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  • Bogleheads on Investing with Paul Merriman – Episode 18

Bogleheads on Investing with Paul Merriman – Episode 18

Post on: February 2, 2020 by Rick Ferri

We are pleased to announce our February 2020 Bogleheads on Investing guest: Paul Merriman.

Paul Merriman is a nationally recognized authority on mutual funds, index investing, asset allocation and both buy-and-hold and active management strategies. Now retired from Merriman, the Seattle-based investment advisory firm he founded in 1983, he is dedicated to educating investors, young and old, through weekly articles at Marketwatch.com, and via free eBooks, podcasts, articles, recommendations for mutual funds, ETFs, 401(k) plans and more, at his website.

Our discussion centers on Paul’s investment strategies, including his popular “Ultimate Buy-and-Hold Portfolio” and newer “2 Funds for Life” strategy that he created with Chris Pedersen.

You can discuss this podcast in the Bogleheads forum here.

Listen On


Rick Ferri: Welcome to Bogleheads on Investing, episode number 18.  Today I have a special guest, Paul Merriman. Paul is an author, speaker, philanthropist, a 50 year veteran of the investment industry, and a former guest on Louis Rukeyer’s Wall Street Week.


Rick Ferri: My name is Rick Ferri, and I’m 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 501(c)(3) corporation. Today my guest is Paul Merriman. Paul is a Renaissance man. He started out in the investment industry in the 1960s as a broker, right out of college. He has run manufacturing plants, he has been successful in his own investment management firm, and now he’s a successful philanthropist and educator, particularly interested in educating young people. With no further ado let me introduce Paul Merriman. Welcome to Bogleheads on Investing Paul.

Paul Merriman: Well it’s great to be with you Rick. I mean that. I’ve been waiting years to have a chance to talk to the Bogleheads.

Rick Ferri: When I told the Bogleheads on the Bogleheads forum that you were going to be my next guest, it immediately lit up and I got all kinds of questions. For, you know, most of them, investment questions of course, strategy questions. Before we get to that, can you tell us something about yourself? Who is Paul Merriman?

Paul Merriman: Well Rick, I’m a very old man who started working when he was very young and could never stop working; and it rarely had to do with money, although if you do good work for people you do okay financially, I think. And so I had the good fortune at age 40 to be able to do what those FIRE people are working to do, and that is to retire at a young age. But retire certainly didn’t mean to quit working. What it really meant was instead of educating and then managing money I could just spend all that time educating.

I was in the investment advisory business for 30 years. During the week when the market was open and markets were going up and down it was always uncomfortable. I was always at a certain amount of anxiety because what that market did was going to impact the people I was working for, and on weekends I felt so at ease with the world. And then I retired in 2012 and started my foundation and started to educate and write and do videos and podcasts and I never had that same sense of responsibility. So I have a good time seven days a week now rather than two days.

Rick Ferri: So you are all about education now?

Paul Merriman: I am dedicated to helping investors young and old. I go from high school all the way up to retired people. Figure out how to do better with their investments.

Rick Ferri: Well Paul you and I have a similar background in many ways. You actually worked as a broker for a major Wall Street firm back in the 1960s. Can you tell us about that experience and how that shaped you for what you did later on?

Paul Merriman: Well I I did start young. In fact I started in the industry at a time when they first started hiring young people. Before then they wanted people to be in their late ’20s or their ’30s, but they were hiring college graduates and training them at the New York Institute of Finance. I don’t know if you went there Rick but it was a sales course basically.

Rick Ferri: I know. I went through the broker boot camp at Kidder Peabody actually.

Paul Merriman: Oh yeah, I was with Harris Upham, which became part of Smith Barney, and I learned quickly that the conflicts of interest in that industry are so great that I just could not live with those conflicts of interest. And so I was a broker for less than three years and went to do other things because I really couldn’t live with what they were asking me to do; and I was working for a great firm in many ways, but I still didn’t like that conflict of interest. 

And many years later when I’m 40 I have a chance to get back into it. So, but I love the business, I love helping people, and it’s just nice to be able to recommend a no-load mutual fund instead of a mutual fund that charges eight and a half percent. It’s nice to be able to recommend an index fund instead of an actively managed fund. You know those kind of things weren’t around in the mid-60s: the index fund and no-load funds like we have today– whole different world

Rick Ferri: Absolutely, completely agree. That was just getting started when I went into the industry. It, so it has been a real benefit and things have really changed quite a bit. Um we can talk about how the industry has changed so much during, well, the… the 50 years that you’ve been in it, if you will.

But you actually left the finance industry and you went into manufacturing and you became the President and the Chairman of a manufacturing company up in the Pacific Northwest. I mean could you tell us a little bit about that experience.

Paul Merriman: Well it really wasn’t about manufacturing for me. I had guided some people to invest in a company I was– not much money–but enough that I felt responsible for them. And the company was going to go bankrupt and I knew nothing about manufacturing, but I had a good relationship with some people in the brokerage industry, so the company invited me. I offered to do it without any compensation.

Rick Ferri: Paul, that almost sounds like a Warren Buffett story in many ways. You had guided investors to this particular company that was going bankrupt and then you stepped in.

Paul Merriman: Well I would hesitate to compare the size of this company with a story about Warren Buffett. But in a way, yes. I mean these people were– many of them were friends–and as it turned out the man who was running the company before I came in to run it did not have a trusting relationship with the bank. And the reason I got in was because a friend of mine from a bank said, “This is a guy you can trust. He doesn’t know anything about manufacturing but I think he’ll tell you the truth.” 

So I went to the people on the floor of the manufacturing company. They knew the solutions I didn’t. I didn’t have much choice but to listen to them and keep the creditors at bay long enough to solve the problem and keep them out of bankruptcy. And we did, and it was a very rewarding, not financially necessarily, but it was a great experience for me. It made me realize I don’t want to run a manufacturing company.

So, but I also, by the way Rick, I had a jewelry making equipment and lapidary equipment supply house at one point in my career. I did a lot of the things before I was 40 and actually found a 30-year career that was absolutely the most fun I’ve ever had.

Rick Ferri: Well once you went into the investment industry back in 1983, I mean back then there was maybe one index fund available, but as you were saying they had the no-load fund started coming out. T. Rowe Price and a few other companies were available in no-load. So what was your strategy back then and then how did it change over the years?

Paul Merriman: Well you of course know that in 1983 we had just been through about 17 years of markets that went up and back down and up and back down and up and it kind of went nowhere for a long period of time and investors hadn’t made much money if any because they had been whipsawed and been disappointed and concluded “I’ll never invest in the market again,” that kind of thing that turns buy and holders into something other than a buy and holder.

And I happen to know something about market timing and I thought, “Well wait a minute, if somebody could help these people navigate these ups and downs in the market, maybe they could stay the course, maybe they would have the trust to wait out the declines, knowing that they wouldn’t get out at the top and they wouldn’t get in right at the bottom, but if they could get the majority of the move that would be a value to them and they might actually have a good long-term return. 

So I became a real expert, I think, on market timing and developed a pretty good following doing that.  And then in about 1993 or 1994 we had a lot of our clients who had money with us but had a lot of money and more money elsewhere and they were using buy and hold. I think they liked our firm–the way we treated them–and they asked if we could provide buy and hold as well. And in fact over the years, Rick, a lot of people ended up being half in buy and hold and half in timing, as I myself happen to be, and yet I know from all of my experience with timing and buy and hold, that probably a good 60 percent of the folks out there could learn how to be a good buy and holder. Maybe 2 percent of the folks out here compared to be a good market timer because there’s no question market timing emotionally, tax wise is the toughest strategy of all. But particularly emotionally.

Rick Ferri: It was a different time, like you were saying. I was actually in college during the 1970s and I was taking finance courses and I remember one college professor, every time we walked in the room he said, “Hey, look at interest rates, now they’re at 11%”.  And then the next week, “Look at interest rates, now they’re 12.”

And it was just a completely different time. Inflation was going out of control in 1980. There was high unemployment and they could, like you were saying, nobody was making any money in either the stock market or the bond markets. So stocks and bonds were highly correlated and they were both bad. Everything was bad and it had been that way for a long time and I can understand where you were coming from that the only way you could hope to make a rate of return when everything is going bad was to try to get in at a better time and try to get out at a better time and do some sort of a tactical asset allocation.

And then I can also understand that later on, by the 1990s, when the market finally bottomed out and started going up, that you would also have investors who decided they didn’t want to do the tactical asset allocation, at least part of their money, they just wanted to do a buy and hold, which has worked very well also. So I can see where you’re coming from. But are you still doing that? I mean do you still look at the markets and try to make a determination whether it’s time to get out, it’s time to get in and, if so, what is it that makes you one of the 2% that that’s able to do it?

Paul Merriman: Well the old firm that I–I sold my firm in 2012–and I did not retain any ownership because I really did not want to have any conflict of interest as I moved into being an educator. But they still do both buy and hold and timing and, by the way, you have a background I know with the Dimensional Funds. We certainly never did any timing with Dimensional Funds or they would have thrown us out. We actually had a good relationship with DFA even though we also did some timing. But we use just traditional trend-following kinds of timing. What made us unique in the’80s is we developed a strategy that focused on asset allocation plus timing, just as we did with buy and whole except you didn’t use the timing. So we had timing with big and small, and value and growth, and US and international, and fixed income. 

But the fact is that you are wrong so often with timing that investors just don’t get it. I think as my recent article focused on this idea of creating better expectations, that the expectations for timing are almost always going to be that the timer is going to get me out at the top and get me in at the bottom and I’m gonna make money when the market goes down even though it may only be money market returns. But it’s never that easy, and you know that it isn’t that easy with buy and hold.

Rick Ferri: Well at least I’m not making any kind of a decision. I’m not hanging my hat, if you will, on my ability to get people in and out at various times. I know how difficult that is because when I first came in the industry I did use active managers who made or break me, you know, on their decisions. It was I hung my hat on their ability to outperform and when they didn’t, I lost clients. One of the reasons I went to buy, hold, rebalance of just index funds is because I didn’t want to lose clients.

You know, I wanted to be able to control what I could control and I was never good at market timing. You know, it’s so hard. You might be able to pick it right when to get out but now you got a ticket right when to get back in. So so difficult.

Paul Merriman: But when it’s all automatic, Rick, it isn’t difficult; and when you tell people that you’re going to probably lose money on half of the trades and that you’re many times you’re going to get back into the market that is priced higher than you last got out. When they go through that boot camp, they come away thinking, “Oh this guy, he knows what he’s doing”

Now, no – I’ve never known the future; I’m only really good on the past. And so if you don’t live up to their expectations it is hard, I think, to keep a client positioned in a strategy when there’s activity and when you’re wrong part of the time. I have 10% of my own portfolio in a fund that I started in 1995. It’s a combination of market timing and leverage. And in the last ten years, the last decade it compounded at a little better than 6%. Now how would a person feel about having spent ten years at 6% when the S&P 500 made twice that?

Well I feel just fine partly because one, I know that ten years is not a meaningful period of time. Well it is in my life, but not in the life of the market, but the previous 10 years when the S&P 500 lost 1% a year almost that fund compounded at over 18 percent a year.

So the challenge for investors is to invest in a way, one that they’ll stay the course, and, two, that whatever’s being done with their money fits within whatever their personal bias might be about the market. And some people have a bias towards buy and hold, other people when you sit and talk with them, their bias is really market timing. They may tell you, “I don’t believe in market timing” but their bias is to doing something when things aren’t going right.

Rick Ferri: As opposed to John Bogle who says, “Don’t just do something, stand there.”

Paul Merriman: Yes and and I had ninety minutes with Mr. Bogle back in June of 2017 it had a lot of impact on me. But I want people to stand in the right place.That’s what I’m trying to get people to do, and we’re–John Bogle, god bless him– I mean I love what he’s done for the world, and my friends, and all the people that are paying less in expenses today than they used to. We had a major difference of opinion about something that I think is of the greatest import in terms of how the investor should think about the market, so yes, I want them to stand there, but stand in the right place.

Rick Ferri: And I want you to elaborate on that a little more because I find this very interesting. So if you could dig into that a little more, what exactly do you mean by “stand in the right place”?

Paul Merriman: Well here’s what John Bogle and his Vanguard, what they recommend. And by the way everything I recommend can be done within Vanguard, it just might not–well it won’t be done the same way that John Bogle and others do it for people. We don’t know the future. We have faith in the future so we’re always preaching at some level, but they tell people that if you put your money into the total market index that you have done the right thing.

Now I’m not suggesting you’ve done a bad thing. I’m not even suggesting that I think that, or that the way I’d suggest to do it will do better, because we don’t know what’s going to happen. But I do know this, that when we invest in a target-date fund–I love target-date funds– and in what you end up with is a portfolio of equities that are total market: total market U.S.; total market international. And what do we get when we get the S&P 500 and the total market index? We get a cap weighted portfolio that means that almost all of your exposure to risk is in large cap growth.

I shouldn’t say almost all, but certainly over 50 percent is in large cap growth. And that’s not necessarily bad but when we look at the past that the academics have recreated going back to the ’20s, what we know is– first thing we know that I want to clear up– is the return of the S&P 500 is virtually the same over the last 90 years. That the total market index is not turning out a better rate of return, or it does not create an expected higher return than the S&P 500. Oh they’ll say they’ve got small cap and they’ve got value, but it’s so little that those big companies that are in there, because it’s cap weighted, they just walk all over the small cap companies in terms of impact on the return.

So what I advocate for is in the US market is a simple approach where you would spread the money away, not based on cap weighted but based on asset class weighted. And this is not anything I ever came up with Rick. I don’t think I’ve had an original thought in my life, but I went through the DFA process, as you did, and I think they teach you a lot of really good stuff about how investing works. And one way to improve earnings, at least looking backwards, is to rebuild the portfolio, to have some small and some value and some large cap in the US

Now whether you add internationals or not, I’d like you to, but you don’t have to, to historically get a decent rate of return. And what happens is that when you go that route, if you talk in terms of underperformance, the large cap driven index funds have produced lower rates of return over time than a combination of big, small, value, growth; and the risk, if you look at it over time, it doesn’t appear to be any more. As a matter of fact, I just did some tables that show the market broken down into decades from the ’30s the ’40s all the way to the last ten years, and I create a look-alike, a big, small, value, growth versus the S&P 500 and there are times the S&P 500 is right at the bottom, or just off the bottom, of all the equity asset classes. But the combination is always just kind of floating in the middle, never gets to the top, can never get to the top because it’s made up of the asset classes that one of them are going to make it to the top. So it never gets to the top, but it also doesn’t get to the bottom.

So my view is, one, people will get a better rate of return; they’ll have more peace of mind and they’ll retire earlier; they’ll have more to leave to others. And I’m not recommending they put everything in this, but to the extent that they want equities, personally, I’d rather see them have it broadly diversified in asset classes than have it basically be one asset class.

And I asked John Bogle about that, and he said where I’m wrong is that I don’t understand the impact on people when they own a portfolio that has this small, and this growth, and this value, and those asset classes stink, and the S&P 500, where they should have had their money is rolling along. And on the other hand when the S&P 500 doesn’t do well, nobody ever seems to come to the conclusion that the S&P 500’s premium is gone, and it’s never going to make a good return again like it did in the past. That’s because people trust it, and they don’t think to throw it out of the house, like you would a kid you didn’t like anymore. It’s this emotional attachment people have to that. Well people in this country have a bias towards the S&P 500 because they’re companies they trust.

Rick Ferri: And what you’re really talking about, well at least what you’re saying that John Bogle was saying here, is not that maybe the S&P 500 is the ultimate way to invest– he’s not saying that–what he’s saying is that people will tolerate bad performance by the S&P 500 but they won’t tolerate bad performance by a slice-and-dice portfolio that has these other magnified sectors. 

I know you keep calling them asset classes. I have a real difficult time calling small value an asset class. To me the asset class is US equity, and that means everything in US equity, and small value is a style value with style size, small cap is a style if you will. So I don’t consider them separate asset classes, but that’s a different conversation.

But anyway it sounds to me like John Bogle’s issue was that people will accept bad returns when the market is bad and probably not jump ship, but when the slice-and-dice portfolio is bad it’s an active type strategy and people will jump ship, and so in the aggregate he doesn’t like it. Staying in the market is really the key, and the total market fund does that for you rather than slice and dice. Is that what I hear you saying?

Paul Merriman: You know something, I love- No I, I understand what you’re saying. But you have said something that I guess I would disagree with. I don’t call it an active strategy. I really don’t. I  would say that the S&P 500, it is an  index that represents large-cap blend. Now I don’t know if you’d agree with that but that’s how I see it.

Rick Ferri: No, I think I agree with that. That yeah, okay, using large-cap blend– yes I would agree with that. 

Paul Merriman: If you agree with that, why couldn’t you- oh and that blend is made up of growth and value? Why couldn’t you call a portfolio of all the large value, standing on its own, large-cap value? Why isn’t that, doesn’t that have the right to be an asset class just like large-cap blend or large-cap growth?

Rick Ferri: Well hold on Paul, I didn’t say the S&P 500 was an asset class. It’s an index of large-cap blend but I didn’t call it an asset class. To me the asset class is US stocks, the entire market, that’s the asset class. Now within there you could divide it up into value/growth; you could divide it into industry sectors. I mean there’s a lot you can do with the asset class called US stocks. So my only question was on semantics. I mean you’re referring to these things as asset classes, whereas to me the asset classes is US stocks, and these are sectors of that. That was the only difference.

Paul Merriman: And the only reason I call them asset classes is because those people at DFA taught me. So I really, I see where you’re coming from. I think the reason that I reject calling them the US market is because I think then a lot of people might say I want to put my money into the US market and so what it ends up following is probably the total market index.

Rick Ferri: I’d agree with that.

Paul Merriman: So I think it’s leading them down a path that is going to hurt them and I might I say, hurt them– I don’t mean it’s going to, they aren’t even going to know they’d been hurt, Rick, because most people I’ve talked to, they don’t know what return they’ve had. They know they’ve done fine, they’ve done just fine. They made good money, they may be two or three percent a year below the S&P 500. What matters to them is they’re doing fine.

So I think a lot of people that are attracted– and, by the way, the number of people who are attracted to my website– it’s in this whole scheme of things it’s a very small group of people — but these are folks, many cases engineers, or you’ve seen that in the Bogleheads, I’m sure half of them are engineers — that know that, but I do, I do believe –.

Let me just give you one more example but with Mr. Bogle, and he was so kind to me. Oh my god, he was supposed to give me 60 minutes and he gave me 90 and he answered every question I had, and he gave me advice on how to do a better job for people. But I asked him about why would a 21 year old have 10% of their portfolio in a target date fund in fixed income? What I have learned is that when you have 10% of your portfolio in fixed income, based on market returns over the last 90 plus years it will cost you 1/2 of 1% a year. Okay, I don’t like that because 1/2 a percent is life-changing over a lifetime. So they’re sitting with 10% in bonds and I’m thinking wait a minute I want young people when the market is in decline to have all of their money buying lower priced securities, not less. And 10%, what is 10%? It’s not going to turn a bear market into something that is much better than what 90% I mean a hundred percent would be. It’s almost meaningless.

But here was his response, and it’s a good one. What we’re trying to do is train them to understand there’s a process that includes over your lifetime a gentle increase in exposure to fixed income and so they are showing them how that works. And I’m thinking to myself, okay that’s great, but what would an education do for these people? What if they understood that they aren’t going to protect themselves very much but it’s going to cost them buying lots of good stuff when the market’s down and dirty etc.?

You know the rest of that story. And yet they do that to make that fund something people can last a lifetime with it. I don’t argue that they may get there but I think with some small changes it could make a huge difference in what somebody has when they retire, how much they live on in retirement, and how much they leave to others and I’ll be dead and buried before I’ll know how it worked out. I’m just hoping somebody will come to my grave and put a little something- I don’t know [laughs].

Rick Ferri: Well okay. So the big difference it appears between a three-fund Boglehead portfolio which is the total, just buy and hold the US total stock market, the international total market and the total bond fund. All right, just do any bond index fund or a CD ladder for that matter. It’s a three-fund portfolio in what you advocate is twofold, it appears. Number one, you treat the various styles of large, small, value and small cap value as different asset classes and to have an allocation to basically those asset classes.

Paul Merriman: Yes.

Rick Ferri: And the second thing is that you also advocate an element of market timing to this. And by the way, I’m going to jump a little bit around here. I’m gonna jump to the Boglehead questions because when I put your –when I announced to the Bogleheads that you were going to be my next guest– like I said, it lit up, and had all kinds of questions. So I mean one of them asks very specifically about market timing. They were, and this is what he asks, “What do you expect the benefit of your portfolio market timing would be compared to buy hold and rebalance?”  And that another person asked very similarly, “What is the exact buy and sell signals that somebody would use for your market timing portion?”

So I want to get into this idea that you brought up earlier about being in the right track and about people who may believe, as you said, when you sit down and you actually talk with them, they believe there is some way in which they could benefit.

Paul Merriman: Well to begin with, what I believe starts with my fear of the market. I believe that it’s highly likely that in my lifetime, which isn’t all that much longer, that I will live through a catastrophic event. Now when I was young that didn’t matter, I didn’t have anything; but now I do, and I have always — in fact it’s hurt me financially by a lot — I’ve always been too conservative because I’ve been afraid of a market collapse like we had in ’29 to the late ’30s and so with that in mind I’m uncomfortable having too much in equities without some sort of an exit strategy, and it’s just that simple: I’m afraid.

Now in my buy-and-hold portion and that’s half of my portfolio, I’m half in stocks, half in bonds; I’m half in the U.S., in the half that stocks; I’m half in international; I’m half in small; I’m half in large. I’m basically a little more than half in value and a little less than half in growth. It’s like I don’t believe in anything but in essence I believe in everything. I’m trying to get the exposure to the market where I’ve got massive diversification– and by the way investors, if they don’t know it, should know it: according to the academic studies, the more diversified we are the likelihood is we’ll get a higher return, not as not a lower return.

You asked about the timing portion of my portfolio. I’m not 50/50 stocks and bonds. I’m 70% stocks and 30% bonds. Why more stocks there? Because when you use timing and you sit out part of the time in money market funds you have at that point, when you’re sitting in cash, you have less volatility than a person who buys and holds equities. So in 1987 — and everybody in this industry goes back to some time when they looked really good — but in 1987 we had all of our clients’ money out of the market about a month before the market crashed in October, and it made me, for them I was a hero.

Rick Ferri: You’re famous!

Paul Merriman: And I got on Wall Street Week, you know, and and you know something, everybody wanted to make a big deal out of it. And I said,  “Wait a minute, I didn’t call the market. I happened to be out of the market when it collapsed. There is a difference.” But people are always looking for gurus. There are no gurus, but the trend-following systems you could use a 100-day moving average; you could use a 150-day moving average. Then it doesn’t have to be something complex. You just need something that forces you to get in and to get out. And yes, you’ll go through whipsaws etc., but here’s the part I think is fascinating. The standard deviation of a 70/30 with market timing, 70% equities/ 30% fixed income is virtually the same as a 50/50 buy and hold. Almost exactly the same standard deviation and the returns are very similar as well. Now, do they go up and down together? No. And in 2008 an all equity portfolio with these simple trend following systems that the company used, after fees they lost 18% or 15%. It was a relatively small amount.

And in 1987 I had accounts, actual accounts that were up over 50%. That’s the good news. And then everybody rushed. In fact, after that weekend, that was on Wall Street Week, or that weekend actually we got four hundred phone calls at my office. Looking for, theoretically, our help. I mean we were not prepared. But the fact is the following year our returns were mediocre.

And by the way, you and I know something a lot of other people may not know and that is a portfolio from ’95 to ’99 properly diversified: big, small-value, growth, US, international, compounded at 11 percent, while the S&P 500 compounded over 28 percent. That’s the way it is.

Rick Ferri: Now it’s also the way that it occurred in the last five years if you look at 2014 going forward till today. 

So the market timing strategy that you employ is relatively simple. It’s a moving average, 100 to 150 days, something, is what you’re saying now. I want to go back to one point before I get off the market timing, and that is that you earlier talked about young people should have almost a hundred percent of their money in the market but so when it comes to market timing, there you mentioned that young people, when the market goes down, they should just work and put more money in the market. So when you’re talking about market timing are you speaking about everybody?

Paul Merriman: Old people.

Rick Ferri: Old people, okay that’s what I was getting at. Old people like me, and you, well you’re older than me.

Paul Merriman: Yeah by a lot, yes it’s for people where preservation is important. But having said that, as critical as I was of the target date fund at age 20, sitting on 10% in fixed income, I’ve met lots of 20 year olds and 25 year olds who have all of their money in fixed income because they are afraid of stocks, and I’m begging them just put 20-30 percent in equities. Let me show you. I’ve got my favorite table called, fine-tuning your asset allocation, and it shows these different combinations of stocks and bonds over the last 50 years and what you see is if you just have 20% in equities it’ll kick your return up by about one and a half percent a year. If you can get up to thirty percent you might even kick your return up… I’m sorry it raised it about one percent a year. If you go to thirty it raises it to about one point five or so. Depends on what asset class you use in the equity portion. But I want those young people who are scared to death of the market to just take a little risk. I don’t want them to have as much money as the target date fund represents because it’s going to end up scaring them out.

Rick Ferri: Okay let’s go ahead and move on to the second phase of that which, we’ve done the market timing thing, you’ve differentiated how young people should invest versus old people. Well now we need to look at the other side really where I think most of the questions from the Bogleheads have come in and it is with your ten-fund portfolio and now your new two-fund portfolio. And so this is actually, if you don’t mind me using this phrase, the slice and dice of what you do and what you really believe in. Number one could you talk about the ten-fund portfolio and the complexity of it, and then move then into the two-fund portfolio and how that solves the complexity problem?

Paul Merriman: You betcha. So this started maybe fifteen plus years ago, that I created something I got from DFA, by the way what I call the ultimate buy and hold strategy, and I was quick to say that it wasn’t necessarily anybody else’s ultimate buy and hold, but it was the best that I could find without placing any big bets. So what I did was, starting with a portfolio that’s a hundred percent in the S&P 500, then all I do is I take 10% of that money and I put it into large cap value, and what happens is you make a little more money. And then I go the next route, next step and I put in 10% of small-cap blend, make a little more money. By the way that little more money is sometimes only one or two tenths of a percent. Then I take another step and I take out another 10% from the S&P 500 and put it in small cap value. No big bets, no big bets. Then I take 10% and I put it in REITs. Now I have 50% in this combination of five different equity asset classes; 50% in the S&P 500. I think people would be probably just happy as could be right there if they stopped, because they would have made an appreciable increase in their return. And I tell young people a half a percent more over your lifetime is truly a life changer, so if you just did that you’d have made a big difference historically. Don’t know about the future but historically you would’ve.

Okay but I keep going because I do want internationals in the portfolio. There obviously are times I wish I didn’t have internationals in the portfolio, but I believe that that diversification is what a person should do if they really want to diversify properly. So I take another 10% and go into large cap blend internationally and then ten in large cap value, and ten in small cap blend and ten in small cap value and then the last 10 goes into emerging markets. So I have a lot of really risky investments in that portfolio and that is what my retirement looks like in terms of equity.

I do exactly that: 10% each in those 10 asset classes. But the bottom line is for people who are really do it yourselfers trying to rebalance 10 different equity asset classes can be something they can’t figure out, and when I was a money manager we had a firm that’s what we did — we did it for them. But Chris Patterson did this analysis of all the ETF’s and he came up with the best large-cap plan, the best large-cap value; every one of those ten equity asset classes he made a recommendation. My belief is, and you probably know this, but supposedly Schwab is going to be trading ETFs with partial shares. One Schwab is able to trade partial shares with ETFs, or their clients are. Then there’s no reason why they can’t let people build a portfolio and have them automatically rebalanced.

Rick Ferri: Moving along then to the two fund portfolio which I find to be really interesting. So you solve the problem of complexity with a two fund portfolio.

Paul Merriman: Well the challenge, and this was, by the way, partly motivated by my meeting with John Bogle because he basically said ,”Paul you’re a nice guy.”  He had been on our radio show for years so he knew us and he knew that we were trying to help people. He said, “But you’ve got it wrong. What you’re doing with 10 funds is- it’s just too complex for people and they aren’t going to do it.”  

And so Chris Patterson, donating his valuable time as a volunteer to our foundation along with Daryl Balls, another systems analyst smart guy, you know, that really understands computer work, have put together this strategy. And what Chris came up with is the key to treating the extra fund, the second fund in a similar fashion as you would with a target date fund, because if you put, for example, 20% in a small cap value and 80% in a target date fund and you don’t ever reduce the exposure in the small cap value fund you could end up with 50% of your money in small-cap value at age 65.

So we really want young people to be exposed to small cap value and then to reduce that exposure as they get older. And what Chris came up with is so simple. You multiply your age, of 20 let’s say, by 1.5. Now you’ve got 30. That is the amount that you would put into the small to the target date fund, the rest you put into small cap value.

Too aggressive? Okay how about large cap value instead? We could do that as well but it would just be less aggressive. So as you age once a year, you could do it every two years and it doesn’t have to be done every year. But what you’re doing, by the time you’re 30 you’d have 45% in the target date, 55 in the small cap value. At age 40 you got 60 and 40.  At age 60 you are 90 percent in the target date fund and 10% in small cap value. At age 66 you’re zero in small cap value.

Rick Ferri: Oh I see. Okay I got it.

Paul Merriman: It is so simple now I know what’s going to happen. If anybody really thinks this is a good idea they’re going to reconfigure it and make it better. Because the idea now is there, it’s a simple thing to do, but how, what formula do you use?

Rick Ferri: It sounds like this strategy would work with the young person who’s just getting invested in a 401-k plan where you’ve got maybe Vanguard target date funds or other target date funds that are available to you and you’re 25, or say you’re 30 years old, you would also need to have in the 401-k a small cap value index fund. If you had those two things available and you wanted to do something more than just target date — and you were more sophisticated, and you knew that you really understood what you were doing — that this would work because by the time you retire at age 66 you don’t have any left in the small cap value, it’s just all in the target date so it does make sense from that perspective.

Paul Merriman: And by the way I work with a lot of people my age suggesting things for their grandkids. When there’s a new grandchild, I’m thinking either a hundred I’m sorry 365 a year for twenty-one years, or three thousand dollars once; put that in small-cap value, keep it in small cap value. When they start working and they can do an IRA, take money out of this account, put it in the Roth IRA and just let it go. Keep contributing ’til that money is gone and literally, literally if you took three percent off of the compound rate return of the past from small cap value, you could have created twenty million in retirement income and thirty million as a gift to the heirs at age 95.

Now, obviously, it sounds like something that you get at a County Fair, but the fact is if you get twelve percent a year — and why is twelve percent unreasonable if ten percent in the S&P 500 is reasonable? And it includes the Depression — then why isn’t twelve percent reasonable for small cap value? It is the premium for taking that risk.

Rick Ferri: I have to tell you that one of the Bogleheads suggested that I get a glass of wine and I put it in front of me and every time you say “small cap value” I have to take a sip so that’s exactly what I did okay? I went and I filled up a glass of wine with some Cabernet in it.

Paul Merriman: Oh we’re friends then now, eh?

Rick Ferri: We’re getting there, and I have to tell you the glass is now empty.  Paul, we’ve been talking for quite a while, I want to get into a few other things before we wrap it up and some of the Bogleheads are curious about just a little bit more about your life. You know one of the Bogleheads asks what is the greatest mistake that you made that you are willing to talk about; that we can all learn from?

Paul Merriman: Well I don’t know. Mistakes I made as an investor? I lost everything. I was conned; I shouldn’t say I was conned– I was talked into putting my original investment of a thousand dollars into a commodity trade, which I doubled in a matter of weeks–and having found out how easy that is, I took the guy’s advice again and I lost it all. And so that money, if I hadn’t lost it, if I had put it into small cap value — ooh there’s another sip!

Rick Ferri: Oh no, the glass is almost empty, you’re going to have to let me go back to the bar!

Paul Merriman: But if you had invested it rather than having it leak out the bottom, rush out the bottom of your pail, it would have meant something just somebody.

And so I made a lot of mistakes like that early in my career. I invested in some small companies that had products that seemed to have some potential. Again, I try to talk young people out of doing that. Their parents say, “I’ll let them make mistakes.” I don’t want to let them make mistakes. The cost of those mistakes are way, way more than people know, and they might even get lucky and hit a good one and think they know something, and then it’ll even cost them more later.

So I did those things and I think the other thing is I’ve never learned. A mistake I’m still struggling with, how do I not work 60 hours? I love what I’m doing. Well anyway I want to go as long as I can, and that’s one of the things that John Bogle did for me. He inspired me and I’ll tell you where I feel my work has value — we are giving advice, very specific advice, on how to invest if you’re conservative, moderate, aggressive. I don’t mean I talk to you. I don’t mean I review your situation. I mean we give you, if you want to learn what we believe, and then we make it possible for you to know what to do if you believe that. That’s not easy for people to do.

Rick Ferri: So Paul, that gives me a great opportunity to ask you, could you tell us about your website, and tell us about all the things you’re doing, and how you educate people?

Paul Merriman:  Well first of all we’ve got free books. Probably the best one is entitled 101 Investment Decisions Guaranteed to Change Your Financial Future. By the way, I quickly tell people I guarantee it will change. I don’t know if it would be better or worse, but I think it’ll be better. But it’s nothing more than best practices. So that was the beginning when we started the foundation. I have portfolios there on our site for Vanguard, Fidelity, T.Rowe Price, and the ETF’s best-in-class ETFs. We have over 400 articles and podcasts there. We have videos that we’ve made.

We have a new book coming out in a few months. It is all about twelve million-dollar decisions, well actually half of it is about twelve million-dollar decisions, and the other half is about two funds for life because I think you can actually do those twelve things and use the two funds for life and take advantage of those what I call twelve million-dollar decisions. That book will be free to everybody who is on our email list and, by the way, if you’re not on our email list and you know the book is out you’ll be able to get it free.

I want to help as many people as I can and I love working for people. I love helping people’s lives get better. I do a lot of nonprofit work here on Bamber’s Island and getting medical publications — free medical publications 0- into the hands of physicians in developing nations through an organization called Global Help. So I’ve got other things I’m working on and I just can’t, I can’t seem to stop.

Rick Ferri: You’re doing a great job for a lot of people. You’ve got tremendous respect by the Bogleheads, tremendous respect from the investment community for providing information. Now everybody doesn’t have to agree with you on everything.

Paul Merriman: Oh, I know that they don’t.

Rick Ferri: Well Paul it’s been wonderful having you on the show and I know that the listeners have all really enjoyed a lot of the conversation which we’ve had today. And I’m really looking forward to talking with you again.The website is Paulmerriman.com. Thank you so much for joining us today.

Paul Merriman: It’s been my pleasure Rick. Thank you and all the best to all those Bogleheads.

Rick Ferri: This concludes the 18th episode of Bogleheads on Investing. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime, visit Bogleheads.org and the Bogleheads wiki, participate in the forum, and help others find the forum. Thanks for listening.


About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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