Podcast #170 Show Notes: Rick Ferri vs Paul Merriman Part 2

This is part 2 of the lively debate between Rick Ferri and Paul Merriman, where we continue the discussion on the pros and cons of factor investing. They both are just a wealth of information and experience, plus their humility makes it all the more impressive how much you can learn from them. It is fun to have a little bit of back and forth between them as they talk to each other about how they really feel about tilting your portfolio. We also delve into the 40 pages of questions that you sent in to ask these men, talking about investing in gold, what to do about low bond returns, preferred stocks, and what they would do differently in their investing career if they could go back and do it again.

COVID has sent your finances into a tailspin. However, there is a silver lining to the pandemic. It’s an amazing opportunity to take advantage of the change in your income or to start that new practice through PROACTIVE tax planning. As the spouse of a physician, Alexis Gallati has over 18 years of experience using the tax code to her advantage to keep more of what you earn. She began Cerebral to help docs have a clear path to success through tax efficiency while eliminating surprises.  Her services are flat rate and she will show you the return on investment before you invest in Cerebral’s services.  If you’d like to find out more, visit Cerebral Tax Advisors or check out Alexis’ new book: “Advanced Tax Planning for Medical Professionals” on Amazon. 

Quote of the Day

Our quote of the day today comes from David Swenson who said,

“Over the past decade index funds beat the results of 80 percent of mutual funds….After adjusting the comparison of index funds to actively managed funds for survivorship bias, taxes, and loads, the dominance of index funds reaches insurmountable proportions.”

Rick Ferri versus Paul Merriman Part 2

Changing Asset Allocation

Now all three of us are fairly die-hard buy and hold types. Paul has his ultimate buy and hold portfolio. Rick has certainly drummed on a buy and hold approach for years and years. I feel the same way. But a listener asks, “is there any market condition, valuation level, or metric that would ever cause a change in asset allocation?”

Paul feels that when you set up a portfolio, you’re supposed to build into it the worst loss. To limit that loss, to whatever level that is, you have to put in the right amount of fixed income. Then you get out of the business of trying to second guess the market.

“I’m just trying to discourage people from second guessing. But human nature is we all love a story that scares us. So, that’s a challenge for people. I have lived all of my life afraid that right around the corner is a catastrophic event. One of the reasons I have an advisor who takes care of our investments is because I don’t even want to think about that catastrophic event. I still worry about it. It’s still about to happen around the corner, but it has nothing to do with how my money is managed. And that’s a real challenge.”

Three Fund Portfolio

Another listener asks, “What type of investor is a three-fund portfolio not the best option for? Is there some income or ability to stay the course, or investment horizon, or willingness to deal with complexity, or risk tolerance? Is there some characteristic there that identifies an investor for whom a three or four fund portfolio is not the best option?” Rick said,

“There is a lot of people who come to me with existing portfolios that have a lot of investments in their taxable accounts, that have low tax basis. And you can’t just sell everything because that would be imprudent. Somebody realizing hundreds of thousands of dollars in capital gains and paying 20%, plus the 3.8% Obamacare tax on top. That’s not what you need to do. You would need to handle that much differently. And if somebody has all of their money in a taxable account, the bond portion wouldn’t be a total bond market fund because they’re probably, if they are in a high tax bracket, they would probably use a municipal bond fund.”

Rick points out that strategy is different than philosophy. Philosophically, the three-fund portfolio sounds wonderful for everyone. But when you start working with individual investors, very rarely do you end up with a three-fund portfolio because of their unique situation. Strategy is personal. In addition, some retirement plans don’t even give the option of using index funds. So you have to work around that and try to do the best you can.

“Philosophically, sure. Three fund portfolio makes a lot of sense. Strategy, what you actually do, it’s usually different than that.”

Vanguard Total Stock Market Index Fund

Taylor Larimore asks Paul if he still doesn’t like the Vanguard total stock market index fund. Paul assures us it isn’t about Vanguard. He is a big fan of target date funds. But there are things about them he doesn’t like.

“I’ve made the point that for people who want one fund for the rest of their life, that a target date fund is an amazing product. And there’s some evidence that just came out this year out of Wharton that shows that people at Vanguard, they looked at 1.2 million accounts at Vanguard in 401(k)s. 880 different 401(k) plans. Those people who have a hundred percent in target date funds made 2.7% a year better returns than the people in those plans that didn’t have any target date funds. Those people who had some target date funds made 1.7% better than those that didn’t have any. So, as far as I’m concerned, for probably 99%, maybe it’s 95%, of the people that we’re going to run into that we want them to put money away on a regular basis, I would heartily recommend a target date fund.”

He doesn’t like that the Vanguard fund has 10% in fixed income for a 21-year-old. He feels that 21-year-old is giving up a half of 1%. That’s what the cost of a 10% position in bonds is. A half of a percent for the first 20 years of their investing life. He doesn’t approve of that. John Bogle told him they are just trying to get people to understand that you should have stocks and bonds. It is more important to Vanguard that they have them get the feel of what that kind of a fund is like. He disagrees with that, thinking education would be a really great way to convince people you don’t want 10% in fixed income.

The target date funds also have the same equity asset classes for a 21-year-old as they do a 91-year-old. It is a different percentage, but, even so, he thinks the 21 year old should have a more aggressive portfolio. But the target date funds don’t have small cap value. Inside the total market index fund there is so little small cap value.

“We have the two funds for life strategy where we show people how to put 10% of your money in small cap value and 90% of your money into the target date fund. That small addition that was cap value based in the past is about a 30% higher return at the end of 40 years. Not a small difference in what you’re going to have to live on and what you’re going to leave to others.”

DFA and AQR

A listener asks, “How has the underperformance of factor investing over the last decade or so affected companies such as DFA and AQR?”

Rick thought the DFA has lost some assets recently because advisors are moving towards ETFs, and that is probably why DFA has decided they finally want to launch ETFs. But also,

“obviously if you’re a small cap value manager and you hang your hat on small cap value factor investing, your performance hasn’t kept up with the total market. So, you may not have collected as much assets as you would have liked to collect. But I don’t think it’s the quality of what they’ve done. I don’t think the way DFA does small value is bad. It’s just as good as anybody else. Same thing with AQR. They all have different ways of doing value. I call it ‘the value is in the eye of the beholder,’ which means there’s a zillion different ways of slicing and dicing the market to come up with what your version of a value is and then creating an index.”

He thinks the problem is more of a behavioral aspect. Maybe people have given up on small cap value and pulled money out, plus being slow to get into the ETF space. They have to do that in order to stay competitive. Rick didn’t think it was their methodologies that are driving any of these assets away.

Paul points out that they had a time when they were on the top of the world in this business. From 2000-2007, they gained huge amounts of assets under management. He is sure they knew they were going to have their time in the barrel because that is the nature of this kind of investing.

“So, I think DFA got real lucky that they got that run in the early part of 2000 through 2002. Now they’re paying the price. But it’s the same smart people running the business for the long-term, which is what we all want to be assured, that people aren’t changing their strategies too much so that we get to stay the course for what we signed up for.”

Rick said if you want to buy a value fund, you would buy the absolute worst performing value methodology that you could possibly find that was created by a very smart academic. Why? Because that is the most out of favor value strategy that there is. And if value does come back, theoretically this would come back the most.

Ranking Factors

We talked a lot about small and value factors. I asked if they had to rank these factors from best to worst, how would they rank the following factors? Small, value, momentum, low volatility, quality, and liquidity.

Paul asked Chris Patterson, who created the list of best in class ETFs for people who visit their site, to share his opinion. Read his detailed response as well as see graphs and charts with more details.  He said that he prioritizes efficient access to the market, value, and size factors in that order, then looks for funds that also give exposure to profitability/quality, momentum, and even low-volatility where possible.  The reason for that order is availability and efficiency.

“So, which factors do I think are most important?  For equities, I prioritize efficient access to the market, value, and size factors in that order, then look for funds that also give exposure to profitability and momentum where possible.  In a sense, profitability/quality, momentum, and even low-volatility become tie-breakers.”

Rick thought that book or enterprise value would be number one. Then number two is quality, the quality of the company’s earnings. He thinks you should come up with the value stocks and the quality stocks together. Then there’s an overlay on top of that from momentum.

“This is very similar to the way DFA does it. So, they have their value screens, their quality screens. They come together with their list, but they don’t buy the stocks or put them into their fund until they hit the momentum screen and then they purchase them. So, momentum can be used along with value and quality. If you try to do momentum separate from value and quality, you end up, in many ways, canceling things out. Because momentum stocks right now are all large cap tech stocks or large cap growth stocks. They are the ones that have all the momentum right now. So, you’d be buying those stocks and canceling out your value and your quality. Maybe not quality, but your value screens.”

Rick points out there are a lot of different ways in which you can do this. “If you’re going to do value and quality, find your companies, find your universe that you want to select from, but don’t actually include it in your portfolio until they hit the momentum screen. Meaning the stock prices have started to move up. And then add them. And that makes a lot of sense. And that’s the way that dimensional fund advisors do it.”

Has it helped? If your quality and your value methodologies are underperforming other quality and momentum strategies, then it doesn’t really help that much, but in the long-term it might help, according to Rick.

Vanguard Factor ETFs

Vanguard has come out with six factor funds or ETFs in 2018. What are their thoughts on those ETFs?

Rick thinks Vanguard does things well, and if you’re going to buy one multifactor fund, if you use the Vanguard multifactor fund, you would just do fine.

Paul said they do an analysis once every two years for the best in class. Those funds are put in amongst all the other commission free ETFs that are available at Vanguard. They go through the series of tests to qualify as best in class. If they make it, they’re on the list. If they don’t, then they have to wait another two years to look at them again. The Vanguard factor ETFs are part of the list that they consider when they put together that best in class.

Small Growth Stocks

Small growth has long been considered the black hole of investing. The place where you put your money to never see it again. But it has been great the last decade, at least compared to small and large value. Were we wrong about small growth? Was it just that it hadn’t seen its time in the sun yet, or is there really something bad about small growth that it should still be avoided?

Rick said he doesn’t avoid it because he buys a total stock market index fund and a total international index one, which has everything in it, including small growth.

“I was aware that small growth historically has been the black sheep of the stock market, but I guess I look at it the same way I look at small value. It has had it’s day in the sun, as you said. Will it continue? I don’t know. I try not to take those risks. I don’t think it’s necessary to take those risks. I just buy a total stock market fund and own everything and not try to figure a lot of this stuff out.”

Bailing on Tilting Your Portfolio

I gave them a situation where an investor has been investing for 10 plus years with a small value tilt and they are thinking about bailing out on it. How would they counsel them now?

Rick said he would tell them to absolutely not bail out on it. You have already taken the risk. You’ve already had the underperformance. It’s like taking all the risk and getting none of the benefit from it. You are guaranteed you’re going to underperform if you bail on this. You have to stay with it for 25 years.

Paul said,

“That is, in essence, a form of market timing, what we call the ICSIA strategy – I Can’t Stand it Anymore. And that’s a bad way to make a decision, at least based on the past. I’m not recommending that people put all their money in small cap value. Something is going to fail. It could be small cap value. It could be large cap value. It could be the internationals. That’s the reason you have a diversified portfolio. It’s just a different way of trying to get the premiums for risk that we have available to us. And I don’t think you should change it if you’re comfortable with the downside risk of your portfolio in total.”

Don’t market time. You are in it for the duration 20-25 years. Don’t jump out. Rick said,

“Again, for the new investor, you don’t need this stuff. It’s unnecessary. 90% of your return is the allocation you have between stocks and bonds. That’s 90% of your return. This other stuff is just potentially higher return, but makes the portfolio much more complicated and more decisions have to be made. And for most people, I don’t recommend they go down that path unless they want to, unless they are very much into it and they understand it and they want to go down the path for the very long-term.”

What % in Small Cap Value

A listener asks Paul, “What percentage portfolio would you recommend go into small cap value for a young physician?

He said if they want to be relatively conservative with a few funds, he’d recommend simply 25% each S&P 500, large cap value, small cap blend, and small cap value. They have tested that going back to 1928 to see how those four asset classes perform and that would be an easy way to access U.S. Or you can do two of them international and two of them U.S. But they are still large blend, large value, small blend and small value.

“But if they want simple, simple, easy to do, I’d recommend looking at the two funds for life. And the two funds are small cap value and the target date fund at Vanguard. The formula for how much in small cap value is 1.5 times your age would be how much you put into the target date fund and the balance goes into small cap value. Too aggressive? okay, use large cap value. If you want to be a little more aggressive, okay. Divided up between large cap value and small cap value. They are very simple strategies to maintain. They automatically reduce exposure to risk, as they get closer and closer to retirement, just like a target date fund does. So, there are some simple things to do that would get you with enough small cap value in your portfolio to make a difference.”

Rick said technically or mathematically that could be correct; if they style-weighted this and they style-weighted that, they might come out ahead before fees. Who knows if they’re going to come out ahead after fees? He is concerned about the complexity. It is a very high probability you’re going to underperform because complexity is a cost. Simplicity is an alpha.

“If you have a simple portfolio, total stock market index fund, it’s very simple. You don’t have to do a thing. You put your money in it. It’s done. You’re done. You don’t have to do anything. If you’ve got all these little, this portfolio over here, you’ve got to adjust it this way, and this one here, you got to adjust it that way. And this one over here, you just adjust it that way. Pretty soon, it’s done. It’s too complicated, too difficult. And it’s not going to last. And people are going to bail at the wrong time. And the net result is going to be underperformance. That’s my real belief.”

At this point in the discussion, they agree that simplicity is better. Paul really pushes the target date funds for simplicity and adding a fourth leg by giving some exposure to small cap value. That is not that much more complicated than having three funds in the portfolio.

A listener asks what is the best small cap Vanguard fund. Paul said SLYV, available without commission at Vanguard. On the international for small value maybe Avantis funds or DLS wisdom tree.

Overweighting FAANG Stocks

What would you tell someone who’s coming in now saying I actually want to overweight the FAANG stocks, these large mega cap growth stocks? What would you tell that person if they came to you and asked your advice, thinking about implementing that strategy?

Paul said it sounds like market timing. You are getting most of that through the S&P 500 or total stock market ETF. Rick pointed out that technology is 23.3%. Remember technology does not include Google or Facebook. Those are telecom stocks, which make up most of the telecom market, which was another 10%. Then if you add Amazon to that, which is neither technology nor communications, but consumer defensive, then that actually adds another 3%. So the U.S. market is 40% large cap tech. In addition, there is the 15% healthcare, so now you’re up to 55% in those two kinds of sectors. The U.S. market is very heavily weighted to what we do really well.  It doesn’t mean that we don’t still use all the other stuff that we import. Therefore, you should have international stocks in your portfolio because you are using all that stuff we import and supporting those other industries.

Rick does not think you need more technology, more communications than what you already have in a total stock market. He would discourage someone from chasing the big tech stocks right now and really all the time.

Current Fed Policy

What are their thoughts on the current fed’s unlimited quantitative easing strategy and its implications on the future?

Rick points out that it isn’t just in the U.S.; central banks all over the world are buying treasury bonds, mortgages, corporate bonds, corporate bonds ETFs and fallen angel bonds.

“The fed is actually going straight out and buying those bonds directly, new issues from these companies. This is unprecedented, uncharted territory. It is driving down all interest rates to levels that have never been seen before. The five-year treasury is 0.3 corporate bonds. Investment grade corporate bonds are below 2%. Short term investment grade corporate bonds are at 1.2%.

Now the fed is targeting a 2% inflation rate. That’s what they’re targeting. I don’t know if they’re going to get there very quickly, but that’s what they’re targeting. And corporate bonds are yielding below that. So, the real return to an investor anywhere in the investment grade bond market,  is below the inflation rate or the targeted inflation rate. And that’s before taxes.

We are at a negative yield, a negative return, in this environment that has been created by the federal reserve. I mean, whether it’s justified or not, this is where we are. And all of this money that’s going into buying these bonds is forcing investors out of these bonds.”

Where does the money go? Into a money market account initially but it has to go somewhere. As Rick says, these pension funds are guaranteeing their investors make 7% return when the 10-year treasury bonds are only yielding 0.6. How do you get there? You have to be in equities.

“Well, that’s driving money into the equity markets, which is driving up valuations. Now, if you’re going to go into the equity markets, do you want to buy the airline stocks? Which, who knows when they’re ever going to come back. Do you want to buy the energy stocks? I mean, who knows when the price of a barrel of oil is going to get over $60 again? I mean, we just don’t know. But we do know that people are using more Facebook. People are using more Google. People are using more Microsoft products and everything because they’re working from home and so forth. So, the earning stream or the visibility of the earnings growth for those companies, those FAANG companies are there. More money is going into stocks because it can’t go anywhere else.

So, this money is going into equity and then it’s looking for earnings growth. And where do you find earnings growth? Well, Microsoft, Google, Facebook. This is where the earnings growth is. This just keeps piling in. And how long can it go on for? A long time, according to Jerome Powell. They are going to be accommodative for quite a long time. And they’re also going to start trying to target the yield curve. So not only are they working on the short-term part of the yield, but they are working on the long-term part. They’re going to keep interest rates way down for a long period of time. We’re using a lot of money to do it. There’s just nowhere to go except equity. It’s just going to drive up values.”

Should an investor do anything about it? He isn’t sure you can do anything about it. Unfortunately, you still have to rebalance. When the market goes up, you still have to take some money out and put it over in bonds. It doesn’t feel right. I mean, why would you want to put money in something that has a negative return, but it’s better than what might happen at the end of this whole thing. When the federal reserve starts to tighten, everybody’s going to rush for the door at the same time, and there could be a calamity in the stock market.

These are all probabilities, but you need to be diversified.

Allocation of Gold in Your Portfolio

Would they recommend allocating a portion of gold in your portfolio considering all the money printing and risk of increasing inflation? I love Rick’s answer.

“I don’t have any gold in my portfolio. 37 years ago, the best investment I ever made was gold.  I bought two gold wedding rings and it has yielded me a wonderful 37-year relationship, three children. So far eight grandchildren. I can’t do any better than that in gold. So that’s my gold story.”

 

Recommended Bond Alternatives – Preferred Stocks

With low bond returns and even the possibility of negative treasury yields like other countries have had, are there other recommended bond alternatives for a mid-career high-income position for the safe income portion of their allocation?

Paul doesn’t have a solution and is hesitant to push people toward alternative investments that don’t end well. He continues to own tax exempt bonds. For a young physician, they are probably better off in equities. You can certainly see why people are starting to talk about putting their money in their small business or buy a rental property down the street or go load up on gold.  If I’m not going to make any real return in bonds, why not pick something that at least historically has kept up with inflation?

Rick says if you can find a duplex down the street with a cap rate of 8%, that is a good investment. But he also brings up preferred stocks.

“A lot of preferred stock is issued by banks. These are federally insured banks that cannot issue bonds because if they issued bonds, they would break their covenants and they would have too much debt on their books. So, they can’t issue bonds. They don’t want to issue stock, diluting their shareholder value by issuing stock. But they still need capital to function.

So, there’s this thing in the middle and it’s called preferred stock where, it’s not a bond, it’s actual equity, but it’s a high dividend yielding equity that might yield 6%. It’s not a tax deduction to the company. But in order for that company to pay that 6% dividend yield, they have to have earnings to do it, obviously. If they would have to not pay that dividend, they would have to cut out the dividend on the common stock, and banks are highly regulated. The fed is watching all of this.

So, they’re going to be very careful with their balance sheets to make sure they’re going to be able to pay their dividends on their common stock. They’re going to pay the dividends on the preferred stock. It’s a more volatile play, but there are some index funds that you can buy. Preferred stock index funds.”

He owns PFF  and there is also PFFD. These are index funds with preferred stocks, which are mainly made up of a banking preferrers. They’ll give you 5.5 percent dividend yield, but they are stock. So, they do go up and down somewhat with stocks, but not as much as common stocks. They are more like a long-term corporate bond.

He owns about 20% of his fixed income allocation as preferred stocks. A lot of people don’t like them. They are very controversial. And you are still in equity with that volatility. Rick said,

“Is it a great solution? No. Does it replace bonds? Certainly not because they’re not safe. But it does give you the prospect of a return without getting the interest income from bonds and without getting growth from stocks, these high dividend yielding investments. And REITs, by the way, are another one. Real estate investment trust index funds, which might pay you 4%. The same idea.”

What Would They Do Different?

What would they do differently if they were just getting into investing today?

Paul said he was a very conservative investor. If he had to do it oveer again he would be more aggressive and invest more in equities in the market.

Rick said,

“Someone asked Warren Buffett a few years ago, “What advice he would give to the trustees who are going to take over managing his portfolio, his money for his family when he dies?” And Buffett, and he reiterated recently, that’s easy. I’ve told them to put 90% of the money in an S&P 500 index fund and 10% in short term treasury bonds, basically for expenses.”

He feels like the simplicity of that is really genius. If he had invested his money for 35 years, 90% in an S&P 500 fund and 10% in treasury bonds, he would have a lot more money today. There is nothing that makes him think the next 35 years will be any different.

Ending

So great to have these two giants in the industry on the podcast. I hope you enjoyed the last two episodes. If you did, can you leave a review at Apple Podcasts and share the podcast with your friends and colleagues?

Full Transcription

Transcription – WCI – 170

Intro:
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 170 – Rick Ferri versus Paul Merriman part 2. Covid has sent your finances into a tailspin. However, there is a silver lining to the pandemic. It’s an amazing opportunity to take advantage of the change in your income, or to start that new practice through proactive tax planning.
Dr. Jim Dahle:
As a spouse of a physician, Alexis Gallati has over 18 years of experience using the tax code to her advantage to keep more of what you earn. She began cerebral to help docs have a clear path to success through tax efficiency while eliminating surprises.
Dr. Jim Dahle:
Her services are flat rate and she will show you the return on investment before you invest in cerebral services. If you’d like to find out more visit www.cerebraltaxadvisers.com or check out Alexis’s new book, “Advanced Tax Planning for Medical Professionals” on Amazon.
Dr. Jim Dahle:
Our quote of the day today comes from David Swenson like last week, who said, “Over the past decade index funds beat the results of 80% of mutual funds. After adjusting the comparison of index funds to actively managed funds for survivorship bias, taxes and loads, the dominance of index funds reaches insurmountable proportions”.

Dr. Jim Dahle:
Thanks so much for what you do. It turns out your work is not that easy. I was in the ER last night and had to set a fracture, fairly simple forearm fracture. But no matter what I did, I couldn’t get the reduction to stay. And so, I was glad to be able to call up an orthopedic surgeon and say, “You know what? This one’s going to have to go to the OR with you”. And to have them understand that, “Hey, some things just can’t be fixed in the ER”.

Dr. Jim Dahle:
And I’m grateful for that doc for going through orthopedic surgery residency so he could help my patient and help her get back to full function. And I know what you do is just as important on a daily basis. So, thank you for that.
Dr. Jim Dahle:
Thank you for those of you who are on the front lines of this Covid pandemic. Because it seems to be ramping up throughout the South and the West of the United States. We’re certainly feeling it here in Utah. And I’m sure you are where you are at as well.
Dr. Jim Dahle:
A few things I want you to be aware of before we get back into the interview, which is going to be a continuation of last weeks. I want to make sure you’re aware that we are recruiting speakers for WCI con 21. We’re hopeful it’s still going to go off next March. Obviously, we may end up having to push that back a little bit, but we need to get speakers lined up either way, whether we push it back or hold it in March.
Dr. Jim Dahle:
And so, if you are interested in doing that, you can apply at whitecoatinvestor.com/speakerapp. A-P-P like application. We also need people to judge the White Coat Investor scholarship that’s generally done in September. We don’t charge you to do that, but neither do we pay you.
Dr. Jim Dahle:
If you’re interested in doing that, send an email to [email protected] include the word “Judge” or “Volunteer judge” in the title of the email. And we’ll get you involved in that as well. If you’d like to donate to the scholarship, Katie and I are matching every donation made by readers and listeners this year up to a total of $50,000. So, you can donate at whitecoatinvestor.com/scholarship donation.
Dr. Jim Dahle:
And then, of course, thanks to those of you who have been participating in our ongoing social media promotion. For those who have paid off their student loan debts, you can submit your picture and your story at whitecoatinvestor.com/debtfree. And we’ll help you celebrate your journey to becoming debt free and paying off those student loans. It’s really wonderful to see what people have accomplished in such short time periods by really concentrating on those debts. So, we encourage you to participate as well.
Dr. Jim Dahle:
Passive Income MD, their course is still on sale for a few more days. It will be on sale until the 9th of August. This is the course that helps you if you are interested in private real estate investments. If you want to know how to evaluate a syndicator, how to evaluate a private real estate fund, understand what all the terms mean in the PPMS that they send out to accredited investors that are interested in investing in these things. This course will help you do that.
Dr. Jim Dahle:
You can sign up at whitecoatinvestor.com/prea for Passive Real Estate Academy course. That’s whitecoatinvestor.com/prea. And like all the courses we put on here, there is a money back guarantee. You can try it before you buy it without being out any money. If you’re interested in that subject, this course is for you. I highly recommend it. Check it out.
Dr. Jim Dahle:
All right, let’s get back into this interview with Paul Merriman and Rick Ferri. I actually recorded the whole thing in one push. I’m just making you listen to it over the course of two episodes. But we’ve been talking about factor investing. You know, things like small and value and momentum and how they can, should, or maybe should not be incorporated into a portfolio.
Dr. Jim Dahle:
It’s been fun having a little bit of back and forth between Rick and Paul. And I think toward the end of this interview is where we really see the claws come out and then talk to each other a little bit about how they really feel about tilting your portfolio to small and value. So, let’s take a listen to that.
Dr. Jim Dahle:
Let’s turn the page a little bit here and take a question from the Facebook group from Josh McKinney. Now we’re all fairly die-hard buy and hold types. Paul, you’ve got your ultimate buy and hold portfolio. Rick, you’ve certainly drummed on a buy and hold approach for years and years and years. And I feel the same way. But he asks, is there any market condition, valuation level or metric that would ever cause a change in asset allocation?

Paul Merriman:
Well, as far as I’m concerned, when you set up a portfolio, you’re supposed to build into it the worst loss. And to limit that loss to whatever level that is, you got to put in the right amount of fixed income. And then you have to get out of the business of trying to second guess the market. We all know that those of us who’ve been around the business, people who are still waiting to get back into the market since 2008.
Paul Merriman:
And in some cases, they’re busting their buttons because they’re in cash. Yeah. Well, they’ve been in cash since 2008. And so, there’s an emotional aspect here about wanting to do the right thing. As you know Jim, I do believe in market timing, but I do not believe that individuals should market time. There’s a big difference. Because what I see with people who try to market time is they have done more damage over their lifetime then by simply buying and holding.
Paul Merriman:
So, the minute that I encourage somebody to consider the PE ratio at Tesla, and isn’t that a sign of something really bad to come. But wait a minute, we’ve got a portfolio that is kind of the opposite side of what happened to me in 1995 to 1999. I’m sitting on these dogs while the technology is going on a big run. Guess what happened following that?
Paul Merriman:
For the next three years, 2000, 2001, 2002, a portfolio that was a balance of big and small and value and growth in U.S. and international made money. Not much, maybe a penny, but it didn’t lose money.
Paul Merriman:
And so, I’m just trying to discourage people from second-guessing. But human nature is we all love a story and we also seem to like stories that scare us. And so, that’s a challenge for people. I have lived all of my life afraid that right around the corner is a catastrophic event.
Paul Merriman:
One of the reasons I have an advisor who takes care of our investments is because I don’t even want to think about that catastrophic event. I still worry about it. It’s still about to happen around the corner, but it has nothing to do with how my money is managed. And that’s a real challenge.

Dr. Jim Dahle:
Rick, let’s turn to a question for you here. This comes off of the White Coat Investor subreddit from Belgian YT has a screen name. He asks, “What type of investor is a three-fund portfolio not the best option? Is there some income or ability to stay the course or investment horizon or willingness to deal with complexity or risk tolerance? Is there some characteristic there that identifies an investor for whom a three or four fund portfolio is not the best option?”
Rick Ferri:
Well, it’s hard to say what the best option is. It’s certainly easy to maintain a logical, very diversified option. But there’s a lot of people who come to me with existing portfolios that have a lot of investments in their taxable accounts, that have low tax basis. And you can’t just sell everything because that would be imprudent. Somebody realizing hundreds of thousands of dollars in capital gains and paying 20%, plus the 3.8% Obamacare tax on top of. That’s not what you have to do. You would need to handle that much differently.

Rick Ferri:
And then if somebody has all of their money in a taxable account, the bond portion wouldn’t be a total bond market fund because they’re probably, if they were in a high tax bracket, you would probably use a municipal bond fund.
Rick Ferri:
Strategy is different than philosophy. Philosophically, the three-fund portfolio sounds wonderful for everyone, philosophically. But when you start working with individual investors, very rarely do you end up with a three-fund portfolio because of their unique situation. Strategy is personal. Now, sometimes you do, but sometimes you don’t. A lot of people have 401(k) plans and 403(b) plans, 457 plans. They don’t even have the ability to use index funds in those plans. So, you’ve got to work around that and try to do the best you can.
Rick Ferri:
Philosophically, sure. Three fund portfolio makes a lot of sense. Strategy, what you actually do, it’s usually different than that.

Dr. Jim Dahle:
Paul, a question for you. And this one comes from the esteemed Taylor Larimore on the Bogleheads forum. He’s got to be 94-95-ish at this point, but he’s still got a great memory. And he remembers an article you wrote in November, 2014, titled “10 reasons I don’t like Vanguard total stock market index fund”. He says, “I have great respect for Mr. Merriman, but I can’t help wondering if he still feels the same”.

Paul Merriman:
Boy, do I. Let me just tell you what that was about. It isn’t about the Vanguard. As a matter of fact, I’ve done a video “America’s number one retirement investment target date funds”. And so, I am a great fan of target date funds. But there are things that I don’t like about target date funds.
Paul Merriman:
But I’ve made the point that for people who want one fund for the rest of their life, that a target date fund is an amazing product. And there’s some evidence that just came out this year out of Wharton that shows that people at Vanguard, they looked at 1.2 million accounts at Vanguard in 401(k)s. 880 different 401(k) plans.

Paul Merriman:
Those people who have a hundred percent in target date funds made 2.7% a year, better returns than the people in those plans that didn’t have any target date funds. Those people who had some target date funds made 1.7% better than those that didn’t have any. So as far as I’m concerned for probably 99%, maybe it’s 95% of the people that we’re going to run into that we want them to put money away on a regular basis, I would heartily recommend a target date fund.
Paul Merriman:
Now, if you go back and look at that article and I’ll have to go reread it to make sure it says this exact same thing, I have always been a fan of these things. What I don’t like about the Vanguard fund is it has 10% in fixed income for a 21-year-old. That means that a 21-year-old is giving up a half of 1%. That’s what the cost of a 10% position in bonds is. A half of percent for the first 20 years of their investing life. That I don’t approve of.

Paul Merriman:
Why do they have that there? Well, I had that conversation with John Bogle when I met with him. Why? Well, they’re just trying to get people to understand that you should have stocks and you should have some bonds. And so, that if they are there, but wait a minute, they’re keeping people from putting that 10% into equities when the market is down.
Paul Merriman:
But it is more important to Vanguard that they have them get the feel of what that kind of a fund is like. And I disagree with that. I think education would be a really great way to convince people you don’t want 10% in fixed income. It is not saving you from any bear market that I know. They also have again, as far as I’m concerned, the exact same equity asset classes for a 21-year-old, as they do a 91-year-old.
Paul Merriman:
It may be a different percentage. In fact, it is a different percentage. It’s I think 30% for a 91-year-old. It’s 90% in equities for a 21-year-old. Why wouldn’t for a 21-year-old, why wouldn’t you have a slightly more aggressive or maybe more than slightly more aggressive portfolio? I think they should.
Paul Merriman:
And the third thing, a real obvious one is that they don’t have small cap value. They’ll say, “Well, we have small cap inside of a total market index”, and yet it does not have any impact at all. There’s so little small cap value. And as I think you know we have the two funds for life strategy where we show people how to put 10% of your money in small cap value and 90% of your money into the target date fund.
Paul Merriman:
That small addition that was cap value based on the past is about a 30% higher return at the end of 40 years. Not a small difference in what you’re going to have to live on and what you’re going to leave to others.
Dr. Jim Dahle:
All right. So, let’s talk about some other companies. We’ve talked a lot about Vanguard. How has the underperformance of factor investing over the last decade or so, affected companies such as DFA and AQR? That seemed to be the cat’s meow certainly among advisors a decade ago.

Rick Ferri:
I know that DFA has according to Morning Star lost some assets recently, but I think a lot of that had to do with advisors moving more towards exchange traded funds than moving away from DFA, which is maybe one of the reasons why DFA decided they finally want to launch ETFs.
Rick Ferri:
But obviously, if you’re a small cap value manager and you hang your hat on small cap value factor investing, your performance hasn’t kept up with the total market. So, you may not have a collected as much assets as you would have liked to collect. But I don’t think it’s the quality of what they’ve done. I don’t think the way DFA does small value is bad. It’s just as good as anybody else. Same thing wtih AQR Alpha Architect, Wesley Glaze firm.
Rick Ferri:
They all have the different ways of doing value. I call it the value is in the eyes of the beholder, which means there’s a zillion different ways of slicing and dicing the market to come up with what your version of a value is and then creating an index.
Rick Ferri:
So, I don’t think any of that is the problem. I think the problem is that we talked about earlier, some behavioral aspect to this. People have given up maybe and decided to pull some money out. But also, companies like DFA have really lagged the rest of the industry when it came to getting into the ETF space and finally now making a move there. So, they have to do that in order to stay competitive. So I’m not sure if it’s their methodologies that are driving any of these assets flows.

Paul Merriman:
But I think it’s important to look at the other side of that coin. They had a time when they were on the top of the world in this business. And that was from about 2000 through probably 2007. And so, they gained huge amounts of assets under management. I’m sure they knew they were going to have their time in the barrel because that’s the nature of this kind of investing. As you have times, you’re in favor and you look special and times that you are out of favor.
Paul Merriman:
Our business, the investment advisory firm that I sold back in 2012, we were not viewed as being very smart in the late 90s, but we were thought of as being brilliant in the early period of the 2000 through 2003. We were not idiots nor were we gurus. We just happened to have a portfolio that we stayed the course on.

Paul Merriman:
And Meb Faber. I don’t know if you’ve had Meb on your show before Jim, but Meb Faber does this one great graph where he shows maybe 20 or 30 different management strategies over a long period of time. And guess what? They end up at about the same place up on the table chart if you stayed the course through the whole 30 or 40 years that he presents in that graph.
Paul Merriman:
So, I think DFA got real lucky that they got that run in the early part of 2000 through 2002. Now they’re paying the price. But it’s the same smart people running the business for the long-term, which is what we all want to be assured that people aren’t changing their strategies too much so that we get to stay the course for what we signed up for.

Rick Ferri:
I think one of the problems of value investing, which is not such a problem for small cap investing. Small cap indices, when you look at where the cuts are between large cap and then mid cap, and then small cap. Whether you’re looking at SNP or you’re looking at Wilsher or you’re looking at Russell or Chris or any of these index providers, the cuts between large cap, mid cap, small cap are very similar.
Rick Ferri:
So, the small cap performance of S&P small cap versus MSEI small cap versus Russell small cap are going to all be fairly highly correlated. That is not true about value investing. Value investing is all over the map. Are you using a return on equity? Are you using book to market? Are you using PE? Some people might use dividends. Some people might use enterprise value. I mean, all these different ways of which managers are creating their value indexes makes why dispersion among the returns of value out there in the universe.

Rick Ferri:
So, I’ll say something now and don’t take it to the bank, but if you right now wanted to back up the truck and buy a value fund, which one would you bought? Well, you would buy the absolute worst performing value methodology that you could possibly find that was created by a very smart academic. So why? Because that is the most out of favor value strategy that there is. And if value does come back, theoretically, this would come back the most.
Dr. Jim Dahle:
Now we’ve talked a lot about small and value on the show so far. Let’s talk about some other factors. If you had to rank these factors from best to worst, how would you rank the following factors? Small, value, momentum, low volatility, quality, and liquidity.
Paul Merriman:
I wish I had the really smart guy in our organization, Chris Patterson, because he’s the one that has actually created the list of best in class ETFs for people who visit our site. As a matter of fact, what I’m going to do is I’m going to ask Chris Patterson to write his list since he’s the guru in this area, and I’m going to send it to you, Jim, and you can put it on your website so that we get it from the horse’s mouth rather than from the big bull and the pasture.
Dr. Jim Dahle:
That sounds good. We will add it to the show notes.
Rick Ferri:
Let me throw my 2 cents worth in. I think that some form of value, excluding dividends as a way of methodology. But book value, enterprise value, number one is a good choice. Number two, quality. The quality of the company’s earnings. Good choice. Once you have those two choices in other words, you do your screening to come up with the value stocks and the quality stocks together.
Rick Ferri:
Then there’s an overlay on top of that from momentum. And this is very similar to the way DFA does it. So, they have their values screens, their quality screens. They come together with their list, but they don’t buy the stocks or put them into their fund until they hit the momentum screen and then they would purchase them.
Rick Ferri:
So, momentum can be used along with a value and quality. If you try to do momentum separate from value and quality, you end up in many ways, canceling things out. Because momentum stocks right now are all large cap tech stocks or large cap growth stocks.

Rick Ferri:
They are the ones that have all the momentum right now. So, you’d be buying those stocks and be canceling out your value and your quality. Maybe not quality, but your value screens.
Rick Ferri:
Like I said, there’s a bazillion different ways in which you can do this, but if you’re going to do value and quality, you can do that. Find your companies, find your universe that you want to select from, but don’t actually include it in your portfolio until they hit the momentum screen. Meaning the stock prices have started to move up. And then add them. And that makes a lot of sense. And that’s the way that dimensional fund advisors do it.
Rick Ferri:
Now has it helped? Well, if your quality and your value methodologies are underperforming other quality and momentum strategies, then it doesn’t really help that much, but in the long-term it might help.
Dr. Jim Dahle:
Vanguard has come out with six factor funds or ETFs. I think in 2018, they came out with them. What are your thoughts on those ETFs?
Rick Ferri:
Personally, I’m real quick. I mean, Vanguard always does things very well. And these funds are multifactor quality, momentum and other factors are in there. And I think that if you’re going to buy one factor from it, not necessarily small cap, but if you’re going to buy one multifactor fund, if you use the Vanguard multifactor fund, you would just do fine.

Paul Merriman:
We do an analysis once in every two years for the best in class. And so, those funds are put in amongst all the other commission free ETFs that are available at Vanguard. And so, they have to go through the series of tests to qualify as best in class. If they make it, they’re on the list. If they don’t, then we have to wait another two years to look at them again. But they are part of the list that we consider when we put together that best in class. And those classes, by the way, are the 10 classes I talked about earlier. Big, small, value, growth, U.S., international, reits and emerging markets.

Dr. Jim Dahle:
Now you both seem to give the sense that small and value have been out of favor for some time now and seem on the edge of coming back and outperforming. Now, I know there’s no guarantees here, but do you expect small stocks and value stocks to outperform the total stock market over the next 1, 5 or 10 years? What would be your expectation in each of those time periods?
Rick Ferri:
I would expect 10 years perhaps.
Dr. Jim Dahle:
You have absolutely no idea for the next 1 to 5?
Rick Ferri:
I mean, people were predicting the comeback of small cap value starting in 2012. So, it’s hard to say, but I think over a 10-year period of time, you’re going to see the risk premiums kick in. And really, you have to be careful though, of how much is that risk premium going to be, and how much are you going to pay for it, and overpay for some of this. And you kind of wipe out any potential return that you might get.
Rick Ferri:
So, I think that I would say better than 50-50, that you’ll see small cap value, give you some sort of a return premium over the total market over the next 10 years. My guess.

Paul Merriman:
If you look at all the 10-year periods, if you look out 40 years value, small cap value has always been number one. When you get down to 10-year periods, I think it’s something like about, well, I’m not sure the number, but it’s a very small number that small cap value is not number one.
Paul Merriman:
The problem is assuming the market’s going to head up in the next five years. If the market goes into a big tumble, then small cap value might not be the big winner. It’s already taken a hit. And so, you could say, well, how much further can it down? But in serious bear markets, small cap value has been very weak historically. That’s why at 10 years I’d feel confident that it would do well, but over a 1 to 3, maybe even 5 years, it might not be that big that out performer. We just don’t know is the answer, of course.

Dr. Jim Dahle:
This question comes from Richard Rhodes off Twitter, Paul, and it’s for you. What effect do you anticipate a global pandemic to have on small value stocks or companies over the next 10 years?

Paul Merriman:
I have no idea. I honestly have no idea. I could go back and look at the history of small cap value and all of the things that faced along the way, whether it be war or political unrest or whatever it might be not just in the U.S. but internationally as well. It’s faced a lot of problems and challenges.
Paul Merriman:
And so, I do not try to make any kind of a prediction. I unlike a lot of other members, I’m the guy that worries about the catastrophic event around the corner. So, if you come to me and ask me, “Paul, you’ve always got list A, the good news and list B, the bad news. How’s the bad news look?” And then I’ll say, ‘Damn tough, Jim. It scares the hell out of me”. And for that reason, I really stay out of the prediction basis because that colors how people respond to how they might approach their investments.

Paul Merriman:
For young people, I tell them to keep that bottle of champagne in the refrigerator, if they must, and when a big bear market hits and the market is down significantly, you just keep buying. And if you want to pop the champagne, you pop it because that’s what you’re looking for. Buying opportunities as a young investor.
Paul Merriman:
And for the rest of us, we better have enough fixed income to address whatever the reason the market’s going to go down 50%. This market didn’t go down 50% yet. It did twice in the last 20 years go down 50%. And the technology went down 80%. So far, it’s been an easy market to deal with. It’s pretty normal. And yet what’s going on in our world is not even the least bit normal.

Dr. Jim Dahle:
Let’s turn the page a little bit. Small growth has long been considered the black hole of investing. The place where you put your money to never see it again. But it’s been great the last decade, at least compared to small and large value. Were we wrong about small growth? Was it just we hadn’t seen its time in the sun yet, or is there really something bad about small growth that it should still be avoided?
Rick Ferri:
Well, I don’t avoid it. I mean, I buy a total stock market index fund and a total international index one, which has everything in it, including small growth. So, I didn’t really have not thought much about what you just said. I was aware that small growth historically has been the black sheep of the stock market, but I guess I look at it the same way I look at small value. And it has had it stay in the sun, as you said. Will it continue? I don’t know. I try not to take those risks. I don’t think it’s necessary to take those risks. I just buy a total stock market fund and you own everything and not try to figure a lot of this stuff out.
Rick Ferri:
If you want to put a little bit of an icing on your cake, spice it up a little bit, maybe you can buy a small cap value fund or something else. But not necessary, just by the total market and the total international market and you’re done with it. So, I really haven’t given a lot of thought to that small cap growth story that you’re alluding to.
Dr. Jim Dahle:
Okay. So, let’s talk about somebody such as me, that has investing now for 16 years, I’ve had a small of value tilt in my portfolio now for 16 years. But let’s say you have an investor has been investing for 10 plus years with a small value tilt. How do you counsel them now? They come to you saying this really hasn’t helped. I’m thinking about bailing out on it. How do you counsel them at this time?
Rick Ferri:
Absolutely do not bail out on it. I mean, you’ve already taken the risk. You’ve already had the underperformance. It’s like taking all the risk and getting none of the benefits from it. In fact, you’re locking in, you are guaranteed you’re going to underperform if you bail on this. You’ve got to stay with it for 25 years. So, if you have a small cap value tilt and you’ve had it since 2012, you have to keep it. You have to keep it. And keep it for at least another 10 years, if not longer. I mean, you’re in it. You need to keep it. That’s how I would counsel them.
Dr. Jim Dahle:
What would you say, Paul?

Paul Merriman:
I’m confused how this is different from owning the S&P 500 from 2000 through 2009. And I really am because is it because the S&P 500 is made up of a bunch of companies that we know and love and trust and seeing them all, or what is it? Because we had heard through the end of 1999, that the S&P 500 count pounds at 10% a year.
Paul Merriman:
And then all of a sudden, for 10 years, it loses money. Well, if we just dig a little bit, we find out that for 10 years back in the 30s, it lost money. In fact, it lost more money in 2000 through 2009, then it lost from 1930 to 1939. And so, what people tend to do is they make judgments about recent performance as if that is the most important thing.

Paul Merriman:
And that is the very thing that leads people down the wrong path, because that is in essence, a form of market timing, what we call the ICSIA strategy – I Can’t Stand it Anymore. And that’s a bad way to make a decision, at least based on the past.
Paul Merriman:
And so, remember, we’re not suggesting, except in the example of the newborn child. I’m not recommending that people put all their money in small cap value. I think young people can put a substantial amount in it, but it’s a commitment based not on the last 10 years, obviously. It’s on the last 90 years.
Paul Merriman:
And you can say, well, what does 90 years have to do with anything? Well, then does that mean we should just base it on the last year? What do we go to? Where do we go for information that gives us a sense that we have something statistically relevant?
Paul Merriman:
But be aware because out of those 10 asset classes that are in the ultimate buy and hold strategy, and Rick’s got them in his strategy too. We just don’t have them broken up exactly 10% each. Something’s going to fail.

Paul Merriman:
Now, maybe the whole thing will fail and that’s going to be too bad, but something is going to fail. It could be small cap value. It could be large cap value. It could be the internationals. So that’s the reason you have a diversified portfolio. I don’t think that you’re saying that you’re all in small cap value. Are you Jim?
Dr. Jim Dahle:
No, absolutely not.
Paul Merriman:
That you have the tilt because you’ve put in more than what the total market index would recommend you put in. Is that the reason?
Dr. Jim Dahle:
That’s correct.
Paul Merriman:
And so, you do not have a cap weighted portfolio anymore. What you have is you have an asset class weighted portfolio. Now, I don’t know how weighted it is to the different asset classes, but it’s just as legitimate a way to invest as the total market. It’s just a different way of trying to get the premiums for risk that we have available to us. And I don’t think you should change it if you’re comfortable with the downside risk of your portfolio in total.

Dr. Jim Dahle:
Now, let’s, let’s turn the page now to somebody new to this and not someone who’s been holding this for a long time. For example, I had a Boglehead here, asked this. “I started a small value tilt in April and May 2020 based on the historic spread between small value and large growth. Bad idea, or stay the course?”
Dr. Jim Dahle:
So how would you counsel someone who’s thinking about adding small and value to their portfolio now, after this long period of underperformance?
Rick Ferri:
Well, market timing. I mean if you start saying things like “I added it based on the spread.” Well, now you’re looking at things you shouldn’t be looking at. I mean, you’re basically saying, “Hey, it’s time, it’s time small cap value outperform. I’m going to take a bet on this”. And it sounds very short term to me. I mean, what if the spread narrowed, what are you going to do? This investor is going to jump out?
Rick Ferri:
I’ve talked to thousands and thousands and thousands of people, and then you listen for clues as to what they’re really thinking. And when somebody says “based on the spread”, it’s a market timing move they’re talking about. They’re not talking about investing for 20 years.
Rick Ferri:
They’re talking about a market timing move when they start saying words like that. And I say, well, wait a minute now, okay. Why are we looking at spreads? If you have this belief that small cap value is a risk premium, in the long-term it’ll pay off, why are you looking at spreads? Well, I just think it’s a good buy right now. Again, this is market timing.
Rick Ferri:
And so, I would say to that person, okay, if you’re in it, you’re in it. And now you’re in it for the duration 20-25 years. Don’t jump out. If you think you’re going to jump out, then get out now or just go to total market for the rest of your life. Don’t even do this.

Rick Ferri:
Again, for the new investor, you don’t need this stuff. It’s unnecessary. 90% of your return is the allocation you have between stocks and bonds. That’s 90% of your return. This other stuff is just potentially higher return, but makes the portfolio much more complicated and more decisions have to be made which value fund and so forth.
Rick Ferri:
And for most people, I don’t recommend they go down that path unless they want to, unless they are very much into it and they understand it and they want to go down the path for the very long-term. Not because the spreads are this or that.
Dr. Jim Dahle:
So, Paul, here’s a question from Matthew Alison from our Facebook group, I believe, who asked, “What percentage portfolio would you recommend go into small cap value for a young physician? Let’s say a physician in his 30s just starting to earn.”

Paul Merriman:
Well, let’s say that they want to be relatively conservative. They don’t want to have a whole bunch of asset classes to try to manage. They want to do it with a few funds. There are a couple of ways they could do it. One is they could use four funds. We have a four-fund combo. That’s simply 25% each S&P 500, large cap value, small cap blend, and small cap value.
Paul Merriman:
And we’ve tested that inside and out, going back to 1928, and we’ve looked at nine decades of performance so that you get a sense of how those four funds together. Those four asset classes would have done. That would be an easy way to access U.S. because it doesn’t have any internationals. And a lot of people are comfortable with all U.S.
Paul Merriman:
There’s a strategy called I think it’s the Trim Four. It to, is four funds, except two of them are international and two of them are U.S. But they are still large blend, large value, small blend and small value. So, they pick up a lot of these asset classes that we would like to have them hold in their portfolio.
Paul Merriman:
But if they want simple, simple, easy to do, I’d recommend looking at the two funds for life. And the two funds are small cap value. And the target date fund at Vanguard would be just great. And the formula for how much in small cap value is 1.5 times your age would be how much you put into the target date fund. And the balance goes into small cap value to aggressive, okay, use large cap value. If you want to be a little more aggressive, okay. Divided up between large cap value and small cap value.
Paul Merriman:
They are very simple strategies to maintain. They automatically reduce exposure to risk, and as they get closer and closer to retirement, just like a target date fund does. So, there are some simple things to do that would get you with enough, small cap value in your portfolio to make a difference.

Paul Merriman:
By the way, a lot of people I talk with, they got a portfolio at the office, they got an IRA, their spouse has an IRA. They have an account for their kids. A person could even, if they wanted to, diversify amongst different strategies for different parts of their portfolio. And I think they’ll do just fine. I do believe they will do better than if you own the total market index.

Rick Ferri:
I have a comment.
Paul Merriman:
I’m surprised.
Rick Ferri:
Technically, mathematically, that could be correct that mathematically, if they held all these different pieces, they style weighted this and they style weighted that, I’m not going to call it small value and asset class, it’s a style waiting. If they did this and they did that, and they did it in this account, in that account and this account, and they get it this way and that way over here and over there.
Rick Ferri:
Technically, mathematically, historically, they might come out ahead before fees. Who knows if they’re going to come out ahead after fees? Except for one thing. And that is when you get that complicated with a portfolio where you’ve got all these little things going on everywhere., it’s a very high probability you’re going to underperform because complexity is a cost. Simplicity is an alpha.

Rick Ferri:
If you have a simple portfolio, total stock market index fund, it’s very simple. You don’t have to do a thing. You put your money in it. It’s done. You’re done. You don’t have to do anything. If you’ve got all these little, this portfolio over here, you’ve got to adjust it this way and this one here, you got to adjust it that way. And this one over here, you just adjust it that way. Pretty soon, it’s done. It’s too complicated, too difficult. And it’s not going to last. And people are going to bail at the wrong time. And the net result is going to be under performance. That’s my real belief.
Rick Ferri:
And one of the big reasons why I liked the three-fund portfolio is because it’s simple. And if it’s simple, people can understand it and they can keep it and they can track it. And therefore, they’ll get their fair share of the market returned. And I take that from John Bogle. So that’s why I believe that simple is better.
Paul Merriman:
But then why not take it one step further, Rick, because I don’t disagree with simple is better, which is why we took it down to two funds instead of three. But why not really make it simple and just put your money into a target date fund that has the large cap total market in the U.S. and large cap, total market in the international and the appropriate amount of bonds to expose you to the right amount of risk at a different age?
Paul Merriman:
In a sense, for people who wanted simple, remember that people in that study by Wharton were making a lot more money than the people who were trying to figure out a way, I guess, to do it better somehow. And so, maybe a target fund is better than what both of us are recommending if we want to keep it simple.
Paul Merriman:
But what I think you’re doing is very similar to what the target date fund. It is not the same, but it’s similar to the target date fund. I am just asking you to add a fourth leg and give some exposure to small tab value. And that is not that much more complicated than having three funds in the portfolio.
Paul Merriman:
So, I would at least encourage people who are using three funds to add a fourth. And you mentioned fees. We don’t have a fee to do any of this. This is all for people to do on their own as we’re not in the business, we’re just teachers. And so, the fee is not accept in the fund itself.
Paul Merriman:
And as long as we stay with funds at Vanguard, we have access to very low-cost funds to be able to do these strategies. So, I don’t think fees need to be the hurdle. And you’re right. What we want for all of the people watching this right now is to find a strategy they will stay with forever.

Rick Ferri:
Absolutely. That’s the bottom line.
Paul Merriman:
And the fact that you’re asking about, “Should I be doing something about my small cap value?” it upsets me because it suggests that you do not have a lifetime strategy. And what Rick is suggesting in as a way is, Jim, you need to get your money into a strategy that you don’t ever have to ask Paul Merriman should I be changing it again.

Dr. Jim Dahle:
Now to be fair, that wasn’t my question. I was merely using my portfolio as an example.
Paul Merriman:
Okay.
Dr. Jim Dahle:
And I certainly do not plan on bailing on my small value tilt in 2020. I got a couple of other practical questions from people. Here’s one out of the Facebook group. “I’ve got the Vanguard small cap value fund, but I’ve read Paul’s posts that it’s not small enough. What would be the best small cap Vanguard fund?” This poster wants to know.

Paul Merriman:
Well, as far as Vanguard itself, I think I’ve got the list right here. So, in the U.S. small cap value arena, it looks like the best in class is what we want here is SLYV. SLYV. Available without commission at Vanguard.
Rick Ferri:
That’s an ETF, right?
Paul Merriman:
That’s an ETF.

Dr. Jim Dahle:
So, that’s this spider ETF based on the Wilshire small cap value index.
Paul Merriman:
Yeah. But the problem, unless you go, at Vanguard is that they’ve got probably so much money. They have got a mid-cap, small cap value fund. It’s still a good fund. And it has done well because large has done better than small. And even at the small cap arena in that group of funds, the larger small cap funds will do better when large cap is doing better than small.

Dr. Jim Dahle:
What about on the international side? What would you recommend for small value international for somebody who wants that in their portfolio?

Paul Merriman:
Small cap, international value. And by the way, there’s the Avantis funds have a small cap international value. We haven’t added it yet. It’s got a chance to be on the list first of the year, but we have used DLS wisdom tree a small cap value.
Dr. Jim Dahle:
Yeah. Now, these days I’m starting to hear people talking about wanting to tilt their portfolio toward large growth. It reminds me of a book I read that was published in the late 90s. It was an otherwise very sensible book, but it recommended a 5% tilt to tech and a 5% tilt to telecom.
Dr. Jim Dahle:
What would you tell someone who’s coming in now saying I actually want to overweight the FANG stocks, these large mega cap growth stocks? What would you tell that person if they came to you and asked your advice, thinking about implementing that strategy?

Paul Merriman:
Well, it feels a lot like what Rick commented on a market timing decision. But what it may just be is that their view of returns are relatively short term and they may make a long-term decision based on a very short history of returns. They will get most of that through their S&P 500. They want 5% in tech. They’ll get 5% in tech usually just buying the S&P 500 and maybe it’ll simplify their whole portfolio if they go that route.
Rick Ferri:
I can tell you right now, based on Vanguard’s website, that the Vanguard total stock market ETF, this is the total U.S. stock market. Technology is 23.3%. Now, remember technology does not include Google. It does not include Facebook. Those are telecom stocks, which make up most of the telecom market, which was another 10%. And then if you add Amazon to that, which has neither technology nor communications, but something else, consumer defensive, then that actually adds another 3%.
Rick Ferri:
So, in aggregate, it’s like 40% of the U.S. market is what we consider large cap tech. If you consider Amazon, Google and Facebook. So, Netflix in there too, as tech, which they’re not classified as tech, but if you did, then 40% of the U.S. stock market. So, in addition to that 15% healthcare, so now you’re up to 55% in those two kinds of sectors in.
Rick Ferri:
The U.S. market is very heavily weighted to what we do really well, which is that. It doesn’t mean that we don’t still use all the other stuff that we import. Therefore, you should have international stocks in your portfolio because you are using all that stuff we import, and we were buying it and we’re supporting those other industries.
Rick Ferri:
But I don’t think you need more technology, more communications than what you already have in a total stock market. And what, of course, this would be the S&P 500 as well would have even probably a higher position than this. But I would discourage somebody from chasing the big tech stocks right now. I would discourage them all the time from chasing the big tech stocks, not just right now.
Paul Merriman:
And not so dissimilar from what happened in 1998, when the S&P 500 because of tech stocks, was flying high during a period of about a year that Warren Buffett’s Berkshire Hathaway was down about 50%. And it was really very discouraging to see that happen. But that was just the nature of how people felt at that time about having bricks and mortar, as opposed to being in the hot stocks. And we’re seeing that again, I would guess.
Rick Ferri:
But not as much. Again, getting back to if you strip out the FANG stocks out of the S&P 500, the S&P can be the price to earnings ratio of the future earnings, or you can call it before the pandemic, past earnings. The PE of the S&P 500 with the FANG stocks, call it at 22. Without the FANG stocks, it’s about 18. So, it does come down, but not that much.
Rick Ferri:
We are nowhere near where we were in 1999, when the SNP was at 35 PE. We’re not there. Now, will we get there? Well, you should ask Jerome Powell if we’re going to get there or not. I mean, if he keeps buying up everything in the universe, except for equity, eventually it’s going to push all the money into equity and we could get back to 35 PE or maybe higher, but we’re not there yet.
Dr. Jim Dahle:
Yeah. That’s actually a good segue. I think we’ve beaten the factor investing to death here over the last hour and a half. I got a whole bunch of other questions from your fans. It might be my listeners, but certainly, your fans that are not necessarily factor related that I thought would be worth spending a few minutes discussing if you guys are willing to stay on and answer a few of these questions.
Paul Merriman:
Sure.
Dr. Jim Dahle:
One of which was a little bit related to your comment, Rick, from a Jerome Powell. This one comes from somebody, a doc by the name of Beaky Got Tom who asked me to ask Rick his thoughts on the current feds unlimited quantitative easing strategy and its implications on the future.
Dr. Jim Dahle:
And a related question from the Facebook group, from Jeanette Patel, “Would you guys recommend increasing your allocation of gold in your portfolio? And if so, to how much considering all the money printing and risk of increasing inflation?”

Rick Ferri:
I’ll take the last one first, because I don’t have any gold in my portfolio. I’d tell you the story. You’ve probably heard it that 37 years ago, I had the best investment I ever made was gold. And I bought two gold wedding rings and has yielded me a wonderful 37-year relationship, three children. So far eight grandchildren. I can’t do any better than that in goal. So that’s my gold story.
Rick Ferri:
But as far as how the current fed policy, and it’s not just the U.S., central banks all over the world are buying, not just treasury bonds, mortgages, corporate bonds, corporate bonds ETFs and if you can believe it or not, fallen angel bonds. And what are those are, are below investment grade bonds issued by companies that used to be investment grade, but because of the pandemic have fallen below triple B to double B or single B who need to borrow money to keep their employees employed like the airlines.
Rick Ferri:
And the fed is actually going straight out and buying those bonds directly, new issues from these companies. This is unprecedented uncharted territory. It is driving down all interest rates to levels that have never been seen before. The five-year treasury is 0.3 corporate bonds. Investment grade corporate bonds are below 2%. Short term investment grade corporate bonds are at 1.2%.
Rick Ferri:
Now the fed is targeting a 2% inflation rate. That’s what they’re targeting. I don’t know if they’re going to get there very quickly, but that’s what they’re targeting. And corporate bonds are yielding below that. So, the real return to an investor anywhere in the investment grade bond market, anywhere is below the inflation rate or the targeted inflation rate. And that’s before taxes. We have to pay taxes on this. So, we pay taxes to the federal government.
Rick Ferri:
We are at a negative yield, a negative return in this environment that has been created by the federal reserve. I mean, whether it’s justified or not effected, this is where we are. And all of this money that’s going into buying these bonds is forcing investors out of these bonds.
Rick Ferri:
And where does this money go? Well, it goes into the money market for a while, and you see M3 money markets statistics go skyrocket. The amount of money that people have on the sidelines right now. But it has to go somewhere eventually. I mean, it has to get into something where these pension funds that are guaranteeing their investors that are going to make 7% return when the 10-year treasury bonds are only yielding 0.6. How do you get there?
Rick Ferri:
But you can only get there through some sort of an equity investment. You have to be inequities. Well, that’s driving money into the equity markets, which is driving up valuations. Now, if you’re going to go into the equity markets, do you want to buy the airline stocks? Which who knows when they’re ever going to come back. Do you want to buy the energy stocks? I mean, who knows when the price of a barrel of oil is going to get over $60 a barrel again? I mean, we just don’t know.
Rick Ferri:
But we do know that people are using more Facebook. People are using more Google. People are using more Microsoft products and everything because they’re working from home and so forth. So, the earning stream or the visibility of the earnings growth for those companies, those FANG companies are there.

Rick Ferri:
And so, more and more money is going into stocks because it can’t go anywhere else. The yield, the dividend yield on stocks, even though dividends have been cut is higher than the dividend yield on corporate bonds, which has not happened in, I don’t know how many years. I mean 50 years. It’s been a long, long time.
Rick Ferri:
So, this money is going into equity has to, and then it’s looking for earnings growth. And where do you find earnings growth? Well, Microsoft, Google, Facebook. This is where the earnings growth is. This just keeps piling in. And how long can it go on for? A long time according to Jerome Powell. They are going to be accommodative for quite a long time. And they’re also going to start trying to target the yield curve. So not only are they working on the short-term part of the yield, but they are working on the long-term part. They’re going to keep interest rates way down for a long period of time. We’re using a lot of money to do it. There’s just nowhere to go except equity. It’s just going to drive up values.
Rick Ferri:
And by the way, real estate. Everybody’s afraid of that too, because everybody’s working at home and we don’t know how many moles are going to go under, how many office buildings are going to under. So real estate has got to be pushed aside. That’s even more money going into equity. And this is the environment that we’re in. This is why I said it’s possible. I don’t want to use that word. It’s fairly probable that the PEs of the U.S. equity market will just continue to climb. It will. And, that’s the best I see it.
Dr. Jim Dahle:
Should an investor do anything about it?
Rick Ferri:
I don’t know if you can do anything about it because as you climb into equities, as the valuations go up, you’re just adding more risk to your portfolio because you’re buying these things at a higher and higher price, but the expected return from there is lower and lower, right? So, the expected return is up here. This is where they expect the earnings to be say, 10 years from now, 5 years from now. As you pay more and more and more for it, the expected return slope gets lower and your risk gets larger.
Rick Ferri:
And so, no. The answer is unfortunately you still have to rebalance. When the market goes up, you still have to take some money out and put it over in bonds. It doesn’t feel right. I mean, why would you want to put money in something that has a negative return, but it’s better than what might happen at the end of this whole thing. When the federal reserve starts to tighten, everybody’s going to rush for the door at the same time, and there could be a calamity in the stock market. And a true calamity.
Rick Ferri:
Again, these are all probabilities. I don’t know, but we haven’t been here before. So, if it does get to be scary, this time is different. Every time it’s different. But in that respect, it certainly is different. I wish I had an answer for you, but I don’t. I mean, you’ve got to be diversified.

Dr. Jim Dahle:
Yeah. It brings us to a related question from a war doc who asked with low bond returns and even the possibility of negative treasury yields like other countries have had, are there other recommended bond alternatives for a mid-career high-income position for the safe income portion of their allocation? Is there anywhere else to go that’s worth going to, given this change in bond interest rates?

Paul Merriman:
I don’t have a solution. I’m not in the industry and involved in alternative investments. Many of them don’t end well. And so, I hesitate to push people in that direction. I continue to own tax exempt bonds. And we can question the ability of those municipalities of being able to support those bonds. And that’s a risk. It is probably a big risk for people to reach very far for return.
Paul Merriman:
Now for a young physician, I guess, maybe that’s like small value. I don’t know. But personally, I would feel to the extent that somebody is truly looking for the long-term, they probably are better off inequities. And this is what Rick says, this is what’s happening. Equities become the only place to be for the long term. And if you hear what he just said, but in the long-term the expected returns are very low. So, it means we’re going to get a short term fixed. It sounds like to me, and then after that, it’s going to be a slob.

Dr. Jim Dahle:
But you can certainly see why people are starting to talk about, “Well, why don’t I invest my money in my small business or buy a rental property down the street or go load up on gold? If I’m not going to make any real return in bonds, why not pick something that at least historically has kept up with inflation?”

Rick Ferri:
I can understand the idea of going down and buying a duplex or a fourplex. Sure, that you’ve got a cap rate on that of 8% or something. That’s a good investment. Absolutely. If you can find it.
Rick Ferri:
What about preferred stock? Okay. I don’t usually talk about preferred stock, but most preferred stock…

Dr. Jim Dahle:
I’m glad you’re getting into it. I’ve got a question on preferred stock. So, let’s go ahead.

Rick Ferri:
So, let’s just talk really generally about preferred stock. So, a lot of preferred stock is issued by banks. These are federally insured banks. That cannot issue bonds because if they issued bonds, they would break their covenants and they would have too much debt on their books. So, they can’t issue bonds. They don’t want to issue stock. I mean, Jamie Dimon at JPMorgan doesn’t want to dilute his shareholder value by issuing stock. But they still need capital to function.
Rick Ferri:
So, there’s this thing in the middle and it’s called preferred stock where it’s not a bond, it’s actual equity, but it’s a high dividend yielding equity that might yield 6%. It’s not a tax deduction to the company. But in order for that company to pay that 6% dividend yield, they have to have earnings to do it obviously. If they would have to not pay that dividend, they would have to cut out the dividend on the common stock and banks are highly regulated. The fed is watching all of this.
Rick Ferri:
So, they’re going to be very careful with their balance sheets to make sure they’re going to be able to pay their dividends on their common stock. They’re going to pay the dividends on the preferred stock. It’s more volatile play, but there are some index funds that you can buy. Preferred stock index funds.
Rick Ferri:
I own one. It’s PFF. Papa Foxtrot Foxtrot is the symbol. There is another one. Papa Foxtrot Foxtrot Delta, PFFD as another one. These are index funds with preferred stocks, which are mainly made up of banking preferers. They’ll give you 5.5 percent dividend yield, but they are stock. So, they do go up and down somewhat with stocks, but not as much as common stocks. They are more like a long-term corporate bond.
Rick Ferri:
I own about 20% of my fixed income allocation is in preferred stocks. A lot of people don’t like them. They are very controversial. I personally have been following this market for 25 years and I have some of my personal money in it. So, that’s one way in which you could help give you a little bit of yield.
Rick Ferri:
And by the way, if they’re in your taxable account, 70% of the dividends that come in are qualified dividends. So, it’s only taxed at a capital gains rate instead of an interest or ordinary income rates. So, you actually get a tax break on it. So, it’s another idea.

Rick Ferri:
I talked with Burton Malkiel, the professor who wrote “A Random Walk Down Wall Street”. I had him on my Boglehead investing podcast, and he talked about the idea of buying stocks that have higher dividend yield. Vanguard has a high dividend yield, U.S. stock index fund, and a high dividend yield international stock index fund that are yielding over 3% in dividends. In fact, the high yield international fund is yielding more than 4% because of the industry group that it’s in. This is another way.
Rick Ferri:
Again, you’re an equity though. You are an equity. You’re not in bonds. But the cash flows are there. So, if you’re young and you could stand the volatility, really is all based on what’s in here and you stand the volatility of this stuff. And the returns of equities start to get lower and lower as the price of equities get higher, so as Paul said, we may get this rush to the top, and then we’re going to sit there for a while potentially. You’re going to be looking for cash flow and these high dividend yield type investments give you cash flow.
Rick Ferri:
Is it a great solution? No. Does it replace bonds? Certainly not because they’re not safe. But it does give you the prospect of a return without getting the interest income from bonds and without getting growth from stocks. These high dividend yielding investments. And REITs by the way are another one. Real estate investment trust index funds, which might pay you 4%. The same idea.
Dr. Jim Dahle:
Well, we’re running out of time here, but I wanted to get one last question in here, which I thought was pretty insightful. And I think a lot of listeners will be interested in your answers. This comes from Dustin Shoat a doc who put this out on Twitter. “I want to know what you guys would do differently if you were just getting going investing today compared to what you did starting when you did years ago”.
Dr. Jim Dahle:
So, let’s start with you, Paul, if you were just getting going today, what would you do differently than what you actually did?

Paul Merriman:
Well, this just came up with my wife. She posed this because I’m working on a book, that’ll be out in a few months. And part of the title has to do with $12 million decisions. And each one is literally a million-dollar decision. And she said, “Well, did you do this?” I said, no. And she said, “Well, if there’s such good ideas, why didn’t you do them?”
Paul Merriman:
And of course, the reality is, is that many of the things that I know about today, I didn’t know about when I started in the industry in the mid-60s. When load funds were 8.5% when you did not have index funds. And certainly, you had basically just active management was the answer for all investment problems in terms of what was right for the investors.
Paul Merriman:
So, in a sense, if I had it to do all over again, and if this is going where you want it to, now if you’re asking me to take life as it really was dealt to me, I’m happy to address that.
Paul Merriman:
But if I think about just as an investor, I had a great success in my own business and that helped a lot. But I was very conservative as an investor. And I think if I had it all to do over again, I would be more aggressive and invest more in equities. I invested in equities that I in essence controlled, my own company. But I found it more difficult to take the risk of turning it over to the market.
Paul Merriman:
And now with the way things are built with index funds, low expenses and huge diversification, I am very comfortable with that 76 being 50% in equities. That’s relatively high compared to many of my friends who think I’m taking a lot of risks and half in small cap. I didn’t know about small cap back in 1966 when I started.
Paul Merriman:
So, things have changed. Investing has never been as potentially profitable in the past as it is today. Everything is working for us except for one thing, the economy ahead of us. And Rick just laid that on the table beautifully. And we have so much risk in front of us, it’s just mind-boggling. And yet it seems like it was actually always like that. It’s just a different story today. But I wish I had been more aggressive with my investments. If I had it to do over again, equities are the place to be for the long term.
Dr. Jim Dahle:
Rick, how about you? What would you do differently?

Rick Ferri:
I’ll start with Warren Buffett. Someone asked Warren Buffett a few years ago, “What advice he would give to the trustees who are going to take over managing his portfolio, his money for his family when he dies?” And Buffett, and he reiterated recently, that’s easy. I’ve told them to put 90% of the money in an S&P 500 index fund and 10% in short term treasury bonds, basically for expenses.
Rick Ferri:
The simplicity of that is really genius because if all I ever did for the 35 years I invested my money was put 90% in an S&P 500 fund and 10% in treasury bonds. I would have a lot more money than I have today. And there’s nothing out there that makes me think that the next 35 years are going to be any different. So that’s what I would tell myself 35 years ago.

Dr. Jim Dahle:
That’s very helpful. Well, we better wrap this up and let you guys get back to the rest of your day. Paul Merriman and Rick Ferri, thank you so much for being on the White Coat Investor podcast today.
Paul Merriman:
Thank you, Jim. It was terrific.
Rick Ferri:
Thank you, Jim. Thank you, Paul.

Dr. Jim Dahle:
Okay. I hope you enjoyed that interview as much as I did. It’s always fun to talk to those two. They are just a wealth of information and experience. If you’ve ever gotten a chance to corner them at a conference, they will just astound you with the pearls they drop. That can be super helpful to you. And their humility makes it all than more impressive in how much you can learn from them.
Dr. Jim Dahle:
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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.