May 3, 2021

Bogleheads® Chapter Series – We’re Talking Millions

An extra ½ percent of return can greatly increase your portfolio's value.

Presented by Paul Merriman and Chris Pederson.

Hosted by the Indiana chapter & virtual Starting Out Life Stage Bogleheads chapters. Recorded on May 3, 2021.

Chapter meetings are listed in the Bogleheads blog calendar. You can add this calendar to your Google account. Notifications are also sent from an email subscription list. See the blog for more information.


Transcript

[Music] 

John: Welcome to the Bogleheads Chapter Series. This episode was jointly hosted by the Indiana Bogleheads and the Starting out Life Stages Chapter, and recorded May 3. 2021. It features Paul Merriman and Chris Pederson from the Merriman Financial Education Foundation.

Bogleheads are investors who follow John Bogle’s investing philosophy for attaining financial independence. This recording is for informational purposes only and should not be construed as investment advice.

First of all, what is a boglehead? Boglehead is a term intended to honor Vanguard founder and investor advocate John Bogle. Bogleheads are investing enthusiasts who participate in the Bogleheads forum. The forum’s members discuss financial news and theory, while also helping less experienced investors develop their portfolios. Bogleheads also follow 10 rules of investing which are:

  • Develop a workable plan 
  • Invest early and often
  • Never bear too much risk or too little risk 
  • Diversify
  • Never try to time the market
  • Use index funds when possible
  •  Keep costs low 
  • Minimize taxes
  •  Invest with simplicity
  •  Stay the course

There are more than 100,000 registered members and the site receives an average of nearly 2,000 posts each day. Some members also participate in national and local chapter get-togethers. The bogleheads community encompasses the forum, the wiki ,three investment books which include The Bogleheads Guide to Investing, The Bogleheads Guide to Retirement Planning, and The Bogleheads Guide to the Three Fund Portfolio.

 Affiliated sites include a presence on Facebook and Twitter,  the John C. Bogle Center for Financial Literacy, a series of podcasts and a blog. And just a little bit of information about this the new idea that Gail Cox started about the Starting Out Life Strategies Chapter and other Life Strategies chapters. The new life stage chapters are geared towards personal finance issues and topics particularly relevant to stage, a specific stage, in our investing life and are designed to complement the already existing geographical based  Bogleheads Chapters.

The Starting Out Life Stage mission is to provide education and discuss investing and personal finance topics geared towards novice investors of any age and young investors just getting started with their finances and careers. Topics will include basics of investing and  personal finance, bogleheads investing and  Jack Bogle, asset allocation, assessing your risk tolerance, risk and return, costs matter--the impact of cost over time, creating and managing your portfolio, selecting funds and staying the course, budgeting and managing your money, insurance long-term investing versus market timing and stock picking and common investor, new investor issues.

We will cover why do I have to save money for retirement when I'm only in my 20s. What me worry, I'm 100% stocks and can handle any downturn.What do I do with this 401-k list of funds so I can get on with my life. I'm following my passion but the salary is low and there's no 401-k or health insurance. If I knew what I know now, advice from senior bogleheads. Investing is a lifestyle, it's more than just putting money in accounts, it's how you live your life.

And now on to our special speaker, Paul Merriman. Paul Merriman is a nationally recognized authority on mutual funds, index investing, asset allocation, in both buy and hold and active management strategies. Now retired from the Seattle-based investment advisory firm he founded in 1983, Merriman is dedicated to educating investors,young and old, through weekly articles at marketwatch.com as well as free, via free ebooks, podcasts, articles and more at his website paul merriman.com.

In 2013 he created the Merriman Financial Education Foundation dedicated to providing comprehensive financial education to investors. The foundation provides information and tools for investors to make informed decisions in their own best interest and successfully implement the retirement savings program. A major project of the foundation is funding the curriculum, development, and teaching of the four credit course Personal Investing for Non-finance Majors at Paul's alma mater, Western Washington University, which began in the fall of 2013.

In his retirement, Paul remains fervently committed to educating and empowering investors. In 2012 he wrote and published the How to Invest series, distilling his decades of expertise into concise investment books targeting  specific audiences. And some of those books would include First-time Investor: Grow and Protect Your Money, 101 Investment Decisions Guaranteed to Change Your Financial Future and Get Smart or Get Screwed: How To Select The Best And Get The Most From Your Financial Advisor.

Paul also has an informative investing podcast called Sound Investing which is available on any of your many options, as far as streaming apps,including Apple Podcast, Spotify, Google Podcast, etc. And now on to Paul Merriman.

Paul Merriman: Thank you John, very much. And thanks to all of you for coming out this evening. It is special to me. I am a great fan of the Bogleheads work. The reality is that over the years I've taken some hits there and I've also, I think, made a number of friends who have taken advantage of some of the work that we have done. 

And the reason I've taken hits is because I'm one of those outliers. I love buy and hold. I love index funds. I also have half of my own retirement portfolio professionally managed with market timing. So I'm kind of an odd duck in this industry. But the one thing I'm committed to is helping every do-it-yourself investor do it better.

One of my favorite websites is called The White Coat Investor. I suspect many of you subscribe and read Jim Dahle's work. But he has an article there entitled 150 Portfolios Better Than Yours. And what it is, it's now grown to over 200-- but he hasn't changed the title-- and they are 200 different portfolios that would legitimately probably work fine in a normal kind of market, over a normal 40-year period, or whatever period you've got left to do your investing. There is no shortage of fine portfolios developed to meet the needs of the individual.

My goal is just a little different. I am trying to fine tune every step we take along the way, and this presentation tonight is going to include some of those steps. I believe what Warren Buffett says when he says you only have to do a very few things right in your life, as long as you don't do too many things wrong. And he was talking not just about investing, he was talking about success. And I do believe that in most challenges we have in life, there are some simple steps that we can take to solve the problems.

I have been on a diet since the fifth grade. I have lost over four thousand pounds. I absolutely know how simple dieting is. How easy it is to lose weight. The challenge  for many of us is that when it comes to food, sex, and money, these are not intellectual pursuits. These are emotional pursuits. So the problems are not just to figure out the right things to do, because the right things to do with diet could fit on two sides of a three by five card instead of what, a 40 billion dollar industry.

And my goal is to try to find-- and by the way--we're going to have some information coming to this evening from Chris Pedersen--but I'm trying to find simple ways for people to achieve the best return they can within their risk tolerance. And what I know about what Chris is going to show you tonight, it is one of the cleverest strategies I have seen, and if I had to look at the 200 portfolios better than yours, I would have Chris's Two Funds For Life portfolio right up there.

In the book, We're Talking Millions, there are 12 different decisions or forks in the road. And the interesting thing is they are all very, very simple.  When I say they're easy to do, for some people they're not easy because of the emotional implications of doing what they ask you to do. But they certainly are simple even if they aren't always easy. And they're all time tested. I will show you evidence. We don't have proof for the future but we have a lot of evidence from the past going back over 90 years. 

Tonight I want that evidence one, to challenge maybe your thinking about how to construct a portfolio. To give you the best unit of return per unit of risk. So that's going to be fun for me. I certainly hope it's helpful to you. But here's the bottom line. There is some reason why this book is being well received because except for talking about the two funds for life that Chris developed, the other things that I recommend are pretty much standard recommendations in the industry.

 

So what is it? That book does that seems to catch the imagination of investors because we've had phenomenal reviews on our book at Amazon. And I think this is it. My point is, and I think it's huge, is for every half a percent that you can make additional return over a lifetime, and I'm talking about particularly for younger investors because they have all that time ahead of them. But for every half a percent, and this includes getting to retirement and then taking money out--so that's part of the reward for all that investment, taking it out, how much you take out and how much, the other reward is you leave to others. 

So you total up how much you take out and how much you leave to others and that is, in essence, that is the outcome of all of your investing and spending and leaving. And I contend that every half a percent more that you make,compounded of course, will lead to likely over a million dollars.

Let me just show you how that works. Let's talk about a young person who's got many years ahead of them. Let's say that they put away $6,000 a year for forty years, $240,000. Let's say that they are able to achieve an 8% compound rate of return. Now there's a reason why

I use this number and that is when I look at Chris Pedersen's research and you look back at the likely return of a target date fund, a fund that I think is probably one of the greatest inventions in the history of investing, eight percent compound rate of return is a very fine long-term return.

Not if you were in equities all your life, maybe, but remember a target date fund, it starts mostly with all equities and then it starts adding bonds to the portfolio. So we don't expect over a 40-year period to necessarily get an all-equity return. But if you got 8% during the accumulation period, and then you worked, you took the money that you retired with, and you live for, I believe, another 30 years, and you make 6% on that money, and you take 4% out: those are the assumptions. 

So what do we know?  We know that if you made an 8% compound rate of return at retirement you'd have 1.7 million dollars. That's great. That's with the $6,000 commitment, and many of you obviously are putting away a lot more than six thousand dollars a year particularly if we're talking about a couple. What I do know is that if I could figure out any way to make an extra half a percent, make 8.5% instead of 8%, I  would have not 1.7 million, I'd have 1.9 million. 

So that is the first kind of major step towards that extra million, million and a half dollars, for that half a percent. But then the important part happens, and that is you start taking money out and you're taking money out at 4% a year and you live until age 95. And that means that at age 95, taking out the four percent a year, you'd have left for your heirs 2.8 million dollars.

Now if you were able during that distribution period to make an extra half a percent instead of 2.8 million, you would end retirement with 3.7 million. It's adding up. But then there's what you leave to others. That counts too. People have often asked me, how have you done with your investments? And my answer is, “Well I've done okay, but the fact is I shouldn't be judged until I die, because it is only at my death that we really know the total impact of all the investing, saving and distributions etc. Whether to myself, or to family, or charities, that all needs to be put into the hopper to make the determination. 

How did that investor do? So what do we know, we know that at the 6% you would have withdrawals of 2.6 million. At the 6.5% you'd have reduced withdrawals of 3.2 million dollars, and when you add up the amount of the withdrawals and the amount of what you leave to others that difference, at the end of this two parts of your life, the accumulation and the distribution, is the difference between about seven million and about five and a half million, or about 1.5 million. That's if we can find half a percent.

And you all know, so easily bogleheads know how to pick up an extra half of one percent. So as I go through some of these ways to do this you're going to say, “Yeah I know that”. And I know that yes, you do know that. But the fact is those little things you already know are those things that are going to be able to add extra returns. I'm going to add a couple things to the pile tonight, of things for you to consider.

Save versus spend, huge decision. I don't have to tell you that, you know that. But bogleheads are oftentimes folks who help others. And the reality is, we know that you get nowhere with investing unless you do some saving. And I think Warren Buffett has one of the best quotes on saving and that is, “Do not save what is left over after spending, but spend what is left over after saving.”

This is the beauty of a 401-k plan that automatically starts taking money out of your income when you start working. You have to opt out of that plan, and industry is finding that tends to work, and by the way, that's how pensions work.

Pensions could pay you that money as you worked for that company and they could tell you now we want you to manage this money because we want to make sure that you're taken care of and we in retirement whether you take a pension or you convert it to an IRA and take the money out of that, whichever way you do it, we want you to have enough money to retire the way you wish. 

Now beautifully, wonderfully they didn't let people put their fingers on the money, because we know what happens. Most people who get their hands on the money blow it. Most people do not do the right things with the money, and I'm going to give you just a couple of numbers. I don't want to interfere with what Chris is going to tell you about tonight, but I do want to tell you there is evidence that most people blow it but the trustees of a pension, see they didn't let people do that.

Now things have changed. We have the equivalent of a pension, theoretically, if you choose to, if you don't opt out. And you have to build it yourself. And that's why it's so important that people do the right thing, and the earlier they do it the better they are. I talked earlier about the idea that I want to focus not on just people who are starting in their 20s. I want to start from the day a child is born.

I want to do things as a parent and a grandparent, and I've done this both as a parent and a grandparent, done things to get them started. And I'm not talking about spoiling them, but to get them started at a young age. So for example, put away a dollar a day from birth to 65, keep it in the  S&P 500 or the Total Market Index--by the way I think most of you know the S&P 500 and the Total Market Index have historically had almost the same return--and so either way you're going to get about the same return with the Total Market Index or the S&P 500 because they are both cap weighted portfolios and the biggest 50 companies in both indexers are driving almost all of that return. So 10% for 65 years turns into almost $1.8 million. You wait until a child is 10 and it turns into $686,000, or if you wait until a child is 21 and put away a dollar a day until they're 65-- by the way I'm not expecting you to put it away, they need to learn to put it away-- but it's $238,000. 

This is the phenomenal impact of starting early, and to the extent that we are, let's I'll call it, thoughtful parents, thoughtful grandparents, we want to do it in a way that we don't ruin people's lives. But wouldn't it be wonderful 40, 50, years, 60 years from now that a child or grandchild didn't have to fight some of the fights I suspect people are going to have to fight 50 and 60 years from now  in terms of survival. 

All right, another way to look at that and you probably know this old story about two people, I happen to use the names Jim and Nadine because they were two of the first clients I had as an investment advisor. And the assumption is they both put away $5,000 a year for retirement but one does it five years earlier.

That first five years, there are so many things about it that are important. You know one thing is that the  first five years could be 1995 to 1999 when the S&P 500 compounded at 28.5%. On the other hand, the first five years could be two of the worst years in stock market history. In which case a great thing has happened. It has given this young person an opportunity to put money away into asset class funds, index funds we all hope, that are down and dirty and make a great long-term investment. Always better in your youth to invest in a bad market than a good market.

That is a hard thing to convince young people of, but that original $25,000 dollars from that extra five thousand dollars a year that Nadine got in at, starting today's 25, you follow the bouncing ball on just that money, you keep that money in equities, it could literally mean an extra seven million dollars over their lifetime.

Now we all know this is not a surprise to anybody that stocks make more money than bonds. We all know that stocks are more risky than bonds. The stocks are the gas and bonds are the brake. And we all know that you certainly do not want to put a young person's money into stocks.

In my 90-minute visit with John Bogle my big complaint, and I thought I had a winner of an argument, was how could Vanguard be putting 10 percent of a 21 year old's portfolio in bonds because every 10% in bonds you put into a portfolio, that takes away from equities, costs you one half of one percent a year. That's magic, remember.  I'm looking seriously, about a half of one percent. And the answer is wonderful. John responded. He said,”This is not about making people more money”. He understood my position, he understood the extra half a percent but the purpose is that Vanguard is trying to get people into a strategy that they understand it is both gas and brakes, and that yes, when you're young almost all of it should be in gas.

Well I happen to believe that all of it should be, not almost all of it, but all of it should be because there is an expected return premium of about five percent. Well that's based on 90 some years of performance, where the bond, the long-term government bond compounds at about five percent and the stock market compounds, talking about the S&P 500 at about 10 percent. Okay here I am, I'm looking everywhere I can to find an extra half a percent, and I'm thinking, the decision to put money in bonds versus the stock market for a young person, particularly the supposedly 23 percent of young people who will not put any money in the stock market.

It just, it makes me so sad that somebody hasn't gotten to them to explain that in fact stocks are much less risky in the long term, it's the short term that we have a problem, but we're not investing for the short term, you all know that, but I just want you to understand that when you're talking to a young person that difference between the ten percent and the five is ten times one half of one percent, and yes it does mean that you could legitimately add another 10 million dollars to your portfolio over a lifetime because you chose stocks over bonds. 

In fact I'm working on an article right now for a couple of months from now, about making the decision as an investor to be all equity all the time your entire life. What are the implications of that and how would you do that?  One company versus thousands of companies. Again I know iIm preaching to the choir here, but I want to make sure if you have not seen the study that was done by Dr. Bessembinder that tracked all public companies from 1926 to I think about 2016,  and then they published. The study, what they found, was four percent of the companies were responsible for most of the great return of equities, the other 96% of the public companies, many of them folding and going out of business by the way, many of the other 96% had a compound rate of return equal to what treasury bills got.

That is an amazing number, which means you've got to have that four percent in your portfolio . We know from this study it's easy to pick dogs. By the way, one of the grandest, greatest performers in that 4% was General Motors. And here's the beauty of the index fund. It doesn't keep General Motors forever. At some point it's off the table, and so what you get is with the index funds, another advantage is you do get rid of the dogs. By the way, you got a lot of laggards in there too. But it is a handful of stocks that drove the market to that 10% compound rate of return.

And beyond that, the academics tell us the expected rate of return is the average of all stocks in whatever asset class you're talking about. But I have never met an investor who buys individual companies that ever believed any stock he picked would turn out to be average. That's just not the nature of an investor. But I'll tell you the average we all get with index funds is a lot higher than the average that the rest of the investors get with their portfolios. 

And I think you all know that I’m looking for half a percent. Again I see it. I see it like I’ve got to bend over and pick it up off the ground. I mean this is so simple. To simply get lower expenses. As you know, we can now-- I mean this is amazing, I’m 77 years old. I started in the industry in the mid ‘60s. We had loaded funds that charged 8.5%. We did not have index funds. We did not have ETFs. We did not have target date funds. We had actively managed funds that charged high expenses. In theory investors today, if they do what is laid out on a plate in front of them basically for almost nothing, they should make more money than I did over the years. I know that will be left to the luck of when the market decides to go on long bull rides, but the bottom line is today we can get rid of so many of the expenses. We don't have to pay a five percent sales fee.

Remember what happens when you pay somebody $500 out of $10,000, that that $500 grows in their family's pocket rather than yours, and it does it for generations. And that $500 is, again, likely costing about a half a one percent if it's taken out of an actively managed portfolio. I'm talking now about all equities, so no load, low expenses, and low turnover. We didn't have many funds that had low turnover back then.

Investing has never been easier or simpler, however we want to look at it. And it has never been available in the best interest of the investor, anything like it is today. That's why we have to make sure that we educate people.

How much better it is than  when I started out. The spread between the bid and ask on a stock was high. The commissions were regulated. You could pay $175  to buy or sell a hundred shares of IBM back in the mid sixties and if you bought a thousand shares through me I got ten times $175. Look at what happens today. It is nirvana, it's investor nirvana.

The problem is one thing that has not changed. There are still thousands if not hundreds of thousands of people who are working hard every day to make you or to encourage you to do it wrong. And that is what you guys, I  think, are doing, is making people aware of that. 

So we get to index funds. I mean the beauty of index funds-- when I look at all the things, the mistakes that people can make, high expensive active turnover, trying to stock pick yourself--diversification, huge, why massive diversification. My wife and I have a portfolio,we happen to use the DFA funds instead. Well we have some Vanguard funds in our bond portfolio but the reality is that by the time you put together a portfolio of some big and some small and some value and some growth and US and international and emerging markets and Reits we have over 15,000 companies in our portfolio. 

And there's no reason that somebody starting out with a thousand dollars or even a hundred dollars can't do that or shouldn't do that. So index funds, I think, are magic. I’ve got, somewhere, on our website is an article entitled Thirty  Reasons I Love Index Funds. So I've never had  any argument with bogleheads about index funds. I think the reason that I've taken a little heat over the years is that I don't recommend that everything go into the S&P 500 or the Total Market indexes. I think that's where the disagreement has come.

We know all of these advantages ,more tax efficient. But here's the one I like because you know what,  every time I'm looking for somebody to help me whether it be a plumber, an attorney, a physician, I’m looking for competence. I'm looking for ethics. And I'm looking for things that I could identify and consider dependable.  And the index fund is almost the only kind of mutual fund that is dependable. And how do I know that?  Well I know that if you look at the SPIVA report, again I'm guessing you all are familiar with s-p-i-v-a,  put out by Standard and Poors. Every six months they update it and they show over the last one, three, five, and fifteen years how did the benchmark do compared to all the folks trying to beat the benchmark. And it turns out over fifteen years about 10% of the actively managed funds will outperform the benchmark. Now normally that means because they've done something different, they've taken more risk.

Chris Pedersen wrote a great article. I may have the wrong title on it here, but it's at  AAII [American Association of Individual Investors]. But it's The Cost of Being Different. There is a cost of being different. It means you might do better, you might get a premium, but you also very likely will underperform unless the way you're being different has historically been better than what you're doing otherwise.

And I'm here to talk about that history a little bit here tonight. But I do know this, that I can end up basically in the top 10 percent and I don't need to know a thing. I don't need to understand any of those 500 companies. By the way, I've got one fund that's got over five thousand different companies, small cap international value. I don't need to know anything about any of them, and I know from all the evidence that because I ,basically we, own them all. That's what the index does with each asset class. Theoretically, I am likely to be up around that top 10%, maybe it's 20%. 

But I'm not going to be falling out of bed. And the problem is you got Bill Miller. You may not remember Bill Miller. I have forgotten the name of his fund. I'm sure that Chris or Daryl are going to remind me here. But he had 15 years when he beat the S&P 500. Magic, truly magic. And the money just poured in. And then you know the end of that story. Probably was he became one of the worst managers in the industry for a decade. I mean literally, from the top one percent to the bottom one percent.

Dependable..What a lovely wonderful thing to have for our children. If they're going to put money away for their retirement, something that we can say is dependable, and of course we know we can save money on taxes when you have a mutual fund that has less turnover. Well yes, it's easy to save money in an IRA, better to do it in a Roth IRA. I happen to be of a group, I do not worry what the income tax rate is going to be, whether it's going to be higher or lower than it is right now. And you're going to have this money you're putting away into a Roth IRA or a Roth 401-k compounding tax free. And then when you get to the age that you have to distribute, make your annual required distributions you'll be thumbing your nose at them because you don't have to. because you got a Roth. And then you take it out and it's all tax-free.

And let me just tell you what it feels like. In fact it's a fascinating memory for me when I think about how we fight with each other politically about taxes. When I came into the industry, the year before I got into the industry the marginal tax rate for people who were making a lot of money was 90%. The next year when I was really in the business it was 70%, and nobody that was--in fact one of the reasons I wanted to be a stockbroker is because I wanted to meet people who had been successful. I found out they weren't as magic as I thought they were going to be. And I only stayed in the business, I didn't-- I thought the conflicts of interest were terrible--but I also found out that there wasn't all that much magic. These people were working hard and being smart, it didn't matter what the tax rate was. They just loved working and they loved conquering the challenges of running a business. And of course they all had expensive CPAs to try to figure out how to get around those taxes. That hasn't changed regardless of what the tax rate might be.

But here's where I’m looking for half a percent. I like this one. This one's good. I don't know if you've ever spent any time going to Morningstar and comparing index funds to the average tax rate of the average fund. And when I say the tax rate, what I really mean is how much the return was reduced by the tax, using the highest tax rate. With the average actively managed fund it's one and a half percent right off the top. So if they report they made 13%--and that's what they're talking to the public about, we made 13%-- but in fact they made, on average, about 11.5%  because taxes had to be paid on those actively managed portfolios. You look at, for example the S&P 500, the tax impact is  0.5%. So theoretically, here's another place where you could find an extra half of one percent.

Here's where I hope that I can make some headway with those who wonder why I have fallen off the wagon and am using other asset classes, other than the S&P 500 or the Total Market Index, which by the way, I see nothing wrong with using the S&P 500 and theTotal Market Index. I am not being critical of it. I am simply saying that I believe I have the risk tolerance to take a little more risk and get a substantial premium.

All of you I’m sure read Larry Swedroe. Larry Swedroe would tell you that the reason that small cap and value and others get a better rate of return, it's no free ride. It's not magic.It's just more risky. But there is some theoretical magic that goes on when you put these assets together, and I’m going to show it to you. 

The way that Daryl, and by the way, Daryl Balhs, I think is with us tonight as well, along with Chris Pedersen. There are two research guys, and Daryl is the one that turns out I think we have 160 tables this year that we've provided to people who follow our work. But here's a simple one. I go back to 1928 to 2020, look at the compound rate of return [CRR] over 93 years for the S&P  500: 10%; Large cap value: 11%; Small cap blend: 11.9%; Small cap value: 13.1%.

And I know what people will say. Yeah well that was then, that was that 93 years. Things have changed and there's not going to be the premium for small cap value and small cap blend and large cap value. And they may be right. That's possible because when we look back the last 20 plus years we see that long-term government bonds have had a better rate of return than the S&P 500. Maybe they're onto something the rest of us just have not gotten.

But I do know this. I don't blame the people who don't like volatility and risk for not wanting to put any money in the stock market,because one year at a time, and if you ask me today what I think the market's going to do next year, or the next 12 months, my answer is pretty clear. I think it'll be somewhere in between a gain of 54% and a loss of 43%. And pinning it right down, or I could say the thing that so many people will say. Well I think we'll probably be up about 10% next year.

Well the reality is on a short-term basis there's nothing easy about investing. You have to close your eyes and hold your nose, or simply believe that you're investing for the long term. You don't care. In fact you see a decline in the market as an advantage not a disadvantage, and to the extent that it's a disadvantage, as it would be to me, there better be some brake on there. And I'm 50% brake and 50% gas because I can't stand the loss of 60 to 80 percent of my portfolio in equities. Yes I know recently it hasn't gone down 80%, but it did go down 60% during that decade of 2000 through 2009.

I just don't want to do that again. So I want you just to peek over here at the four fund combo because I'm going to show you some numbers I think you'll really find interesting. The small four fund combo has taken 25%out of each one of these four. Now notice what that means in terms of the kind of diversification we're talking about. The S&P 500 and the Total Market Index are cap weighted, so you are getting a view of ownership of the US public corporations such that the bigger the companies, the bigger their impact on what you make.

Many people believe in rather than capital weighting, asset class weighting. This is a very simple asset allocation, 25% each, that's it.  And the compound rate of return over that period of time was 11.7% and the standard deviation was higher. By the way, the standard deviation looks not only at the upside, the downside, but the upside. So part of that higher standard deviation includes going higher on the upside as well as going lower on the down side.

But I don't judge volatility one year at a time. I don't know about you. That would be an interesting thing to ask yourself. What is the real measure of volatility? I might say for a 20 year old the real measure of volatility is 40 years, or whenever you're going to start adding fixed income to the portfolio. I'm going to show you that in a few minutes, but I want you to look at what I'm trying to get young people to look at-- think 40 years,not one year. Look at the bad times in 40 years.

I mean there are some bad times. Here for example, by the way about half of those public companies from 1926 through the end of 2016, over the life of the company ended up not making money. Okay, so it's not like there isn't a lot of risk out there with individual companies, but when you get rid of the individual companies and you're left with these indexes here's the terrible times. The worst 40-year compound rate of return for the S&P 500 was 8.9%. The best was 12.5%. That's pretty good.

What's interesting, you inflation-adjust these periods of the best and the worst returns and they come much much closer. Notice here with large cap value 15.6% best 40 years, 8.8% about the same as the S&P 500. Small cap blend a little higher on the upside not as low on the downside. Small cap value higher on the upside not as low on the downside.

So you can see why I'm thinking that for a first-time investor I would like them to have some small cap value. There are lots of companies. Some will survive and be big winners. Some won't. But that's true with the S&P 500. And then we look at the four fund combo, I mean you're really hiding in the weeds with the four fund combo, and I'll show you why in a second, but 13.8%. I’m looking for half a percent. That's all I want. I want to change a life with half a percent.

But here's where I’m looking for half a percent. I like this one. This one's good. I don't know if you've ever spent any time going to Morningstar and comparing index funds to the average tax rate of the average fund. And when I say the tax rate, what I really mean is how much the return was reduced by the tax, using the highest tax rate. With the average actively managed fund it's one and a half percent right off the top. So if they report they made 13%--and that's what they're talking to the public about, we made 13%-- but in fact they made, on average, about 11.5%  because taxes had to be paid on those actively managed portfolios. You look at, for example the S&P 500, the tax impact is  0.5%. So theoretically, here's another place where you could find an extra half of one percent.

Here's where I hope that I can make some headway with those who wonder why I have fallen off the wagon and am using other asset classes, other than the S&P 500 or the Total Market Index, which by the way, I see nothing wrong with using the S&P 500 and the Total Market Index. I am not being critical of it. I am simply saying that I believe I have the risk tolerance to take a little more risk and get a substantial premium.

All of you I’m sure read Larry Swedroe. Larry Swedroe would tell you that the reason that small cap and value and others get a better rate of return, it's no free ride. It's not magic.It's just more risky. But there is some theoretical magic that goes on when you put these assets together, and I’m going to show it to you. 

The way that Daryl, and by the way, Daryl Balhs, I think is with us tonight as well, along with Chris Pedersen. There are two research guys, and Daryl is the one that turns out I think we have 160 tables this year that we've provided to people who follow our work. But here's a simple one. I go back to 1928 to 2020, look at the compound rate of return [CRR] over 93 years for the S&P  500: 10%; Large cap value: 11%; Small cap blend: 11.9%; Small cap value: 13.1%.

And I know what people will say. Yeah well that was then, that was that 93 years. Things have changed and there's not going to be the premium for small cap value and small cap blend and large cap value. And they may be right. That's possible because when we look back the last 20 plus years we see that long-term government bonds have had a better rate of return than the S&P 500. Maybe they're onto something the rest of us just have not gotten.

But I do know this. I don't blame the people who don't like volatility and risk for not wanting to put any money in the stock market,because one year at a time, and if you ask me today what I think the market's going to do next year, or the next 12 months, my answer is pretty clear. I think it'll be somewhere in between a gain of 54% and a loss of 43%. And pinning it right down, or I could say the thing that so many people will say. Well I think we'll probably be up about 10% next year.

Well the reality is on a short-term basis there's nothing easy about investing. You have to close your eyes and hold your nose, or simply believe that you're investing for the long term. You don't care. In fact you see a decline in the market as an advantage not a disadvantage, and to the extent that it's a disadvantage, as it would be to me, there better be some brake on there. And I'm 50% brake and 50% gas because I can't stand the loss of 60 to 80 percent of my portfolio in equities. Yes I know recently it hasn't gone down 80%, but it did go down 60% during that decade of 2000 through 2009.

I just don't want to do that again. So I want you just to peek over here at the four fund combo because I'm going to show you some numbers I think you'll really find interesting. The small four fund combo has taken 25%out of each one of these four. Now notice what that means in terms of the kind of diversification we're talking about. The S&P 500 and the Total Market Index are cap weighted, so you are getting a view of ownership of the US public corporations such that the bigger the companies, the bigger their impact on what you make.

Many people believe in rather than capital weighting, asset class weighting. This is a very simple asset allocation, 25% each, that's it.  And the compound rate of return over that period of time was 11.7% and the standard deviation was higher. By the way, the standard deviation looks not only at the upside, the downside, but the upside. So part of that higher standard deviation includes going higher on the upside as well as going lower on the down side.

But I don't judge volatility one year at a time. I don't know about you. That would be an interesting thing to ask yourself. What is the real measure of volatility? I might say for a 20 year old the real measure of volatility is 40 years, or whenever you're going to start adding fixed income to the portfolio. I'm going to show you that in a few minutes, but I want you to look at what I'm trying to get young people to look at-- think 40 years,not one year. Look at the bad times in 40 years.

I mean there are some bad times. Here for example, by the way about half of those public companies from 1926 through the end of 2016, over the life of the company ended up not making money. Okay, so it's not like there isn't a lot of risk out there with individual companies, but when you get rid of the individual companies and you're left with these indexes here's the terrible times. The worst 40-year compound rate of return for the S&P 500 was 8.9%. The best was 12.5%. That's pretty good.

What's interesting, you inflation-adjust these periods of the best and the worst returns and they come much much closer. Notice here with large cap value 15.6% best 40 years, 8.8% about the same as the S&P 500. Small cap blend a little higher on the upside not as low on the downside. Small cap value higher on the upside not as low on the downside.

So you can see why I'm thinking that for a first-time investor I would like them to have some small cap value. There are lots of companies. Some will survive and be big winners. Some won't. But that's true with the S&P 500. And then we look at the four fund combo, I mean you're really hiding in the weeds with the four fund combo, and I'll show you why in a second, but 13.8%. I’m looking for half a percent. That's all I want. I want to change a life with half a percent.

It looks to me in the equity portion of that portfolio, yes I can have the S&P 500, lots of big companies, lots of big large cap value companies. And then a lot of small companies. This is US only and that range is 15.9% to 10.8%. So the worst 40-year period for that strategy is 10.8% versus 8.9%, it's about a 2% difference for the worst outcome. And of course people want me to put the word guaranteed. Stamp that right up on the screen. Unfortunately we all know these are all risky investments. They, every one of them, each individually have a risk of going out of business. It's hard to believe but who would have thought remember-- for those of you who happen to sneak into this presentation--for young people remember back to the time when they said, “as goes General Motors, so goes the United States of America.” If General Motors is doing well, get on board in the stock market.

So that's the risk range I want to see. Not one year at a time. I love this table. My thanks to Daryl for doing this table because what this table does, it takes those 90 plus years of individual performance for every one of those four equity asset classes. And look at here, we've got the S&P 500, 1928 , up 43.6%; small cap blend 42.9%; small cap value 32.4%, large cap value 24.6%. They all had a good year, even the four fund strategy was up 35.9%. A great year. Who'd have thunk it was right before a year that people would remember forever.

Not many people remember 1928's returns. Oh but there's one thing about that year that's kind of interesting to me. I looked at those term returns and I saw that small cap value is the best, and yet here's small cap value down here towards the bottom even in the good times. So obviously one year at a time just as it doesn't tell you anything about the long-term performance of any asset class. It also doesn't tell you who should be first over the long run, because we know in hindsight who was best, but we know when we look one year at a time it doesn't look nearly as pretty.

But I'll tell you what does look pretty. I’m talking about people who don't have a lot of risk tolerance. What does look pretty to me is the four fund strategy, look at it here, I'm going to see how many years they were number one. Oh wait a minute, of course they can't be number one ever, because it's the average of the  four, but I'm sure there are some years they were, no wait a minute, they can't be number four either. Which means they are forced to be either number two, three, or four in terms of performance, but most of the time they're right there in the middle. So when we look at a period of time, like here's a 20-year period, which is not 40 but 20, there's the four fund combo never at the bottom, never at the top. Huge diversification, it truly has more diversification than the S&P 500.

Now somebody might say, well the Total Market Index has small cap value. Two percent, not enough to move the dial. I mean that  it's fine that they have it. It is not changing anybody's life. You are not picking up the small cap value premium with two percent in the portfolio.

Oh and by the way, just where we think they should be, the bonds are right down here. Well here's a 20-year period where T-bills were the worst. S&P was 6.1%; long-term government bond 7.6 %, and one a half better for bonds over the S&P 500. Look here, S&P under the four fund, S&P over the four fund, S&P under the four fund.

And here's the challenge with owning small cap value. This is another Daryl Bahl beauty. This is the telltale chart. And to the best of our knowledge, John Bogle named it. It's a relative return of the S&P 500 versus US small cap value accumulated over time. So it starts out in 1930 and when you see that line going down right there, that means the S&P 500 is either losing less or making more than small cap value. And then it came back, and then went down, then it came back and it really didn't break out for 13 years.

Well I can tell you back then nobody was waiting around for small cap value to break out because nobody had identified the asset class, small cap value, back then. We know it now. But over the next three and a half years a rocket,up 28.6 % over the S&P 500.  And then it goes dormant for 19 and a half years. Then another rocket, then dormant, then a rocket, then dormant then a rocket, and this goes through to 2019. And as we all know, value's been doing better lately, but it still has not taken off like a rocket to get out ahead of what the S&P 500 has been able to accomplish.

The point here is this, and it's so simple anytime. You invest in an asset class that you're getting a premium. By the way, this would be stocks over bonds too. You are going to live through long periods of underperformance. You are going to, if you are in the business, trying to help people make money, and you have a diversified portfolio that includes value as well as growth, and small as well as large, international as well as US etc. You are going to look like a dog.

This is the cost of being different. So from 1995 to 1999, I was in the business then. I have not been an investment advisor since 2012. I am but a lowly teacher, and I'm loving it. But I remember what it was like. It was hell. Because for five years, while the S&P 500 was compounding at 28.5%, our all equity portfolio compounded at 11%.. I think that was easy to keep people staying the course. Boy that is when you're doing your business, you're doing your work as an advisor.  But then we came back gangbusters the next 10 years.

Another mistake people make is market timing. I said earlier, I confessed my sins. I mentioned that I believe in market timing, but I do not believe in individuals doing market timing. I do not believe that many individuals can even turn it over to a professional to do it. Because market timing requires you to make short term decisions, which are often very bad. That's a big deal. Market timing turns people emotionally inside out and if you have struggles with having regrets, for making mistakes, market timing is the worst thing you can do. It is based on making mistakes. Those are big obvious mistakes so don't do it. 

Buy and hold over 40 years. Now see, in the buy and hold index fund end, you're making mistakes all the time. Companies. Enron was there at one point, Eastern Airlines was there at one point. So it's not like you don't have mistakes going on there.

And one of the things I truly believe is that if you make that one decision upfront, which is one of the reasons I am so in favor of target date funds for people who truly do not know what they're doing, or in some cases for those who think they know it all, that's another another group, but buy and hold is far, far superior.

I want to share something with you. I talk about the work that Daryl does. This is an example of a tool that we hope will help people make better decisions. This tool is called a fine-tuning table. The fine-tuning table takes one asset, one portfolio, and who would call the S&P 500 one portfolio for life equity wise. John Bogle would have. Early in the years when we used to have him on our radio show, he didn't talk about the Total Market Index, he talked about the S&P 500.

So what do we know about the S&P 500? Well here it is without any expenses taken out, and here it is with the expenses taken out at the rate you would pay today. So you can see the good times and the bad. And the bad are the red numbers, here with the minus before them. And there aren't too many bad times, and the compound rate of return was 10.4%. Normal historically, about the same as going back to 1930. If we go back to 1950 or 1940, when you go back and include the depression, it goes down a little bit, but not much, still around 10%. 

But then here's what I want you to see. I want you to see that, okay, the compound rate of return was 10.7%  for this particular 51-year period, standard deviation 16.3  or 16.9. I don't know what standard deviation is in the minds of most investors, but I do know when I tell you the worst three months was a loss of 28.7%, there were six months a loss of 41.8%, the worst 12 months a loss of 43.3%, the worst drawdown was a loss of 51% peak to bottom before it goes back up to that last peak, and the worst compound 60 month annualized rate of return was a - 6.7%, that was a terrible five years to be taking money out to live on.

So what can we do with that? Well we can look at the other side. Over here, year by year the bonds, all bonds. Now I'm kind of embarrassed to suggest this information is pertinent because for so many of those years bonds were sky high and then they went down to nothing. In the early 1980s I got a five-year CD from the Bank of Chicago that paid 16% a year for five years in my IRA. It was an amazing period, so is this a legitimate period to look at.

Look, we don't know what the next 51 years are going to do. Do you think there'll be any wars in the next 51 years? Do you think that we'll have higher interest rates or lower interest rates? You think we could have a period of high inflation? Does anybody in the world have high inflation anymore? Well are there people that are worried we're going to have it if we keep throwing money into the pot to spend ?

I’m not taking a stand. I'm saying I don't know. But I do know this, that if I at 77 have half of my money 50/50, half from bonds, half from stocks, I know that that changes the return. And when the losses were losses, instead of 14% it was 4%; instead of 26% it was 10%; instead of 7% it was 3%, and on down. In fact there was a big  loss in  2008, the 50/50 was down 21%.

And if you're a young person expect that 21% loss again from a 50/50. We like to think that the bad stuff in the past is not going to jump up and bite us again. Well let me tell you what happened from 1930 to 1939, you actually lost less money than the S&P 500 did from 2000 to 2009, plus from 2000 to 2009 you had inflation but from 1930 to 1939 you had some deflation so you actually made money after adjusting for deflation in the ‘30s. So what we saw in 2000 through 2009 was basically the same as what happened earlier.

We have this kind of table for the S&P 500 for what we call our worldwide ultimate buy and hold strategy, with 10 funds worldwide. With four funds all US, the four fund strategy over that period of time. We have an all value portfolio. We even have an all small worldwide small cap value portfolio. In every case we look at these different combinations of stocks and bonds. Some of you may know that Larry Swedroe has a lot of money in a combination of small cap value and bonds.

And here's a great table for young people. Just another one of Daryl's beauties. Here's the assumption. We take that same S&P 500 and all those other strategies that I talked about and we assume we put away $1,000 a year in 1970.  And every year we increase the amount of that contribution at three percent a year, which is 83.33 cents a month. What do we find out? We find out that we would have had, with a 100% stock portfolio, 2.4 million dollars over the 51 years. You would have invested $137, 000. If you were 50/50 you'd have 1.4 million.

Now it's not going to surprise you to find out that some of these different combinations of asset classes come up with more like 5 million at the end of this period of time. But there's a huge lesson here for a lot of young people. Look at the valueof their portfolio in the early years and they don't get very excited. Well they shouldn't get very excited because when you put in a thousand dollars and at the end of the year in 1970 you're left with a thousand and twenty two dollars. And somebody has told you if you just put the money in the S&P 500 you're going to be rich someday, you're going to be a millionaire. By the way, in 1970 being a millionaire was a big deal.

What I find fascinating when I teach classes up at Western, is to college students today, a million dollars is still a big deal. They really should be thinking five million, not one million. But that's another story. But you would understand this. Who would be happy with one thousand, and twenty two dollars in profit. But the twenty two dollars isn't the amazing thing. It's the $1,000 for the first 10 years. It's really about what you put in, it's not about what happened. Later it's about what happens to it that makes the difference. But the celebration is not the profits, the celebration is the foundation that you're building, and slow and steady does win a lot of races.

And then because I'm here, we are here to help people at all stages, all stages of their life. We have distributions. I don't know how many different tables we have, but this one happens to be a million dollar investment and a forty thousand dollar distribution, four percent, and every year it is increased by actual inflation over this 51 years. So that you can see the impact of being all equities and how bad it can be compared to being 50/50 or 60/40.

And you can see that all of these columns, even the one that says all bonds, makes it to the bottom of the page. I mean at 77, I'm not worried about 51 years, but there are a lot of people who are going to retire at age 40. I know it, they're part of the FIRE movement. I talk with them or answer emails to them often. And they're for real and they are likely to retire at age 40 and that money's going to work for 51 years. These are important tables.

We also have another table that shows flexibility, so we show three, four, five, and six percent distributions. We show them at the first of the year, and we have some where we actually show the distribution at the end of the year. What would that mean? It would mean that you, in order to make it through the first year of retirement, had to save a little separate pool here on the side. And it does make a difference. You'll see it in the tables.

Today a new website was born. Well at least for us a new website. This is the new front page. You're going to have a chance in a minute to subscribe to our newsletter and when you do we are also going to send you a pdf copy of We're Talking Millions and I do hope this is my dream. I would give this away to as many people as I can reach. On Wednesday I talked to a high school class somewhere back east and I'm hoping that every one of those kids actually has a copy. My hope is to get it, because it's a pdf. As you know you can send that to all your nieces and nephews and friends and co-workers because it is built to try to help people make better decisions.

The income of the three people who are here tonight on behalf of our foundation, Daryl, Chris and myself, our total income for all three of us is one big goose egg.This is not about our life getting better, it is truly about the lives of others. So there it is. Here's the place you can sign up. By the way, you can go to the website and do this, or I think you, some people will be able just to click through here and do it. But that is my hope, is you'll join us as a subscriber. 

And we do an article every two weeks. We do a podcast every week. Very, very often the podcasts are a combination of Daryl, Chris and myself just answering your questions. Very often they're an interview I've had with somebody else asking me questions. But we're looking for any way that we can to educate people. 

And I want to introduce one of the smartest people that I know in the industry, and by the way, when I say in the industry, he is not, he's never been a stockbroker. He's not a target financial analyst. He's not a CFP [Certified Financial Planner]. He is an engineer, and engineers sometimes understand things better than stock brokers and certified financial planners. And by the way, Daryl Bahls is also an engineer. They're both retired, but Chris Pedersen joined us in 2016 and he has done a whole bunch of work that's life-changing for people.

One is he has created the best-in-class recommended ETFs. And if you are interested in how he selects those, we have articles on that, and in fact, he may talk about it briefly tonight. But the bottom line is  that he has picked the best small cap value, the best large cap value, the best of all of the different asset classes that you could then put to work  with our portfolios. And those could be done at Vanguard commission free. But they're not all Vanguard because sometimes Vanguard doesn't represent the best in-class.  But just for people who are Vanguard all the time we also have a Vanguard ETF portfolio to try to accommodate those folks as well. 

So Chris has changed the lives, I think, of a lot of people. But the biggest thing that he did was develop the two funds for life. When I met with John Bogle he was so critical of the work that I have done for many years because it was too complex. He said, “You can't do that to people.” And the great thing is that at that very moment Chris was back home working on two funds for life. 

And he has a book coming out in the coming months. I have read the book. I think it's just tremendous. And Chris, would you please saddle up here and take over.

Chris Pedersen: Sure glad to. Just one disclaimer on those best-in-class funds. Nobody, no, just like we don't know future returns, we don't know which funds are going to do best. But we do try to pick them based on some objective criteria that we think gives them higher expected returns per unit of risk, or per expense dollar paid. And so hopefully they serve people well if they're patient and can stick with them.

So let me enter this.The brief story, Paul kind of introduced it, regarding two funds for life is that back in 2017 we were trying to come up with a way to offer investors a simpler approach. And I loved the 10 steps, the 10-step Boglehead list that was given up front because our strategies really do align with those. But there were two steps in that list that really mean a lot to the work that I've done on two funds for life. Step three, which is don't take too much or too little risk, and step nine simplify. And this strategy is really aimed at both of those steps.

Now when Paul and I worked this up in 2017 and Paul talked to John Bogle, that really  did light a fire under us too to complete the work. And it was in the fall of 2017 that we first introduced two funds for life, and I always thought it was super simple and one article was enough. And Paul kept saying, well I think there's a book in there, you should go write a book. And as is often the case when you peel the onion on something and you dive into it and get into a little more detail, you realize that yeah, you could actually write a book on that. 

And over the years, the four years since we first introduced this strategy, I've received all kinds of really, really thoughtful questions from investors. And so of course, now it's not out yet, but you can see that I have a whole book with the material. Paul comes to me and says could you summarize it in like 15-20 minutes. I'm doing this boglehead thing.

But the gist of it is that we wanted, like I said, to focus on these two questions. I'm tied to number three and number nine of the boglehead strategy number three, don't take too much, don't take too little risk, and number nine, simplify. So if we want to do something really simple, the easiest place to start is with the target date fund. A lot of investors today are defaulted into a target date fund in their retirement planning accounts. In a 401-k, an employer will often have that as the default investment, and in fact, over half, I think, of 401-k participants have some of their money in a target date fund. 

It's a very simple strategy. It can be very low cost. If it's based on a Vanguard target retirement fund it can be very inexpensive and under the hood it basically is built on index funds. And what it does is it tries to adjust risk with age. So you would invest in a fund that's tied to the year in which you plan to retire. If you're planning to retire in 2060, there'd probably be a fund called the 2060 target retirement fund and that's the one you would invest in. And what would happen is in the early years you would be primarily invested in stocks.

So you'd primarily be invested in international stocks and US stocks, but there would be, as Paul pointed out earlier, a little bit of bonds and you could argue that those bonds are there to smooth the ride. But as Paul pointed out, they are a drag on the return. And in all of the back testing we've done, it does have the effect of lowering volatility slightly, very, very little. But lowering the amount of money that you have going into retirement, and at the end of retirement substantially.

So that's a problem but before we go into that and how we might fix it let's just look at this thing called the glide path. What happens is as you get to about age 40 the asset allocation starts to shift so that as you approach retirement you're at about a 50/50 allocation, 50% in investment grade bonds plus some treasury inflation protected securities or TIPs, so that combination adds to about 50%, and you're 50% in equities. And the equity percentage continues to ramp down as you go into retirement for about seven years until you get to about a 70/30 portfolio where you've got 30% in equities and 70% in bonds.

So if you want the simplest possible strategy for an investor, putting them in a target date fund does a lot of good things. It takes into account this idea that your your risk budget, or your ability to to take on risk, declines with age because you have fewer years to work, you have fewer years for compounding to work for you, you have fewer years to recover from a drawdown or a loss, and you don't have to think about how you're going to manage that risk posture manually by changing your asset allocation every year. And it's very low cost and it just happens in the background automatically for you.

So the simplest possible strategy is just to target date fund. But as i pointed out it has well at least one imperfection, this bonds in the early years. It has another imperfection, and that's that there's limited equity diversification. You're entirely in a cap weighted asset class. You have no meaningful exposure to small companies or value companies.

Yes there are small companies in there and there are value companies in there, but the value companies are offset by the growth companies, and the small companies are offset by the very large companies, so that you get no exposure to those potentially higher return, and admittedly more volatile but not always correlated asset classes. So what can you do about it? What if somebody wants to get a broader diversification across a wider range of these types of stocks and also take on a little bit more risk in the early years.

Well what we developed in this two funds for life was the idea of adding some small cap value to the portfolio, and we do it with or without age scaling and with or without a minimum allocation. So in the book we cover three strategies I call easy moderate, and aggressive,and  the one that's in the middle, that's moderate.

You may have been exposed to what I'll call the classic two fund for life strategy, where you basically take your age in this case it's worded as years to retirement but I’m going to start with age. If you take your age times one and a half and you put that into a target date fund and you put the rest into small cap value what happens is that at say age 20 one and a half times your age is 30, so you'd put 30 percent in the target date fund and you'd put the rest 70% into this second fund, or small cap value. And basically as you ramp that down as you come up to retirement at age 65, it's age 66 and a half if you do your age. If it's yours to retirement, it works out that you're zero right at retirement at 65, if you're retiring at 65. So this moderate strategy is that you know you're investing some in small cap value declining with age until you get to retirement, where you're 100% in the target date fund. And I'll show you in a minute how that plays out. 

The other two strategies. The simplest one is that you take 90% and put it in the target date fund 10% into the small cap value fund and then you don't rebalance. And the reason we described this really easy approach is that sometimes people won't have access to a small cap value fund in their 401-k, and if you have to access small cap value in a second fund it's advantageous not to have to rebalance, because it's hard to move in and out of a 401-k. So we model it that way. And then in retirement we use a very simple approach,and we do this also for the more aggressive one, I'll talk about in a second, we call this nudge withdrawals. 

So if you're taking out a 4% withdrawal in retirement, you just take it out of the  asset class that is oversized, if you will. So if your target is that you have 10% in small cap value and you've got 12% at that point in time, when it's time for your annual withdrawal you would take the whole annual withdrawal out of the small cap value. If on the other hand, the target date fund was at 95% instead of 90%, you would take the total withdrawal out of the target date fund. And what that means over time is that you kind of ping pong back and forth, and take it out of one fund or the other fund. And it's much much simpler than doing annual rebalancing and it produces a very similar result. We document that in one of the appendices of the book.

So that's one of those examples of details that's in the book. So we have this easy approach. We have the moderate approach and then we have an aggressive approach, where perhaps, as you've gone through time, you've become comfortable with the small cap value allocation and you want to continue holding it into retirement. And in this approach  what we do is we take a higher multiple, two and a half times years to retirement, and then we add  20%  to that so you can't go over a hundred percent so at age 20 you're going to 65, so you're 45 years before retirement; 45 times two and a half is over a hundred ,so you're a hundred percent in your second fund, in small cap value. And by the time you get to age 40 you start to ramp down and you ramp that second fund down, the small cap value until you get to 20% at your retirement age, and then you hold it into retirement. 

So these are the three examples we model throughout the book. We've got the easy, the moderate and the aggressive. This one is annually rebalanced during the accumulation phase and then we use the nudge withdrawals during the distribution phase. So if we look at why you might want to do that, or what the impact is. The straight up target date fund, as I said, it does some really great stuff for you. 

What we've got here is the amount of money you end up with as an end balance, and the amount you end up taking out in retirement, as a multiple, a real multiple, of the amount you contributed. And then down below we have the drawdowns you would have had to have to tolerate or experienced to get to that result, based on the history from 1970 to 2020. 

So if you just had a target date fund and you put in, I'm going to just say, a thousand dollars a year for 40 years, increasing with inflation, which means a real $1,000 per year for 40 years that's $40,000 real contributed. You would expect, based on the history, to be able to take out six times, or yeah to take out 5.5 times that or $220,000 during retirement, and to be left at the end with six times that, or six times the $420,040, and this is based on forty years of accumulation and thirty years of withdrawals. 

Now if you look at the easy approach where we put 10% into small cap value and 90% into the target date fund you basically end up with 28% more that you are getting in terms of total financial benefit. And most of it is at the end of your life. It's at the the end balance although you do have a little bit more, you have six times instead of 5.5 times that you're able to take out in withdrawals. And the increase in the risk is very, very small. So you go from 42% drawdowns to 44% drawdowns, the difference there is 2%. If you look at it on a percentage basis to make it more like the comparison at the top, that's a 5% increase in the drawdown depth.

Now if you look at the moderate strategy you get 30% more financial benefit but it's more equally divided between the withdrawals and the end balance. So most people, I think, would prefer that because you get to enjoy more of the money while you're alive, and this is because you took more risk early on, and that meant you had more money accrued when you got to retirement. Admittedly this means you have to tolerate more risk, but the risk is really concentrated in the early years when you have the ability to take that risk. So here the difference is that the maximum drawdowns over the period of time from 1970 to 2020 were 47% instead of 42%.  That's a difference of 5% or if you calculated it on a percentage basis it's 12% deeper drawdowns--and 47% is 1.12 times 42% I believe. 

And then if you look at the aggressive strategy you get over double the financial benefit, you get more, you get the most  money, nine times the real contributions, available to spend in retirement 18 times the real contributions left to heirs at the end of a 30-year retirement period. But you also have to tolerate the most risk, and it is concentrated in those earlier years, to a large part. The maximum drawdown here was 56%. That's a difference of 14%, or about 33% more than 42% in terms of a percentage increase of the drawdowns.

So the bottom line is by adding some small cap value you can substantially increase the amount of money that you have in retirement and to leave to heirs. You do increase the risk that you have to tolerate in accrual and also potentially in retirement, but those increases in risk are relatively small compared to the increases in the financial benefit .And you can do it all with two funds and you can do it with or without annual rebalancing, and you can do it with something super simple in retirement that doesn't require any rebalancing. You can do it simply with these nudge withdrawals between the funds. 

There is a huge amount of detail in the book. So we do things like show the shape of the drawdown risk over time. This is the most aggressive strategy I just described and you can see that the drawdown risk is concentrated in the early years. As you approach retirement there's less in the drawdown risk. We show an example of how the asset allocation fluctuates over time. There's a whole bunch of other stuff.

The thing I think is really important though for investors is that in our back tests we show what the best, the worst. So down here were the real high, real median, and real low balances. So these are the spending power you would have after accounting for inflation over time and you can see the price you have to pay that you might actually have to tolerate a long period of time where you have underperformed and that's part of the price that you have to pay, to live through this experience. But it also shows you at the end that there is a potential bad news scenario, median case scenario, and best case scenario, in terms of real dollars. Or you can look at it in terms of nominal dollars. This page incidentally is all based on 833 dollars per month which is roughly 10 thousand dollars per year contribution. 

So I'm not going to go through this in any more detail because that's what the book is for. But I just wanted to give you a flavor for what the strategies are, and give you an idea of what the book will contain. I'm looking forward to getting the book out and I hope it's valuable to some of you.

John: You actually reference the White Coat Investors notorious 150 best portfolio post that he did, I don't know ,five or six years ago, and he actually has an updated post with 200 of the best buy and hold portfolios or the best portfolios out there. And included in those portfolios are your ultimate buy and hold strategy, the bogleheads Three Fund Portfolio, portfolios from Bill Bernstein, Rick Ferri etc. What's the best recommended portfolio for each individual investor?

Paul Merriman: Well it depends on what they believe in, John. It's what they trust, what they'll stay the course with. I will tell you what--I've been in discussions with Rick and with Larry Swedroe, and almost everybody in the industry will say the best strategy is a strategy that you will stick with through thick and thin because they all do okay. I will say this, if we really want to believe the past, and that's all we have to make this judgment, I would think those that add some small and some additional value are going to do better than those that haven't. 

We did a study that looked at 30 years worth of data and it actually covered Rick Ferri’s portfolio, J.L. Collins, and  the Three Funds from bogleheads. We eliminated the fixed income from any of them and just compared the equity returns. And our portfolios were amongst the best.

But it's not that we did it because of our high end of our high intelligence that we got a better return. We were willing to take more risk. And what is interesting, I go back to those four funds versus the S&P--versus small cap value, large cap value, small cap blend--that four fund strategy. I just think it's an amazing strategy because it's not doing anything that's outrageous. I’m 77, half of my buy and hold equities are small cap, half of those are value, half of those are international. I’m not afraid, but then I’ve got 50% of my portfolio in bonds. It appears I am afraid but you can see it really is about what's right for you. If somebody is willing to stay the course, like Chris said, target date fund, there's nothing wrong with a target date fund. 

According to a study that was done by Wharton School of Business they looked at twelve of Vanguard's retirement accounts over about a 10-year period. The people who used the target date fund had about a 2.3% per year higher expected return--I think about that, I'm looking for a half-- 2.3% better than what the people who don't have target date funds. Which means they probably don't have enough access to, or exposure to equities. They need more but they're afraid to do it. The target date fund allows them to do it with a professional running it for them.

So hopefully we can convince them to go to the target date fund. But gosh, I think about that extra 10% that Chris is talking about, to put into small cap value. This is not like a huge risk you're taking, and yet it does have over a lifetime, really quite a large impact on the total return that you'll have to spend and leave.

John: Many bogleheads go to sites such as Morningstar.com for research on individual ETFs and mutual funds. They'll look at information about whether it's a passive or an active fund. They'll look at the Sharpe ratios, they'll look at what asset style this fund is seeking to mimic, such as small cap value, such as midcap, such as large cap value etc. Many bogleheads will get hung up on the passive versus active debate. And this might be a really good question for both Chris and Paul. Can you tell us why such a fund such as Avantis US Small Cap Value which is presented as an active fund on Morningstar's website isn't actually all that different from let's say, the Vanguard S&P 600 Small Cap Value Fund which is presented as a passive fund and what are the advantages of having a fund like it. Avantis versus the S&P option.

Paul Merriman: Go man, Chris, you got it.

Chris Pedersen: Yeah. It is a great question and  first of all the definition of active versus passive is fuzzy. So to me what I don't want in terms of a type of active is somebody who's trying to time the market. Because I think that philosophically disagrees with what the academics say works. What bogleheads are trying to do and what we're trying to do--and one way to check that is to look at the stability of a fund's style or exposure to small versus value versus growth versus large-- the Avantis fund is very systematically managed and it's very consistent in terms of its exposure to those. 

One way to check that is if you go to a site like portfolio visualizer and run a regression analysis on it. You can look at factor exposures. If it has a very high r squared, that means it's very predictable. It basically means that what you're buying is something that can be described by these factors that academics have documented and understood in the market. 

So AvantIs has that quality, as a very high r squared  98, 99, something like that. And so I don't worry that there is somebody behind the curtain trying to be the Wizard of Oz and second-guess things. So that's step one. As you know it may be classified as an active fund but I think mostly what that means is that in the world of ETFs they don't have to disclose all of their trading so that they might get front run by somebody else in the market. They don't have to be quite as transparent externally about what they're going to trade before they trade it. But it doesn't mean there's somebody guessing.

Now the second thing is how is it different from a Vanguard fund and the biggest difference is that it's going to give you a little bit deeper exposure to value or size, plus they filter on quality. And what we know from books like Larry Swedroe's book and academic, lots of academic research, is that when you combine multiple factors, exposure to multiple factors you get more consistent delivery of the premiums.

And so when I'm doing my selection I look for size and value because that's the way our portfolios are built. But anything that people can cost effectively out on top of that is a bonus. And the the Vanguard funds have if I do an analysis to look at their expected return after expenses, it's a little bit lower than the expected return I see in Avantis after expenses, and I also see a little

bit more balanced exposure to a wider range of factors. So that's why Avantis won.

If somebody believes in Vanguard though and that's going to keep them invested and they care deeply about expenses--and that's their headline-- and they want to go with the Vanguard fund, go for it. That's awesome, that's great. Stick to your guns, do it.  The difference in the end of what you get is going to have far more to do with your discipline to stick with what you've chosen. And the basic asset classes you've chosen rather  than the individual fund choice that you make within those asset classes.So I have absolutely no problem with somebody who wants to be all Vanguard because it's cost effective.

Paul Merriman: Well I just make one comment, John. 

John: Okay.

Paul Merriman: The S&P 500 is an actively managed index,let's just be aware of that. They don't have the same companies in the index today that they had 30 years ago. So they areusing  a form of active management. In fact there was a study some years ago, and I don't have a note of where to find it, but they had tracked the the companies that had been thrown off of the S&P 500 and compared the return of those companies with the companies that were put on the S&P 500 and it turned out the ones that had been taken off had a better rate of return in the future than the ones that were put on. 

Now this does actually make sense because it's probably simply a way to go to value because the reason people are being taken off is probably because they're not doing as well, and then they maybe become viewed as a value stock, and people love growth. I mean if you look at the biggest companies on the S&P 500 I think we would agree  those are really great growth companies. 

And so it's true of the Russell 2000. It too is reconstituted from time to time and in the reconstitution there is a cost to that of getting in and getting out, and like Chris said, there's front running that goes on and that hurts the shareholders when that goes on.

And the people at Avantis come from DFA. DFA does everything they can to maximize the return for the investor. And part of that is with their S&P 500 or Large Cap US fund. They don't move in and out at the same time as everybody else. They do it when the price is right, by their definition.

John: If a young investor has a set it and forget it portfolio, how long can they forget their portfolio before they get in trouble. Do you recommend rebalancing for a young investor, and if so how often?

Paul Merriman: Go ahead, Chris. Why don't you take that one. You’ve got younger people than I do in your family.

Chris Pedersen: Yeah. Rebalancing is a way to keep the risk in line with what you set as your target or what you thought you could tolerate. So somebody who's not going to be rebalancing regularly. On the plus side they may also not be looking very regularly, and for a young person there's something that's not broadly understood or documented. It is in my book.

And that's their regular contributions, especially if it's automated on a monthly basis, are smoothing the ride for them. So they have a volatility reducer just in the dollar cost averaging that they're doing. The 10%  allocation to small cap value is modeled in my book as an unrebalanced asset and it does keep the risk, the drawdown risk, fairly almost constant. It still declines, even with the target date fund as you get closer to retirement, but it bumps it up a bit.

So if the investor is skittish and they're going to be trading out of the market when they see a substantial drawdown then not rebalancing is dangerous for them and so it's a behavioral question. If an investor though grew up in an environment where they were taught to ignore the ups and downs of the market, they don't look at their account very often, they have a really solid understanding of the idea that if your account's down 60%  that just means you're buying cheap, and cheer for the next contribution that goes in. They might be able to tolerate it just fine.

So I think it's a very personal question but when my book comes out I think you'll be able to look at some examples. There's actually quite a few examples in there, of unrebalanced portfolios, and you can see what the impact is. It can be pretty substantial.

Paul Merriman: And we have to remember that the whole idea of rebalancing is basically to take from the rich and give to the poor, and the poor are the asset classes that haven't been doing so well lately. If in fact small cap value is a better investment for the long term, by punishing it for its premium you are taking away from what you're likely to make now. 

Having said that, when we get into the fixed income versus equity question I think rebalancing probably has some meaning. Because when I was an advisor I always told my prospects and my clients if you follow my direction I guarantee you will lose money and given that I can make that guarantee let's be real serious about how much money you're willing to lose and not go beyond that. And if you have that kind of an agreement with your client your job is to maintain that limit of exposure to risk because you have a choice. I wrote a book once, 101 Investment Decisions Guaranteed To Change Your Financial Future. It's also free at our website.

But the reality is it's a decision whether you are going to rebalance or not. It is a decision whether you think you have the ability to see into the future or not. And if you can then you should be a very different kind of investor than if you can't. I can't. I have absolutely no ability. In fact I have so little ability to see in the future and so little desire to be involved in the process of investing I have almost no interest in my own account. 

Somebody manages our money. My wife and I have our money managed by somebody. I don't want to be part of it. I do have an emotional attachment to money, and so it makes me, if left to my own devices, I make bad decisions. I know myself, so I've got a real good advisor. They take care of it. We're doing fine. We over saved so maybe we don't have to get the same return as somebody else might feel they have to get. But it's, we, everybody in this business, I think knows it's about controlling emotions.

And what I do love about Chris's work is you can choose how much emotion you want to have, but everything else is automatic, particularly if what a person does is put their money in a target date fund period and maybe 10% in small cap value. Simple, simple, simple, and no reason to be involved.

John: One more question. What is the best advice for a young investor just starting their investing life, balancing career, budgets, family, student loans, and beginning investments. If you have more than one piece of advice, what is your best advice?

Paul Merriman: Well I'll take a shot at that first. Chris I know you'll have something very thoughtful, you're good at that.

I honestly believe if they will simply read We're Talking Millions and take those 12 decisions seriously and do those things, the low expenses, the right amount of equity, etc. All of those things. They're all simple. The advice really is get an education, remembering that whatever you do with your money there are thousands of people, if not hundreds of thousands of people--I want you to stop doing that right now and do what we recommend! Because we have a better way! Have you looked at cryptocurrency lately, why our people have made a ton! You haven't been in crypto, are you kidding me! Come on, let's get in just part of your portfolio. 

I mean it's a wicked business. I promise you, having been in it for three years, it is a wicked business. There are people who care a lot but  I've always looked at being in the drug business and being in the securities business are two ways to make a ton of money, a ton of money.

I'm not surprised that young people get into the business of selling drugs. It's a good way to make a lot of money. Well it's a bad way to make a lot of money but it can lead to the same thing in the financial industry.

But the way you make a lot of money in the financial industry is you do bad things to others.

And I don't mean everybody's evil. I’m not saying that. But the money that Bernie Madoff made is peanuts. Peanuts compared to what mutual funds take out of people's pockets over a lifetime. They talk in the press every once in a while, people overpaid by 11 billion dollars this year or something like that. They never, when I see those, they never say people paid 11 billion dollars that they shouldn't have, and that's 11 billion dollars that could have grown for them at six percent a year or eight percent a year, whatever, and then been passed on to their kids. That's the real cost of bad advice. Of all those years and years of compounding less money.

So my goal ,and I don't have much longer to be able to do this stuff, is to get those basic lessons. And you already, you read the lessons, most of the lessons are right there in what the bogleheads believe in. They just left out the value and the small, but I mean that that's what I'm hoping for, that would be the advice. Get an education first. Chris you've got to have some ideas.

Chris Pedersen: Yeah. I guess I would first of all, I love the way the question was phrased because it was balanced. The person asking the question realizes you have short term, medium term, long term goals, that you have to work on and work on in parallel. So I think I would encourage somebody who asks that question to, yes, be balanced. You don't have to wait until you've done all of one to do the next, to do the next. You can work on all of them in parallel and it's important to balance life along with saving. You don't want to suffer forever just so you can hopefully have a rich retirement, only to die before you get there, right. You know you've got to enjoy life along the way.

So the “be balanced” I think would resonate with the person who asked the question. And then I know you asked for my best advice, but I would make it a compound sentence, and I would say don't learn the wrong lessons. And this kind of goes to Paul's comments about you need to learn, you need to study.

You know you can take a ride in your car and text and drive and not have anything bad happen, and learn that texting and driving is okay-- until it's not. You can do that with drinking and driving. You can do that with investing. The problem with investing is that it takes 20 years 30 years before you have meaningful data to derive patterns, and so unless you are willing to study history, if you try to learn from your own investing experience, you'll learn a lot of the wrong lessons. And so I think so many people, you know, they do that. They invest in an asset class or the stock market or bonds and it goes sideways for a year, and they decide, okay, I'm never going to do that again.

So I think be balanced and don't learn the wrong lesson. That would be my starting point for good advice to a young investor.

John: Yeah, I certainly think that fits in the category of best advice. Thank you so much to Paul Merriman and Chris Pedersen in this presentation of We're Talking Millions. And thank you so much to all the bogleheads that attended.

[Music]


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