The Benefits of a Simple Investment Approach with Rick Ferri

[00:00:00] Welcome to Excess Returns where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long-term investor. Hey guys, this is Justin. In this episode of Excess Returns,

[00:00:22] Jack and I sit down with Rick Ferri of Ferri Investment Solutions and the creator of Core4.com, a free website offering portfolios with different asset allocations based on risk tolerances and objectives. We talk to Rick about a wide range of topics. We explore the concept of investing

[00:00:35] with simplicity and why avoiding complexity is important, and the stages investors go through to reach the final stage Rick believes is best for most people. We dive into the importance of asset allocation and how gaining insight and buy-in from investors is key to successful

[00:00:46] advising and investing over time. Additionally, we discuss the role of passive investing in today's market and whether fundamentals are still relevant. Rick also shares his thoughts on what he's most optimistic and concerned about regarding the economy and the markets.

[00:00:57] As always, thank you for listening. Please enjoy this discussion with Rick Ferri. Rick, thank you very much for joining us again on Excess Returns. Appreciate it. Well, thank you for having me back again. We were talking about the lighting before

[00:01:11] and you were holding your phone and we were getting some bicep workouts, but we decided that podcast this is an investing podcast. Well, I'm actually on the beach in North Carolina

[00:01:22] right now. I went into a library and grabbed a little meeting room to do this. So my lighting isn't perfect. I was trying to get it a little better. Yeah, that's okay. I wouldn't want to

[00:01:34] be in a workout podcast with you anyway, Justin. You would kill me. You can even come close for keeping up. And I think Rick could probably keep up though. Yeah. He used to be

[00:01:45] able to 20 years ago. So anyway, I did play pickleball this morning. So got my workout in. There you go. Very nice. So yeah, we want to have you back on to talk about really it's almost

[00:01:59] the way I get to describe it is a grab bag of investing topics, things that we think you'll have some opinion on, things that we think our audience will sort of get some value from. And

[00:02:10] it's going to range from everything to why as investors, we tend to want to complicate things to maybe talking a little bit about inflations, 60-40 portfolio, passive investing, direct indexing, your four core approach and just a wide range of topics that I think you'll have some

[00:02:27] perspective on. And that I think investors can take people to this hopefully and learn a little bit of something along the way from your experience. So that's going to be the topic.

[00:02:35] There's no one big story arc or topic arc here, just a whole bunch of just random things that we think will be a good sort of discussion. Sounds good. Great. We've been, Rick, we've been

[00:02:46] talking about all kinds of complicated stuff and we need you to rein us in a little bit. So hopefully you'll be able to do that. I don't know. The older I get, the less complicated I like things. So. Well, speaking of that, why do you think as investors,

[00:03:04] a lot of us tend to want to like complicate our portfolios and think that we need to do that in order to get the best returns? Well, I mean, investing is complicated. At least when you're first starting out, you have money that you've saved and you need to

[00:03:24] invest it. And it's overwhelming the amount of information that's out there, different directions you can go and different opinions. And at first, when you're in this stage of darkness that I call it, you don't really know what to do. So you tend to do a lot of things.

[00:03:45] And when something doesn't work, you dismiss it and try to do something else and then something else and then something else. And it takes a while. And some people never get to the point

[00:03:59] where you realize that, gee, if I didn't make it complicated, if I just made it simple, actually made it as simple as it can be, then I don't really have to worry about it very much.

[00:04:12] And I don't have to change it very much. So but it is a learning process. I call it the education of an index investor. There's really four levels to it and I can go through them if you want, but it's a learning process to learn to become simple

[00:04:28] in your investment approach. And that is how you'll get the best return. I think you should, and often taking something away from you, Jack, I think you should walk through those records. And then we go ahead. I can go through quickly. So there's darkness.

[00:04:40] Like I said, people are just beginning to invest. They listen to their friends. They read something on the internet. They have a 401k. They've got all these investment options. They ask their colleague, where should I put my money? And it gets to be kind of short-term

[00:04:56] oriented. Oh, this is good. That's good. This has done well. That's done well. I really like this. I really like that. But they're in a darkness. They really don't understand. They hadn't really researched or must have educated themselves on investing

[00:05:11] and really don't know in many ways how they're performing. So this darkness can last for a lifetime for many, many people. But the ones who really begin to look at how are they performing? How is their portfolio performing? How's their 401k performing in relation to

[00:05:30] appropriate benchmarks? And what do I mean by a benchmark? The S&P 500, the basically large U.S. stocks, 85% of the market. How's my stock portfolio doing in relation to that? Or the bond market, total bond market index, for example. How was my bonds doing in relation

[00:05:48] to that? Or the international index, for example. So in other words, you start benchmarking your investments to these really broad, basic indices that are out there. And you come to the realization that, hey, you know what? I'm not doing very well. And no matter what I do,

[00:06:04] I really don't do that well. I mean, I do okay, but I don't do as well as the markets. So you have this enlightenment, which is the second stage. And enlightenment, you realize that,

[00:06:15] you know, if I just bought the markets through index funds, then I'll probably do better. So you start investigating indexes and index funds, and you'll learn that there's a lot of different indexes out there and a lot of different types of index funds and ETFs.

[00:06:29] And so you start putting this portfolio together of indexes, and you add more indexes as you learn more, and then you add more ETFs as you learn more, and you end up overcomplicating your portfolio again. And this is now the complexity stage,

[00:06:44] but now with a lot of indexing products. And the last stage, that's the three stages, right? So we have darkness, we have enlightenment, we decide to do indexing, and then you have complexity where now you've kind of compacted too many of these things in

[00:06:59] there. You go back to the fourth stage, which is simplicity. And you find that once you reach this fourth stage of simplicity, that this is the answer. That this is how you get your fair

[00:07:12] share of the returns from the market at the lowest fee. And once you get to that stage, there's no regression at that point. You're there from good. And so you have to go through it,

[00:07:22] you have to learn the process. And for some people they never learn it. Other people, they're at various stages. They might be in complexity. They haven't gotten to simplicity yet. I mean, it really does take sometimes a while to get to simplicity. And then there's

[00:07:36] the lucky people who somebody clues them in early in life that this is what they should be doing. They're really the fortunate people. I wasn't fortunate like that, but some people are. It's interesting. Our industry is definitely to blame as well for this. I was just looking at

[00:07:50] a family member's portfolio that was managed by a wirehouse and it was an assortment of individual stocks, like a bunch of random hedge funds in there. No benchmark to be found anywhere. I'm sure you see these when clients come to you, but our industry definitely does

[00:08:03] this. We try to just jam a bunch of stuff in there, maybe without as much of a plan as we should have. Well, the industry has a different motive, it's an ulterior motive, is to collect fees. And complexity is job security. So a lot of advisors,

[00:08:23] whether they know that simplicity is the way to go or not, will muck up a portfolio with a lot of stuff because when clients look at it, they don't want the client to really understand the

[00:08:35] portfolio. They want the client to say, well, I don't really know what all this stuff is, but you're the advisor, that's why I pay you. So I'm trusting you that this is what I need, when in fact it's not what they need. And a lot of advisors, unfortunately,

[00:08:48] who have been around for a while know that's not what the clients need, but again, complexity is job security in the advisor business. So you tend to see a lot of portfolios from advisors and wirehouses and even schwobs manage intelligent portfolio

[00:09:05] and Fidelity, I think is the worst when they put a portfolio together of ETS, it's just 50 ETS. Like, well, what are you doing? Well, they don't want you to really understand it as a client because if you don't understand it and you don't really get why they're doing

[00:09:20] what they're doing, the odds are you're going to stay with them longer. Complexity is job security. And it's unfortunate, but it happens. I'm guessing that like in a simple portfolio where once somebody reaches that stage, reacting to things like,

[00:09:38] an inflationary market regime, while you comment on that, like, when you have a period in the economy or markets where you haven't seen something for a while, like we have with inflation over the last few years, it was pretty dormant coming up into 2020 for more than a

[00:09:54] decade. And a lot of investors' portfolios may have been maybe heavier in bonds or different types of positions. Do you have any thoughts or feelings as if an investor should react to that? Or is that not really something they should be paying that much attention to?

[00:10:07] Well, again, we're talking about investors who have reached the stage of simplicity. And the answer is they're going to set their allocation to stocks, bonds, cash, and real estate based upon big numbers. So the classic is 60% stock, 40% bonds, a 60-40 portfolio.

[00:10:31] But that doesn't include an element of cash, and it doesn't include a large amount of cash. It doesn't include an element of cash, and it doesn't include real estate in there. But that exists also. I mean, that is part of their financial life. And you just want to

[00:10:44] maintain that because this is now not something that we're trying to mess with over a five-year period, a two-year period, a three-year period, but more like your lifetime. If you're able to stay with an asset allocation for decades, you'll do fine. You'll do fine. You don't really

[00:11:07] want to try to change it. Now there are times you maybe should change it, and that is, talk about this retirement transition phase where you're going to go from accumulating money to distributing money from your portfolio in retirement. Okay, that might justify

[00:11:24] a change in your asset allocation. Other than that, there really shouldn't be that many changes. And you get to the simplicity stage. It's setting an asset allocation, selecting the securities you're going to use for that asset allocation, and just leaving it alone. Maybe do

[00:11:41] some occasional rebalancing, but a lot of that can be done with just cash or new additions to the portfolio. But you really need to look beyond anything that might be happening in the near-term and recent, recency. I wanted to ask you about the 60-40 portfolio,

[00:11:58] but first I want to tell you that there is some hope out there for all of us because I was just looking at our episodes the other day, and we've talked to a bunch of big-name investors.

[00:12:05] We've talked about a bunch of complicated strategies in our most viewed episode of all time with over 30,000 views is with Mr. Rick Ferry. So we outlined the portfolio of all time, and it's been watched. Is there anything else we've done? Maybe that

[00:12:20] means there's hope for all of us out there. It is really that simple. I'm in my mid-60s now, and I always tell people, I wish I knew how to invest this way when I was

[00:12:36] in my mid-20s because I'd have a heck of a lot more money today personally than I do, because I made all the mistakes too, believe me. I did the options. I did futures contracts,

[00:12:48] commodities. I did it all, trying to pick individual stocks. I mean, I did everything, and trying to time markets, trying to time interest rates. Yeah, sometimes you're right. Sometimes you do get it right. Of course, that's the only thing you remember is when

[00:13:04] you get it right. You don't remember all those times you get it wrong. But in the end, if I just would have had a simple allocation and a few index funds, I'd be a lot better off. I'd have more money. And that's true for 99% of the people, not 100%.

[00:13:21] I mean, I have clients who, for one reason or another, ended up buying Apple stock back when the first iPhone came out, and they just held it forever, and they never sold it. And that's a big, huge position in portfolio. Unfortunately, it's a big

[00:13:39] tax problem too for them. But I mean, that does happen sometimes, but it's rare. But even them, the rest of their portfolio, they realize that they just got lucky there and that

[00:13:50] they have this big position in Apple, which now is a tax problem. But the rest of their portfolio, they're doing indexing with because getting lucky is great, but we're just not lucky like that most of the time. Yeah, and talking to clients, I think one of the biggest

[00:14:08] things is what you said, which is accepting the fact that you were lucky and not trying to go chase the next Apple because you found the first one thinking you're going to find the next one because that's when people usually get themselves in trouble. Yeah, well,

[00:14:17] every Apple stock that I bought probably went out of business or... When I remember back in the day, there was Dell Computer. I could have bought Dell Computer or a company called ZEOS.

[00:14:30] ZEOS was the name of it. It was Dell Computer or ZEOS, and I'm like, which one am I going to buy? And Dell Computer had some accounting irregularity that happened overseas. So I bought ZEOS

[00:14:40] computer. Of course, the company, I think went out of business. Right? Yeah, I mean, no matter what you do, it seems like it's bound to be the wrong thing. Not all the time.

[00:14:53] I mean, you could get lucky, but we don't know anything. I mean, what do we know about Nvidia? What do we know about the big companies, the small companies? We don't know anything.

[00:15:04] We think we know something, but we really don't. And whatever is known is already in the price today. So I don't know the answer to that. I really don't. And I kind of gave up on thinking

[00:15:17] that I was Warren Buffett a long, long, long time ago, and I'm glad I did. And I switched over to this indexing idea. I remember I've been in the business 35 years. So I switched

[00:15:26] over to the indexing idea about 25 years ago, 26 years ago. And that's what I've been doing for the clients and for myself. But I still wish I could have picked Apple when they came out with the first iPhone. I mean, that would have been nice,

[00:15:45] but didn't happen for me. So if we accept that simple is better, what do you think about the whole argument against the 60-40 portfolio? Because people will argue, well, you can put together a civil portfolio that has something for an

[00:15:57] inflationary environment beyond stocks and bonds. Or other people could argue, well, the 60-40 has done great over really long periods of time as long as you're willing to hold it. Don't worry about the inflation. You don't need that other component. How would

[00:16:07] you think about that? Well, the 60-40 portfolio is just kind of a middle of the road between stocks and bonds. There's a little bit more growth in it than income, meaning 60 versus 40. Peter Bernstein years ago, before he passed away,

[00:16:23] looked back at the 60-40 portfolio and said, for some reason it just kind of magically works. It seems to be a good mix if you don't know where to begin. So if you're in your mid-40s

[00:16:36] and you've been in darkness and now you've come to enlightenment and now you say I need to do things differently, where should you start as far as thinking about an asset allocation?

[00:16:47] Generally, 60-40 is a good start. Now you could go up from there on equity or you'd go down in equity and that becomes very personal at that point. But it's just staying with the asset allocation. That's what makes the 60-40 portfolio work is you actually have a target.

[00:17:04] I'm going to be 60 percent stocks, 40 percent bonds, and you stick with the target. So if the market goes down, the next amount of money that you're going to invest goes into stocks. If the stock market goes up, well, maybe the next amount of money that

[00:17:16] you're going to invest goes into bonds. And you just try to maintain this simple allocation. And if you maintain it long enough, you'll find that you're outperforming most everything else out there. It really is all about discipline. So 60-40

[00:17:28] is really more about discipline than some magic number between stocks and bonds. It's just a disciplined number that people can stick with. And that's why it works. Yeah. The challenge can be like if you're going to add something to the 60-40,

[00:17:43] like what is it? If you're going to put commodities in there, well, they can have ridiculous periods where they'd struggle for very long periods of time. It's like, yes, they'll do well in inflation, but are you paying a bigger price for having them?

[00:17:53] So that can be the challenge. I think if you're going to put something else in there besides stocks and bonds, like what it is that you can buy and hold is challenging. Well, you put your house in there, right? Real estate. That's true.

[00:18:02] Now, a lot of people say, well, your house is not an investment. Okay. If you don't own a house, then you're paying rent, and that certainly is not an investment. So your house can be looked at as part of your asset allocation.

[00:18:18] It is real estate. So you've got stocks, you've got fixed income, and the fixed income doesn't have to be bonds. It could be a CD ladder or a TIPS ladder, Treasury Inflation Protected Security ladder if you're concerned about inflation. It could be a treasury ladder.

[00:18:35] So it doesn't have to be a bonds or a bond fund or a bond ETF. It's some sort of fixed income in a disciplined way and how you do it. So your house, some sort of a disciplined

[00:18:45] fixed income portfolio, and a couple of equity index funds, a US equity index fund, an international fund, and you need a cash component as well for emergencies. That's it. I mean, you're done at that point.

[00:18:57] Do you worry at all on the other side of passive? I mean, most people would agree passive investing is the way to go, or for most people is a great option. But do you worry on the other side in terms of this idea that passive distorts the market,

[00:19:07] that as it gets bigger and bigger and bigger, it's driving up the biggest companies, the apples of the world, and it doesn't care about fundamentals. And eventually there's some problems in the market because of that. Do you agree with any of that?

[00:19:19] Indexing doesn't set valuation. I mean, indexing just takes the market as it is and buys everything. So with indexing, it's the amount of money coming into the market through index funds. Let's call it a total stock market index fund. You've got

[00:19:35] money coming into that fund. They go out and buy everything, so they're not over buying the big stocks or under buying the small stocks. They're buying everything. And same thing when they sell, it's across the board. They sell

[00:19:51] everything in equal proportion. So indexing is not setting prices. What setting prices are earnings from different companies, a company doing buybacks, hedge funds that are coming in and doing various things. Remember the amount of trading on the stock exchange

[00:20:12] that's from index funds is only 5% of the daily volume. I'll call it the New York stock exchange, 5%. The other 95% of the daily volume on the New York stock exchange is something else. It's not index funds. Index funds only trade when there's money that comes into the fund

[00:20:32] or money that comes out of the fund. And that's not that much on a daily basis that comes in and out of the indices, or at least the funds. So the idea that it's

[00:20:43] distorting markets, it really doesn't. I don't get that. I mean, it sounds good. It sounds like a sound bite if I was an active manager for a reason to say, oh, you don't want to do this.

[00:20:54] This is dangerous. This is worse than Marxism or whatever all these crazy things that you hear about indexing, but in fact it's not true. There's no evidence of it at all. You look at the

[00:21:04] dispersion of S&P 500 stocks. This is individual S&P 500 stocks. You look at the dispersion of returns between S&P 500 stocks. That hasn't changed to 50 years. So indexing isn't doing anything to the market. People will argue that it is, but I don't see it and it'll never

[00:21:23] happen in our lifetime where it's really going to have any effect. I don't believe. Did you listen to David Einhorn in Masters in Business with Barry Riddles or did you hear about it when he did it? What exactly did he say?

[00:21:35] So basically he was talking about this idea that fundamentals is dead. And this kind of flows through from the passive thing. The idea was he was saying like in the small business, the small business is going to be

[00:21:45] the big business. The idea was he was saying like in the small cap types of stocks, he plays around in that basically because everybody is indexing and they're buying those bigger stocks that when they have good news or good earnings report, nobody really cares anymore.

[00:21:57] So there's no one to build up the stock in response to their fundamentals. So he had kind of given up on expecting the market to figure out the value that he was figuring out.

[00:22:07] And he went into buying special situations where he was getting buybacks or dividends that were he was just getting the money returned to him.

[00:22:13] Sure. I was wondering if you have any thoughts on that? If you have any thoughts like in that in that capital cap space, do fundamentals matter less now because nobody's playing around in there anymore?

[00:22:20] Well let's go back to the dilemma that active managers have. I mean they have a maybe a three year time window where they have to outperform.

[00:22:28] If they don't outperform, they're gone. They're fired. Call it two years. Okay. If you look at the turnover of money in active funds, if an active manager doesn't outperform over a two year period of time, they're losing money.

[00:22:43] The money is leaving their funds. So they have to find something out there.

[00:22:50] So the idea that the market is not reacting to fundamentals. Last time I heard that was in the 1990s, late 1990s. I remember being at a CFA meeting in Detroit and I was talking to a small cap manager and he said exactly the same thing in 1999.

[00:23:09] So I'm going to go back to the exact words that you used. Fundamentals don't matter anymore. Everybody just buying these large tech stocks. I mean, you know, the world is a new paradigm.

[00:23:20] I mean, I don't know if you remember that phrase or not, but that was thrown around a lot in the late 1990s during the last tech run up. I know that's been now 25 years, but these are the exact same words that are being used today.

[00:23:34] And the fact is, okay, there might be some momentum there in the large cap growth stocks. I own them in my total stock market index fund. I'm happy.

[00:23:44] Right? I mean, I don't need to worry about these things. I don't need to worry about this section of the market not doing well because this section of the market is doing better.

[00:23:53] I own everything. I own everything. So I don't it doesn't matter to me. Money might move from here to here, but to me it's just one big ocean.

[00:24:00] If you take a bunch of fish from this part of the ocean and you put them in that part of the ocean, it's still fish in the ocean.

[00:24:07] So to me, it doesn't make any difference. You know, indexers like me who have gotten to this point of simplicity, all that stuff is important to the active managers who are suffering right now. But it's not important to me and it's not important to any of my clients.

[00:24:24] To bring in your 90s analogy and compare it to what's going on right now, one thing both have in common is people were talking about how crazy expensive the stock market was.

[00:24:32] And I want to ask you like, how do you think your average investor should think about valuation?

[00:24:37] I mean, obviously we know we can't time the market with valuation, but when you get in these periods where the market's really expensive or even if you think about Japan, you know, back in the 80s when it got to like a cave of 100 or something,

[00:24:47] is there anything like your average investor should do with that or they should basically say valuation is beyond me. It's going to, the market's going to be expensive. It's going to be cheap. Just stick with my funds and move on.

[00:24:57] It is more dangerous to try to make an active decision about valuation than just to do a rebalance. So if you're supposed to be 60-40, if that's what your asset allocation is, and the stock market went up 12% this year so far, whatever it's gone up 15%, the total market.

[00:25:14] And your bonds did not go up that much. And so you're off a little bit. You should just put some money into bonds. That's it. And as far as valuation, valuation, yes, the market has been going up, but for good reason.

[00:25:27] Earnings have been going up and earnings outlook, even though we really don't know what is going to happen, is still good. I mean, you know, forecast growth for U.S. stocks is still fairly robust. And, you know, in the end it's the earnings that drive the valuation.

[00:25:53] So, okay, these are all a lot of reasons to do active management. But if you're not doing active management, if you're just doing the passive, I don't know what's going to happen in the future. I don't know that the market is really that overvalued relative to future earnings.

[00:26:09] I'm just going to do by 60-40, 50-50, whatever the allocation is, and I'm just going to stick with that. You're going to be better off. We're talking about you doing what's best for you. And what's best is, like Jack Bogle said, don't just do something. Stand there.

[00:26:28] Just run your simple strategy consistently, and you're going to be better off. And don't all this other stuff is, yes, people make a living doing it. They make a living talking about it, but it's not something that you need to react to. You shouldn't be reacting to that.

[00:26:46] So I assume when I ask you about market concentration and the fact that, you know, the big stocks are such a huge portion of the index, the answer is going to be the same, right? It's not something your average investor should be that concerned about.

[00:26:55] Well, again, I own the whole ocean, right? So if money comes out of large cap stocks and goes into small cap stocks, does it make any difference to me? No.

[00:27:03] As long as it stays in the market, it doesn't make any difference to me because I'm a total stock market investor. Where the money is in the market doesn't matter. Maybe the money comes out of the U.S. market and goes into the international market.

[00:27:15] Well, guess what? I own that too. OK, so money starts leaving and going to Europe or going to Japan or back to China and the China market finally starts to recover. Fine. I mean, as long as the money stays in equities globally, that's all I'm looking for.

[00:27:34] I'm looking for the growth of the world economy is really all I'm looking for. What part of the ocean that money is in doesn't really matter to me. I'm going to do fine just by staying the course in this global index portfolio of equity.

[00:27:50] So you are a believer in international diversification, though, because that has been called into question a lot recently. The idea that international stocks have struggled for so long. A lot of people think these U.S. companies have international exposure.

[00:28:00] Just buy the U.S. You don't have to worry about that. You do believe international is something that adds value. Well, a lot of international companies sell to us. So, yeah, I mean, look at all our stuff.

[00:28:11] All the stuff that is around me right now, I'm going to guarantee you half of it came from China, at least my iPhone probably this case that I carry around. It's all made in China, right? And so China's a big manufacturing area.

[00:28:28] Obviously we buy a lot of stuff from China, which, by the way, has really helped keep our inflation rate low. And we'll continue to do that as well. So the bottom line is I just want to own everything. And yes, U.S. companies sell internationally.

[00:28:49] International companies sell to us. So if I'm buying this stuff, why wouldn't we want to own those companies if we can't? I'm trying to capture and make this as clear as I can. With my equity portfolio, I'm trying to capture global growth, real global economic growth.

[00:29:14] And with that GDP, call it global GDP. If you can capture real GDP growth, you get maybe a 2% there. You have inflation nominal GDP, which is made up of inflation plus real GDP, call it 4.5%. You get dividend yield of about 2%. So you add all that up.

[00:29:37] I'm going to say it comes out to about 7%. So I can get 7% from a global equity portfolio trying to capture this worldwide global growth. That's all I'm trying to do. And if it happens in the U.S. for a while, which it has, that's great.

[00:29:57] There are times when it doesn't happen here. It happens in Europe. There are times it happens in the Far East. I don't know where it's going to happen. Right now, it might be happening in India. Fine. I want to own it all, all of it.

[00:30:12] I just want to capture this global growth component. I will outperform inflation. I will outperform taxes. And I'll get an excess return of maybe 3% above all of that, a real after tax, after inflation return of 3%. And that's about what I should expect from an equity portfolio.

[00:30:32] And I believe I will get that just from a global equity index fund that has very low costs and low taxes. That's what I'm trying to do. So if I'm going to challenge other people's investment strategies, I've got to challenge our own as well.

[00:30:44] So I want to get your views on factor investing because it's interesting. We try to sell it as like a, it's kind of a hybrid. We're not here picking stocks. It's a systematic process. So it's kind of index-like, but it's not an index.

[00:30:55] We're not buying stuff with market cap weights. We're trying to use value. We're trying to use momentum. What are your views? How should your average investor, do you think, look at something like factor investing? Well, quantitative investing is factor investing, has grown tremendously in the last 20 years.

[00:31:11] You start out with the core index, like I said, but this idea that I'm just trying to capture global growth, that's where you begin. And if you want something extra, you know, maybe we can get a little bit higher rate of return.

[00:31:25] Granted, we're going to have to take a little bit more risk to do it, but let's go ahead and try to get a higher rate of return than that global growth. How can you do that?

[00:31:36] Well, the way you do that is you look at the world and say, well, which companies should give us a higher rate of return than the rest of the market just because their cost of capital for those companies is higher? Maybe there's smaller companies. Maybe they're not well-capitalized.

[00:31:59] Maybe they're industrial companies. The industries are in. And the bottom line is the cost of capital for these companies, equity capital, fixed income capital, is higher than say for the large S&P 500 tech companies.

[00:32:16] OK, so if you're going to invest in a portfolio of those companies, you wouldn't want to buy just one company because you have no idea which company is going to do well.

[00:32:25] So you're going to buy hundreds, if not thousands of these smaller value companies that have a higher cost of capital with the idea that in the very long run, and I mean like very long run, 25 years,

[00:32:43] what you really have to give yourself if you're going to do this, you should eke out a higher rate of return because you should be paid as a person who's providing capital to them. You should get paid a higher rate of return. So it's a risk thing, right?

[00:32:59] It's a risk thing. And yes, at times it might be a behavioral thing too, but to me, it's a risk thing.

[00:33:03] So you're taking higher risk with companies that will pay you more money to get capital from you, not much different than the difference between a AAA rated corporate bond and say a double B rated corporate bond.

[00:33:17] The double B rated corporate bond has got to pay you higher interest because there's more risk there than a AAA rated corporate bond. So it's the same thing with equity. Same thing with equity.

[00:33:27] So what you're doing is you're trying to isolate those companies that where that's the case on the equity side, they have to pay more to get the money from you. And in the long run, statistically it has shown academically that you get a risk premium for doing that.

[00:33:46] Again, not that different than the difference between high yield corporate bonds and investment grade corporate bonds. It's just on the equity side. Now some people would kind of disagree with me on this, but I'm trying to make it as simple as I can.

[00:33:58] So if this is what you wish to do in your portfolios, fine, as long as you know how long it takes and as long as you're broadly diversified.

[00:34:07] And of course you have to do it at the lowest cost you possibly can because every basis point matters here, especially since it's now popular.

[00:34:16] I don't realize a lot of the data on that came out when people really didn't realize this was the case, but now of course it's become very popular.

[00:34:24] There's a lot of funds out there, a lot of hedge funds out there, ETFs out there that are doing this type of investing, quantitative investment. It's not as easy, I don't think, to maybe get that excess return. But I think it will still happen.

[00:34:40] And you just have to keep the cost low and you have to be very diversified and you have to be very, very patient. And you also have to minimize the amount.

[00:34:50] I don't say minimize, but you have to put a cap on the amount, the asset allocation of your equity portfolio that you're actually going to put into this.

[00:34:57] So if you're doing a 60-40 portfolio, and let's say 40% of that is in U.S. stocks and 20% is in international stocks. So of the 40% in U.S. stocks, maybe 10 of that 40 would be in small cap value and 30 would be in the rest of the market.

[00:35:15] So there has to be some limit on it because it may not happen for years and years and years. I know it hasn't happened for years and years and years. And if it's not happening as an advisor, you run business risk.

[00:35:28] If you put everything into small cap value and it doesn't work, you're in trouble because your clients are going to leave you. And that's not good for them and it's not good for you. So there are some things you would do as an advisor.

[00:35:41] But I'd say 10% of a 60-40 portfolio could go into something like small cap value. I know it was a long-winded answer to your question. No, it was a great answer.

[00:35:50] And that word long run you kept using is so, so important because you'll ask people, am I investing in these factors for the long run? They'll say absolutely, and then you'll say, well, what is the long run? And they'll say, well, it's three years.

[00:35:59] And then when they actually invest six months in, they're like, well, this isn't going to really work out the way I'd hoped it would work out. It's like you have to understand. I mean, Meb Faber talks about this a lot.

[00:36:08] I mean, with some of these portfolios, the long run really is 20 years. It is. It's absolutely 20 years. Just behaviorally, that's very, very challenging for investors, knowing that it's that long. It's extremely challenging. Yeah. So we have a lot of things we're up against as investors.

[00:36:22] We're up against number one, inflation. I mean, people say, hey, my portfolio's done great. Well, okay. But the inflation rate is up 10% or 20%. I mean, yes, your portfolio is at an all time high.

[00:36:38] The S&P 500 is at an all time high, but so isn't the inflation rate, right? I mean, prices are higher now than they've ever been. So that's the number one culprit that we run into is inflation. The next culprit we run into is taxes.

[00:36:50] It doesn't matter if it's in an IRA or 401k or taxable account. Now Roth is different, but I mean, most money is in accounts that has to pay, eventually have to pay taxes. So you've got the tax man to deal with.

[00:37:03] So we got inflation and we got to pay taxes. Well, the hurdle rate just on inflation and taxes, if you believe the Federal Reserve, you know, 2% is where they're going. You got to add another 1% tax. I mean, you need to make 3% just to break even.

[00:37:20] I mean, if you had $100,000, you need next year to have 103,000 just because of inflation and taxes. Or you don't have the same purchasing power. So inflation and taxes. And the next thing you're up against is fees. Of course, you know, investing isn't free. There's fees.

[00:37:37] There's mutual fund fees, advisor fees, there's trading costs. I mean, there's fees. So you got to keep the fees down to a minimum. And the fourth thing you're up against is yourself, which is behavior, which is what we're talking about. Are you going to stick with the strategy?

[00:37:51] If you do not stick with the strategy, then don't do the strategy. Just do the total market equity, do some bonds, buy a house and have some money in a savings account for your emergency or that's all you should do.

[00:38:10] You shouldn't do anything else because if you're not going to stay the course, if you're not disciplined enough to stay the course, you're going to end up behind. And you don't want to do that because you're going to get out of the wrong time.

[00:38:20] Like you said, three years is the long term. Well, what's the definition of a long term investment? It's a short term investment that didn't work out. That's an old joke, by the way. But anyway, so, you know, just that one more. It's hard. It's very challenging.

[00:38:39] Yeah, it definitely is. One more for me before I pass it over to Justin.

[00:38:42] I want to ask you about ESG because ESG, for someone like me who's a factor investor, I never understood ESG because how I'm taught, if I want to get a premium, I have to endure some sort of pain.

[00:38:50] So it's like I can do good for the world and I can get a better return in the market. It just never worked with me very much. Like I should be buying the SIN stocks.

[00:38:58] I'm not saying to do that, but I'm saying if I want to get a premium, that's the kind of stuff I should be buying. So it never made sense to me, but how do you evaluate ESG and how do you think about that when you look at portfolios?

[00:39:08] Well, so again, this wasn't called ESG 35 years ago when I started. It was called Socially Responsible Investing. And of course they just kind of changed the name, added some more things to it. And, you know, remember the big tobacco litigation that occurred in the 1990s, right?

[00:39:28] I mean, this was ESG back then. You know, slay the tobacco companies, you know, take all their money away so people will stop smoking. Well, they did slay the tobacco companies, but tobacco companies are still making a lot of money.

[00:39:43] Bottom line is, on ESG, it's not a good way to express your desire not to have fossil fuels or not to have nuclear weapons. It's not a good way to express that desire because it would cost you money to do it.

[00:40:01] Those funds are more expensive than just buying the total market. And as you said, the SIDS stocks, the stuff that, you know, you would want to avoid in an ESG fund tend to do better because they tend to be value stocks.

[00:40:17] So in the long run, so it if they really wanted to support your cause, you would just buy a total stock market index fund as cheaply as you possibly can.

[00:40:29] And the amount of extra money that you make above what you would have made with ESG, you just take that money and donate it to whatever your cause is. That's a much better direct way of doing it.

[00:40:41] I also make one more thing about ESG. If you don't own the stock, you cannot vote the stock. And the way that you could affect companies is by voting their stock. And if you don't own it, you can't affect it.

[00:40:52] And ESG doesn't own it, so it doesn't make any sense. You know what I mean? ESG funds can't vote against ExxonMobil because they don't own ExxonMobil. So the only way you can actually make a change is by owning the stock and voting the stock.

[00:41:07] And you don't own that in an ESG fund. So it doesn't make any sense from a lot of different ways except from marketing, right? Marketing makes a lot of sense. Do well while doing well or do good for the environment while doing well for yourself.

[00:41:20] Whatever the active managers are talking about today trying to get you to invest in their ESG fund so that they get higher fees. But I've never been a big fan of it because I've seen it replayed. This is like a rerun of an old movie.

[00:41:33] And the same thing happened last time, by the way, with socially responsible investing. It just sort of went away in the late 1990s and now it's come back as ESG. And I suppose it's going away again, at least in this country.

[00:41:45] Now, maybe it's more popular in Europe, but not here. Just one of the things with ESG and also this idea of direct indexing is that people can have more of a say in the building of the investment strategy that you're in. So I'm just curious.

[00:42:02] It doesn't have to be related to those two specific things, but do you think when investors have a little bit more skin in the game, they're able to stick with a strategy?

[00:42:12] Maybe more when it goes through a difficult time because they've actually had some input or is that really not true of most investors? That is very, very true of asset allocation. And Justin, you really hit on a strong point.

[00:42:27] But I'm going to instead of getting on the ESG part of it, I'm going to talk about asset allocation. When I start talking with somebody about asset allocation between stocks and bonds in cash, this is how the conversation goes.

[00:42:38] But Justin, how much do you think you should have in an account over here that's sort of your reserve fund or your emergency fund? It's a dollar amount. How much do you think you need? And you tell me, oh, $50,000. OK.

[00:42:51] And then over here, Justin, you've got this other million dollars. What do you think, Justin, what would you feel comfortable with being in stock and what would you feel comfortable with being in bonds for the long term?

[00:43:04] You know, and forget about what everybody else says and forget about rules of thumb like your age and bonds and all that. I'm just talking about you personally. I mean, you know, what's your comfort level between, say, stocks and bonds?

[00:43:15] And believe me, I don't care if you said 20 percent stocks or 80 percent stocks. It makes no difference to me. You know, what is it? What do you think it should be? And I stop. Why?

[00:43:26] The only one who really, really knows what their allocation between stocks and bonds with that they're going to stick with for the long term is you, Justin. You're the only one. You have to tell me. I have to draw that out of you.

[00:43:40] An advisor doesn't give a client a bunch of questionnaires and says, hey, fill out these questionnaires and my computer's going to tell you what your asset allocation is. That's a bunch of gobbledygook. It's nonsense. Only you know, and you've thought about it a long time.

[00:43:53] You know, how much should I have in equity? How much I haven't fixed it? When I ask people that you get remarkable, diverse answers and I'll give you an example. I had these two fellows who sold an app.

[00:44:06] It was a travel app and they sold it for 80 million dollars back in the day. Now, they each got 40 million dollars and they were both the same age, about 30 years old. And I'm working with both of them, but not together. Just different, you know, independently.

[00:44:21] And I said to one, you know, what did you think your asset allocation should be? And he said, I don't want any stock. Zero. None. I've taken my risk. I want no stock. I want complete safety.

[00:44:31] I ended up talking him into about 20 percent stock because he really does need to have that inflation edge in there. So he did have 20. The other person, how much stock do you think you should have? 100 percent. I want all in. I'm in. I want to get maximum return.

[00:44:46] 100 percent. Ended up talking him down to like 80 percent because he did need to have some fixed income because he was going to buy some real estate. I can't tell. I don't know. There's no magic formula out there, you know, based on your age or your wealth or whatever.

[00:45:00] There's no magic formulas of what your asset allocation should be. But I do know that if you come up with it or if you help, you know, if I help you draw that out of you and you come up with that asset allocation and we agree.

[00:45:13] OK, Justin is going to be 70 percent stock, 30 percent bonds that you'll stick with. You will stick with that asset allocation. And in the very long run, that is the biggest driver of your investment return is sticking with that asset allocation, whether it's 20 percent stock or 80 percent stock.

[00:45:32] That doesn't matter as much as sticking with the allocation for the long term. So getting back to your point. Yes, it's true that if the investor comes up with the idea that there's a higher probability they'll stick with it as far as the ESG thing.

[00:45:47] I think it's too faddish for you know, it's in the news like AI right now. Oh, let's do AI. Let's say I tend to say let's let's not do any of this faddish stuff. Let's just stick with the total market and just do the asset allocation.

[00:46:01] It's very tax efficient. It's very low cost. And and you're going to do fine with that. And most people will say fine. Now, some people like Jack would say, you know, but what if I want to have some small value? I'll say, OK, fine. Yeah.

[00:46:13] How much small value are we going to use? Are we going to use it just in the U.S.? Are we going to use it internationally? Let's take an element of this.

[00:46:19] Not too much, but let's put an element of small value as long as you're willing to stick with it for the next 25 years. Well, let's just call it the rest of your life. Are you willing to do that? Yes. OK, then we can go down that road.

[00:46:30] I hate to say it, but I'm trying to keep things as simple as possible. No, I think you brought it to the asset allocation part. I think that that's more relevant and probably more long lasting. So I think we certainly appreciate that. Let me ask you this.

[00:46:44] And this might be let's see if I can sort of thread the needle here. So I'm just wondering for clients that you've worked with that are like at or nearing retirement, when you think of.

[00:46:56] The key things that set them up for a successful retirement, what would you boil those down to?

[00:47:04] For example, and you may disagree with this, but I'm thinking you might not want to have a mortgage going into retirement where your portfolio might want to be a certain amount so that your withdrawal rate is isn't more if you're drawing, let's say, a certain amount off of it.

[00:47:18] It might not violate that percentage of the portfolio. But I'm thinking things like Social Security, mortgage, portfolio. Like how would you is if you can kind of paint a picture and I know it's different for everyone because your point is very good.

[00:47:32] Like everyone's asset allocation is different based on the risk tolerance and their goals and what they believe in. But if you could think of like the optimal person going into retirement in terms of what their portfolio would look like, how would you sort of take that?

[00:47:46] Yeah, so I'm a cash flow person. So I look at you, Justin or Jack and you're going to go into retirement and say, okay, what's your budget look like? And I don't help them come up with the budget. I mean, they have to come up with one.

[00:48:01] I can they don't have a budget. I can figure it out just by asking. I can look at their numbers.

[00:48:07] You know, they're like they're how much they pay in taxes, how much they pay in the state of the country, how much they pay in the state of the country. I can look at the numbers.

[00:48:14] You know, they're like they're how much they pay in taxes, how much they save each year. And I can pretty much come up with pretty close to how much they're spending. But we really need to know what the spending number is.

[00:48:26] How much are you going to be spending? That's the number one question because we want people to be able to spend what they're comfortable spending. And then once we come up with that, then we have to look at sources of income.

[00:48:40] Where where's the money going to come from? Is it going to come from pensions? Is it going to come from Social Security? Is it going to come from how much is going to come from the investment account?

[00:48:51] And then and then I have to ask them a question because it's really important. And that is that how much do you want to leave to your heirs? How much do you want to leave to your children or your family or charity? Is there a dollar amount?

[00:49:09] Now, let's say somebody had four million dollars when they retire. Do you want to leave inflation adjusted four million dollars to your family? And I have to wait for an answer on that one because you get this whole range of answers.

[00:49:23] Some people will say, I don't care if there's anything. They're going to get what's left no matter what it is. Well, that means they could spend a whole lot more money in retirement if they're not that concerned with their children getting four million dollars inflation adjusted.

[00:49:38] A lot of people say, well, I'd like them maybe to get what I have now. So if I have four million dollars net worth now, inflation adjusted, I'd like for them to get four million dollars.

[00:49:48] OK, well, that means that we can take out a certain dollar amount out of your portfolio. If your portfolio is giving you six percent or five percent and you're going to take three percent out of that, then you're then you're at two percent.

[00:50:04] So, you know, you start working the numbers and you start backing into this withdrawal amount that they could take out from their portfolio. And then there are other people who say, I want my children to actually have more.

[00:50:15] It's very rare, but I want my children to have more. There is much as they can have. And then there's the question of, well, how much how well do you want to live in retirement? These are really important questions to ask people during this conversation.

[00:50:29] It's what you have to get in your mind as an advisor. What's their cash flow needs? And by the way, there's this smile to spending where you have your go-go years, your slow-go years, your no-go years, which you've probably heard that phrase before.

[00:50:43] And people, when they first retire, they spend money. But then later on, they've traveled. They're not going to spend as much anymore. And then later on, there might be some health care issues, but they could be selling the home and all of that.

[00:50:54] So there's a lot of things that get packed into that. And I have to drag out this answer, but you really got to get a good picture in your mind. Oh, what's the cash flows for these clients?

[00:51:04] What's it going to look like and where is the money going to come from and how much of that money is going to come off of that portfolio to get a percentage draw rate?

[00:51:13] And then there are so many people out there that have saved way more money than they really need. Say, well, OK, I mean, I remember this one client. He had a Ph.D., Stanford University, very smart person.

[00:51:32] I won't say where he worked, but he was a brilliant, brilliant mathematician. It saved $20 million. And I said to him, well, how much are you spending? Do you think you'll spend a retirement? And he said, oh, I don't know. I'm kind of concerned. I'm thinking maybe $100,000 a year.

[00:51:51] And I said, OK, I said, you're a mathematician. You got a Ph.D. in math from Stanford University. How much is one percent? I bet you it's $100,000 of 20 million, you know, like 0.5 percent. You're never going to run out of money. But, you know, I mean, oh, thank God.

[00:52:08] He said, thank you. Thank you for telling me that. It blows you away. And I know that any advisor out there who has had these conversations with clients or realized when it comes to doing the math of your own portfolio, we struggle so hard.

[00:52:20] And all all we as advisors really have to do is confirm or validate to the client that everything's going to be OK. You know, you're going to be you're going to be fine.

[00:52:29] And you could take three percent out of your portfolio and your kids will still inherit the same amount of money you have today adjusted for inflation. There's not going to be any problem if you take four percent.

[00:52:37] That's fine, too. Maybe they'll make maybe they'll won't get as much. But that's OK because you don't care. Or maybe you could take five percent at least for a while, because I know you're not going to be taking much more than that.

[00:52:48] Or you probably take less than that later on down the road. I mean, so it's it's there is no one size fits all. But it really has to be approached from the from the spending side. How much do you want to spend? That's how you approach that question.

[00:53:02] And then you back into how much is going to come out of the portfolio to find out whether or not they they have enough.

[00:53:10] Now, I'd say with ninety nine point nine percent of the clients that I work with, they have enough, even though it may not have a lot. They have enough because they realize their spending needs need to be very low and they're they're OK with that.

[00:53:21] But that's the way I do it. And I know I know I've dragged on this this answer again. I apologize for that. That's all right.

[00:53:30] That's a great response. Two more quick questions for you kind of coming out of the investing realm, maybe a little bit is when you look at the future and think about the future.

[00:53:39] What do you what do you just in general, what are you most optimistic about and what are you most worried about? Well, I think that I'm most worried about the federal deficit.

[00:53:51] I you know, historically, if you look at countries that eventually borrowed so much money that they couldn't pay their bills, that meant bad things for that particular country. So I don't know how far we can go as a percentage of GDP.

[00:54:10] I was talking with a Vanguard economist earlier in the year, and she suggested that our federal deficit could get up to two hundred and forty percent of GDP and would still be OK. I mean, we're over 100 percent now. But that that's my biggest worry is is.

[00:54:30] There has to be controlled spending and we have to try to get this deficit at some point.

[00:54:41] Stop spending more than we have coming in now with that, it will also say that the reason why you can go to two hundred forty percent is because the value of our of our wealth in this country is just growing and growing and growing.

[00:54:53] So as a percentage of the wealth of the country, it really has. It's not at an all time high, strangely enough.

[00:55:01] So in other words, if you say, well, you know, I own all these assets and I borrowed this much money that money you borrowed may be at an all time high, but relative to the amount of assets you have, it's not an all time high.

[00:55:11] We in this country are at that point. The wealth of the country has gotten so large that the deficit is high, but it's not at an all time high relative to wealth. So that's kind of a good thing, I guess. What's the optimism?

[00:55:30] I mean, I look at productivity. I mean, we have incredible made incredible strides with technology and the standard of living around the world. Fifty years ago, you know, there were countries that half their populations were starving to death. We don't see that as much anymore.

[00:55:56] I mean, the standard of living of countries all around the world, including the United States, has just has just gone up remarkably, especially for countries that were very, very poor 50 years ago. So that's really positive.

[00:56:11] And all these people now are living better and will continue to live better. And I think that, you know, the Internet has a lot to do with that. You could teach people how to do things, how to make things better for them over the Internet.

[00:56:25] And, you know, AI, I think it's going to be very positive for helping people.

[00:56:30] So there's a lot of optimism for me out there as why the world should continue to grow and why this GDP number, global growth of GDP and global growth of living standards should just continue, which means equity should continue to do well over the long term.

[00:56:47] So I hope I answered your question. You did. Thank you very much, Rick. We always appreciate you coming on and your insights and wish you all the best this summer. Thank you, Justin. Thanks for having me again. Thank you.

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