This episode is based on an email that we received from a listener who has a specific allocation in their portfolio to taking speculative bets. The rationale was that it helped control their behaviour by allowing them a designated allocation, while the rest of the portfolio remained untouched. We explore whether a strategy like this, called 'Mad Money', can work for investors.

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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: All right, Shani. So this is the first one we're recording this year. And we're finally doing it. Because we were supposed to do this last week. And I was really sick and you made me come into the office.

Jayamanne: I didn't make you come into the office.

LaMonica: Well, you did.

Jayamanne: I did.

LaMonica: So I had this like perilous journey from my apartment. And frankly, it made the Donner Party look like just a walk in the park.

Jayamanne: Who is the Donner Party? It reminds me of like, do you know what Doner Kebab?

LaMonica: I do.

Jayamanne: Yeah. Is that what it is?

LaMonica: No. So the Donner Party. So, how everyone was migrating out west in the U.S. So they were a group of farmers and they lived somewhere in the Midwest. And so they're going out to California and somebody told them to go the wrong way. And so they lost all this time because they went the wrong way. And then they got to the Sierra Nevada mountains. So they're in between. They basically separate California from the rest of the U.S. They got there too late in the year and they got caught in this huge snow drift and like lost all their cattle and they ended up eating each other.

Jayamanne: They ate each other.

LaMonica: There was, yes. I mean, there's kind of no other way to put it.

Jayamanne: And this is how you felt?

LaMonica: I mean, my journey was similar. Like it wasn't exactly the same, but, you know, I think there were some parallels. So that's what you made me do.

Jayamanne: Did you feel like at any point in your journey that you were going to result to cannibalism?

LaMonica: Well, no, because I wasn't that hungry because I was sick. But it could have happened.

Jayamanne: I'm always hungry when I'm sick.

LaMonica: I know you're always hungry. But I had to take the train. I had to walk through the (windier tunnel). But I came to the office and I walked into the office. You looked at me and you said, you look horrible. Go home. I was like, well, I've already made a lot of effort to get here. But anyway, we're going to do the episode now.

Jayamanne: Sounds good.

LaMonica: Which is exciting. So let's get started. And this episode is based on, roughly based on an email that I got about gambling.

Jayamanne: To participate in gambling?

LaMonica: Not to participate in gambling. An email from a listener of Investing Compass about gambling. And first of all, I guess just to describe this email. So the investor that sent this seems to be relatively conservative, relatively boring strategy. And I don't mean that in a bad way. Boring is often better from an investing standpoint. So he doesn't chase returns. He isn't into trendy investments. Doesn't trade a lot. Just kind of like a blue chip buy and hold type investor.

Jayamanne: It sounds a lot like you Mark.

LaMonica: It does. It's not actually me, though. This is a real email, which you saw. And the emailer said that he takes this slow and steady approach. But he also often has this urge to just swing for the fences and chase some speculative investment.

Jayamanne: And this isn't unusual. It's hardwired into our brains to be, want to be part of the herd and to belong. And we naturally have action biases. Decision making is heavily influenced by emotions. And this was outlined in the risk as feelings theory by George Lowenstein, which basically says that the emotional reactions often drive behavior and that those emotional reactions often misperceive risk.

LaMonica: And the point is that it's incredibly hard to completely deny all those feelings. So they're driven, of course, as we talk about all the time by fear and greed. And they cause us to do things that are not in our best interest. And this reader had come up with what I thought was a pretty unique way to combat these feelings. So a couple times a year, he took a set amount of money out of the bank and a small amount compared to his overall portfolio. And he just went and gambled it.

Jayamanne: And on the surface, some people might think that this is crazy. But it's actually known to a similar concept called mad money. And the notion of mad money is that the bulk of your money should be invested carefully, but a little bit of it can be used for speculation.

LaMonica: Yeah. And the wild thing about mad money is that this actually came from Ben Graham.

Jayamanne: The OG boring guy.

LaMonica: Exactly. And so this is the guy that, yeah, he professionalized investing and the investment industry. He made this huge distinction between investors and speculators. And of course, he looked down on speculators.

Jayamanne: And when Ben Graham talked about mad money in chapter one of The Intelligent Investor, he mentioned that the speculation could be done with a small percentage of funds in a segregated account or mentioned just to take some money to the casino. So our emailer was onto something.

LaMonica: Yeah. And we are right next door to a casino, Shani. So Crown in Sydney is right next door to our office.

Jayamanne: Is the casino open?

LaMonica: Yeah, the casino is open. What do you mean for today?

Jayamanne: Oh, no, I just mean in general.

LaMonica: What do you think that giant building is and all the people that go there?

Jayamanne: I just thought it was restaurants.

LaMonica: Well, there we go. So obviously, zeroing in on what Shani likes to do. But mad money, the basic premise is this. So if you do want to follow Graham's advice, you would never add money to this account, to this mad money account. So if you put in 5% and that's what he recommends and it goes to zero, then you're done. Your mad money is gone. If you happen to do really well and the account starts to become self-funding, then you can keep going. And he was very careful to stress that you can't commingle those funds. So you have one account, which is the vast majority of the money you have invested conservatively. Then you have this other account where you can go speculate. So it has to be a separate account. And yeah, it's just this way to scratch that speculative itch, Shani, without blowing your whole nest egg.

Jayamanne: And honestly, it isn't too far different from a core satellite approach. Core satellite is an investment approach that is supposed to combine the benefits of a passive and active strategy. The passive portion brings the benefits of passive in the core portion, and to speculate and try and beat the market in the satellite portion of the portfolio. The biggest difference is the amount. There's no set rule for how much goes into the core and how much goes into the satellite, but generally, you hear about 10% to 20% in the satellite. What do you think about this notion, Mark? Do you think core satellite, mad money?

LaMonica: I don't know. I've been thinking about it, obviously, because I knew we were doing this podcast. I am a bit torn about the whole thing. I guess I'll call them intellectual issues with all of it. So why don't we talk about mad money first? And basically what you're saying is that you think speculation is a dumb approach if you're taking this, and you're saying that speculation is basically gambling. That's kind of the premise. But you're still going to take a portion of your portfolio and do it anyway. So that's one side of it. But then on the other side, I think it's a lot better than the alternative. So I do think it's acknowledging there's a difference between, let's say, like drinking all day every day and having a couple drinks on a Friday.

Jayamanne: Which one do you do, Mark?

LaMonica: Unfortunately, they make me come to work. So I do have to stick around work till like one or two o'clock before I can sneak off to the Crown to get martinis.

Jayamanne: So it's like having a cheat day on your diet, basically.

LaMonica: I think so, right?

Jayamanne: Yeah. So something that keeps you going in what is a very hard process of remaining patient and consistent over long periods of time.

LaMonica: And I think it's important with any investor, right? We do need to acknowledge and, of course, remember that we have all these biases and that our decision making is driven by emotions a lot. So if you acknowledge that and accept it and you don't do anything about it, it's not really going to do anything but hurt your returns.

Jayamanne: And I think the real question is how this would look if you hit it big on the mad money portion of your portfolio and what happened if you lost it all?

LaMonica: Okay. So we can look at, obviously, we can model out what would happen in, you know, completely made up scenarios, but what would happen with returns based on this? Okay. So let's say you have $100,000, Shani, and you plan to invest for 30 years, 95% in your core, and then you get a return of 8% per year in that sort of core portion. 5% is in this mad money speculative bucket, and you make 16% a year. So you're very good at this. The end of 30 years, you end up with $1.385 million. So, Shani, you do the like lose all your money scenario.

Jayamanne: All right so we can compare it to $100,000 at 8% per year for 30 years we end up with $1.005 million. So the mad money scenario results in 38% more money of course it is a ridiculous scenario as investor earned 16% a year for 30 years.

LaMonica: Which is pretty good right. So if you lose all your money. You were not doing the lose all your money, you were doing the baseline scenario. If you lose all your money you have$955,000 or 4.9% less money than that baseline scenario. So I don't know, depending on if you think 4.9% is a lot, it's not huge.

Jayamanne: The conclusion seems to be that if you can hit it big, this makes a huge difference. But if you lose all the money, it doesn't really make that big of a difference.

LaMonica: Yeah. Yeah. But the problem is, of course, that we always recommend that investor creates a framework to try to govern decision making so that those decisions that you make, they're thoughtful and they're disciplined. So this framework consists of goals, set of investment strategy. We talk about this all the time. And it also includes criteria and rules that guide your actions.

Jayamanne: And writing things down helps. Having set criteria helps. Justifying in structure the decision making process because that helps. But this isn't a magic bullet. It doesn't mean that you won't get caught up in the greed of some top performing investment and it doesn't mean that you would freak out in a bear market and you would sell.

LaMonica: And that's kind of my concern, right? That we have to think about human psychology and how it works in various scenarios. So once again, we'll go back to this mad money scenario. Let's say five years into it, you've earned those 16% returns on that speculative part of the investment and you've earned 8% on the regular part. You're going to start thinking you're pretty smart, right? You are going to start thinking that maybe I should start investing more because I've gotten these 16% returns and you just add more money. You wouldn't follow that rule by Ben Graham.

Jayamanne: I mean, the other thing that could happen is you could lose all of your money in the first year.

LaMonica: Which would happen to me.

Jayamanne: And you'd have to go 29 years without having that mad money. So if you could go 29 years without it, you could probably do the 30.

LaMonica: That is true. That is true. Let's talk about core satellite because it is, as we said, it is different. So I shared my mad money opinion. What do you think about core satellite, Shani?

Jayamanne: I have a lot of opinions about core satellite.

LaMonica: And in general, about Zac Efron in particular, who Shani was talking about before this.

Jayamanne: But you're not here to listen to me speak about Zac Efron. First off, I don't like the strategy if it's just used to speculate with the satellite portion of the portfolio. And the difference between mad money is that the allocation to the satellite portion of the portfolio is much higher. And I've seen a lot of advisors use this just to keep clients happy, basically saying, here's your play money, you go and do whatever you'd like with it. But I do like the strategy when it's used to dilute or concentrate exposure in the core portion of the portfolio.

LaMonica: So you've had all your little finance jargon, Shani. What does that mean?

Jayamanne: So let's say that you have a 30 year timeline and you've chosen the ASX 200 or 300 as your equity exposure. And you've got a really long timeframe. So I could choose to concentrate that exposure on mid cap or small cap shares, which would dilute my exposure to large cap shares.

LaMonica: Okay.I do think that that makes a lot of sense. And, you could do that in all types of different ways. So you obviously use one example. You could pick a dividend ETF to tilt your portfolio towards income in that satellite portion. You could pick a sector tilt. So you could own the S&P 500 in core and satellite, you could do NASDAQ 100. And that would tilt you towards technology. So there's obviously lots of different options.

Jayamanne: Yeah, exactly. And we've always said that we're agnostic to the strategy that people use. The strategy just needs to be aligned to what you're trying to accomplish and have it make sense to you.

LaMonica: Yeah, I completely agree. I think my own view and back to this kind of framework discussion we're having is that what is actually more important than having a framework is having that intellectual attachment to the approach you're taking. So you have to believe in it. That belief should be documented, of course, in an investment strategy. But writing down something you don't believe in and don't understand isn't going to be a catalyst to sticking with it over the long term.

Jayamanne: And we do have to understand that there is an intellectual disconnect between these two approaches. There are lots of reasons to be a passive investor, namely that most people don't beat the market and your tax and fee impacts are significantly less. Believing in passive investing is different from using passive investments in a non-passive way. If you're constantly changing your asset allocation or trading one passive investment to another, you are not a passive investor. The point is that you need to believe in it. So if passive investing is your core belief, then why would you allocate any portion of your portfolio to something different? 5% in the magic money example and 20% in the core satellite example.

LaMonica: Yeah.I mean, it's kind of, we were talking about religion before this as well, not directly related to Zac Efron. We'll certainly not talk about the religious side of the things, but it's kind of like being this like die hard believer in one religion. And then you just say 20% of my time, I'll just believe in this other religion. Like it's just a strange intellectual disconnect, I think, as I said before. And I think that that's often just how we talk about it from an investing standpoint. You want to do all this crazy stuff, so you just allocate a little bit of money to do that. It's just strange.

Jayamanne: Which religion are you calling crazy?

LaMonica: I'm not calling any of them crazy. Although, you know, I read about this thing the other day, the church of sub-genius.

Jayamanne: Where are you reading about these religions?

LaMonica: I heard it on this podcast and I read about it on Wikipedia. And so they have this very interesting belief system and they think that their founder went to Tibet and he spoke to Yetis. You know what a Yeti is?

Jayamanne: I know what a Yeti is.

LaMonica: Well, I just didn't know. There's no snow in Australia, so I'm not sure if you know what a Yeti is. And that the church members believe that they were descended from Yetis.

Jayamanne: Okay. Well, we apologize to any Yetis for causing any offense.

LaMonica: What about the sub-genius?

Jayamanne: Yes, them too.

LaMonica: Yeah, I mean, I think everyone.

Jayamanne: Okay. Well, we apologize to any sub-genius followers that might be listening to this podcast. But I think it might be time to get back on target. Ultimately, there is no data we could find that supports core versus satellite or mad money as a way to limit bad behavior or improve investment returns. It's a good story and people gravitate towards the narrative.

LaMonica: Much like that whole Yeti story.

Jayamanne: Should we be on topic.

LaMonica: Okay. Just to finish this thing out, because somebody needs to put a bullet in this podcast. It is our first one back.

Jayamanne: It is. We made a lot of errors. We're really sorry, Will.

LaMonica: Yeah, most of them have been edited out. But anyway, ultimately, we just want to once again say, try to create, try to come up with a strategy where you have this intellectual connection. So have a reason for what you are doing and why. Understand the risk to your strategy and the downsides, because there will always be downsides to anything that you do. Learn as much as you can about it. That's the ultimate foundation that will provide the structure needed to limit behavioral mistakes. And those are the things that trip so many different investors up.

Jayamanne: And we don't think there is one investment strategy that's right, but there is one that is right for each of us. Find what's right for you and have a core investment philosophy that you believe in. Believe in whatever you want. Just create a plan and strive for consistency and patience in your journey to financial independence.

LaMonica: All right. We did it. So thank you for putting up with Yetis and cannibalism and everything else. To be clear, just for legal reasons, we are not recommending you join sub-genius religion. We'll use that term loosely. But you should know, one of the things I learned on Wikipedia is their religious ceremonies take place in bars.

Jayamanne: I'm in.

LaMonica: Yeah, exactly.

Jayamanne: Let's do it.

LaMonica: Anyway, thank you guys for listening. My email address is in the show notes. Just shoot me an email if you have any questions or comments or want to learn more about any of the strange topics we talked about.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)