bit in last week's episode, if you want to go back and listen to that—that wasn't a law of nature that only the 500 biggest companies were included. That was a decision that someone made to actively cut off the inclusion of the 501st company. Every passive index fund was actively created by someone who determined what should be included in that index. So there was an episode of Rational Reminder—it's a great podcast, very technical, but if you're into that, it's a good one—where they compared and broke down nine different small cap value index funds, assuming that they would all have mostly the same holdings and very similar performance. And yet they had wild variations and performance differences, despite all of them being classified as small cap value index funds. 

So passive in general, bit of a misnomer, it's more descriptive of the retail investor’s involvement in the investment and less descriptive of what the investment actually is. All index funds were actively assembled by someone, or more likely a team of someones, who determined what would be included and in what proportions. And I know that we're getting a little bit pedantic here. I'm really into the weeds of this stuff, but in any case, even cap weighting is a bit of an active decision. You are deciding to give more favor and more weight in the fund to the larger companies, rather than weighting all 500 companies equally. The popular S&P 500 index funds and index ETFs are cap weighted, which means the biggest companies by market cap are granted the highest percentages in the fund. So as of this recording, Apple is the largest company in the S&P 500, comprising 6.4% of the fund’s total value. That means that Apple as one of 500 companies is 0.2% of all the companies represented, but makes up 6.4% of total value. That was an intentional decision. Now, there is a degree of active strategy involved when you're constructing your own portfolio, too. Even if you are constructing it with index funds or index ETFs. You are deciding which indices you want to own, and in what proportions to one another; you are choosing if you want to introduce things like Bitcoin, or if you want to avoid international exposure by opting to include or exclude those things. That is to some degree active.

So we're all a little bit active—not as active as day trading, but still active. It skews passive. Most people who create a portfolio of index funds consider themselves passive investors, myself included, but it is still an interesting distinction to make. Now, the passive camp does get described interchangeably sometimes with that “buy and hold” camp. And that's likely because these two strategies are so often linked and employed together, but buy and hold usually is just referencing having a long-term investing outlook of buying something you believe in and hanging on to it until your lifestyle needs require you to sell it and use the funds. This is in opposition to trading, which is more speculative in nature and involves you buying a stock because you think it will be trading at a higher price in the near future, and you'll be able to turn a profit on the purchase. It’s the difference between believing in the long-term viability of what you're buying, and simply seeing an arbitrage opportunity that you want to exploit. 

So now that we've sufficiently driven that discussion into the ground, let's talk about why most people believe passive, as it’s colloquially defined, to be better than active. To start the case against actively managed funds. Well, there are two major arguments against traditionally defined active management that tend to arise whenever this topic comes up. The first and the major one is about fees. Almost always, a traditionally active strategy comes with some baggage. Either you have to pay someone else to devise and enact that strategy for you, or you are dealing with higher taxes because you are creating a bunch of taxable events. Now, active management fees have been steadily declining since the popularization of index investing. That's the Bogle effect we talked about last week. But they are still orders of magnitude larger than the little old expense ratios on funds like VTSAX that I believe now are in the neighborhood of three or four basis points—that's 0.03% or 0.04%. Very little. Active management fees typically are north of 50 basis points. So 0.5% and can be as high as 200 basis points. So two full percent. So it doesn't sound like much, but it is substantially larger than the expense ratio on your typical index fund. And it eats into your returns over time. That's a very important concept to grasp as your net worth gets bigger and bigger. If you have someone else that's managing it for you, the fees compound in the same way that positive returns compounds; it's not negligible. That said, the complement to the fee argument is the fact that you often do not get what you pay for. If someone charges you a 2% fee, but they could outperform the market or really protect your downside, or some of these other selling points that active managers will give you, and they could consistently beat the benchmark by even 3% per year, you would be coming out ahead. You'd have a net positive. The issue is that that's very hard to do consistently over time. And there are so many statistics available about how few active managers beat their benchmark on a one-year, five-year, ten-year, 30-year basis. 

One quick one to illustrate this point: After 15 years, 92% of large cap active funds underperformed the S&P 500. Aka, only 8% of the active managers that are charging you high fees to beat the market actually did. The statistics do not sound like active management’s odds are in your favor, and you will pay more for it, too. So that's the general argument against it in two key bullet points: high fees, general under-performance over time. Again, the general consensus is that the chances you're going to be or find the person that can do that are slim enough that it's not even worth the risk, when there's an easier, cheaper path available to you that has better odds of producing the outcome you want. 

But remember, this is where the blurry lines make this a relatively difficult, binary, this versus that conversation, because much like a lot of the other things in life, active is a spectrum. It ranges from fully handing your money over to a hedge fund manager who's attempting to beat the market on your behalf, to simply applying a specific strategy to buying your own index funds or individual stocks in a particular arrangement, and getting in or out of the funds after your strategy changes. How often do you have to be changing your strategy to be considered active, right? Is this a subjective measure? An objective one? To my knowledge, there's no objective answer to this question. I used to only own VTSAX, and then I realized I was way overexposed to large cap US equities, and I started buying other funds. And then I dipped my toe into private real estate. That said, there are some oddly compelling arguments for a more active strategy, and some of what I've been diving into recently. Now, the funny thing about discovering some of these thinkers that I've been listening to, they all came as recommendations from my friend Logan, known on the internet, on Instagram, as the Why of FI. He's a very big Bitcoin guy…is that it's revealing to me yet another upper echelon of financial knowledge that is honestly just way over my head. Like as if I do not disclaim this enough, I am not a licensed financial professional. I've never formally worked in finance. I'm not a registered investment advisor. These are not qualifications I've ever purported to have. So I've been listening to podcasts, interviews, primarily with people like Chris Cole from Artemis Capital and Mike Green from Simplify Wealth. And these are people that are so smart, yet so obscure that you've probably never heard of them. But it's funny, because much like the bell curve that I mentioned at the beginning of this episode, the production value and the popularity of the podcast these guys are on is almost reminiscent of the really small beginner shows that don't have any traction. Like there's no Dave Ramsey mega following. They're not household names. And that's the reality, I think, of some of the thought leaders in this hyper niche wealth management world, and honestly, a lot of what they say goes over my head. But I still want to attempt to break down the big stuff for you. 

So what I've picked up thematically from them—and the reason why I'm interested in talking about active at all—is because they tend to make consistently interesting points about the fact that the world we live in today is very, very different from the world that we lived in 50 years ago. Mike Green is probably my favorite that I've listened to. He is really smart. His viewpoints seem to be all over the place, which is kind of fun.

And frankly, a lot of what these active arguments boil down to is the fact that the US has been losing its spot as a global hegemonic power. And as most US investors probably know, the majority of our portfolios are pretty dependent upon future US success and US companies. And a lot of these big name thinkers, like Ray Dalio included, have called into question whether or not the US’s reign as the dominant global economy is coming to an end. And if that's the case, we may not see performance like we've seen in the past. 

One of the best ways I've heard the case for active described is more of a criticism of passive, which is, to assume future returns will resemble past returns is also an assumption that the future will be like the past. And there's a lot of somewhat compelling evidence that it won't be. And I think that uncertainty is what opens the door, intellectually at least, for making the case that just buying the S&P 500 and being done, or just buying the total stock market in the US and being done, may not work 2022 to 2052 the same way it worked 1992 to 2022. 

Henah: Katie! Can you hear me? 

Katie: Yeah, Henah, I can hear you. Is everything okay? 

Henah: Katie, this rocket ship is going backwards! 

Katie: Wait, what?

Henah: I was told stocks only went up. I'm setting a course to your house.

Katie: I mean, maybe a giant field would be better to land in.

Henah: It’s too late!

Katie: What? Whoa! Henah, no! Okay. Sit tight, my friend, I'm coming for you. [barking] Beans, calm down. Everything's fine. Mommy’s got it. Oh my God. She crashed right through the ground. Henah, can you hear me? 

Henah: I can, but you left the show. Come back for me. 

Nora: There's a lot going on in the world right now. And more of it than ever seems to be about business. 

Scott: How do workers benefit from the great resignation? Will TikTok change the music industry forever?

Nora: I'm Nora Ali.

Scott: And I'm Scott Rogowsky. And we host Business Casual, a podcast for Morning Brew that dives into the unexpected business story behind everything. We're bringing you conversations with creators, thinkers, and innovators who can tell you what it all means and why you should care. Listen on Apple, Spotify, or wherever you get your podcasts. 

Katie: That Henah! Always so selfless. Okay, let's get back to it. So again, to assume that future returns will resemble past returns is an assumption that the future will be like the past. I say all of this while also acknowledging that these boom and bust, doom and gloom predictions are pretty par for the course. I choose to diversify the index funds I invest in anyway. This isn't, you know, investment advice by any means. Please refer back to two seconds ago where I said I have no idea what I'm doing. But I do invest in emerging markets and various international funds and things that provide exposure to stuff outside the United States. I think being all invested in the US is in some ways a very concentrated position. Even if you own every stock in the US, right, you're still making a big bet on one country. 

The other thing that's really interesting to mention about the individual stock investing philosophy in general is that oftentimes we hear headlines that say hedge funds or big active managers can't beat the index. But importantly, those people are working with very short time horizons. They have to report numbers quarterly, and the stakes are very high for them. If they underperform their benchmark or don't do well for a quarter, they could potentially face the loss of clients and experience cash outflows. So they are thinking on this very short-term window, this very short-term timeframe, and people will go invest with someone else who they think can beat the market. Brian Feroldi, who has been on the show in the past, he makes a really interesting argument for taking a more active approach as an individual retail investor, investing their own money like you or me, that you actually may have a better shot at outperforming than the big guys over time. And that feels totally counterintuitive, right, to everything we read. You know, we hear these hedge fund guys with thousands of man hours going into research and more money than they know what to do with can't do it over time. How could you, the little guy, do it? But Feroldi postulates that precisely because you aren't beholden to anyone, you can make longer-term plays. You could be losing money for three years and then have a big bet pay off hugely. Whereas a hedge fund that did that would lose all their clients, because nobody wants to underperform for three years and pay 2%. So I'm not sure if the data would support his thesis at an aggregate, but it is an argument that has always stuck with me. That individual investors do have a bit of an edge here because they're not beholden to quarterly returns or at the risk of losing the capital they're investing, because someone else takes it away or someone else doesn't like or understand the strategy. They can really drill down into the value or the fundamentals of something, and then sit on it for 10 years, if that's what it takes. But if I'm being completely honest, my consideration of active as a potentially viable strategy has less to do with some hubris that I could ever beat the S&P 500 and more to do with the fact that some of these brilliant people who are undoubtedly a lot smarter than I am think that the world could be changing enough to warrant a switch in strategy. Mike Green, for example, famously very anti-passive. His qualms, though, seem to stem more from the idea that too much money in index funds distorts the overall stock market, because it's what he calls dumb money.

In other words, when you buy the S&P 500, you are not sitting there and assessing the price of every stock in that index and determining whether it's fairly priced, overpriced, or underpriced, and then making decisions accordingly. You are likely just dollar cost averaging your paycheck into these indices, whether they are up or whether they are down. And that's generally a really good strategy, right? That's the goal. But his complaint would be, if you have too much money in the market that is not considering the prices, that can make the market behave irrationally on the whole, or contribute to things being widely misvalued. That's probably an oversimplification, but that's the general argument against passive.

At this point in time, actively managed money and active investing still does make up less of the stock market than passive does. And here's an excerpt from Bloomberg from 2021 about the trend in the US called “Building on Passive’s US Equity Lead.” Okay. “Passive vehicles’ lead in the $11.6 trillion US domestic equity fund market will likely expand. Passive overtook active around August 2018. And its market share stands at about 54%, driven largely by the growth of funds tracking the S&P 500, the total US stock market, and other broad US indexes. US large cap stocks are widely recognized as comprising the world's most efficient equity market contributing to passive’s dominance. The $6.2 trillion in passive assets still accounts for less than a sixth of the US stock market with its market cap of about $40.4 trillion.” 

Okay. See, I warned you. I am not going to be providing any easy binary answers today, but I do think it's an interesting conversation worth having. And so I wanted to bring on my friend Jack Raines, who is candidly, I think, one of the best personal finance writers out there right now—he writes a blog called Young Money—to talk about it more. So Jack, welcome to The Money with Katie Show. Thank you for being here. 

Jack Raines: Thank you for having me. Happy to be here. 

Katie: Yeah. Especially since you are…tell the audience where you are right now and what time it is.

Jack: I'm in Porto, Portugal. It's 9:00pm over here. And I'm sitting in, I guess, the bathroom of the hostel that I'm staying at, kind of. So very, very excited to be here. 

Katie: Yeah. So we've overcome both time zones and distance  to make this happen. So anyway, all that to say, I appreciate it. So I wanted to bring you on the show today to talk specifically about this piece that you published in April called “A New Definition of Alpha,” where you identified, you know, part of the broader discussion between passive and active, and that was the goal of investing. Can you tell us a little bit more about that?

Jack: Sure. To me, the goal of investing is to make sure that you have more money in the future, and you can do that through…some people choose active investing, passive investing, real estate, stocks, but at the end of the day, you want to make sure 40 years from now you have enough money to live off of. And I think people really get caught up in the weeds of maybe you need to outperform or do this or do that. But the goal of investing for everybody is pretty simple. 

Katie: Yeah. And one thing that you had said that kind of stuck with me was just that if you obsess over these huge returns—like if you were to say, oh, well, I really want to work to get some crazy return, it's like, if you're not investing that much money, or you don't have that much capital to start with, that even big returns are not, you know, anything to write home about. So if the goal is to make more money, you had an interesting point about the opportunity cost of being an active manager. Please expound. 

Jack: Right. So, say for example you have, I don't know, $25,000 in your portfolio, and you're confident that you can put a lot of time and effort in and make a hundred percent returns in a year. Considering that the market averages around 8% or 9% returns a year, obviously a hundred percent would be phenomenal. And you put, I don't know, like a thousand hours of research, and you do it. You make a hundred percent return and you make $25,000. But my question is, could you have made an additional $25,000 by investing that time in a skill that you can make money off of, if that's a side hustle or something that would help you get a promotion at work, or any other non-stock market way to make that same money? And I think people feel like you get style points for outperforming the market. But if I could leverage my ability as a writer to make an additional $50,000, and then just throw that in the S&P 500 and never think about it, versus putting 500 or a thousand hours into, like, figuring out what stocks to buy, you're making the same money either way, right? But the biggest thing is when you're just putting that time and effort into finding the right stocks, if you're wrong, then you put all that time and effort in and you can still lose money. And if you're wrong about basically any other skill that you can develop, whether that's learning to code, right, like starting a YouTube channel, basically, anything else, it's going to benefit you, but you can still lose money if you do it with stocks. So then the trade-off just seems worse and worse and worse, the more that you think about it. 

Katie: Yeah. So the reason I think it's so fascinating that you in particular have this perspective—and I wasn't planning on going here, but I want to now, is that you made a ton of money in was it 2021 or 2020?

Jack: Both. It was over the course of both years. Yeah. 

Katie: It's like, yeah, I did it over two years. Okay, I might butcher these numbers, so keep me honest, but it was what, you turned $6,000 into $400,000? Is that right? 

Jack: Correct. I would like to point out that I did that with a Roth IRA. So there were no tax liabilities. 

Katie: Tax-free gains.

Jack: I know that you're big on the minimizing your taxes. So for the audience, I don't recommend trying to day trade or anything like that. But if you do day trade with your Roth IRA, you don't have to worry about the taxes. So that is the one benefit. 

Katie: So you did that. I know you did end up losing some of it. Well, you lost $150,000 on a single trade?

Jack: It was in about five minutes. Yeah. I lost, I was making a salary of $60,000 and I lost almost triple that in five minutes, last August. 

Katie: Oh my God. So I guess you were, I think trading SPACs, you said.

Jack: Correct.

Katie: So I'm curious, like how you reconciled that experience with kind of this perspective on alpha. Like, did that experience drive this kind of realization of like, yeah, I mean, it can be done, but your risk/reward analysis here is a little bit off. 

Jack: So in the back of my head, like I already realized that the risk/reward was off, because it really started around May of 2020 when I started trading these SPACs. And I can just tell, like, I would try to pivot every conversation back to something stock market-related. My family was tired of it. My friends were tired of it. My girlfriend at the time, I know, was tired of it. And I knew it was an issue. And I knew I was spending way too much time thinking about it and talking about it. Yeah. When I lost the $150,000 in a day, it was kind of like the wake-up call that was like, you don't have to do this anymore. Like I still had a decent sum of money I made from it, but it was just, it was almost like I was looking at myself in the third person. Like you got so obsessed and into this, you completely lost sight of the fact that you made a good sum of money. You were just chasing a higher and higher number. Like I wasn't looking at it like I've made 6,000% in nine months. I looked at it like I was 150% away from being a millionaire at 23 or 24 years old, which is so just skewed, looking back. So the way that I reconciled it was, one, when it happened, I went to the gym. I’d sold everything. Went to the gym and probably had the best workout of my life, because I was pretty angry at myself. And then after that, I just decided, all right, like you're not going to trade anymore, because you shouldn't be doing something that has the potential to lose you $150,000 in a day. That was, it was a very sobering moment. I had the ups and the downs from it where I had already realized I'm spending too much time on this. And then when I lost the money, it was like, I've spent, I don't know how much time looking into these stocks. And I still just lost so much money from it. So what was the point? 

Katie: Yeah. Well, and so to kind of bring that home, too, I started this interview by saying that you are one of my favorite writers, and I can't help but think about the fact that when you're just trading, anyone's just trading—I mean, the third person you—you're not adding any value to society. You're just kind of skimming off the top and finding opportunities for arbitrage, right? But in the way that you've now pivoted and kind of lived out this exact cycle you're describing of like, you are trying to trade stocks, you're trying to make money doing that. And then you're like, you know what? This actually isn't a very safe bet for me. Let me go invest that time, now, in a skill. You are now earning a good amount of money writing in a more predictable way, but you're also adding value to other people's lives, which I feel like is that kind of nuanced piece of this, that even though the argument for investing the time and energy into a skill is practical on a financial level, it also has some wider ranging implications from the standpoint of, now other people get to learn from you and benefit from your talent. Whereas like if you're just sitting around trading SPACs all day and talking about it and driving everyone crazy like that, that really is only benefiting you. Especially assuming if, you know, if it works out. Obviously at some points it doesn't, and you're not going to make any money. But anyway, I just think that's kind of interesting. So it brings me to my next question, which is, do you think it's possible to consistently beat the stock market? Like what do you think it takes to do that? 

Jack: Yeah, I think it's possible, because people have done it, right? Like if it wasn't possible over an extended period of time, you wouldn't have a Warren Buffett or a Stanley Druckenmiller or any of these guys. So it's possible. But then if you look at what they sacrifice to do it, like with Warren Buffett, for example, like he has a pretty turbulent family life, to put it nicely, with his wife and kids, or like former wife and kids. Because of the amount of time and effort it took for him to do that, right? So I think the biggest problem with the whole active/passive investing is people only look at the alpha side of investing as, did you outperform the market? And they forget about, there's a trade-off. It's like we were talking about earlier with time, right? If you're making more money, but you're spending literally your entire life doing it, I think you missed the point. In pure financial terms, yes, you can outperform the market. Now, I don't think you will.

Katie: Point of clarification: You won't. 

Jack: Right. You can be like me and maybe you do for a year, but to do it consistently, somebody listening to this probably could, but that doesn't necessarily mean that you should try to, because one, there's no way of knowing for sure if you can until you go for it, then you probably won't do it. And then two, even if you do it, you are going to have to sacrifice so much time, and just so much of your focus from other parts of your life to do that. Why do that when you can just do something else? 

Katie: And I think it's hard over the long term not only to achieve it, but to really know for sure that the strategy that you've picked, that you've dedicated the time to—even if someone was just doing it casually on the side and wasn't trying to make it their entire life, and was like, I'm just going to dedicate 10% of my portfolio to picking individual stocks. And I'm going to do 15 minutes of research a week. And, you know, there are ways, I guess, that you could just almost treat it like a gamble and just have fun with it. But I think over the long term, unless you're really watching and constantly comparing to the benchmark, it's kind of hard to know, even if you have a few lucky breaks and you make a lot of money quickly in short order, over the long term, though, your losing bets may be overshadowing your winning ones, and you might not even really realize it over the decades. If you're kind of just, you know, from bird's eye view, sometimes making money, sometimes losing it. And I think that's the other piece of this that, you know, even in this world, this hypothetical world that we're talking about, where someone could theoretically give up everything to get amazing returns, I think at the end of the day, there is some compelling data to say that the easier strategy actually does usually generate the most money. 

So you mentioned a great piece from Nick Maggiulli in your article about the psychological burden to bear with an active strategy. And I am familiar with the piece that you're talking about, but for our listeners, can you tell us a little bit more about that? 

Jack: Yeah. So this piece that Nick wrote—and I think we both agree that Nick is one of the best finance and personal finance writers out there—but he wrote a piece about the problem of stock picking. And it basically boiled down to this: There's no way of knowing for sure if you're good at it or bad at it until you've done it for an extended period of time. And he compared it to, if you go shoot a basketball, the basketball coach will be able to tell within five or 10 shots if you're good at shooting a basketball—you can either shoot or you can't. But because stock picking is such a nuanced activity where you can buy something and make a lot of money off of it, and you can make a lot of money for a reason that had nothing to do with why you bought it, right? Like you might've bought the stock for this product they roll out. And in reality, investors are just bidding up that sector right now. And it takes a really long amount of time to know for sure if you're good or bad, and it's not like six months—it can be five years. You know, market cycles are long. So you could spend years 25 to 30 thinking that you're really good, and get blown up at year 31, and have invested 2,500 hours just to match or underperform the S&P 500 or NASDAQ, or whatever benchmark you use. That was kind of the background foundation for the piece that I wrote, is that there's just no good way to measure if you're good or not. Because the market averages 8% to 9% returns a year, is it really worth throwing all your time into this thing that you can't even judge your skill for until you've wasted five years or a decade? It just doesn't make sense to. 

Katie: Yeah. So, and for the audience, we'll link both Nick's piece and Jack's piece in the show notes so that you can read both of them, but I love that example of like, you could invest in a stock because you have this premise or this thesis that because they're releasing this product that like the price is going to go up, and it could end up going up for an unrelated reason, but now it has erroneously reinforced this idea to you that like, oh, my thesis was correct. Like, my hypothesis was right. And I'm good at this. When in reality it had nothing to do with that. 

So lastly, to finish up, I'm not sure if you're familiar with Mike Green or some of the other kind of prominent anti-passive investing voices in wealth management. A lot of them, I think, are the ones that typically talk about how, like, it's dumb money that manipulates markets, or that over time it's going to manipulate markets. I think there was an Atlantic article that compared it to Marxism, which was kind of hilarious, but I'm curious how you think about this whole changing world order thesis that comes from that camp. You know, I'm not going to over-generalize, but Ray Dalio is all about, you know, the future is going to be fundamentally different enough from the past that US equities are not going to perform like they have in the past. How are you thinking about that? 

Jack: So I have, I guess, two points to that. First, I think somebody has to be the active stock picker, right? Like there has to be some price discovery mechanism. And I would say, save that for the institutional investors who have access to the management teams who have more data, and they can figure out if Apple should be trading at 10 times earnings or 30 times earnings. Because if everybody else like you and me are passive investing, somebody is still setting those prices. My thing is that I don't think the average 20-something who's sitting on their phone should be the one that's trying to participate in that price discovery, but on The Changing World Order, I thought about that a little bit. Like you see market cycles where sometimes value stocks are in play, which you've seen over the last six months or so, because growth has outperformed over the last decade. But as far as geography in general, I don't think it's as big of an issue as maybe Ray Dalio says, just because American companies aren't necessarily just American companies anymore. Like they're international. For example, Tesla, one of their biggest markets is China. Even though it's listed on US stock exchange. The iPhone is everywhere. So just because Amazon is American or UPS is American or Coca-Cola or Apple or anybody, we have a global economy now. So I would say it almost makes a bigger bull case for the biggest American companies that they now have global markets that they're in and they can expand to.

And I know Ray Dalio is pretty bullish on China, but I don't necessarily see Chinese companies expanding into European and American markets, as much as I see maybe American companies expanding into Latin America and these other markets. And you just have much lower regulatory risk too, between like the CCP and the SEC, for example. So I would say the flip side of it, that there is a changing world order, but it's really the globalization of American companies, more so than needing to find these developing markets. 

Katie: Well, that is the perfect optimistic note to end on, Jack. Thank you so much for being here.

Jack: Katie, thank you for having me.

Alex Lieberman: What's up, everyone? I'm Alex Lieberman, cofounder and executive chairman of Morning Brew. And I'm so excited to tell you about our newest podcast, Imposters. Every week, I'll sit down with the most respected names in business, sports, and entertainment to discuss how they overcame personal challenges and continue to find professional success. You can find Imposters on Apple, Spotify, or the podcast player of your choice. 

Katie: All right, everybody. To close this out this week, we've got a new segment for you: Rich Girl Roundup, audio edition. Astute readers will think, wait a second. Isn't Rich Girl Roundup the name of your newsletter section for your resources? And yes, yes it is. My creativity has limits, people, bear with me. So maybe we'll do a contest to rename the segment. I don't know. Here's how it works. We will take listener questions every week. I'll put out a call for questions on Instagram. So follow @MoneywithKatie on Instagram, if you're not already, shameless plug, and then we'll pick one that feels interesting and widely applicable and answer it. As my standard disclaimer, I am not a licensed financial professional. This is not financial advice. This is simply “What would Katie do in your situation?” Here is this week's, from Brooklyn. 

Brooklyn: Hi, Katie. My name is Brooklyn and I'm calling into Rich Girl Nation from Burnsville, Minnesota. I recently got a new job doing sales for a tech company, and I'll be making a base plus commission. I'm hoping you can explain how commission is taxed, and also how to approach this from a tax perspective, as well as from a budget and investment perspective. 

Katie: Okay, great question. So let's break this down into three parts. We want to understand how to plan for the impact of commission income from a tax perspective and investing perspective and a budgeting perspective. Let's tackle the taxes first. 'Cause I think this part will be the most complex.

So the way commission is taxed varies a little bit from person to person based on how you're being paid. So if your commission is part of your regular paycheck, as in, you receive one big paycheck each month that is combining your regular payroll and your commission, and doesn't break them out as separate line items, it'll be taxed the same way as your regular paychecks. At least that's technically how it's supposed to work. If you receive commission checks separately, either as an entirely different pay stub or a specific line item on a pay stub that's broken out from your regular amount and your employer is like distinguishing between the two, they'll usually withhold 22% flat, according to the 2022 version of IRS Publication 15.

So we'll link that in the show notes, but this is because commission, like bonuses, is considered a supplemental wage. And the withholding rate for supplemental wages is 22%. So depending on how much you earn, that could be more than you're normally taxed, or it could be less than you're normally taxed, but here's the important part. It all comes out in the wash during tax time. As in, you're not actually paying more taxes on that money, they're just withholding more of it up front. So when the calculation is done at the end of the year and the IRS is sitting there tallying up how much you actually owe and all your income, and then making you guess like a demented scavenger hunt, technically all of your wages will be taxed the same way, regardless of whether it came from a regular paycheck or a bonus or a commission or whatever. It's just, you know, more is typically withheld as you go.

So from a planning perspective, there's not a whole lot that you can do, since your employer will determine how the commission is paid out and whether it's lumped in with the regular or if it's subject to that higher withholding. But what you could consider is making sure you fill out your W-4 form as correctly as possible. This is when you start your job and they give you all the paperwork to fill out. This is where you tell the government and the employer how much money you anticipate making that year, total. So they know how much to withhold. If you estimate a generally correct amount for both base pay and commission, you are less likely to find yourself in a position later where you owe money.
From a budgeting perspective, I think it depends on whether or not your base pay is high enough to live on. So some roles are almost entirely commission-based. So the base pay isn't very consequential at all, but if it's possible, I would try to build a budget around my base pay only, then treat the commission income as a mix of discretionary and investing funds, i.e., psychologically you're thinking of it as extra, especially since commission can be volatile—not always, but it can be. It's a good idea to avoid making major decisions based on expected commission, like how much house or car you can afford, for example. 

And then lastly, from an investing perspective, I don't know that the source of the income makes much of a difference here, but I would lean toward the same conservative approach: trying to build your budget based on the base pay, and then investing some or most of the commission income, if possible. The only caveat that I'll note here is that you probably will have to make your 401(k) contributions out of your base pay. So if that base pay is not high enough to contribute as much as you would like to to your 401(k) and fulfill the needs of your budget, you can experiment with that and start with the contribution you're comfortable with, and then work your way up as you get more comfortable with the amount of commission that's coming in. But regardless, I would not ignore the 401(k). This is still one of the best bets for long-term wealth building that we have, and it'll probably have to come out of your base pay, but I think that's something worth doing regardless. The big thing, I think, is just making sure that you are diligent about investing more during those big juicy high commission months. 

And that's that for our first Rich Girl Roundup. Thank you, Brooklyn, for the question. I hope this helped. And I think that's all for today's episode of The Money with Katie Show. I will see you next week, same time, same place. Our show is a production of Morning Brew and is produced by Nick Torres, and me! Sarah Singer is our VP of multimedia, and additional content editing comes from our lovely senior editor, Henah Velez. Sam Cat is our vice president of chaos, who turns recording a podcast into an obstacle course. And JoJo Beans is our chief of woof, especially if we're recording while the mailman is out making deliveries.

All right, we're a mile down now—means we're sure to find her soon. I know you're worried, but we have to keep hope alive. Oooh, okay. We hit metal. This must be it. Henah, open the hatch door. 

Henah: Katie, thank you. 

Katie: I thought you could have dug yourself out with your diamond hands. All right, anyway. 

Grab my hand. Let's get you out of there. What is this? 

Henah: Katie, wait, I can explain. 

Katie: Diamond hand gloves? 

Henah: This, this isn't what it looks like. 

Katie: You were hiding paper hands all along? Noooooo…