David Baughier switched seats with host Rick Ferri and interviewed him about many personal finance topics. David is a retired Naval Officer with a passion for helping people pursue and achieve financial independence. He is the founder of www.fiology.com, a free resource that escorts you through 52 concepts of financial independence over the course of one year.
This podcast highlights the first 50 minutes of David’s The Forget About Money YouTube video, which we recorded in May 2024. We discussed a diverse set of topics, from John Bogle to asset allocation to the biases in most investment advice. The podcast is David’s latest passion project, and it encourages you to take action today so that you can focus on what matters most to you.
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This podcast is hosted by Rick Ferri, CFA, a long-time Boglehead and investment adviser. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.
Since 2000, the Bogleheads’ have held national conferences in major cities nationwide. There are also many Local Chapters in the US and even a few Foreign Chapters that meet regularly. New Chapters are being added regularly. All Bogleheads activities are coordinated by volunteers who contribute their time and talent.
This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax deductible donation to the Bogle Center is appreciated.
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Transcript
00:00:10 Rick Ferri
Welcome everyone to the 72nd episode of Bogleheads on Investing. Today, my special guest is David Baughier, who is a retired naval officer with a passion for helping people pursue and achieve financial independence. In this episode, in a twist of events, David is interviewing me, which is a first for this podcast.
Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.
Before we begin, I have one announcement. Tickets for the 2024 Bogleheads Conference in Minneapolis, MN are now on sale at boglecenter.net. The conference begins at 1:00 PM on Friday, September 27th and runs through noontime on Sunday, September 29th. We’re going to hit the ground running with the full agenda. Lots of great speakers. I hope to see you there. My guest today is David Baughier.
He’s really not my guest. What happened was David contacted me to interview me for his Forget About Money podcast that he published on Fiology.com.
The podcast came out. I thought, very well, and I asked David if it would be OK if I reran the first 50 minutes of that podcast, and he graciously allowed me to do that. David’s website and the free information that he puts up there is primarily for people who are trying to achieve financial independence.
But many of the things we talked about are applicable to everyone. We talked about Jack Bogle. We talked about the Bogleheads. We talked about taxes, we talked about target date retirement funds, and we talked a lot about asset allocation and how to figure out what your asset allocation should be.
So, with no further ado, here is David Baughier interviewing me, Rick Ferri.
00:02:41 David Baughier
Welcome to the Forget About Money podcast, where we encourage you to take action today so that you can focus on what matters most to you. Today we have a legend in the financial space, Rick Ferri. Welcome, Rick.
I asked Chad GPT, who is Rick Ferri? Here’s what ChatGPT had to say. “Rick Ferri is a prominent figure in the world of finance, particularly in the realm of passive investing. He is an accomplished author, financial adviser, and speaker, known for his expertise in low-cost investing strategies and index funds. Ferri is recognized for his straightforward approach to investing, advocating for simplicity, diversification, and long-term thinking. Through his books, articles, and speaking engagements, he has helped countless individuals understand and implement sound investing principles to achieve their financial goals. Ferri’s insights are highly regarded with the investment community, making him a trusted source of wisdom for both novice and seasoned investors.”
00:03:40 Rick Ferri
Well, can I argue with artificial intelligence?
00:03:45 David Baughier
Well, did they miss anything?
00:03:46 Rick Ferri
I’m a pretty good pickleball player, too. I think they missed that in there.
00:03:50 David Baughier
I’ve got it in my notes though. I saw that in another podcast. I was going to bring it up, and one thing they did mention is you were a fighter pilot in the Marine Corps.
00:04:00 Rick Ferri
Back in the day, yeah, about 40 years ago. Yeah. Carrier landings and everything.
00:04:04 David Baughier
I imagine you had some harrowing experiences, and I know landing on a carrier is not the easiest thing for a pilot to do.
00:04:11 Rick Ferri
Yeah, I think the most harrowing was at least coming about the carrier. We were coming aboard at night. It was very bad weather. The seas were very rough, raining like cats and dogs.
And as we’re approaching the back of the ship about a half a mile away, and I’m trying to navigate aboard the ship, the back of the ship came up out of the water and we saw the screws or the propellers on the ship come out of the water. And the LSO, who’s a single officer there, says, “Can’t see you. Sound good? Keep it coming.” The ship came down. It goes up and comes down. But as it comes down, basically it comes down. Boom. When we hit the deck, and we caught the wire and all is good.
00:04:51 David Baughier
There was a period during my surface warfare officer days, it was in 2003, during the time of shock and awe out in the Gulf. And we launched Harriers.
The Marines flew Harriers off of our ship, LHA-1 Tarawa, I think. I don’t know how many. Seventy straight days of flight operations, so I definitely understand. You’re flying around a starboard delta waiting to land and those kinds of things. How did you transition from the military to the finance industry?
00:05:18 Rick Ferri
Well, actually my undergraduate degree was in business administration. I graduated from the University of Rhode Island in 1980. And instead of going to Wall Street, I decided to serve my country and go into the Marine Corps. And that led to an opportunity to go to flight school, which I took, and led to 8 years of active duty. And then 12 years of reserves after that.
But even while I was in the Marine Corps, I took the IRS’s volunteer income tax course to be able to help fellow Marines do their own tax returns. I used to write an article for the local base newspaper about finance, personal finance, and investing. So, there was always an interest to me.
And when I got out 1988 and decided to get out of active duty, I decided that I was going to go into this field rather than go become an airline pilot. Which is what all the other pilots did in my squadrons. I decided I was going to go this direction. And I’m now very pleased that I did. I went into the brokerage industry back in 1988. And you can talk about what that actually is versus what people think it is.
It was very depressing to be in that industry when I found out what it really was because it really isn’t about personal finance. It’s really about sales, and I decided that maybe I want to leave this industry. And my backup was to go to the airlines. Luckily, I had an epiphany that we can talk about and went a different direction with my career.
00:06:46 David Baughier
Rick, you started out as a broker and then at some point you transitioned into the Boglehead mentality. Can you just describe that transition and why you have been set on the Boglehead mentality for so long at this point?
00:07:01 Rick Ferri
Well, at the time there wasn’t a Boglehead mentality. This was 1996. I had been in the brokerage industry for call it almost eight years. I knew what was going on at the time. I had achieved at that point, my Chartered Financial Analyst charter, and I was a portfolio manager, managing portfolios as well as being a broker.
So, I had a lot of advanced education, if you will. I was getting my Master of Science in Finance. So, I was going down the path, and I was self-educating myself, too. This wasn’t being encouraged by the brokerage industry. Far from it. They really don’t want their brokerage to be educated, but I was doing it on my own because I thought it was necessary. I thought I was behind, quite frankly.
I was in the military for eight years prior to that, and I really thought I was behind my peers. So, I went out and I got all of this education on my own. So, I thought I was catching up. Turned out I got to be quite far ahead of my peers in the stockbroker world.
It’s depressing because I came to the realization at some point that that the industry is really not about doing what’s right for your clients, it’s doing what’s right for the industry, doing what’s right for the company.
So, there’s a saying that Wall Street isn’t in business to make money for you, they’re in business to make money from you. We do need Wall Street. We do need the creation of capital and so forth. I mean that’s all very, very important to our economy. But I mean the way it’s sold to individual investors, my clients, really kind of put a bad taste in your mouth as to what goes on. It still goes on in that industry, but I decided that, hmm, what am I going to do?
I ended up going to a CFA conference in Charlotte. I believe it was the CFA Institute annual conference, and this fellow by the name of Jack Bogle was speaking. This was 1996.
And he was the founder and CEO of the Vanguard Group of mutual funds, which was a fairly large company. But they had created the first index fund, and they were creating more and more index funds in different industries. So basically, very, very low cost, broadly diversified U.S. stock fund, international stock, and bond fund.
Real estate funds that we’re just tracking the market. And I’m listening to him talk. I’m seeing the data that he’s putting up there and it just aligned 100% with what I was seeing and what I was thinking. And I said, “oh, buy this, this is really important stuff.” I went out and got his book, Bogle on Mutual Funds, which he had written a couple of years earlier.
I read that and I had my “aha moment.” I said, this is what I should be doing. This is the direction I should be going, which conflicted 180 out from what the brokerage industry was all about. And I needed to make a decision to either try to work within the brokerage industry on this, which was impossible to do, or leave the brokerage industry and start my own company. So that’s how I ended up getting into this low fee industry.
00:10:01 David Baughier
Is that the first time you met Jack Bogle was in 1996?
00:10:05 Rick Ferri
Yeah, I mean, I shook his hand. I said thank you. That was a great talk, but that was about it. I mean, I didn’t have a conversation with him. I didn’t really meet him face to face and have a conversation with him until about 2001. I had been out of the brokerage industry, and I started my own low fee advisory company just managing portfolios using index funds. And I finally met him at a Bogleheads conference.
It wasn’t called the Bogleheads back then. It was called Vanguard Diehards. But we had a conference in Chicago where he was speaking at a Morningstar conference. I went to that Morningstar conference, and I saw him out in the hallway, and I walked up to him. Had my very first conversation with hm, but I had many conversations with him since then, and until he passed in 2019.
00:10:45 David Baughier
I know that and you interviewed him at some point, correct?
00:11:01 Rick Ferri
I did. I interviewed him three months before he passed away. As a matter of fact, he had come out with his last book called “Stay the Course.” And it was really about his life in Vanguard. And you know, his beliefs and was my very first podcast that I did. My podcast, if you don’t mind me mentioning it, is the Bogleheads on Investing.
It’s a nonprofit organization called the John C. Bogle Center for Financial Literacy. I used to be the president of the organization up until a couple of years ago. Now, Christine Benz of Morningstar is the president. But basically, we started this podcast, and it was all non-commercial. And the very first person that I interviewed was John Bogle. And it happened to be just a few months before he passed, so it was a really memorable event.
In fact, I went back, and I listened to that podcast just the other day. It’s fantastic and a very popular one. Podcast #1 of Bogleheads on Investing with Jack Bogle. That people call him Jack, by the way, I mean, I know a lot of people know him as John, but he liked to be called Jack.
00:11:51 David Baughier
Your relationship with him, did it develop over time or is it just something that you met in 96 and then you interviewed him later?
00:12:06 Rick Ferri
It did. He wrote a blurb for almost all of the books. Not the first one, but after that he wrote a blurb for almost all of my books. And then the last book that I wrote was called “The Power of Passive Investing,” and he wrote the forward on that book. And I used to speak with him, not frequently, but we would e-mail, and I would see him at our conference. We’d be together at a conference.
The Bogleheads reunion now is just called the Bogleheads Conference. And he would come to the conference, and I would speak with him. I’d be on panels with him and so forth. You know, he’s a great man. He had had great vision and he’s done so much for so many people. It’s hard to put a number on it.
00:12:39 David Baughier
It seems that you were far ahead of your time for your passive and index investing approach, and not just understanding it, but then establishing a business model around that for your own business. I went to college probably right around 2000, and I was familiar with Rick Edelman and Robert Kiyosaki. But what I did not see, I didn’t see any books about passive investing at that time.
00:13:04 Rick Ferri
There weren’t that many. I mean, I started writing my first book. I published it in 1999. Jack’s book was published in 1993, I believe. There was another book, the Index Fund Revolution, that was published in 1998. But I think that was it. There just weren’t any books.
It was all about active management. It was all about beating the market. Now, since that time, a number have books have been published. But no, there just weren’t a lot of books, so you wouldn’t have run into them, particularly in the mainstream media, because there is an ulterior motive for promoting things to the public. And that is to sell products. So, you’re not going to run into a lot of indexing books in the media that are being highly praised, nor are you going to run into a lot of people like me on CNBC or Bloomberg Daily Interviews or anything like that because they have a different agenda.
Their advertisers in the media expect to get the support of the media outlets to sell their products. Yeah, this has all been grassroots effort by a lot of people that have brought indexing to the forefront. It certainly hasn’t been the media, though there are a lot of the media, like Jason Zweig, Jonathan Clements, and so forth who talked a lot about indexing when they could.
But the mainstream media is going to promote their advertisers. That’s just the way it is, and it still is that way. When Jack Bogle first came out with the first index fund of Vanguard, the S&P 500 fund, there was a poster created by one of the mutual fund companies. Indexing is Unamerican.
00:14:53 David Baughier
And your thirst for this knowledge as well as your passion for helping others led you to write a number of books. And this is how I came across you. I was having a conversation with Paul Merriman up in Palm Springs maybe about a month ago.
And as we were finishing up our conversation, get up to leave and he said, have you read “All About Asset Allocation?” I said no. Embarrassingly, I had not heard of this book.
But upon research, I find it is surprising because when a guy like Paul Merriman says this is the Bible of asset allocation, I listen. And so, it’s a book that you wrote originally in 2005. It was updated in 2010, I believe.
Why did you write that book? What were you thinking about at the time? What service? What message were you trying to get across?
00:15:41 Rick Ferri
Well, by that time I had written two books on index investing. The first one was “Serious Money: Straight Talk About Investing for Retirement,” which I self-published.
Unfortunately published it with a publisher that went out of business shortly thereafter, so I ended up with five crates of books sitting in my driveway I ended up giving away. But the second book I published was called “All About Index Funds,” and I published that through McGraw Hill.
But what was missing was a book about how to put all these index funds together in a portfolio, basically asset allocation. So, I went back to McGraw Hill, and I said I’ve got an idea for a book about how to use these index funds being an asset allocation. Because that really is the most important decision that people make, so let me write a book called “All About Asset Allocation.” And they said sure, go ahead. It turned out to be my bestselling book. I think I’ve sold over 100,000 copies and I don’t know how many worldwide. So, it’s sold well, but it really is just the basics of asset allocation and then how to apply that to index fund investing. And now of course ETFs as well.
There was nothing Earth shattering about the book, but I think I did a pretty good job explaining the uses of asset allocation and the limitations of asset allocation.
00:17:06 David Baughier
For a new investor, what is asset allocation?
00:17:08 Rick Ferri
That’s a good question. So, let’s back up a little bit. An asset class is stocks, Treasury bonds, money market funds, real estate. These are big major asset classes that you can invest in, and you can have U.S. stock index funds and international stock index funds that cover the international market, Treasury bond index funds, total bond market index funds that also have corporate bonds, real estate index funds that cover the real estate investment trust markets.
These are asset classes. Now how you put those asset classes together in your portfolio. How much you have in Treasury bonds, how much you have in real estate, how much you have in U.S. stocks, international stocks, this is what’s called asset allocation. It really is the most important decision that you’re going to make in your portfolio, is your asset allocation.
And then the second decision is how do you fill that asset allocation with individual funds? So how do you fill the US stock allocation, and how do you fill the international allocation, and for that you could use actively managed funds versus index funds that cover the markets. And you know I advocate for index funds.
00:18:24 David Baughier
So, for someone who, let’s say they’re 25 years old and they’ve got a 401(k) or a Roth. And they’ll say, OK, I just stumbled across this YouTube video that talks about asset allocation. Maybe I should pay attention. How do I use this information to go back and look at a 401(k) listing or my Roth options to then say I should be allocated in this ratio of US broad market index international index? Stocks, bonds, real estate. How do you do it?
00:18:54 Rick Ferri
OK, so we’ve gone from the philosophy of indexing, meaning I’m just going to buy the markets. Whatever market that is. The US market, the international market, the bond market, Treasury market, real estate market, I’m just going to buy the market. So, the philosophy of indexing is I’m going to do this. Now, you’re talking about strategy, what strategy is, is how do I do this? How do how do you do it? How does somebody listening to this podcast do it based on their unique situation? Based on their time horizon, what their goals are, how much they’re trying to accumulate, and also how they feel about risk (which people refer to as risk tolerance).
Kind of two definitive words. How do you feel about risk and what are you going to do if you have stocks in your portfolio and the stock market goes down 50%?
And if the answer is, oh, I’ll probably sell or I’ll probably cut back the amount of stocks that I have, you probably don’t need to do that because the market’s doing that for you. But, even more than that, then you probably are starting with too much stock to begin with, so there’s two sides to the asset allocation coin.
There’s academically, what you should do if you’re young. And you have a lot of time in front of you, you probably academically should have more equity. You should be taking more risk because you’re going to get a higher return. That the expectation is to get a higher return from equities over a 30-year period of time. That’s all wonderful. So, you might say, OK, I’m going to be 80% in stock. But it’s not wonderful if the stock market goes down 50% and then you decide to bail out.
If that’s what you do, then you shouldn’t have started with 80% in stock. You should have started with something that you will not bail out of. In fact, you’ll do a rebalancing and get back to it. So maybe you start with 60% stock, 40% bonds. The market goes down 50%. You actually take some of your bond money and you buy more stock.
You may not be comfortable doing that. But you’ll do it. And so that’s how you figure out what your asset allocation is. Academic side: yes, stocks outperform in the long term. You should have more stock if you’re young, but there’s also a behavioral side. And oddly enough, I can talk about the technical side.
I can’t talk about the behavioral side unless I know you and we’ve had a conversation about it. I’ve had clients who are young, in their 30s, who have sold their companies for many millions of dollars, and they’ll be very risk averse.
They don’t want equity, they just want a minimum amount of equity. And then I’ve talked to same situation, 30-year-old sells their company, and they want all equity. 100%. So, you can’t tell what a person’s ability to handle risk is with a mathematical model. It doesn’t work. I mean you need to have a conversation. You need to talk about a lot of things.
What are your goals? That’s how you set asset allocation.
00:22:05 David Baughier
So, in my research I found that there are basically two philosophies towards asset allocation and one of them is the strategic asset allocation approach, which is what I believe that you are endorsing. And that is more of a buy and hold approach and is focused more on long-term returns of the portfolio rather than the tactical asset allocation approach which is trying to make changes based on short term trends that might generate a higher return.
So, you’re advocating for the strategic asset allocation approach, is that correct?
00:22:36 Rick Ferri
Yes, absolutely. That’s absolutely it. Yeah. Technical is what do you know that everybody else doesn’t know? I mean, what do you know about the US stock market that everybody else doesn’t know? Oh, interest rates have gone up. Oh, people don’t know that? And of course they do. Oh, inflation is over 3%. Oh, what people don’t know that? I mean, of course they do. It’s already baked into the price.
So, there’s nothing that you’re going to know about the markets that people who are a lot smarter than you who manage a lot more money than you don’t already know. It’s already factored in. So, what do you do?
You just stay the course. You have your strategic allocation of however much in stock. However much in bonds. And stay the course. And I will advocate here that if you’re in a 401(k) plan and you have a low-cost index target retirement fund that you use that. Because you don’t have to do anything, it’s already done for you.
So, you do a target date 2060 fund. Now, you may not be retiring in 2060, but if you just look under the hood and see what the asset allocation is. If it’s a 2060 fund, it’s going to stay at that asset allocation. It might be 90% stock, of which on the stock side, maybe 50% is in US and 40% is international and 10% bonds.
But you don’t have to do anything. You just keep plowing money into that target date 2060 fund for years and let the company who’s managing it, Vanguard, BlackRock, whomever, do it for you. Simple. Keep it as simple as you can. I mean, why make it hard?
00:24:17 David Baughier
So, I think academically, target date funds are a little too conservative for young investors, but at the same time, I understand the behavioral aspect of it is, if you’re going to mess with it at all, just do it. Do a target date fund and leave it alone over time because you’re probably in a better off than even someone who probably knows better and knows this stuff a little better and even enjoys it because they’re going to tinker with it even if it’s only a few times throughout the duration.
That slight tinkering could offset when compared to just a “fire and forget” target date fund. They might not perform as well.
00:24:51 Rick Ferri
I think it’s statistical noise. If you’re going to do everything perfect and not try to time the market and you want to buy your individual funds because they have a little bit slightly lower expense ratio than the target date fund? OK, I’m fine with that. I mean, it’s going to be maybe not even measurable what the difference is.
But if you’re prone to do anything other than follow the strategic recipe that you created, you become a trend follower. Oh, I don’t want to be in international. International stinks. Oh, the performance stinks, but that’s a bad way to invest. Meaning you’ve got recency bias. I mean, you’re looking at the world based on what just happened in the last 5,10, even 15 years. You’re not thinking about what’s going to happen in the next 10, 15, 25 years. So, you’re looking backwards. You’re driving in the rear-view mirror.
The point is that the target date fund stops you from doing that. I generally recommend target-date funds for just about everybody who has a 401(k) and they have a low-cost target date index fund. Now, there are the target date funds that are very expensive. And I don’t recommend them. But there are low-cost target date index funds that are very reasonably priced by Vanguard and BlackRock. Fidelity has them, I believe. But the point is it’s simple. If you get a long-dated target date index fund, you’re going to be 90% equity.
And what’s statistically, what’s the difference between a return that’s 90% equity versus 100% equity? The answer is not much. So, for simplicity, for ease of management, I say to people if you’ve got these really great target date funds in your 401(k) or 403(b), why don’t you use those? And then if you’re going to do individual funds, let’s look toward your taxable account or maybe your Roth account for that, because in the taxable account, you may be better off doing something else than a target date fund. Or your Roth account.
Because you really don’t want fixed income and your bonds in your Roth. So, you may do something else, but at least for your 401(k) or 403(b), if there’s a low-cost target date index fund available, I recommend people use it.
00:27:05 David Baughier
And I know Paul Merriman recommends that, or one of his many recommendations for portfolio asset allocation would be to have used a target date fund.
And then on top of that, add some kind of small cap value. So, if that was the strategy you’re going for, would you just hold the small cap value outside in like a Roth or something because it’s a little more volatile, potentially more return?
00:27:27 Rick Ferri
You’re speaking about what Paul calls the “two funds for life” portfolio, where you have a target date fund and then you have a small cap value fund and then over time as you get older, you diminish or you reduce the amount that you have in small cap value. That’s the two fund for life strategy.
And yeah, if you’re going to have small cap value, if you want to take that tilt in your portfolio, you take that extra risk in your portfolio, then fine. But I wouldn’t put the small cap value fund in my 401(k) or 403(b) because let’s not joke around. I mean, the idea is that small cap value is expected to outperform the market. That’s why you’re doing it. You’re deviating from the market return and you’re saying I’m going to go into the small, very niche, very small portion of the market, which might be 1.5% of the value of the entire market might be small cap value. It’s a very small niche in the market.
And you say this particular niche in the market has shown academically that it has outperformed the rest of the market. Which is what really the bottom line, the basis of the argument is. Now you could argue whether that’s behavioral or whether it’s risk or whatever it is. But the bottom line is the idea is I’m going to outperform with the small cap value tilt in my portfolio. Well, that’s great if this is what you believe and you’re willing to do it for, say, 25 years, because that’s what it’s going to take to take that tilt and actually have a high probability (if it happens) of you getting that excess return. Fine. But don’t do the tilt in your 401(k) or 403(b) because it’s a pre-tax account and you haven’t paid taxes on this money yet.
If you want to do the tilt, do it in your Roth account because you don’t have to pay any taxes. So, if in fact it actually works out and small cap value actually gives you a higher return than the rest of the stock market during this period of time that you’re investing in it, at least it’s in your Roth account and you don’t have any taxes on that extra gain. I’m not disagreeing with Paul on this. We’re just talking about his “two funds for life” portfolio.
I’m talking about asset location, which is where are you going to put these two funds? And the answer is you put the target date fund in your pre-tax 401(k) or 403(b) or maybe an IRA rollover and you put the small cap value in your Roth account.
00:29:55 David Baughier
You’ve been a financial advisor for a very long time. And you’re dealing with clients on those first and those initial conversations. We talked about the risk, and you said you can’t tell a person’s risk until you actually have a conversation with them, correct? Whenever I talk to people and say, hey, maybe they’ve never started a Roth, I say, OK, go to Fidelity, go to Vanguard, go somewhere, start a Roth. One of the things that they go through is a risk tolerance survey and then it provides them a recommendation of something. And I have a huge issue with that, not necessarily because risk isn’t something that should be considered.
But, it’s what does the person who is starting a Roth for the first time understand about risk in the context of financial markets and portfolios, which is almost zero at that point? How do you have that conversation about risk and how do you balance what you know about the markets and behavioral finance and your experience with what they’re telling you in that conversation? Like, you can’t ask a potential client, do you want to lose money? They’ll say no.
But OK, they have to understand that it’s still a possibility that in one month to the next, they could lose a percentage. But they also need to understand that it will bounce back if they stick to their plan. So how do you balance that in that conversation and get them on a solid footing that you as an experienced advisor, and them as someone who’s new and who might be anxious or a little bit scared about putting their money in this account. How do you resolve that? How do you close that gap?
00:31:42 Rick Ferri
So, let’s first talk about the risk tolerance questionnaires. They were designed to find the maximum amount of risk that you could handle. That’s why they were designed, not whether you should actually take that risk or not. That is a whole different story. But that’s what they were designed for. Is that the right way to go about investing to find maybe what the maximum amount of risk you could possibly handle is and go right up to that level? I don’t think that’s a good way of doing things.
Secondly, as far as the questionnaires themselves, they remind me of questionnaires that you might see in Cosmopolitan magazine. They’re just really flaky questions. If this happened, what would you do? If this happened, what would you do? I mean, people are taking a risk tolerance questionnaire. They are going to be brave when they take the questionnaire. They’re going to say, oh, if the market went down 50%, the correct answer is to buy more, right? I mean that that’s what I’m supposed to be saying because this is a risk tolerance questionnaire. Anyway, they’re notoriously inaccurate, but at least it gets you thinking about what happens if the market goes down. What am I going to do, David?
Here, here’s how I start that conversation. Well, David, we’ve talked a lot about your background and your family and we’ve talked about your income and whether it’s secure or not and if you’re married, your spouse’s income and your children and their education and how much you’re putting away, your taxes, your insurances to make sure your insured, your income coming in through life insurance and disability insurance and an umbrella policy of some sort.
We may have talked about some estate planning to make sure that you’ve got everything set up correctly from your wills and trusts, or maybe not a trust, but the powers of attorney, guardianship for your children, and we talked about all of these things. So, I have a really good feel for where you are in life, where you’re trying to go.
You know how you’re trying to get there, when you expect to get there, and we could do a little bit more work on that as far as projecting out, based on how much you’re saving and a reasonable rate of return in the markets. But now it comes to the point of this conversation where we need to talk about your investment portfolio and of course we start with asset allocation, which is the allocation between stocks, bonds, cash, and maybe real estate.
So, David, where do you think you should be?
00:34:07 David Baughier
Hmm.
00:34:08 Rick Ferri
And I’d like you to answer the question. Why? You already have an idea of where you think you should be. Tell me anything. We’ll just keep role-playing. Let’s start with cash. How much do you think you should have in a reserve fund? Some people call it an emergency fund. So how much do you think you should have there? Dollar amount.
00:34:26 David Baughier
I’m good with $40,000 in an emergency fund.
00:34:29 Rick Ferri
OK, you’ve got $540,000 saved, so $40,000 goes to the emergency fund. We’ll put that aside. Now we have $500,000 and that’s more long-term investment, let’s call it retirement. We’re not going to count your kids’ 529. This is just you and your spouse or just you. Perhaps this is your retirement money. So, we’re just going to focus on that. What do you think the allocation should be between, say, stocks and bonds or stocks and fixed income? Doesn’t have to be bonds. It could be CDs or something.
00:34:59 David Baughier
Well, right now I’ve got a pension. So, I think of that as adjusted for inflation over time. So, I think of that as the bond aspect of my portfolio. So, I would like to be more aggressive with that $500K. I don’t need it right now, and I’m OK not paying attention to it. And I would like just for it to get somewhere and grow at the rate of the market.
00:35:19 Rick Ferri
OK, very good. So, 100% equity, all of your $500K, all in equity, I mean, how would you feel about that?
00:35:29 David Baughier
I feel OK with that.
00:35:31 Rick Ferri
Is that what you’ve been doing with your money? Is it 100 percent equity, right now?
00:35:35 David Baughier
It’s not.
00:35:36 Rick Ferri
Let’s just stop that. But this is the point. You see, you’re looking up, you’re thinking about it, this and that. This is how we get to you need to get to your asset. I can’t tell you what your asset allocation should be. No risk tolerance questionnaire should tell you what your asset allocation should be. Only you can come up with your asset allocation because if you come up with it, odds are higher that you’ll stick with it, so it has to be your decision, not mine.
You see what I’m doing here? I’m forcing you to come up with the plan. I’m not going to come up with your asset allocation. You’re going to come up with it, but I’m going to pull it out of you.
I’m going to get it out of you, OK? And it might end up being 100% equity. Yeah, I’m OK with that. OK, fine. I’m still a little bit of role-playing, so market goes down 50%. Your $500K goes to $250K. I mean, is it going to affect you? I mean, what do you think about that? And we’re just going to continue like that. That’s how I figure out what a client’s asset allocation should be. Now, granted, in my mind, I’m saying does this make sense? I mean, should you be 100% equity?
If somebody started out with, well, right now I’m 100% in cash because, you know, when COVID came along, man, I just freaked out and I sold everything. And now they’re telling me they want to be 100% equity. No, that’s not going to work. OK, so I have to pull it out of you. You know what it should be. I have to pull it out of you. That’s how I do asset allocation.
A little awkward, perhaps, but that’s how I do it now.
00:37:07 David Baughier
I like that answer, and I actually learned something right then too, because for me, I feel like I (better than most) at least understand how the market plays out over time and how to make decisions based on that.
And that’s what I have been giving 51% of the vote towards how I think not only how I should invest, but how I think other people should invest. And what you got to was, will they stick with it or not? And that’s the number one factor.
00:37:33 Rick Ferri
Absolutely, no question. It’s not the asset allocation, it’s whether you’ll stick with it or not. That is the issue right there. That’s what all the years of experience do.
00:37:44 David Baughier
There you go. You mentioned real estate as well as far as part of asset allocation. What is your thought on real estate and how do you incorporate that into your portfolio?
00:37:58 Rick Ferri
Do you own a home?
00:38:00 David Baughier
I own a number of rental properties, but no primary residence at the moment.
00:38:04 Rick Ferri
Oh well, that’s interesting. I actually have some clients that do that. They actually rent and they have rental properties.
That’s fine. Real estate is a fine way to invest. If you own rental properties, you are an active manager. I mean it’s a business. You’re buying properties, maybe you’re fixing them up, finding renters to go into them. I mean, this is a business. This is not passive real estate investing, which is perfectly fine. It’s a great business if you choose to go down that path. If you choose not to go down that path, but you still want more real estate in your portfolio, then you could do a REIT index fund. Now that’s a one end of the spectrum. You don’t have to do anything.
You just buy a real estate index fund like the Schwab REIT ETF. They own120 REITs (real estate investment trust) that are traded within the stock market. So that’s easy allocation. Now, the expected return of that is no higher than the stock market. It’s no higher than the stock market, but you just want a little bit different path if you will, of return with real estate than you would say with the total stock market index fund because total stock market index fund only has a very small amount allocated in REITS. Just maybe 3%, whereas so now you’re getting maybe a 10% allocation to real estate. It’s going to have a little different tracking than the stock market. Sometimes it’ll be non-correlated, sometimes it will be highly correlated, it’ll go up and down together sometimes, sometimes it doesn’t. But that’s why.
And then there’s in the middle. In the middle, you’re going to do syndicated. You’re going to get partners. You’re going to either buy a partnership, you’re going to participate in a partnership, or maybe private REITS, which is sort of the same thing as a partnership, but it’s not traded on the stock exchange. So that’s sort of in the middle. So, you’ve got individual ownership, which is what you do. You’ve got REITs over here, which is just market based. And then you’ve got the stuff in the middle.
Now, which one are you going to do the best in? Which one is the rate of return going to be higher? Well, basically the one that’s going be higher is the way you’re doing it. You’re buying individual properties and because you’re managing it and you’re putting sweat equity into this, so the rate return should be higher, maybe 10% versus 7% for REITs.
And then in the middle because there’s management involved, maybe you’re looking at maybe 8% return, although it hasn’t really been that way. REITs have actually done as well, if not better than the syndicated real estate at least over the last 25 years or so. But that’s sort of the spectrum of expected return.
Now, how much of this should you have in your portfolio you could have? I mean, I don’t know what the what the upward limit is. If you’re going to be on this side over here, it could be quite a bit. If you’re in the middle with syndicated real estate, I’d say no more than 20%. And then if you’re going to do a REIT fund, maybe 10% of your equity portfolio.
Or nothing. You just don’t have any REITs or real estate with the exception of maybe you own a house which is real estate. I mean realize when you buy a house, you’re paying yourself rent every month to live in the house. And it appreciates in value. So, people say well, that’s my house. I have to live somewhere. Well, guess what? People sell their homes later on in life and they use that money for things like assisted living and nursing care.
So, it is actually an investment and a pretty darn good one to own your own home because if you’re married the first $500,000 of capital gain is tax free. And if you’re single, the first $250,000 is tax free. So, owning a piece of property to live in is a good investment, especially from the after-tax return of it.
I don’t know if that answered your question, but that’s it.
00:41:42 David Baughier
Is this a lot this recording?
00:41:45 Rick Ferri
Well, I know I’m just kind of what I just said about that is a tax question. Let me talk to this for a second, because I think it’s important as a financial advisor, we can figure out what your asset allocation should be, what your investments should be in your 401(k) or IRA, in your Roth account and your taxable account and all that using index funds. Low-cost funds. That’s all very well and good, but what do financial advisors who really know their stuff really try to understand as best they possibly can? And that’s taxes.
Taxes drive so much financial advice that it has a lot to do with investing and we talked about asset location. Why would you put small cap value in your Roth account rather than your pre-tax account? And this is because of taxes. A lot of nuances in the tax code. But when you’re working with individual investors really you should know the tax code as best you possibly can.
Of course, I don’t know everything. I’m learning every day as well. But there’s an awful lot of interesting things in that tax code that helps a lot of people. Just yesterday, I had a client who had a very large position in a stock and is about to retire this year. And he makes $1.5M per year in his income, but next year he’s going to make $0 because he’s retiring. But he’s got this big position in this one stock and he’s saying I think I’m going to give some of it to charity.
And I said, well, put it in a donor advised fund, take a big chunk of it, if you make $1.5M per year you can take 30% of $1.5M, which is $450,000. Take $450,000 of that stock, put it in a donor advised fund. That $450,000 is a tax write off against your ordinary income, which is 37%. Because if you wait till next year to do this, it’s only a tax deduction against capital gains, which is taxed at 20%.
Based on the amount of stock that he has plus the 3.8% net investment income tax. So, it’s a much better tax deduction for you to make that donation to the donor advised fund of appreciated property this year, up to 30% of your adjusted gross income. I mean, by doing that, the difference between a 23.8% benefit if he did it next year versus the 37% benefit because he’s in a state that doesn’t charge any state income tax is huge.
I mean it’s $50,000 in tax saving difference by making the gift this year versus next year. Now this has nothing to do with whether you should be in stocks or bonds or cash. This has to do with just an understanding about taxes, but it is investment related and I’m saying if financial advisors, if they’re really good, they’re not just going to be trying to sell you some product. They’re not going to try to sell you a direct investing portfolio.
They’re not going to be trying to sell you just some annuity or something. They going to understand your whole situation. That’s why we sit down with the client for the first time, and I do everything over the phone. I might spend an hour and a half just listening to them and understanding their situation because that’s important, when you start talking about investing the money.
Who’s going to get the money when you die? What are your ambitions for giving money to charity? When should you give money to charity? How should you give money to charity? What should you give to charity? This is advising. It’s not selling a product. It’s not selling asset management services. I mean this is advising. So, advisors really need to know the tax code as best they can and continue to learn.
So, I didn’t want to get on my soapbox, but I just wanted to put that out there.
00:45:26 David Baughier
I’m glad you did, because I think I’m on. I’m in the financial independent space and we just kind of like lock on it broad market index funds forever and I mean, yes, there are tax implications and other aspects of the portfolio. And life planning.
And so, I think tax taxes are something that we should talk about more, particularly the financial independence space, where we’re usually just, it’s usually the two things we’re focused on is like life design and low-cost index fund investing. And then almost no tax.
00:45:58 Rick Ferri
Taxes are huge. Taxes are sort of the underground river where everything flows. These are the kinds of things that financial advisors should be talking with their clients about a whole lot more about taxes. I think the investing side is pretty much solved. To me, the investing side of a conversation with the client, if it’s two hours long, a new client is maybe 30 minutes, the other hour and a half is devoted to all this other stuff. Getting to know them, talking about taxes, looking down the road and saying what’s it going to look like for you? What’s it going to look like for your heirs? How do we go about managing your estate, distributing money from your retirement accounts? What’s the most tax efficient way? Are you retiring before the age of 65 and going on Medicare? Well, we need to have a talk about Obamacare, the Affordable Care Act, and whether or not you want to distribute any money and do Roth conversions before 65 because that’s going to ruin your chances for getting tax credits through the Affordable Care Act.
I mean, I’ve got a lot of clients who don’t a lot of financial advisors have this who are multimillionaires. I mean they’re worth $5, $6, $7 million dollars. That’s your net worth. They’re getting almost free health care from the government between the age of 60 or 55 and 65 because they qualify for the Affordable Care Act.
And you say, well, that’s just not right. I’m not saying it’s right or wrong. I’m saying this the way the law is written. If you keep your income down low enough. You’re not doing Roth conversions. You delay Social Security. You have your taxable portfolio set up so it’s throwing off very little dividends. You could qualify for basically the government to almost pay all your healthcare costs, even though your net worth might be $5,000,000. Which is not the intent of the Affordable Care Act, but that’s the way the law is written.
And so, this is how you quote-unquote “add value.” And I hate that phrase. This is what we should be doing because we are financial advisors. We’re not investment advisors, and we’re not tax advice. We’re financial advisors. We supposed to be looking at the whole thing. And again, I’m getting on my soapbox here a little bit, but I think it’s important.
00:48:00 David Baughier
Do you have any children?
00:48:00 Rick Ferri
We have three and eight grandchildren.
00:48:05 David Baughier
When your children were in their 20s, or if you met someone else’s child or a college graduate in their 20s, we’re not talking multi-millionaires. We’re talking to young people who are starting their professional careers and their personal lives. What advice do you give them as far as how to establish their portfolios and then how to manage that portfolio over time?
00:48:28 Rick Ferri
Well, certainly if they have the ability to put money into a 401(k) or 403(b) at work and they’re going to get a match they definitely want to put money in there just to get the match. Now, whether you put it into your Roth 401(k), which is the after-tax side where you the money can grow tax free or you put it into the traditional pre-tax side depends upon your tax bracket. And so, for a lot of young people, they’re going to put the money in the Roth side because their incomes are not that high. They’re just getting started.
So, they’re going to put money in the Roth 401(k) or the Roth 403(b). Their employer is going to match it. Right now, the employer has to match it to a pre-tax account, but starting in 2025, that can go into Roth also.
Anyway, now that’s where you start. And then do you qualify for just a regular Roth account? Which depends on how much you make. And if the answer is yes, then you put the $7,000 in your regular Roth account. Is there an HSA (health savings account) available to you because you’re in a high deductible plan? If the answer is yes, you should put money in the HSA. By that time, you probably put enough money away where you need the rest of the money to live on.
But I mean, if you still have extra money, then, if you’re married and you have kids or just have kids and you want to start a 529 plan, that’s a good idea to start saving for your child’s education.
And after that it’s just basically going to go into a taxable account, and there you need an emergency fund of some sort. Six months-worth of living expenses just in case. I don’t call it an emergency fund, I actually call it a reserve fund because that money can be tapped for things like a new car. Getting a new car is an emergency? No, but it may be nice to have.
So, you could use that money for that. I don’t know if I answered your question, but the whole thing begins with what’s available to me, what types of accounts are available to me and how can I start utilizing these accounts to grow my wealth?
00:50:28 David Baughier
Let’s assume you did all that, and now you’re putting money into a taxable brokerage account. And you still want to invest in a similar philosophy. We’re not adding real estate at this point. We’ve decided we’re going to go simple, non-complex passive. And we want asset allocation to be a high priority. There’s something out there called asset allocation ETFs. Is this the same thing as target date funds?
00:50:56 Rick Ferri
The asset allocation ETFs are going to have a fixed allocation to stocks and bonds, rather than one that diminishes the stock allocation over time. So, it’s what we call a balanced account. Is it an option? Sure. I mean if you want to make it easy, just put it into a balanced ETF. And there are finally a few of them out there. iShares has them, and I think there’s a couple of other firms that finally decided to launch these.
I will say if you really going to get into the minutiae of this from a tax standpoint, it may be better to not do that. Because if the stock market goes down and you’re just in a stock fund and maybe a bond fund, you could do what’s called tax loss harvesting in the stock fund only because the stock market went down. And move it into a different stock index fund.
So, you sell one stock fund at a loss, you turn around, you buy a similar fund but not substantially identical. And again, I’m getting to the nuances here. But the bottom line is you could take the tax loss and you could write that off against your ordinary income up to $3,000 a year and save a little bit of taxes. But if you don’t want to get into the minutiae of it, you know the optimal tax management of your taxable account, sure. A balanced indexed ETF works just fine.
00:52:20 David Baughier
Do you have an overarching philosophy on what the perfect portfolio is?
00:52:27 Rick Ferri
Yeah, the perfect portfolio is one you’re going to stick with. That’s the most important point. You come up with this philosophy of how you’re going to invest. You develop your strategy of what your portfolio is going to look like and you just stick with it for a long period of time. And I’m not saying you’ll stay with it for the rest of your life because you may decide to make an asset allocation change later on as you transition from accumulating assets to retirement and distributing assets.
And there might be another asset allocation after that, too. You realize you don’t need to distribute that much in assets. You’re going to save more money for the next generation. So, you might actually go back to a higher allocation to equity. But you know you can make asset allocation changes based on your situation, but staying the course is by far the most important thing that you’ll do.
00:53:13 David Baughier
And one of the podcasts that I heard you were being interviewed and you said complexity to an advisor is job security. Should that be something we interpret as stay away from advisors?
00:53:27 Rick Ferri
No, it’s not. I mean, I’m an advisor. But there are there are different types of advisors out there. There are brokerage world advisors, and I won’t name any names, but you know the big brokerage firms. I call them brokerage firm because that’s what they used to call them. And you know the Merrill Lynch’s. So, there are many names. UBS, Wells Fargo, and so forth. These people are registered with their firms as Series 7 brokers and registered reps.
And they take the Series 7 exam, which is a brokerage exam. I mean that’s what they do. They get paid. They send a percentage of the money they take in for their firm. And their goal is to maximize their own revenue. Hate to say it, but that’s what it is. Now, that doesn’t mean going out and selling everybody the highest cost thing because people will catch on to that. And they won’t be maximizing their revenue for very long.
But they’re going to develop a mix within their clients of products that they’re selling them, which sort of guarantees them as a broker to get a certain amount of revenue per year. And that’s their focus. What is the incentive? What’s the advisor’s incentive? Well, their incentive is their own revenue. How they make money. That’s their incentive.
So, they’re going to, when they look at you and you come to them and you sit down, you’re looking at them and you’re saying, OK, I’m the client. You’re the advisor. You’re supposed to be helping me make my decision. But the advisor is saying (and I was a broker for 10 years at two different brokers firms and then I have my own money management company – well used to manage investment portfolios) so I more than know this stuff.
This isn’t me just speculating on this. And I lived it. They’re sitting here sizing you up. Oh, you’ve got $500,000. OK, if I can put $100,000 into this product, I’m going to make this commission. If I could take another $300,000 and put it over here, I can make this fee per year and all net total, I can probably make off your $500,000, I could probably make $6,000-$7,000 a year in fees. That’s what they’re thinking.
That’s how they’re sizing you up, even though you over there on the other side is saying oh, he’s making these recommendations because he thinks it’s in my best interest. It is not. It is not.
Now, I’m not saying they give you bad advice. It’s just, I’m not going to give you the best advice. The best advice is go buy a target date retirement fund. It is a very low-cost index fund. Very low. In your taxable account just put the money in a T-bill and then maybe a total stock market index fund. And in the middle maybe buy a couple of CD’s. That’s all you want to do over there.
What’s the problem with that advice? If you’re a broker, you don’t make any money. It might be the right advice. You might be doing great things for your clients, but you’re going to starve. So, yeah, it doesn’t work.
So, what’s the incentive to the advisor? That’s your first clue that there might be a problem. Now, advisors who gets you to give them their money? I get you to give me your $500,000. What is my incentive then? To keep you as a client. I want to keep you as a client. I want to get that revenue stream in every single year. Am I just going to put you in a simple portfolio of a U.S. stock index fund and a bond fund? No, because after a while, you are going to say I’m paying you $5,000, $6,000, $7,000 a year and you’ve just got me in these two funds. Or maybe this one fund? This balanced index ETF, one fund, and I’m paying you $5,000. Why do I need you?
Advisors add complexity to the client’s portfolio for the sake of their own revenue stream and the security of their own revenue stream. It’s complexity for job security. So, you have to figure out the advisor. How is the adviser being paid? Is it from sales of commissions? Is it from assets under management? Is it an hourly or a subscription base where you’re just paying them for their time? And that’s going to be very telling as to whether or not you’re getting unbiased advice.
00:57:34 David Baughier
If you’re OK with sharing it, looking back at your own financial moves and financial mistakes, we hate to admit it, but we have all made some. What do you think is one of your largest financial mistakes in your own personal history? If you’re willing to share?
00:57:51 Rick Ferri
Well, I mean, if I had a crystal ball, then back when I was a young a second Lieutenant in 1982, when I was down in Kingsville, TX, going through advanced jet training, and I finally had accumulated a couple thousand dollars, I would have sent the money to Vanguard and put it into the S&P 500 index fund.
And I would have never done anything else my entire life, except buy that fund, and that would have been it. And if I did that, I’d probably have three times the amount of net worth I have today. And I don’t think the next 40 years is going to be any different than the last 40 years.
00:58:36 David Baughier
Rick, thank you so very much for your wisdom and insight. It’s a pleasure meeting you. And I hope that our paths cross again. And look forward to our next conversation.
00:58:37 Rick Ferri
Well, thank you for having me. It’s been a lot of fun and thank you all for listening.
This concludes this episode of Bogleheads on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads Wiki, Bogleheads Twitter, the Bogleheads YouTube channel, Bogleheads Facebook, Bogleheads Reddit, find one of your local Bogleheads chapters, and get others to join.
Thanks for listening.
