Rick Ferri versus Paul Merriman on Factor Investing – Podcast #169 – The White Coat Investor – Investing & Personal Finance for Doctors
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This week we have Rick Ferri and Paul Merriman on the WCI podcast at the same time for a lively debate on the pros and cons of factor investing. These are two opinion leaders who have affected the investing views of literally millions of investors. When I told you I was bringing them on the show, I received 40 pages of questions to ask them about asset classes, changing your asset allocation, small cap value and other factor investments, as well as total market investing. We talk about the historical performance of these investments. We really delve into the details of factor investing and whether it is right for you. This may be an interview you need to listen to more than once, there is so much to learn from these giants in the industry. The interview went so long we cut it into two episodes, so make sure you come back next week to check out part 2.
Guideline is a 401(k) provider on a mission to help people save as much as possible when saving for retirement. Their investment portfolios contain low-cost Vanguard funds which are automatically rebalanced to keep it diversified and on track for retirement. And the best part? No added AUM fees, which would typically take a chunk out of your retirement savings year after year after year. Check out Guideline.
Our quote of the day today comes from David Swensen, the chief investment officer of the Yale Endowment Portfolio, who said,
There is a lot of truth to that. When you know enough to properly choose an advisor, you often know enough to do it yourself anyway.
If you are interested in being a speaker at the next WCI conference, fill out the application here . I expect this is going to be a somewhat competitive process. But I’m looking forward to having a great selection of fantastic speakers and I encourage you to apply.
We are still raising money for the White Coat Investor scholarship, so you can donate to that. 100% of the proceeds we raise go to students, to help them directly reduce their student loan burdens. Katie and I are matching all the reader donations. You can donate here or through paypal to [email protected] with “scholarship donation” in the notes.
We also could use some more judges for that contest to read the submitted essays. We need your help to decide who is going to win these cash prizes. If you are willing to help, email [email protected] with “Judge” in the subject line.
Peter Kim, from Passive Income MD, has a real estate course. The purpose of his course is not to teach you how to do direct real estate, but to teach you how to invest in passive real estate. He teaches you how to evaluate syndications, evaluate private real estate funds, know what a fair set of fees is, what a good waterfall is, how to evaluate whether this particular sponsor knows what they’re doing, etc. If you’re interested in that course, you can get on the waitlist between now and the 31st of this month. Sign up for the Passive Real Estate Academy waitlist to get a $200 discount on the course. Of course, it comes with a money-back guarantee so you can try it before you buy. Check it out if you’re interested in private real estate investing.
Paul Merriman began his career as a stockbroker. He’s the founder of the Merriman Financial Advisory firm and the Merriman Financial Education Foundation. He is the author of four investing books, leader of more than a thousand investor workshops, the host of the weekly Sound Investing podcast, and a speaker in our most recent online course – The Continuing Financial Education 2020 course.
Rick Ferri is a marine fighter pilot who also started a career after that as a stockbroker before founding a low cost advisory firm. He has also been an adjunct college professor and is now an hourly fee consultant. He is the author of at least seven books, a speaker at WCI Conference 2020, the host of the Bogleheads podcast, and the president of the John C. Bogle Financial Literacy center.
Together, these two opinion leaders have affected the investing views of literally millions of investors. That is a scary proposition and a weighty responsibility, to think that other people base the decisions they make with their serious money on your opinions. We talked about whether that ever scared them to think about how many people listen to them and consider their opinions. They both agreed that it is a big responsibility and the challenge is that they don’t know the individual investor. Paul said,
The first part of the interview we talk all about factor investing. We started with asking them to define asset class. Rick said,
Paul would include small cap value as an asset class stating that there is a lot of evidence done to track its risk and return. He has a bigger list of what he would call asset classes.
We discussed the definition of total market investing. Rick said,
I asked Paul to define the term factor investing and how it differs from total market investing. He said the factors are groups of equities that have something in common, like their size or growth-oriented or value-oriented.
Some people look at diversification and they say, “well, the more companies you own, the more diversified you are”. So, the most diversified you can get is to own all of them, to invest in the total market, buy a total stock market index fund, for instance, and own all the companies as maximal diversification. A factor investor tends to argue that it’s not so much that diversification matters as your diversification between the factors. I asked them which of those they feel are the more important, as far as diversification goes. Rick said your exposure to the market is the most important factor that you can invest in.
Paul pointed out that if all you owned for the rest of your life was the S&P 500, John Bogle would be very proud of you. You would be invested in great companies.
This concept of tilting towards small and value stocks comes out of research done by Fama and French, published in the 90s. They went back and looked at basically all the stock market data we have. The best data set goes back to perhaps 1927, and, of course, it can be extended to today.
Looking at that, they determined that small stocks and value stocks had higher returns than the overall stock market. Knowing that finance is not physics, this is not something where we can put it in a lab and test it over and over and over again, we have a limited data set. So, the question is, is factor investing real? Or is it just the product of retrospectively data mining a limited set of data? Rick said he would let us know in 50 years.
Paul admits he isn’t going to last that long but takes the stance that people will know long after he is gone.
As Rick quoted Paul, “We don’t know the future, but we have faith in it.” But let’s assume that it is real, that over the long-term going forward, small and value stocks are going to outperform the overall market. Is this historical outperformance, as well as this performance moving forward, is this a behavior story? Or a risk story? And if both, is there a way to quantify how much of each?
Rick believes it is a risk story.
Paul believes it could have to with behavior.
Rick makes an argument that you don’t necessarily have to buy a value fund to do value investing. You can do it as a global investor. He feels like you are talking about industries when talking about value.
He tells his clients they don’t really need to do a lot of value investing if they have a third of their money in international stocks because it is already value investing.
Paul just wants investors to realize it is just a different way of owning the whole market.
The “FANG” acronym is a descriptor for the high-flying Facebook, Amazon, Netflix, and Google group of tech stocks that have a large portion of the market. I asked Rick and Paul what similarities and differences they see between this phenomenon and the years with the dot-com boom and bust? And the Nifty-Fifty era of the late 60s and early 70s. Rick didn’t think we were anywhere near the dot-com bubble of the late 1990s but are closer to where the valuations were at with the Nifty-Fifty era. Paul said,
We all three agreed that if you are going to tilt a portfolio toward factors, it needs to be for the long term. It is a lifelong investment strategy.
Rick has never been a strong advocate for factor tilting. He has this portfolio, Core Four Portfolio, with no small cap value in it. It is just the total U.S. stock market, total international stock market, a small slice of real estate and a total bond market. In one of his books he showed that, statistically, if you had about 30% of your U.S. equity portfolio, just your U.S. equity portfolio, if you had 70% in the total market and 30% in small cap value, so, 70/30 mix, that it historically gave you a higher return risk-adjusted than the stock market. So same risk but higher return. But he has never gone above 25% in a small cap value for his clients.
The conversation I had with Paul and Rick was over two hours. Come back next week to hear us talk more about small cap value and other factor investments, as well as non-factor investing related questions that listeners submitted on our various social media channels.
This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We’ve been helping doctors and other high-income professionals stop doing dumb things with their money since 2011. Here’s your host, Dr. Jim Dahle.
Dr. Jim Dahle:
This is White Coat Investor podcast number 169 – Rick Ferri versus Paul Merriman on factor investing. I want to introduce today’s sponsor Guideline. A 401(k) provider on a mission to help people save as much as possible when saving for retirement. Their investment portfolio contains low cost Vanguard funds, which are automatically rebalanced to keep it diversified and on track for retirement. The best part, no added AUM fees, which would typically take a chunk out of your retirement savings year after year after year. Check them out at guideline.com/wci.
Dr. Jim Dahle:
All right, thanks for what you do. What you do is difficult. I remembered this yesterday during my shift. I went to intubate a patient, and of course, we are all wearing spaceman suits these days when we go to intubate somebody. And of course, naturally, it’s a difficult intubation to start with and entire mouth and pharynx full of white froth. And I’m trying to see through my goggles and my spaceman suit and breathe, and we can’t hear anything because we got wind rushing past our ears from the pappers.
Dr. Jim Dahle:
And naturally, the intubation gets difficult at the same time to make it very challenging. It’s a good reminder that medicine is not easy. Luckily the patient did okay. And hopefully, we’ll make it out of the ICU as well.
Dr. Jim Dahle:
And then of course, at the end of it all, the Covid test comes back negative and you realize you did all those precautions that weren’t maybe necessary anyway. But that stress of not knowing which patient comes in at the door and actually has had Covid until you’ve already taken care of them definitely adds some difficulties to our lives these days.
Dr. Jim Dahle:
So, those of you like me who are on the front lines, stay safe, take those precautions. You don’t want to bring this stuff home to your family and thanks for what you do. It’s not easy.
Dr. Jim Dahle:
Our quote of the day today comes from David Swensen, the chief investment officer of the Yale Endowment Portfolio, who said, “Ironically, upon acquiring sufficient information to assess the skill of an investment service provider, individuals end up empowered to take control of their portfolios and make their own decisions”. There’s a lot of truth to that. When you know enough to properly choose an advisor, you often know enough to do it yourself, anyway.
Dr. Jim Dahle:
Lots of things going on with the White Coat Investor right now. We are in the early stages of preparing for another White Coat Investor convention next March. We are taking applications for speakers. If you’d like to be a speaker at WCI con 21, you can sign up at whitecoatinvestor.com/speakerapp. I expect this is going to be at least a somewhat competitive process.
Dr. Jim Dahle:
And so, you got to fill out a few things there and what your talk would be about, et cetera. But I’m looking forward to having a great selection of fantastic speakers and I encourage you to apply.
Dr. Jim Dahle:
We’re also still raising money for the White Coat Investor scholarship. You can donate to that 100% of the proceeds we raise go to students to help them directly reduce their student loan burdens. You can donate at whitecoatinvestor.com/scholarshipdonation.
Dr. Jim Dahle:
We also could use some more judges for that contest. Remember they all submit an essay and we have three rounds of judging. And so, we need a fair number of judges in order to help us choose the winners for that scholarship. We’ve taken our staff out of the process completely. So, we are not judges. We need your help to decide who’s going to win the cash of these prizes.
Dr. Jim Dahle:
Also, thanks to those of you who have been participating in our promotion. We’ve been titling it with the hashtag Live Like a Resident. We’re basically helping you celebrate if you have paid off your student loans. So, as you pay those off, please submit a picture and your story at whitecoatinvestor.com/debtfree. And we will help you celebrate. We’ll publicize this and use your story to inspire others to do the same.
Dr. Jim Dahle:
If you know Peter Kim, the Passive Income MD, you know that he has a real estate course. And the purpose of his course is not to teach you how to do direct real estate, but to teach you how to invest in passive real estate. He teaches you how to evaluate syndications, evaluate private real estate funds. Really know what a fair set of fees is. What a good waterfall is, how to evaluate whether this particular sponsor knows what they’re doing, etc.
Dr. Jim Dahle:
If you’re interested in that course, you can get on the wait list between now and the 31st of this month. So, you can sign up for that at whitecoatinvestor.com/prea – Passive Real Estate Academy, whitecoatinvestor/prea.
Dr. Jim Dahle:
There will be a discount for those who are on the waitlist. They will be offered a discount if they buy the course between the 31st of July and the 2nd of August. Between the 2nd of August and the 9th of August, you can still buy it, but you’ll have to pay full price for it. So that’s the point of getting on the wait list. So, you get an email that allows you to have, I think it was a $200 discount on the course.
Dr. Jim Dahle:
And of course, it comes with a money back guarantee. I think you can get through the first two modules and still get 100% of your money back. So, no risk to you. Try before you buy. Check it out if you’re interested in private real estate investing.
Dr. Jim Dahle:
All right, today, we have a couple of really special guests. I’m sure you’ve been looking forward to hearing from. I’m going to bring them on and introduce them once I get them on.
Dr. Jim Dahle:
Today on the White Coat Investor podcast, we have two very special guests I’d like to introduce. Our first guest is Paul Merriman. He began his career as a stockbroker. He’s the founder of the Merriman Financial Advisory firm. Also, the founder of something he is a little bit more passionate about I think, the Merriman Financial Education Foundation. He’s the author of four investing books, leader of more than a thousand investor workshops, the host of the weekly Sound Investing podcast, a speaker in our most recent online course – The Continuing Financial Education 2020 course. Welcome to the White Coat Investor podcast Paul.
Paul Merriman:
Thank you, Jim. Great to be here.
Dr. Jim Dahle:
Our other guest also probably needs a little introduction for most of my audience. He’s been on before as well. This is Rick Ferri. As you’ll recall, he’s been a marine fighter pilot. Also started his career after that as a stockbroker before founding a low cost advisory firm. He’s also been an adjunct college professor and now an hourly fee consultant. He’s the author of at least seven books, a speaker at WCI con 20, the host of the Bogleheads podcast, the president of the John C. Bogle Financial Literacy center. And I understand a very talented pickleball player.
Rick Ferri:
You got it, man. I’m getting better every day.
Dr. Jim Dahle:
Welcome to the podcast, Rick.
Rick Ferri:
Thank you.
Dr. Jim Dahle:
Together, these two opinion leaders have affected the investing views of literally millions of investors. That’s a scary proposition and a weighty responsibility to think that other people base the decisions they make with their serious money on your opinions. Is that ever scare you to think about how many people listen to you and consider your opinions?
Paul Merriman:
Well, I can tell you if I can start here, Jim, it’s a huge responsibility. And as you know, the challenge we have is that we don’t know the investor. We know about investing. We know about all of the different kinds of mutual funds. But at the end of the day, successful investing is more about what we know inside of us. So, we’re kind of flying blind and that’s the biggest limitation, I think, as a teacher on the internet.
Rick Ferri:
Yeah. I’d have to agree with what Paul says because when we write and when we talk and even presentations like this, we’re sticking to the average investor yet there is no such thing as an average investor. Everybody’s different. So, what we’ll put out is geared towards the middle of the road, but I’ve yet to meet anybody who consistently drives down the middle of the road. So, it really is when you get to strategy, which is different than philosophy, and we can talk about that. Strategy is very personal to each individual. And I think that it’s important to differentiate.
Dr. Jim Dahle:
I think that’s very helpful. So, the first part of this podcast, and I suspect this is going to be broken into two podcasts. I’m just going to warn you right now. Both these gentlemen have plenty to say on these topics. And we have 40 pages of questions from listeners, not all of which we are going to get to today, obviously. But we’re going to try to divide this up so that the first podcast we do here is going to be all about factor investing. And I think we ought to start with a question that was submitted on Twitter from FI Physician, who asked me to ask each of you to define what you mean when you say asset class.
Rick Ferri:
To me, asset classes are very broad. You have stocks which are common equity. You have real estate. You have fixed income assets. And then from there you can divide it into sub-classes such as U.S. stocks versus international stocks. And to me, those subclasses are mutually exclusive. There are no U.S. stocks and international stocks.
Rick Ferri:
And the bond side, you could say treasury bonds versus corporate bonds and mortgages so that you sub asset classes are again mutually exclusive. But to me, asset classes as a whole are very broad – Stocks, bonds, real estate, cash, commodities. And that would be it.
Paul Merriman:
I would drill down beyond what Rick does and also include what I think you would consider a sub asset class, something that like a small cap value. That’s an asset class that there’s a lot of evidence, a lot of research has been done to track its risk and its return.
Paul Merriman:
And so, to me, the S&P 500 is just another asset class that has these characteristics that lead to certain historical returns and certain historical risks. So, I have a bigger list of what I would call asset classes. But at the end of the day, it’s that portfolio that Rick would put together, I would put together, that it doesn’t matter whether they are sub asset classes or they are general asset classes. They are still going to be chosen because of these characteristics that they carry to make it hopefully a more profitable and maybe a less risky portfolio.
Dr. Jim Dahle:
All right. The next thing I want to talk about is let’s just get a definition up front. Let’s start with the definition of total market investing. Let me give this to you, Rick. How would you define total market investing?
Rick Ferri:
Total market investing, if we’re talking about the U.S. stock market is the universe of stocks that is available to the investor. Now, it doesn’t mean all stocks. There are stocks that are not available. Private equity is not available, for example. Some small micro-cap stocks are generally not available. Stocks that Mark Zuckerberg personally holds at Facebook are not available. So, it’s the universe of available investments, available equity investments to anyone, any individual investor would define the total U.S. stock market.
Dr. Jim Dahle:
Okay. And Paul, do you want to define for us the term factor investing, if you will? And maybe distinguish between how that differs from total market investing?
Paul Merriman:
Well, as a matter of fact, the factors are simply, these are groups of equities, let’s say. And these equities have something in common. It could be the size of the company. It could be how growth oriented, how value oriented.
Paul Merriman:
In theory, you’re looking for factors that are going to give us a premium over, let’s say the S&P 500. Or certainly in the beginning the most important factor in terms of the big payoff is going to be the decision to go into the stock market. That is a life changer for investors. And literally a multimillion-dollar decision to use the factor of the market versus the fixed income, even the riskless fixed income, like the treasury bills.
Paul Merriman:
So, when you talk about the total market typically, you talk about a cap weighted index. In other words, each company is going to have a relative value in that index that is based on the side. So, that yes, you’ll have some small companies in the total market, but they are so small in terms of they are multiplying the number of shares, times the price in the market. They hardly have any impact on the return.
Paul Merriman:
As matter of fact, going back to 1928, the return of the S&P 500 is virtually the same as the total market index. And yet the total market index has small cap, small cap value, and all of these other factors, but not enough to make a difference. And so, what some of us are fighting for is in a sense, we want more small cap. We want more value represented in that total market index.
Paul Merriman:
So, we’re lobbying for a different percentage breakout of these different asset classes rather than by capitalization, which means 50 companies, 50 companies are going to drive a big part of what you make as an investor. That’s a big difference from this approach of looking at these factors and breaking the portfolio down into some individual pieces that really are not represented “fairly” in a total market index.
Dr. Jim Dahle:
So, some people look at diversification a couple of different ways, and they say, “Well, the more companies you own, the more diversified you are”. So, the most diversified you can get is to own all of them to invest in the total market, buy a total stock market index fund, for instance, and own all the companies as maximal diversification.
Dr. Jim Dahle:
A factor investor tends to argue that it’s not so much that diversification matters as your diversification between the factors. And I would like to hear from each of you on which of those you feel is more important, as far as diversification goes.
Rick Ferri:
So, I’ll start out. So clearly, as Paul pointed out, your exposure to beta, which is the market is the most important factor that you can invest in. It explains more than 80% of the return of your diversified equity portfolio and your exposure just to the market. And if you’re just buying a total market index fund, it explains everything.
Rick Ferri:
But if you’re going to do factor tilts as well, where you’re going to have value, and you’re going to have momentum and you’re going to have quality and size, small cap and so forth. It’s still explained more than 80% of the return of your portfolio is whether you’re actually investing in stocks or not.
Rick Ferri:
So, that is the number one decision, by far, the overwhelming decision that you make. It is the cake. And what Paul was talking about is the icing on the cake. And sometimes the flavor of the icing on the cake. The cake is whether or not you invest in stock or not.
Paul Merriman:
And I think that the reason that a lot of us are wrestling with this factor question, because the reality is, if all you owned for the rest of your life was the S&P 500, John Bogle would be very proud of you. And he would say, “You know, it’s okay because you’ve got great companies”. You have companies that are financially more secure than some of those companies you’re going to end up with in a portfolio that’s adding some more value and some more small cap.
Paul Merriman:
But at the other end of the spectrum is though there are those of us who see the Holy Grail as figuring out, “How could I help somebody earn an extra one half of 1%?” Because an extra one half of 1% compounded over a lifetime during the accumulation, during the distribution, can be literally over a million dollars for somebody.
Paul Merriman:
And so, if there’s an extra half a percent by balancing the portfolio equally, for example, I have this thing called The Ultimate Buy and Hold strategy. It’s my ultimate buy and hold strategy. It’s not Rick’s, it’s not yours, Jim, but I hope whatever you have, you could say, that’s my ultimate strategy, which is the best I know. But that strategy is built with equal parts of the S&P 500 and large cap value and all of these other factors so that the portfolio is more balanced.
Paul Merriman:
It isn’t dependent upon 10 companies or 50 companies to get us to whatever our goal might be. It’s dependent literally on the 12,000 – 14,000 companies that my wife and I have in our portfolio. So, that’s a very different approach to how you expose yourself to equities.
Dr. Jim Dahle:
So, this concept of tilting towards small and value stocks kind of comes out of research, done by Fama and French published in the 90s, where they went back and looked at basically all the stock market data we have. The best data set goes back to perhaps 1927 to the 90s and of course, it can be extended to today.
Dr. Jim Dahle:
And looking at that, they determined that small stocks and value stocks had higher returns than the overall stock market. So, the question knowing that investing, knowing that finance is not physics, this is not something where we can put it in a lab and test it over and over and over again, we have a limited data set. So, the question is, is factor investing real? Or is it just the product of retrospectively data mining a limited set of data?
Rick Ferri:
We will let you know in about 50 years. It’s hard because the problem is once the data gets published in academia, especially when someone wins a Nobel prize for it, which Eugene Fama did at least part of his research, everybody starts doing it. I mean, in many ways could potentially just dilute away whatever factor benefits there were. We certainly saw a tremendous surge in factor investing in the mid-2000s with ETFs and all kinds of small value factor related ETFs coming out of all different types of factors, the factors Zoo, if you will.
Rick Ferri:
I mean, Robert Arnott came out with the term fundamental indexing. And then there was this term smart beta, which was a great marketing term. It doesn’t mean it’s actually smart. It just means it’s different than beta. And it got very, very crowded. The trade got very crowded.
Rick Ferri:
And ironically, maybe because of this, or maybe not, the factor premiums went away, for a long time. And if you look at the small cap premium and literally hasn’t been there since the first research came out, I believe it was and Paul, you can correct me if it was in the 1980 timeframe, where a lot of the data on the premium of small cap actually was first published. And since that day there hasn’t been a premium. And again, ask me in 50 years, if this is all going to work.
Paul Merriman:
Well, I’m not going to last long. So, I’m going to have to take a stance here that people again will know after I am long gone. Factor investing has never worked the way people thought it would work. That is true in the real time application. And that is also true looking at the historical data that the people like Fama and French looked at it. And let me tell you why I think this is so. I know the way I present it, and I don’t know if Rick does it, but we look back to 1928.
Paul Merriman:
We look at the return of the small and the large and the blend and the value. And what do we see is this very neat relationship, the S&P 500 at 9.9%. The large cap value at 11% compound rate of return. Small cap blend is about 12%. Small cap value is about 13.2%. So, what do we know? We know that if you add those other asset classes, you’re going to make more money than the S&P 500. So, people do it. The problem is they don’t realize how badly factor investing failed, even when it worked.
Paul Merriman:
And the greatest failure of all was a guy who discovered something that today we take it for granted. And that is Lawrence Edgar Smith, the economist who wrote a book in 1924. It was the first book that made the case that stocks paid a premium over bonds. That was not commonly known at least by the public. So, he became a hero. His book was a big seller. And what happened after he became successful, he even, I think he started a mutual fund. It eventually failed because just as he made the case out of this factor, he then calls it factor of the market was better than fixed income, the market failed. And the same thing happened. If you look back at the 1930 through 1949 period, large cap value, fails. If you look at the 1950 through 1974, small cap fails versus large cap and value worked over growth.
Paul Merriman:
If you look at almost any long period, it turns out that all these things we believe about factors on a relatively short period and Rick and I would both agree that 25 years is a short period. I think you would agree, Rick.
Rick Ferri:
Yes.
Paul Merriman:
And yet over 25 years, these things fail. And what do we know about the last 20 years? The S&P 500 made less than long-term government bonds. What’s wrong with that picture? So, the nature of this process is we don’t know whether we will get the premium in the future. The academics believe we will. I believe we will. But I can almost guarantee it’s not going to be the smooth ride that people would like it to be, because it isn’t a science. It isn’t even an art necessarily. It’s unknown. The series of returns that we’re going to get. And that’s the challenge.
Rick Ferri:
Let me quote somebody to just sum up what Paul just said. So, I’m going to quote Paul by the way, I’m letting you know. Paul said to me one time, “We don’t know the future, but we have faith in it”. And I think you’ve just seen that from him. I think there’s a great quote, by the way, I use it all the time.
Paul Merriman:
My mother wanted me be a preacher.
Rick Ferri:
On a dollar bill it says “In God we trust”. Yeah, you better believe it right now.
Dr. Jim Dahle:
So, let’s assume that it is real, that over the long-term going forward, small and value stocks are going to outperform the overall market. And let’s move forward with that assumption. Is this historical outperformance, as well as this performance moving forward, is this a behavior story? Or a risk story? And if both, is there a way to quantify how much of each? And if there’s no way to quantify it, what’s your gut sense for how much of each explains the premium?
Rick Ferri:
First of all, I personally believe it’s a risk story. You’re investing in small cap stocks or investing in value stocks that have low growth, high debt. They’re kind of crummy companies when you look at them, especially like energy stocks right now. So, there’s more risk there. And so therefore, since there’s more risk, there should get a higher return. That’s the value side.
Rick Ferri:
And then on the small side, you’ve got again, smaller companies don’t have the ability to finance like large companies. They pay more money for capital, whether it be equity capital of fixed income capital. If it’s equity capital, then that means you should get a higher rate of return.
Rick Ferri:
So, to me, the story of small cap value is a risk driven story. And the behavioral side of it, where it may have actually happened in the past, perhaps. And it could be happening right now with technology, large technology stocks collecting all the money and leaving small value aside, if you will. It maybe isn’t going to be as strong. Maybe that story isn’t going to be as strong. I mean, we know that the premium tab, and maybe it’s on the behavioral side. I don’t think it’s on the risk side.
Paul Merriman:
Well, I do think that there’s a very important aspect of the timing of the process that could have to do with behavior. I know for example, from 1995 to 1999, that the S&P 500 compounds at 28.5% a year. And when surveyed at that point, people predicted that for the next decade, that the compound rate of return of the S&P 500 would be somewhere between 20% and 30%. Now, I’m thinking about behavior in here. What’s going on here? According to John Bogle, at that point, people through Vanguard were selling the values funds, and going into the growth-oriented funds. This again, sounds like behavior.
Paul Merriman:
So, I think a lot of the money, not all of the money, but I think a lot of the money is going to come just like with dollar cost averaging. If in fact we’re dedicated to rebalancing, taking from the rich and giving to the poor, when prices go up in one part of your portfolio, so is it true that when the stock market is down and I keep putting money in there a hundred dollars and buying more shares of the unwanted companies with the belief that it’s coming back in the future. A lot of that is behavior, and that behavior will drive at least some of what happens to the pricing in terms of the timing.
Paul Merriman:
But the bottom line is that we’re going to fight with people forever trying to convince them to stay the course with whatever reasonable strategy that they will accept today. What I’m seeing is people challenging the value part of the portfolio, both large and small and saying, “Isn’t there something better we could do? Isn’t there something that would look like what just happened and would have been better for me?” And I remind them, there is no risk in the past. We always know what we should have done. And that behavior, the behavior has more with the return that people get out of these factors than what happens to the factors themselves.
Dr. Jim Dahle:
Now, I got a question from somebody on Twitter, calls himself, Bring the Pain. I think it’s an ophthalmologist based on their handle, but this question is for you, Paul. And I think you may have just answered it. He wants to know what your logic is as to why the small cap value premium still exists. And it sounds to me like you think it’s both a behavior explanation, people not wanting to buy those stocks because they’re not the sexy Google and Facebook stocks, as well as the risk issue that Rick illustrated so well.
Paul Merriman:
If we look back at times when the market is under serious negative consideration, people really worried about it. Those out of favor companies could get hit pretty hard. Now, people I’m not surprised people are looking not just because of the technology run, but to the S&P 500 for stability. Not so unlike what happened in 2008 when government bonds went up a lot and corporate bonds went down and in some cases a lot. And that’s because there was a rush to quality. We may be seeing the same rush to quality in the S&P 500.
Paul Merriman:
I remember in the late 90s, I was a terrible investment advisor because for the five years, from 1995 to 1999, our all equity portfolios compounded at about 11% while the S&P 500 was making almost 30%. And people were asking how come we’re paying you 1% to help us make less money than we could have. It’s always “what we could have done”. And what did we hear from the press? The small cap premium has gone. The small cap value premium is gone. It’s a thing of the past. And what happened for the next 20 years? Small cap bland and small cap value way outperformed as did large cap value the S&P 500.
Paul Merriman:
So, I don’t see where the evidence is that it’s dead. It may be resting. But the fact is that I think Rick is right, the built-in premium is about the risks that people are taking. And if you do not get a premium for small companies, why would anybody invest in them? Because that risk we know it’s there. Why does the bank charge me more interest than they do Bill Gates? Because I’m riskier. But you know what? I’ll pay and they’ll make more money off of me, although it will be a very little bit, then they will loaning money to Bill Gates. So, I think that risk premium is going to be there what the academics, when you press them will say, it may be very small, or it may be large. But from 2000 to 2019, it was large.
Rick Ferri:
It wasn’t large from 2010 to 2019. It was very large from 2000 to 2009. And then it fell apart.
Dr. Jim Dahle:
Particularly in the last year.
Rick Ferri:
Yeah, 10 years, actually. But these things are cyclical elements. They go back and forth. If you really look at it, we’re talking about industries. We get all bogged down on value versus growth. I think it really got up, pop open the hood and look at what are you really talking about? You’re really talking about the differences between technology, health care, communications, a heavy weighted U.S. equity market, which are growthier, if you will, industries versus brick and mortar industrials energy materials, which make up a lot of the value side of the equation.
Rick Ferri:
So, to me, when I’m comparing value and growth, I’m really comparing differences in industry weightings. And you could see them even in the industry weightings between U.S. stocks and international stocks. Sometimes we talk about, well, you should be more diversified into different countries by using international stocks. And that’s true, but why? Well, because if you look at the underlying industries, they are value industries. It’s manufacturing, it’s energy, it’s materials, it’s a consumer cyclical stock type industry, and this is what makes up value. And we have here like it or not, we have times when tech and growth do really, really well. And we have times when the other stuff does very, very well tracking in the 1980s, manufacturing and industrials were doing very well and international outperformed the U.S. and value outperform growth.
Rick Ferri:
And the 1990s, it was exactly the opposite. We had technology doing very well with the dot-com bubble and so forth. And lo and behold growth outperform value and U.S. outperformed international. And then in the next 10 years, 2000 to 2010, we had a flip flop again. I mean, technology did very poorly. Communications did poorly, healthcare did not do well, but industrials did well. Manufacturing did well. All the things kind of value did well. And value really outperformed growth and international outperformed U.S.
Rick Ferri:
And then in the last eight years, we had the exact opposite again. We had technology doing very well, communication, which would be Google and by the way, Facebook or communication stocks and not technology stocks, and neither is Amazon, but these things all put together did very well. Healthcare did very well and energy and industrials and materials and commodities did not do well.
Rick Ferri:
So, value underperformed growth. And lo and behold U.S. stocks outperformed international stocks. What’s going to happen over the next 10 years? I don’t know. I mean, if technology doesn’t do well and energy comes back and industrials come back, materials come back, then value will outperform growth again, and international will outperform the U.S. So, this is just what goes back and forth.
Rick Ferri:
So, I tell my clients, you don’t really need to do a whole lot of value investing if you actually have, say a third of your money in international stocks. Because it’s already value investing. It’s a little bit different approach then maybe not the direction you wanted to go here, but it is a way of getting in a sense what Paul is talking about without actually buying a value fund.
Dr. Jim Dahle:
I think there’s a lot of good sense there. I mean, they are different companies. They’re different companies, different industries, different sectors. Particularly when you look at a small value index versus a total market index.
Rick Ferri:
Absolutely. I’m not opposed to doing value investing, but I don’t know if you’d necessarily have to actually buy a value fund to do it, if you’re a global investor. That’s all I’m saying.
Paul Merriman:
I try my best to keep the “do it yourself” investor, that we’re asking them to be calm for the next 40 years or 50 years if they’re actually a real “buy and hold” investor and to have a glide path at some point going to fixed income and all of that. My challenge is, I try to stay away from the story of investing, what’s going on inside of those industries.
Paul Merriman:
I totally agree that if we go back and track all of that, it isn’t just about the outcome of small cap value. It was what was going on with those companies. But the minute that we encourage people to start getting involved in kind of the story of how this all works, it starts to be a little closer to Jim Cramer than I want to come.
Rick Ferri:
Are you accusing me of being Jim Cramer?
Paul Merriman:
No, no. Not at all. Jim Cramer though. But if we just get them to realize it’s just a different way of owning the whole market. It is not weighted to the size of the company. It is weighted to these magnificent historically asset classes that if you own a little bit of each one of them, in our case, it’s 10% each in 10 different asset classes, you’re not calling the next winner. You’re saying that if value is better than growth, I’ve got it. And if growth is better than value, I’ve got it. If big is better than small, et cetera, I’ve got it. And I can quit thinking about what should I be doing next? Just be happy owning the entire market, but in a different way than you do, I think Rick.
Dr. Jim Dahle:
All right. I think we all agree that if you’re going to tilt a portfolio toward factors, it needs to be done for the long-term. How long is the long-term?
Paul Merriman:
Rest of our life.
Rick Ferri:
I’ll agree with that. Okay, I’ll go with you.
Dr. Jim Dahle:
But it’s certainly not 10 years. Or even 20.
Rick Ferri:
It’s a lifelong investment strategy.
Paul Merriman:
When people ask me how I’ve done as an investor, I tell them to contact my wife after I’m dead. Because we don’t know until the last rock is turned over, because who knows what we’re going to run into in the next 15 years? I’d like to just keep doing this as long as John Bogle. He’s kind of my hero in this regard. I want to keep teaching as long as I possibly can.
Paul Merriman:
So, let’s say that is another 10 years, legitimately. 10 years as Rick said, that’s a very short period of time. It’s statistically not meaningful, but try to tell somebody in the family that was parroting the money in that last 10 years, that it wasn’t a meaningful 10 years. Yeah, it was a meaningful 10 years to them, just not to the academics or the market.
Dr. Jim Dahle:
Now the top five largest stocks in the total stock market index right now are Microsoft, Apple, Amazon, Alphabet or Google and Facebook. The FANG stocks, I guess, minus Netflix, which is number 21 right now, these top five stocks, a lot of people would call them tech companies, sounds like Rick would call several of them at least communication companies, but they make up 18% of the market. Well, it’s technically not a tilt. That’s an immense amount of a portfolio to have in just five mega cap growth tech stocks. Isn’t it?
Rick Ferri:
It’s not like we haven’t been here before. I think that if you look back in the history of the U.S. stock market, you’ll see that started out with the railroads were basically the entire market and then banking became the entire market. And then eventually around energy companies. If you look back 50 years ago, energy companies were the entire market. And then Ford and General Motors were the entire market. I mean, so this is not unusual for one industry or a couple of industries and a couple of big companies to become the market.
Rick Ferri:
But despite all of that, as Paul was saying, the S&P 500 still compounded at whatever it was 11% per year. And I don’t know if it’s going to be that way going forward. But despite that this cap weighted index, which has a few big companies in it that overwhelms the index at the moment, still did fine.
Paul Merriman:
By the way, it’s fake news, the S&P return. I mean, I’m sorry. I did. I shared fake news when I said it was 11%. Well, the average 40-year return of the S&P 500 of all 40-year returns is 11%. But since 1950, I think that became the S&P 500 in 1957 and prior to that, all of this work that’s been done is hypothetical mostly by the academic community, as far as I know.
Paul Merriman:
And then when you look at the return of the S&P 500, where the heck is Tesla? I mean, does it really represent our country when we don’t have Tesla in the S&P 500? Well, there’s a way you get on the S&P 500 and they haven’t qualified so far. But here they come, possibly getting on the S&P 500 just in time to hurt the S&P 500.
Paul Merriman:
Now, when I say that I’m not picking on Tesla for a second. But academics have traced the returns of the companies they threw off the S&P 500 compared to what happened to the S&P with that new company coming on, the companies that were thrown off, generally value companies, by the way. Those companies made more money in the long run according to the study I saw then the S&P 500 itself.
Paul Merriman:
So, there’s a lot of things about that index that may not represent the real story. It’s really meant just to be an approximation of what kind of a premium we should get for being in equities. And I’d be curious if I may ask a question of Rick, Jim.
Dr. Jim Dahle:
Yeah, absolutely.
Paul Merriman:
When you talk about an equity’s position, what premium over the risk-free T-bills do you expect that our investors will get?
Rick Ferri:
The S&P 500 is one portion of the U.S. stock market. I generally don’t invest in the S&P 500. I invest in the total stock market, which is all 3,700 stocks. So, that’s number one. I just want to clarify that. So, over T-bills, you’re looking at 5% premium over T-bills for investing in the total stock market. That’s historic. So, today, if T-bills are zero, you’re looking at about a 5% expected risk premium over that.
Paul Merriman:
So, in a sense, the return of the stock market over the last 20 years has not been terrible. It’s been terrible in nominal numbers, but when we risk adjusted, it is not a terrible return.
Rick Ferri:
Well, inflation adjusted. That’s true.
Paul Merriman:
Yes.
Dr. Jim Dahle:
It’s interesting this FANG phenomenon we’ve been seeing in the last five years or so five plus years with these big tech companies. What similarities and differences do you see between this phenomenon and the years with the dot-com boom and bust? And perhaps in my opinion, also with the Nifty-Fifty era of the late 60s and early 70s. Can you compare and contrast our era today with each of those and which one do you think our era is more similar to?
Rick Ferri:
We are nowhere near the dot-com bubble of the late 1990s. That the PEs are not even close to what we were at in the 1990. That was clearly a bubble. And it was not only a few tech companies, it was all tech companies. Even the tech companies that just came public, half-baked companies like eToys and just a whole slew of other ones.
Rick Ferri:
We are nowhere near the valuations that we were at in 1999. Now we’re closer to where the valuations were at with the Nifty-Fifty back in Jerry Seng and that era back in, I guess, you could think it was late the 1960s era. So, I think the valuations of tech stocks got higher, the TRON stocks, so to speak, I think they were called. So, we’re closer to that. We are certainly closer to that than we are to the 1990s.
Paul Merriman:
And I think the lesson for us, if we think of the Nifty-Fifty, and as one of you said that they came around in the late 60s, but they really didn’t become available to the public in terms of a popular thing to do until about, I think, 1972. And that list includes, I think, Sears, and it includes GE and I suspect, I don’t know that General Motors was on that list, but a lot of companies that today haven’t done very well.
Paul Merriman:
And I suspect that will happen again, that a broad diversified portfolio or index like the S &P 500 may do again to the techs today as they did to the Nifty-Fifty. You did better in the S&P 500. You did better in small cap value. You did better in large cap value. You did the better in small cap blend than you did in what was perceived the 50 stocks that everybody could buy and put away in their lockbox and not have to think about it because they were of such great quality and had such great futures. That I think probably is still true today.
Dr. Jim Dahle:
My next question, I think might be a little bit more interesting. I got several questions like this from the listeners and readers on the various forums. Perhaps most concisely said by Vagabond MD on the White Coat Investor forum. He basically said, “Paul, are you still backing up the truck with small cap value? And Rick, when are you going to back up the truck with small cap value?”
Paul Merriman:
Now, wait back up the truck. Let’s define backup the truck. Yeah, I have recommended backing up the truck in an article that is entitled “How to turn $3,000 into $50 million?” Now, in order to turn $3,000 into $50 million, you back up the truck for the newborn child, and you put the $3,000 into small cap value. They’re not going to need it for a while. Then as it grows, and by the way, you don’t have to do it with $3,000. You could do $365 a year for 21 years, the same outcome.
Paul Merriman:
Is it possible that the S&P 500 will get 10% over the next 100 years? Is it possible that small cap value would get a premium and make 12%? I don’t know either one, but I do know this. That $3,000 growing up until that child, let’s say is 21 and you start using the proceeds to be put into an IRA, a Roth IRA, and you just let it go until they reach retirement, it could literally turn into $20 million in income. And at age 95, a $30 million gift to the rest of the family. All it takes is a 12% compound rate of return. Would I back up the truck and fill it up with small cap value for that newborn child? You bet I would. I think it’s an okay thing to do. I encourage the grandparents to do that.
Paul Merriman:
I have backed up the truck for our own portfolio. We are half in small. Half of that is in small cap value. We are half in large. We are half in U.S. We’re half in international. We don’t play any favorites. We just like to believe that the team players are working for us for the long term. By the way, I’m also half in fixed income, but I’m 76 years old. So, yeah, we’re still backing up the truck.
Dr. Jim Dahle:
Let me give a follow up question to Paul, before we turn to Rick. You’ve been steadfast as a small and value tilt there for a long time. However, due to terrible small and value performance, particularly in the last year, a tilted portfolio has now underperformed a total market portfolio for something like 27 years, back to the time that Fama and French first published widely on the topic. Has that given you any hesitation whatsoever on recommending this strategy? And if not, is there a time period over which you would say I was wrong about small and value tilting a portfolio is a bad idea?
Paul Merriman:
When Eugene Fama was approached and asked the question, “Do you realize that your small cap blend asset class has underperformed large cap blend?” his response was “You’re not very patient. Are you?” As a matter of fact, when I talked to my university students, I encourage them. I hope that the first 10 years they invest that whatever they invest in, as long as it’s an index that has a history of doing well, I hope it goes down. I don’t like it going down quite honestly, because I’m in the last years of my life. But for the young people who are dollar cost averaging into a 401(k) plan, I am not worried for the long-term. The small cap value asset class underperforms the S&P 500 going back to 1928. When I say underperforms, that difference in return sometimes better, sometimes worse, is 15% a year. It is not unusual for it to underperform the total market. That is not unusual.
Paul Merriman:
What we don’t know and none of us do is what the future will bring. I think there are people today who are now considering investing in international markets. And I’m not making this in a political way, I’m just saying that there are people who were saying, “Hey, you know something? It may be that other countries are going to learn how to deal with the problems of the future and be as successful as the U.S”. And so, they are expanding into internationals. We’re already there. I have not been hurt by small cap value nearly as much as I have by my position in international securities.
Dr. Jim Dahle:
Rick, let me turn to you for a minute. More and more each year there’s this sense among Bogleheads, among others that listen to you and read your works, that you’ve been backing away a little bit from small and value tilting is a great strategy for investors and leaning more toward a total market or a three-fund type portfolio. Why is that? What has changed besides recent performance?
Dr. Jim Dahle:
And I’ll give you an example of one of the people asking this, Life Soft. Live Soft, the most prominent poster on the Bogleheads forum says “Small cap value tilting seems to be a dead horse. Mr. Ferry has gotten off that horse, but Mr. Merriman has not. When should one get off a dead horse and why?” Just as an example of somebody wondering this, feeling like your position is maybe changed, or you’ve emphasized it a little bit differently. What would you say to that? I don’t know if criticism is the right word, but a sense that your recommendations have changed over the last decade.
Rick Ferri:
Okay. So, I had this portfolio called the Core Four portfolio that goes back 12 years or something. There’s no small cap value in it. It’s just the total U.S. stock market, total international stock market, a small slice of real estate and a total bond market. And I think you might be familiar with the Core Four concept. It goes back probably to 2009 or somewhere around there.
Rick Ferri:
But I’ve never been a strong advocate of factor tilting. I wrote about it in my books, and I showed that statistically, if you had about a 30% of your U.S. equity portfolio, just as your U.S. equity portfolio, if you had 70% in the total market and 30% in small cap value. So, 70/30 mix. That it is historically gave you a higher return risk adjusted than the stock market.
Rick Ferri:
So, in other words, actually you had the same risk as the stock market, but a higher return. So, I have that in the book. But I’ve never been up. I’ve never gone actually with the clients that I’ve ever managed money for. I never went above with their U.S. equity portfolio. I never went above 25% in a small cap value. I’m not saying you shouldn’t do that.
Rick Ferri:
But what I keep saying all along about small cap value is number one, it has to be something you’re going to be in for 25 years. Your lifetime basically. So, you can’t be a flash in the pants. And what happened after 2009 or so, during this heyday of small cap value with a VAP returns, a small cap value from 2000 to 2009, I believe were the highest they had ever been. I mean, huge returns of small cap value versus large cap growth during that decade.
Rick Ferri:
And then all of these products, of course coming out, small cap value, fundamental indexing, as I talked about before, anything at all that were any excuse whatsoever to launch a fund that basically tilted to small cap value, I became a little, well, you know what? I mean maybe I’m not as hot on it as I used to be now that everybody has decided they’re going to be hot on this. Maybe now’s a good time for me to just sort of back down from not being as aggressive.
Rick Ferri:
I was never really aggressive, but it just… Look, I mean, in the end, 90% of your return is based on your equity to fixed income exposure. And this idea of factor investing, small cap value investing is simply the icing on the cake and sometimes it’s the flavor of the icing on the cake. Sometimes it’s the sprinkles on top of the icing. It is not the cake.
Rick Ferri:
So, in trying to keep things very simple for investing for investors, you have to decide how much they would have in equity. How much are you going to have in fixed income? How much are you going to keep aside in cash? And then maybe slice the equity between international and U.S. And after that, it’s really the icing on the cake. If you want a little bit of small cap value, that’s fine. We’ll put as a small cap value in there.
Rick Ferri:
Do you want some real estate in there to boost up your real estate a little bit, because real estate is a big portion of the economy? That’s fine, we can put a little portion of real estate in there as well. But don’t focus on it. Focus on the cake, don’t focus on the frosting or the candles, or all the little decorations or all the sprinkles. And that’s what all this is. And that’s the best explanation I can give you.
Dr. Jim Dahle:
All right. So, we’re going to cut this podcast off right there. This conversation I had with Paul and Rick went two hours and 10 minutes. So, there’s no way I’m going to force all of this into one podcast. It’s going to be too long podcast as what it’s going to end up being. But we’re going to continue this conversation next week.
Dr. Jim Dahle:
Not only are we going to talk more about small cap value and other factor investments, but we’re also going to take some, non-factor investing related questions that you guys submitted on our various social media channels like the Facebook group and the subreddit and the various forums. And so, we’ll get into that next week as well. So, expect that coming soon.
Dr. Jim Dahle:
I do want to thank today’s sponsor Guideline. There are a 401(k) provider on a mission to help people save as much as possible when saving for retirement. Their investment portfolios contain low cost Vanguard funds, which are automatically rebalanced to keep it diversified and on track for retirement. And the best part, there’s no added AUM fees, which would typically take a chunk out of your retirement savings year after year after year. Check them out at guideline.com/wci.
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Dr. Jim Dahle:
I also mentioned at the beginning of the podcast, Peter Kim, the Passive Income MD. His course is opening up again soon. Get on the waiting list, whitecoatinvestor.com/prea. If you’re on that list, you will get an email offering a discount for the course. It’s about a $200 discount, so it’s not insignificant, but you need to sign up right away. I think the waiting list ends tomorrow.
Dr. Jim Dahle:
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Dr. Jim Dahle:
Keep your head up your shoulders back. You’ve got this and we can help. Stay safe out there. See you next time on the White Coat Investor podcast.
Disclaimer:
My dad, your host, Dr. Dahle, is a practicing emergency physician, blogger, author, and podcaster. He’s not a licensed accountant, attorney or financial advisor. So, this podcast is for your entertainment and information only and should not be considered official personalized financial advice.
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