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World Class Investing
James Lange, CPA/Attorney
Guest: P.J. DiNuzzo, CPA, PFS®, AEP®, AIF®, MBA, MSTx
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|Click to hear MP3 of this show|
- Guest Introduction: P.J. DiNuzzo, CPA, PFS®, AEP®, AIF®, MBA, MSTx
- Different Investors, Different Thoughts
- Emotional Investing versus Objective Investment Strategy
- What is Asset Allocation and Why is it Important?
- Asset Allocation versus Diversification
- Common Diversification Mistakes
- Asset Class Decisions
- Indexing versus Active Money Management
- The Difference Between Vanguard and Dimensional Fund Advisors
David Bear: Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney, and author of three best-selling books: Retire Secure!, The Roth Revolution: Pay Taxes Once and Never Again and now, Retire Secure! For Same-Sex Couples. As 2014 comes to a close, how secure is your financial future? Asset allocation, diversification, class and rebalancing are key factors in maintaining a balanced retirement portfolio. Active investing versus index investing: which strategy is best for you? For perspectives on maximizing your retirement assets, The Lange Money Hour welcomes P.J. DiNuzzo back to the show. A nationally recognized expert in investment management, P.J. has been featured in numerous business publications and TV shows. Approved as one of the first one-hundred Dimensional Fund Advisors, he’s rated a five-star advisor by Paladin Registry Investor Watchdog, ranking in the top one percent of America’s more than 800,000 investment advisors. Based in the Pittsburgh area, his firm DiNuzzo Index Advisors also consistently ranks among the country’s top five hundred investment firms. P.J. and Jim will discuss world class investing strategies to maximize your retirement income. So, without further ado, I’ll say hello, Jim and welcome, P.J.
Jim Lange: Welcome, P.J.
P.J. DiNuzzo: Hello. Good evening. Thank you.
Jim Lange: Before we get into the substance of tonight’s program, I feel honor bound to have full disclosure. Usually when I have a guest, I have no financial interest whatsoever in any listener doing business with the guest. So, I might have, you know, whether it’s Ed Slott or John Bogle or whomever, and I often, if they have written a good book, I will often plug the book, but other than maybe a dollar or two royalty from the book, there is no financial incentive really for either the guest or for myself, and I don’t have a financial incentive with the vast majority of the guests. I do with P.J., and I feel honor bound to reveal that. P.J. and I have an arrangement where if somebody goes to P.J. through our office, that is, if you come to a workshop, you go on my website, you come in and meet me or somebody in my office, P.J. and I have an arrangement where our office does the things that we like to do, such as determining the appropriate amount for Roth IRA conversions, the appropriate amount and strategy for Social Security, how much can you afford to spend, what should your retirement plan look like, what should your wills look like, what should your tax returns look like. That’s the kind of stuff that we have been doing for close to thirty-five years now and that we love to do. P.J., on the other hand, is a low-cost index money manager, using what I believe is the best set of index funds on the planet, and P.J. and I combine our services. So, if I get a prospect that is interested in the things that I do and in the things that P.J. does, I will then refer that prospect to P.J. P.J. will do the money management things, which is what we’re mainly going to be talking about tonight. I’ll do the other conceptual things that I had mentioned earlier, and then, rather than each of us sending the client a bill, the client is billed for just one time, and the fee is between, well, one percent at the highest, and then it goes down by percentages the more money that is invested. So, I clearly do have a financial interest in people doing business with P.J. and feel honor bound to disclose that. But anyway, getting into the substance of the show, P.J., there’s different types of people and different types of investors. Can you tell us what some of the people in the audience might be thinking and how different people think about investments?
P.J. DiNuzzo: Yeah, Jim. That’s a great segue into the asset allocation question. Before we think about specific asset allocation, that’s just a fancy word for the audience of listeners as to the percentage of stock in their portfolio(s) versus the percentage of bonds and cash in the portfolio. There’s three types of investors that you were mentioning, Jim. If we can, think of delegators, validators and do-it-yourselfers. Now, most of our clients, the super majority of our clients, would be delegators. Just to use a big round number, if they had a million dollars, they would delegate all one million dollars of their portfolios to us to manage, provide, as you said, the financial planning, retirement planning, investment management and all of the services that you and your firm perform. If they were a validator, they would probably give us $500,000, let’s say, and they would manage $500,000 themselves. Now, there’s nothing negative about this, but the trait that comes to mind is an engineer. A lot of engineers like to manage their own portfolios. They’re very good with numbers and spreadsheets, but oftentimes, they recognize at the point of influxtion when they’re getting ready to retire, “Maybe I’m just not that comfortable managing everything.” Do-it-yourself investors are exactly as the definition implies. That would be a terrible fit for us. They’re literally hands on and they’re going to perform the investment management themselves.
Jim Lange: On the other hand, hopefully, this information will be of use to all the investment types. So, one of the issues with investors is that we are all human animals, and we tend to get exuberant when times are good and we tend to get down and fearful when times are bad. Can you tell us about the emotional rollercoaster (as you sometimes call it) that investors just naturally have and what they can do to avoid that emotional rollercoaster?
P.J. DiNuzzo: Yeah, Jim, and that was a good point you just made a second ago that I’d like to reiterate. Everything that you had laid out for tonight’s program is of value for every type of investor. Every type of investor will go through all the points that we’re going to discuss this evening. The one main point, investment rollercoaster, again, our bias would be that we are advisors, if you can think of us as coaches, so to speak, and the data would prove that, by and large, if you find the right coach, and the key is that if you find the right coach for yourself, that they can greatly enhance your returns by the handholding process, the advice, getting to know you. Again, if you’re a self-directed investor, you are going to go with yourself, but you’re going to have to have a philosophy, a strategy and the discipline to maintain your financial discipline when you go through the rollercoaster of investing that you just mentioned.
Jim Lange: Well, sometimes, you talk about what you call the ‘emotions return gap.’ And this actually isn’t your concept because, as I understand it, this is the result of a famous study. Can you tell our listeners about the difference between, let’s say, emotional investors and an objective investment strategy?
P.J. DiNuzzo: Yeah, Jim. The emotions return gap is what we refer to. There’s a company out of Boston, Massachusetts (Dalbar) that does market research, and they’ll go out and take a look at individual investors, again, the do-it-yourselfers, self-directed do-it-yourselfers, who are managing their own portfolios, and they’ll go and take a look at E-Trade, Scottrade, Charles Schwab and Company, Fidelity, TD Ameritrade, all the large custodians, low-cost brokerage firms. And over the last approximately twenty-year period of time, what we see is around half the rate of return for these individuals and their stocks and stock mutual fund returns versus just the S&P 500. So, what ends up happening is, as you referred to that investment rollercoaster a moment ago, that the average individual investor, over the last couple of decades, has gotten on and off of that rollercoaster numerous times. We all make mistakes. You know, nobody’s perfect all the time, but they’re getting on and off of that rollercoaster numerous times, making decisions of what the behavioral economists, the behavioral scientists have found out about investing is we just caution the audience listeners that when your gut is telling you something regarding investments, it’s been proven to be wrong about two out of three times. So, if it’s telling you that you have a burning desire to buy stocks, if you have a burning desire to sell a position, on average, again, incorrect about two out of three times.
Jim Lange: Well, that leads into issues of asset allocation, and, of course, the famous Ibbotson study that he actually says, “Well, it’s not quite accurate,” but the original study said that the asset allocation decision accounted for roughly ninety percent of your financial success. Now, even if that is high, could you tell our audience, first, just being a basic question, what is asset allocation, and how important is it to an investor’s long-term financial success?
P.J. DiNuzzo: Yeah, Jim. Asset allocation, and oftentimes, our average client in retirement (which I think we’ll touch on in just a little bit), has three different asset allocation strategies. But asset allocation, at the basic level, again, would be the portion of stocks in your portfolio, that’s the portion that you’re looking to for your growth, versus your portion of bonds and money market funds or cash in the portfolio. So, let’s say, if someone were to say to you, “I have a 60/40 portfolio,” they’d be indicating that they have 60% in stocks and 40% in bonds. The study that you had mentioned regarding Roger Ibbotson, Brinson, Beebower, etc., basically, if the audience can just understand by common sense that 100% in stocks over the rest of their lifetime is going to produce the highest rate of return. The probabilities are astronomical that’s going to occur. Eighty percent in stocks in your portfolio is going to have a slightly lower return, 60%, etc. If you think of a tabletop, if anybody’s sitting at home right now, you have the top of your table, your dining room table, your coffee table, wherever you’re sitting at is a 0% rate of return. 100% in stocks when the market is down would be all the way down at the floor. If you had 80% in stocks, well, it’s not quite all the way down to the floor, it’s down a little bit less. So, everybody, it’s always amazing, Jim, we talk to them and they understand that fundamental concept. “Yeah, I know. The more I have in stocks when the market’s going up, I’m going to make more money, and the more I have in stocks and the market’s going down, I’m going to lose more money.” But again, there’s that inner, that gut feeling that people get that they want to make decisions, and again, they’re making bad decisions at bad times. You know, to quote Roger (and I know you’ve had him on the show a number of times), you know, the national research again is 90% of how much you’re going to make and 90% of your risk in your portfolio is going to be identified by that stock-to-bond mix. All the things that we tell clients (and I know you guys are drinking from the same water, Jim), are, you turn on one of the stock channels on TV, what are they talking about? They’re not talking about asset allocation. They don’t talk about indexes. They’re talking about…
David Bear: Buy this stock.
P.J. DiNuzzo: Yeah, all the sexy and exotic things. You know, buy this stock, just as Dave said. What’s the hot stock for today? About market timing, hey, maybe you should get in, maybe you should get out, maybe you should back off of your equities by ten or fifteen or twenty percent for whatever’s going on. All the other topics is well, liquid alternative investments, but again, we would just refer to that as noise. Again, that most important decision you’ll make that will determine over the rest of your life how successful you’ll be in your portfolio and portfolios plural will be that asset allocation decision.
Jim Lange: Well, I know that you do asset allocation a little bit differently. So, you had mentioned 60/40, but your client doesn’t typically have one portfolio that might be 60% stock and 40% bonds. You have, what I have heard you refer to, as the bucket analysis, or the stack analysis. Could you tell our listeners what you mean by the bucket analysis or the stack analysis?
P.J. DiNuzzo: Yeah, Jim. What we’ve come up with over time is, we take a look at when the behavioral economists go back and sort through the financial forensic work, and they take a look at the market, and want to know just what really happened in ’08 and ’09 when we had the worst meltdown since the Great Depression, what happened in 2001 and ’02, even what happened in ’73 and ’74 in these bad periods. Basically, water finds its level. Warren Buffett says that you get to find who’s swimming without any swimming trunks on when the tide goes out, and when the tide goes out in the market and you get a washout, everything eventually, water eventually settles back to its proper level. So, if an individual really is only comfortable with 50% in stocks and they had 100, those are the people that sell out. Oftentimes, they don’t get back in in a month or two. Sometimes it’s six months later or a year or two or three years later. They’ll eventually get back to their comfort level, but what we recognized is, whenever I first got in this business in the late 1980s, truthfully, I thought it was pretty straightforward. I said, “Hey, stocks do this really big number, bonds do a lot less than that, short-term bonds do barely above inflation, there you go.” What we find is, what we had mentioned earlier, you know, the emotions return gap. With the emotions return gap, individuals are making emotional decisions if their portfolio is too volatile. So, what we look for is customizing with the DiNuzzo Money Bucket Stack Analysis, for their needs bucket, their wants bucket and their dreams and wishes.
David Bear: Well, that makes great sense, and it also makes good sense to take a break right now.
David Bear: And welcome back to The Lange Money Hour, with Jim Lange and P.J. DiNuzzo.
Jim Lange: So, before the break, we were talking about asset allocation, and you had mentioned the bucket analysis, and I know that you always like to say that every client is different.
P.J. DiNuzzo: Yes.
Jim Lange: So, what would you do…let’s even say that the client is, or two clients might be, equally comfortable with a certain amount of risk, but let’s say that one has either a high Social Security or maybe even a higher pension plan than a different client who has maybe the same amount of money. Would you have different asset allocation recommendations for two different clients who have the same amount of money, the same comfort level, the same ability to sleep well at night, or should the issue of asset allocation be looked at in a vacuum regardless of Social Security or any pension income?
P.J. DiNuzzo: Yes, Jim, exactly. We both do feel very strongly about Social Security maximization, doing a very deep dive to give our clients the best and highest level of objective advice on how to maximize their Social Security decisions, which is a very complex analysis, especially for an individual trying to do it themselves. But this has an integral correlation to what we call our needs bucket. The entire purpose for us going through the deep dive that we do with our financial statements, and we tell anyone that we meet with, any prospective client, that we would look at them as their own household, their own organization, and that needs bucket is mission critical. That’s the first bucket that we’re looking to satisfy. We’re looking for all sources of guaranteed income. The guaranteed income that we count is Social Security, from one or both individuals in the household. Then, we’re looking at, what you had mentioned, defined benefit plans, as well. So, with the guaranteed income, about three out of four times, defined benefit pension plans are going the way of the one-eyed dodo bird. I mean, they’re getting rarer and rarer. You just don’t see…
David Bear: Because two-eyed dodos are still around!
P.J. DiNuzzo: Yeah, the two-eyed, yeah. There’s a few of those walking around. But three out of four individuals do not have enough money with just their Social Security in their household to satisfy that needs bucket. So, they have, what we would call, an income gap, and I can just tell the listeners in the audience, if they’re attempting to have a growth portfolio, for example, with sixty or seventy or eighty percent in stocks in their entire portfolio, and they have a shortfall on food, clothing, shelter, healthcare and transportation, that they have a high probability, looking at the national statistics, of having a material degree of anxiety in retirement if they’re invested too aggressively for those basic core expenses.
Jim Lange: All right. Why don’t we move on to diversification? So, first, why don’t we do a basic question: what is the difference between asset allocation and diversification?
P.J. DiNuzzo: Yeah, Jim. Going through the logical sequence for the listeners and anyone who just tuned in, the first decision we have is, are you going to do this yourself? Are you going to engage the services of a professional? Then, the next decision, whether you’re doing it yourself or engaged the services of a professional, would be how much are you going to place in stocks versus bonds in your portfolio? So, we’ve been mentioning a couple times the 60/40 portfolio, 60% in stocks and 40% in bonds, 60/40 would be the asset allocation. Once you’ve made that decision, when you’re looking at the 60% that you’ve decided, proactively that you’re going to place in stocks, the next question is: how am I going to diversify that? Am I going to place all 60% in stocks just in the S&P 500, for example? Or am I going to place any of this in international stocks? Am I going to purchase any small cap stocks? Am I going to purchase any real estate in the emerging markets? So, those are what we refer to commonly as asset classes: U.S. large, U.S. small, U.S. large value, U.S. small value, real estate, international large and small value, emerging markets, etc. Those would be the asset classes, and that is where the diversification comes into the strategy.
Jim Lange: All right. A lot of listeners, I think, don’t do this right, and I know when people come into our respective offices, that we see a fairly common mistake. What are some of the mistakes that you find investors make with their diversification?
P.J. DiNuzzo: Well, the most common mistake again, Jim, is what we had mentioned earlier: do you have a philosophy? Do you have a strategy? Do you have the discipline to maintain that? And we know, nationally, just the pure facts are that the average individual investor does not. The average individual investor holds their average stock position for three years, on average. Five years is the average U.S. business cycle. So, you’ve got to hold your position for at least one cycle. Ideally, you want to hold it for multiple, multiple cycles. So, they’re not even holding it long enough. So, the average individual investor looks at their portfolio, and they’ve made their purchases, and they’ll go through and take a look at the end of a year, whenever it is, and the underperformers look like, I always call them, they look like the weeds in their garden to them, and they’ll say, “I’ve got six investments that are up and four that are down. That disturbs me. I want to sell them and I want to buy things that I think are going to grow.” They just don’t hold their positions long enough, and it’s understandable because they don’t have a philosophy or a strategy. They’re just sort of return junkies, and they’re just looking to just return whatever they purchased.
Jim Lange: All right, and that can obviously…if they do that (and we’ll talk a little bit about rebalancing later), but basically, what that means is that they are selling low and buying high.
P.J. DiNuzzo: Yeah. That’s the two out of three times that they’re wrong. What we’re basing everything on in the portfolio is the highest level of empirical research and empirical data that I know of. We’ve got an 86-year track record, what the research at the University of Chicago Graduate Booth Business School started. So, our U.S. large position, U.S. large value, U.S. small, U.S. small value, all the indexes, we know what they’ve done through thick and thin, World Wars, regionalized wars, inflation, deflation, presidential assassinations, very long periods of time, and there’s a very rigorous normal distribution to all of the investments that we place our clients in.
Jim Lange: All right. Then, after diversification comes the issue of asset class decisions. Can you tell us a little bit about asset class decisions, how that might be different than asset allocation and diversification?
P.J. DiNuzzo: Yeah, so asset allocation, again, stocks versus bonds, diversification, let’s say U.S. versus international. Then once we get in and we start doing the…which I started a little bit ahead of myself, to drill down a little bit deeper. If we’re going to have two-thirds in U.S. and one-third in international, again, that two-thirds in U.S., are we just going to buy S&P 500 or, what Jack Bogle talked about on your show, just buy the total U.S. stock market. Are we just going to buy a real big broad asset class, or are we going to drill down to more specific? We believe, and as the data represents for the last 86 years, that there are what we would refer to as certain ‘premiums’ in the market. There’s a manifested value premium. Large value stocks do better than large growth stocks. Small value stocks do better than small growth stocks. We see the same premium manifest itself internationally as well as in the emerging market. That’s one of the biggest components or elements of the reason why Professor Fama won the Nobel Prize last year. So, what we’re doing, recommending with these asset classes, is indexing the entire plan…I know we’re going to get to indexing in a second, but covering the entire planet Earth and tilting it towards all the known areas that have done better over full market cycles.
Jim Lange: Okay. And by the way, just to clarify for people, when you were referring to stocks or equities, that’s when you literally own a portion of a company, as opposed to a bond or a fixed income instrument where you are essentially lending money to a company or a government, and I think that that’s probably important to define those terms…
P.J. DiNuzzo: Yes.
Jim Lange: …just to know what we’re talking about. The other thing that you mentioned is you distinguish between value and growth. Is it fair to say that value companies are companies that have a lower price earnings ratio, not as sexy, perhaps not on an individual basis, and a lower potential to meet the sky? I always think of boring companies like the electric company that nobody ever really got rich on. On the other hand, you don’t pay your bill, they cut you off, as opposed to a growth company, for example, like Amazon, that doesn’t make any money but it sells for a lot of money.
P.J. DiNuzzo: Yeah. Yeah, exactly. Low price earnings ratios on the value, oftentimes they’re beaten up too much unjustifiably. You know, sometimes the baby gets thrown out with the bathwater. With them, everyone knows who the growth stocks are, and what happens over time is they’re actually overbid. The prices are at too high of a premium. They don’t beat their earnings estimates enough years in a row, and it ends up showing up in the underperformance.
Jim Lange: Well, speaking of underperformance, sometimes people read something or they hear something, “Oh, international’s bad,” or, “Oh, small companies are bad,” or combine the two, “Why should I have international small companies in my portfolio?” And particularly, I think there’s a lot of people that have certain trepidations and hesitations about investing in small or even third world countries. How would you answer a concern that, “Gee, I just don’t want all that volatility of a smaller company, or of, let’s say, a third world county company?”
P.J. DiNuzzo: Yeah, great point, Jim. The key there is to buy huge baskets of those stocks. When we look at all of our stock positions, if we did an X-ray of our U.S. and international, as well as the small amount we hold in emerging markets, we’d have a fractional ownership position. As you said, we’re owners. These are equities. We have fractional ownership in these companies. We have a fractional ownership of over 18,000 stocks in over forty countries across the globe. So, that’s where you can get really hurt with the individual stock positions. We know what these large baskets have done. Again, smaller stocks are more volatile than large stocks. There’s also been a commensurately higher return associated with them, and the same story follows through to the emerging markets. DFA, when it comes to small stocks and emerging markets, I think is as disciplined or more disciplined than anyone. For example, we basically don’t have any exposure. As large as some people think China’s market is, there are just not a lot of fundamental protections in there for the owner of those companies. So, basically, we are not invested in China at all, for example. So, they have a tremendous amount and a very high level of the due diligence that they perform to have the highest level of safety for the companies that we’re purchasing.
Jim Lange: All right, and why don’t we go back to, I would say, the core of Dimensional Fund Advisors, who is the, let’s call it, underlying company from which you choose the investments from which, again, you were one of the first one-hundred and one of the top guys. And by the way, I should also add that when I was approved as a DFA provider, and didn’t actually want to do the money management, and I called DFA and said, “Who’s the top guy in Pittsburgh?” They said you, and that was the beginning of us getting in touch.
P.J. DiNuzzo: Umm-hmm.
Jim Lange: But one of the fundamental differences between your general approach and most money managers’ approaches is that you have an index approach, or a low-cost index set of funds that make up a portfolio, and the other side of that is an active money manager. Can you tell our listeners the difference between indexing and active money management?
P.J. DiNuzzo: Yeah, Jim. As we’re walking down the portfolio investment sort of class for today, the discussion we’re having, once the audience members, if they can think that they’ve made that diversification decision, you’ve decided that you want to have, of your stock portion to keep it simple, two-thirds in U.S., one-third in international, let’s say of which you have in the U.S., you want two-thirds in large and one-third in small. So, you’ve made these decisions. “I’d like to own some large core stocks, such as the S&P large value and large value, small, small value.” Then your next question is, “How am I going to access that asset class? Am I going to access that position with an active manager who, by definition, says ‘I believe I’m smarter and have more financial acumen and that I can pick the stocks that are going to beat that index.’?” Or do you invest directly in the index?
Our belief is that the market is highly efficient, especially over long periods of time. We would expect that over the average ten-year period of time that, on average, the index is going to outperform the active manager in these asset classes by asset class comparisons about three out of four times. Now, the challenge is that that one active manager out of four who outperforms gets an awful lot of attention. They get the articles in Money magazine, in Kiplinger’s, and they’re being interviewed on the stock channels, etc. The challenge is that no one’s ever devised a way to identify that outperforming manager in advance. We all know who they are retrospectively. Sitting here today, we know who’s outperformed the past ten years, but unfortunately, it’s nowhere near as simple as we can invest in them today. They just basically don’t ever repeat in the following period. So, at the risk of oversimplifying, you don’t know who they are ahead of time. Once you see who they are in retrospect, they don’t repeat again.
So, we say, “Let’s invest your life savings and/or your hard earned 401(k), 403(b), SEP IRA, IRA, in an index position.” And index is even drilling down a layer deeper. It’s really investing in efficient market theory. The market is very, very efficient. People think that an active manager’s going to outperform because they have a very high IQ. They have a team of investment experts who have very high IQs. They have floors and floors of computer power to crunch numbers to be able to have better price discovery than anyone else. They have more individuals in research and development on the ground interviewing CFOs and CEOs of organizations, and they went to a better college. They burned the midnight oil. They’re harder workers. And a lot of it is true. But the only challenge is there are millions and millions of investment experts who meet that definition. So, it’s all these millions and millions of very, very smart people, very educated people, tons of computer firepower, all looking at that same stock, and that’s where the price discovery gets very, very, very close to as accurate as humanly possible so that no one can sit in Poughkeepsie, NY, Sacramento, CA, Chicago, IL, and say, “I have the power that I can see something that millions of other people can’t see, that that stock is mispriced, and I’m going to make more money off of it than anyone else.”
Jim Lange: All right, and you actually cited a statistic that 75% of the index investments do better than the actively managed investments? Because I’ve heard different percentages, depending on where money’s invested, how money’s invested, etc.
P.J. DiNuzzo: Yeah, when I refer to 75%, I’m always referring to a full ten-year cycle in the market. Over five-year cycles, it may average around two out of three times that the indexes are outperforming the active managers, but over ten-year cycles, on average, it’s three out of four that the indexes are outperforming the active manager.
Jim Lange: I know that you are a big index fan, and I know in the early part of your career, you used to represent the Vanguard funds to your clients, and, of course, Vanguard is the, let’s say, the big elephant in the index world. But there is a competing set of index funds called Dimensional Fund Advisors. Could you tell us a little bit about the difference between Dimensional Fund Advisors and Vanguard?
P.J. DiNuzzo: Yes, Jim. Vanguard, you hit the nail on the head. When I started, I was using Vanguard indexes before DFA was making the investments available to advisors. DFA (Dimensional Fund Advisors) was only managing money directly from age or pension plans, institutions and foundations, and I had taken my lumps early in my career on individual stocks, stock mutual funds, and had decided that rather than trying to beat them, I was going to join them, and that’s when I decided (after looking at the research) to go with the empirical research and index as much as possible. Vanguard basically, I say that every organization, or most organizations, at least a lot of them, follow the leader, the people at the top, and Jack Bogle, God bless him, he’s a tremendous leader. He’s probably the largest advocate, the greatest advocate in the history of individual investors. All he ever wanted to do was have the best investments possible at the lowest fees and expenses for his shareholders, and his dream, so to speak, has come true with Vanguard. But Vanguard’s driven, in my personal opinion, professional opinion, by low cost, low fees, just mirroring an off the shelf retail index, so to speak, S&P 500, EAFE, Russell, etc. Whereas DFA really had a huge first mover advantage. This is really, if you get into a trivia question or some type of geek research, really is the soil that indexes were grown out of, the research that started at the University of Chicago in the late 1950s through the 60s.
So, you got Professor Fama, who’s been on DFA’s board, their investment committee, for four decades now, writes the groundbreaking paper in 1965, ’66, says, “Hey, the stock market’s very efficient.” And he was sort of ostracized by the financial community. He writes this paper a full ten years before Vanguard launches their S&P 500. But it’s all this time in the incubator and the workshop and the research lab that at the University of Chicago, they’re doing the research, they’re slicing and dicing, they’re seeing that small stocks do better than large, they’re seeing that value does better than growth. Rex Sienfeld and David Booth, two students of his, graduate, one with a PhD, one with an MBA from the University of Chicago Graduate Booth Business School, in the early 70s, say, “Hey, well, neither of us has a job. Let’s do what Professor Fama’s been talking about in class.” For the last handful of years, they are credited with building the first S&P 500 fund in the early 1970s, a few years prior to even Vanguard launching theirs. So, to try to simplify it as well as possible, they build the best, purest indexes, and if small does better than large, you want that small to be as pure as possible, and that’s what they’ve been able to do.
David Bear: All right, well, this is a good time for us to take our second break.
David Bear: And welcome back to The Lange Money Hour. I’m David Bear, here with P.J. DiNuzzo and Jim Lange.
Jim Lange: And before I get back into the last quarter of the show, I do want to remind listeners that I am not independent with regards to P.J. DiNuzzo. P.J. DiNuzzo and my firm have an arrangement where if we share a client, or if somebody comes to our firm first, our firm will then, say, do Roth IRA analysis, Social Security analysis, how much money you can spend, is backed up by the law firm that actually does wills, trusts, beneficiary designations of IRAs, etc., the retirement planning, and we like to, and our strength lies in those areas, but we are not money managers, and we think that P.J. is a fabulous money manager, representing the best set of index funds on the planet. So, what we do is we combine our services. Our firm does what we are good at, things I had mentioned before, and his team actually does the money management, and rather than each of us charging a fee, what we do is we charge one fee of one percent or less, depending on how much money is invested, and then P.J. and I split that, which is consistent with the idea of low cost for indexing.
Now, P.J., let’s say I am a skeptical listener, and that’s certainly fine, and I’m thinking, “You know, okay. I get it with the indexing. We’re going to try to keep costs down. You can’t beat the market. I get that. And Vanguard certainly is a trustworthy company. They’ve been around for a long time, and, as you sometimes say, Jack Bogle is the cheapest guy in America, even though he did say there was great value to having a financial advisor. How can one set of index funds, and specifically Dimensional Fund Advisor funds, how can they, even after taking into consideration fees, and not just the fees of the internal cost of the fund, but the fees of the advisor, how can they possibly outperform Vanguard? And is there any empirical evidence to suggest that they do?”
P.J. DiNuzzo: Yeah, Jim. All I can do is speak to the facts and the statistics. The oldest fund that DFA has, it launched in approximately 1981, so we’re into our fourth year of live data, and the DFA small cap index has outperformed, for example, the Vanguard small cap index for four decades by about 1.2% per year. And again, I remind the audience, Vanguard is a phenomenal company. If you’re a self-directed investor, I would recommend that you run, not walk, to Vanguard and use their indexes. But, just again, the facts are that DFA has been able to maintain purer positions, so again, if we recognize that small stocks have done 11% for the last 86 years, large stocks have done 9%, then we want to access whatever is in those small…we know it’s small stocks, but we want to access those small positions as well as possible. And again, we’re well beyond the point that the proof is in the pudding, asset class by asset class, small, small value, large value, etc. We can just simply go to the website and look at DFA versus all the national benchmarks, and again, I’m not impugning anything about Vanguard. Maybe it’s better and best, great and greater would be the best way for the audience to maybe think about it.
Jim Lange: All right. So, that might be one or two, but does a typical investor with Dimensional Fund Advisor funds, where, by the way, they are required to go through a financial advisor. That is, somebody on their own could not say, “Oh, well, that sounds like a good fund. Why don’t I buy some DFA small cap?” They have to go through an investor. So, what kind of other differences might there be other than just, say, performance differences in each category? Will a DFA portfolio typically look different in terms of asset allocation than a recommended Vanguard portfolio?
P.J. DiNuzzo: Yeah, I would speak, Jim, to real world experiences. When we do talk to folks who have Vanguard indexes and they come in, they tend to be very under-diversified. They’ll have just a couple or a few indexes, and again, materially skewed away from what we would follow from major institutions, foundations, endowments, as far as their diversification, their exposure, just by the proper diversification, we’re able to usually have material improvements for them. Again, just the proof’s in the pudding. The DFA indexes across the board, not just the U.S. large and small, international merging markets, are…we’ve gotten hired by an awful lot of people over the years who thought that Vanguard was the benchmark for them to use versus the other active managers in their portfolio, and we’ve been hired time and time and time again. We try to…not try to, we’re very successful in convincing individuals that they should use DFA as the benchmark for everyone else to measure against because, again, they’re accessing these index positions better than anyone else in the country.
Jim Lange: Well, I know Paul Merriman, who is now retired, but during his career, he used both Vanguard funds and DFA funds, and Paul sometimes says, “Don’t listen to the people on Wall Street. Don’t listen to the people on Main Street. Listen to the people in academia, the people who have pure, objective analysis.” Has academia blessed DFA, and didn’t DFA actually come out of academia?
P.J. DiNuzzo: Yeah, it’s really exciting to me every time that I go to a DFA conference. I’ve been to dozens and dozens. It may even be approaching a hundred. It’s a very large number since the early 1990s that I’ve been involved with, and when you meet individuals like Gene Fama, Sr., Ken French, it may not sound real to the audience, but they are just as objective as the day is long. All they’re looking for is what’s in the data. They don’t have any sales approach. They’re not trying to figure out how to make more money off of an individual. It’s really the exact opposite of the way that the majority of our industry works. I mean, how can you fleece someone out of as much money as possible?
With that honesty, Professor Fama, I think, has maybe only recommended one person, if not one, maybe two or three at the most, but I know he recommended Marlena Lee, a very intelligent woman. She’s born over the Pacific Rim, went to the University of Chicago, got her Masters, and also got her PhD, and Professor Fama called up DFA and said, “You know, you have to talk to this woman.” And, you know, the first time I heard her present, she said, and again, just with the innocence of a babe in the woods, so to speak, she said, “What I can’t figure out about the stock market is it’s a foregone conclusion with all of my colleagues that I talk to and present to and analyze the research nationally, that active management doesn’t work.” I mean, she was just speaking about it as simple as two plus two equals four. Doesn’t everyone know that? And it’s just with that honesty, when you get extraordinarily intelligent people with access to the largest database on Earth and all the firepower that you could possibly have as far as the research goes, looking at something objectively, again, the reason I get asked an awful lot of times, why doesn’t this catch on more? Why don’t I hear about it?
As you mentioned earlier, Jim, our average client, we’re billing them .7 and some-odd percent per year. So, let’s say, three-quarters of one percent. I can go out and find dozens and dozens of investments that I could sell and make a commission of 7 ½% per year just for selling someone one investment and walking away. So, I’ve got to work for ten years in our relationship, day in, day out, quarter in, quarter out, progress meeting after progress meeting, to be able to earn an aggregate of 7.5% for the average client over a ten-year period of time. It’s not by itself, or in the corpus or body of it, a very profitable…I hate to say it’s like a Wal-Mart or like a larger operation, but it’s a very small profit margin that you need to have a large base of clients for the economy of scale. So, it’s not profitable, but in my heart of hearts, when I started the practice in 1989 with zero dollars, I said, “I’m going to do right by my clients. I’m not going to have them get screwed over like my father got screwed over. I’m going to do right by them, and I’ll follow my nose and see where it leads me.” And today, you know, we’re over $400,000,000. We’ve got a 99% retention rate with our clients. It’s even a little bit higher working with you! But it’s tough to get higher than that. But again, you know, every penny we have on Earth is invested exactly the same way as we recommend to our clients. I’m not saying we’re any smarter than anybody else, but we truly believe this is the best way to invest.
Jim Lange: Well, by the way, you said something that was pretty interesting, which was, in effect, with the arrangement that you have with your clients that are not with me, you literally have to do ten years of work seeing people, meeting people, doing all the asset allocation, everything else, to make the same amount of money that you would make if you just sold them one product for the same amount of money. And in our arrangement, I hate to say this, but you have to work twenty years, because we’re not making a lot of money per dollar invested for the client. But I will remind viewers and listeners that both of us are fiduciary advisors, meaning that we not only have a moral (which I believe we all have), but a legal obligation to do what we believe is in your best interest. So, I think we only have, we have…
David Bear: We have two minutes, yeah.
Jim Lange: …about two minutes, so why don’t you just mention, within a two minute period, the last thing that is critical that most people don’t do, which is rebalancing?
P.J. DiNuzzo: Yeah, rebalancing would be the final step in the process. Again, initially, an individual has to decide, “Am I going to do this myself or hire someone?” Then, they have to decide, “What is my asset allocation? How am I going to diversify? Once I diversify, is it going to be through indexes or active managers? And once I’ve got this portfolio set up, do I just set it and forget it, or do I need to pay attention to it?” I mean, you need to pay attention to it, in plain English. We average one to four rebalancing traits per year. If you just take a look at a year such as two years ago, when the U.S. stock market was up 30% on average, even our small stocks were up 40% that year, but if you started off with a 50% stock portfolio and they were up 30%, just using some simple math, you could’ve been at 65% in stocks by year end. I mean, you’ve got a completely different return, but, most importantly, a completely different risk profile now in your portfolio. If you let that run for a few years, you can take a look at a lot of two-three year periods in the history of the stock market where you could start off with 50% in stocks and be up to 70% or 80% within a few years. Now, you’re in a completely different risk profile. So, the audience needs to pay attention to their portfolio whether they’re doing it themselves or if they’ve delegated that to an advisor, hopefully that they’re paying copious attention to it. But years ago, it used to be one time per year rebalancing. Then, we were looking at rebalancing semi-annually, then quarterly. Now, with the advent of extraordinarily powerful computer firepower, we analyze every position for every client on a daily basis. If it’s growing by more than 20% or shrunk by more than 20%, we’re either looking to give it a haircut or to fill it in from another one that’s growing real well, and over time, that’s going to help us maintain our profile, help us make a little bit more money in the portfolio, and force us to do what you had said earlier, Jim, the hardest trait on Earth to do, it forces us to continually sell high and buy low.
James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.