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Should You Invest Differently for Your IRA, Roth IRA and After-Tax Investments?
James Lange, CPA/Attorney
Guest: PJ DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.
|Click to hear MP3 of this show|
- Introduction of Guest – PJ DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
- Order to Use Your Three Pots of Money
- The Three Most Common Strategic Asset Allocations
- Long-Term Money Asset Allocation
- Caller Q&A: Should a Roth IRA Conversion Be Done in the Beginning or End of the Year?
- The 60/40 Portfolio Asset Allocation
- The Short-Term Bucket Asset Allocation
Hana: Hello, and welcome to The Lange Money Hour, Where Smart Money Talks. I’m your host, Hana Haatainen Caye, and of course, I’m here with James Lange, CPA/Attorney and best-selling author of the first and second edition of “Retire Secure!” and “The Roth Revolution: Pay Taxes Once and Never Again.” Once again, P.J. DiNuzzo, CPA, PFS is joining us tonight. He is a nationally recognized expert in investment management who has appeared in or on numerous national and international publications and TV shows. P.J. has been rated by Paladin Registry, investor watchdog, as a five-star advisor, scoring in the top one percent out of over 800,000 advisors in America. His firm, DiNuzzo Index Advisors, Inc., has been consistently ranked as one of the top 500 firms in the country on numerous occasions by multiple national publications. On tonight’s show, P.J. and Jim will be discussing different ways of investing for your IRA, Roth IRA and after-tax investments. They will share why you should do this, how you structure a portfolio with this idea in mind and what affect this has on your portfolio’s performance. P.J. will also share the number one thing you can do to achieve greater financial security. But before I turn it over to Jim, I want to remind our listeners that the show is live, so please feel free to call in with your questions for P.J. The number is (412) 333-9385. Good evening, Jim, and welcome back to the show, P.J.
P.J.: Good evening.
Jim: Before we get started with the substantive part, I feel honor bound for full disclosure. P.J. and I…I am a registered investment advisor, as P.J. My area of expertise is IRA planning, Roth IRA planning, how much money people could spend, estate planning, etc., and not specifically money management. P.J.’s specific expertise is money management. There’s certainly overlap, and there’s going to be overlap in the content that we’re going to talk about tonight, but I do feel honor bound to tell you that there are…many of my clients become mutual clients of me and P.J. where we both work for the client, me on what I’ll call some of these big picture issues, P.J. on the actual investing side and other services that he does, and we do have a fee-sharing arrangement. So, I cannot tell you that I am completely independent of P.J. as I am with most of the guests. I think that that is only fair warning. The other thing that I wanted to do is kind of set the stage a little bit for the topic of different investment strategies for different funds of money, and the reason I wanted to do a little background is because I think it’s important to realize what money is going to be spent first, and I’m going to do it in reverse order. First, I’m going to talk about if you are retired. So, picture that you are retired, and I’m going to assume, for discussion’s sake, that…and maybe you have some income, whether it’s Social Security or a pension. Forget dividends and interest for the moment, but assume that you have those forms of income, or at least one of them. But the Social Security, or even the interest and dividends that you receive do not constitute enough money to pay for all of your expenses, and that you’re going to have to go into your portfolio. And let’s also assume that you have three basic types of assets: one, that I will call after-tax assets. That might be a savings account or an investment account, etc. The second would be an IRA or retirement plan or a 401(k) or a 403(b) or a SEP or a Keogh, what is in common with all those types of accounts is that you have not yet paid income taxes, and when you do make a withdrawal, you will have to pay income taxes and even if you never during your lifetime make a withdrawal, your heirs will eventually have to pay income taxes when they make withdrawals. And the third type of money that you might have is actually Roth IRAs that might have come from Roth IRA contributions and their growth, or it might have come from Roth IRA conversions, of which we have done many shows and we’ll continue to do shows because we are great believers in typically a series of Roth IRA conversions for many people. So, let’s say that you are in that situation, or if you are in the accumulating stage. I’m sorry, let me finish the distribution stage. So, you have basically after-tax dollars, IRA dollars and Roth dollars. Generally, I’m going to recommend that you spend your after-tax dollars before your IRA dollars, and the reason for that is because if you spend your IRA dollars first, you’re going to have to pay income tax. The money that you pay in income tax will then no longer be available for investments. So, and that’s one of the points of my first two books, which was retire secure and pay taxes later. When you are retired, spend money that you’ve already paid tax on first because you won’t have to pay tax when you make a withdrawal. Save your IRA money for when you either have to take it at seventy, or when you actually just need the money. And finally, and there are subject to some exceptions, with a Roth IRA, I typically want to spend that money last. Roth IRAs grow income tax-free. They’re not subject to minimum required distributions, and they are a wonderful asset to pass on to your family after you’re gone because they will pass income tax-free, including the growth of those assets, to your spouse, your kids and your grandkids. So, typically, I’m going to recommend the order in which you spend these three pots of money, the after-tax, the IRA and the Roth IRA, in that exact order. After-tax, IRA and Roth IRA. In the accumulating stage, when you are planning for retirement, I almost always recommend (subject to some exception) that first, you contribute whatever an employer is willing to match. Always do that. Then, put money in Roth IRAs or Roth 401(k)s or Roth 403(b)s, and then if that opportunity is either maxed out or not available to you, then put money in traditional IRAs, traditional 401(k)s, etc. But the reason I wanted to bring P.J. and talk about this topic is because many people will have various pots of money, that is after-tax, IRAs and Roth IRAs, and I wanted to bring up the issue of how this money should be invested and whether there is any difference between investing after-tax dollars, IRA dollars and Roth dollars. So, P.J., I’m going to ask you first, is it fair that many of your clients and many of our mutual clients do have those three pots of money, after-tax, IRAs and Roth IRAs?
P.J.: Yes, Jim. That’s very typical.
Jim: Okay. And let’s assume, for discussion’s sake, that between Social Security, and maybe some interest dividends or a pension, but there aren’t quite sufficient assets to cover what people’s needs are, and they’re going to have to go into their portfolio. Is it also fair to say that in general, again, subject to exceptions, that you would also typically agree that people should spend their after-tax dollars before their IRA dollars, and their IRA dollars before their Roth dollars?
P.J.: Yes. That’s our typical process.
Jim: Okay, good. And this is nothing new to you. I know you’ve been doing this for many years. So, let’s say that somebody comes to you and they’re a new investment client, or even just for the people who are trying to figure this out on their own, how would you advise them in terms of investing, and what difference would you make in investing, let’s say, after-tax dollars, IRA dollars or Roth dollars?
P.J.: Yeah, Jim. That’s a very pertinent question that you’re asking. For our average client who’s retired, our average retiree has approximately three different strategic asset allocations/strategies. The bucket that has the taxable assets generally is more conservative. The bucket with the IRA assets has material percentage of growth, and then the bucket that has the legacy assets, as we refer to it, has a comfortable level of growth for the client of maybe 60% in stocks, 70%, or even, in some cases, up to 100% in stocks for their legacy bucket.
Jim: All right. When you talk about buckets, most financial advisors who I work with and even know about, they might have, I don’t want to say an imaginary bucket, but they actually will have…let’s say they give you the nice pie chart with so many percentage and different asset classes, and it’s basically that whole pie chart refers to the whole portfolio, and they might actually separate out IRA and after-tax and Roth dollars. In your process, do you actually have separate accounts for what you would call, let’s say, the short-term bucket and the medium or five-year bucket and then the longer range money, do you actually separate that money out or is it just kind of mushed together? In your mind and in the client’s mind, they know that certain parts are available at different times.
P.J.: Yeah, Jim. At our practices, we literally separate those buckets of assets. We tell clients that when they come into the office, if they can consider if they’re going to monetize or liquidate their entire portfolio as taxable assets, IRAs or Roth IRAs, they bring that money into the office in $20 bills or $100 bills in a wheelbarrow or two, or the more wheelbarrows the better, and we’re going to stack that money from the floor up to the ceiling, and we tell them the base level, the bottom of that stack is going to be what we refer to as their cash reserves. Money kept at local banks for paying the electric bill, the gas bill, etc. We want our clients to have twelve months in that area, or their sleep at night number, which may be a lot higher than that. Then the next level, when we look at the other dollars in the stack, that would be what we refer to as their risk capacity. That’s going to pay for their food, clothing, shelter and transportation. Now, we want our clients to have those assets invested a lot more conservatively than their middle-of-the-road assets. The next level would be what we refer to as risk tolerance. We joke around sometimes and tell clients that you probably don’t need to have, as much as you may love your dog or cat, you don’t need to have, like, the dog or cat food with guaranteed income. Hey, that money can float around a little bit. Let’s let it grow one or two or three percent more per year in the market. And then, if we look at the very top of your stack up by the ceiling, we’d recognize that this stack at the bottom of the floor, your checking account’s located in your cash reserves, you get withdrawals coming in every month off of the risk capacity, the risk tolerance, you’d say you know what? Like, I’m never relatively speaking going to touch my money off the top of this stack. So, those are legacy assets for my children, grandchildren, charities, etc., and that money’s extending well beyond my time horizon. You know, when I look at it, there’s probably potentially even a fifty, sixty, seventy-year time horizon, and if there’s one thing that amazed Albert Einstein and it certainly amazes me, it’s the miracle of compounding. You take a look. If I can compound the top of that stack, one, two, three, four percent more a year over decades, your children, grandchildren, charities, etc. are going to be very happy that you did that.
Jim: Well, another thing that Albert Einstein said is that income taxes are one of the most complicated things in the world, and what he might not have completely appreciated was the difference in compounding money either income tax-deferred, which, in our case, would be an inherited IRA, or an IRA while the IRA owner is alive, and we’re talking about legacy assets, so this would be after they would die, leaving it to spouses, and then, in my Cascading Beneficiary Plan that we do on the estate planning side, typically we name spouses first. Sometimes, we have B trusts for non-IRA assets, then to children, and then children with the ability to disclaim for grandchildren. So, you could have an IRA owner who might be 65 years old, and he might have money in an IRA, or better yet, a Roth IRA. He could consider that as a legacy asset, and let’s say he lives twenty years and then he dies with a five-year old grandchild, and that grandchild lives to, let’s say, even eighty years. You could end up with over a hundred years of tax-deferred, or in the case of a Roth IRA, income tax-free growth. And by the way, I will personalize it. My wife and I, in 1998, we actually had a fire in our office. I think some of our listeners and my clients remember we used to be above a pizza shop, and there was an electrical fire in the pizza shop, and one lesson of that is never, ever put your office above a pizza shop. But anyway, we did have this fire and that year, my income was very low, and the benefit of that was back then, you weren’t allowed to make a Roth IRA conversion unless your income was less than $100,000. Mine was, so my wife and I made a conversion of…we actually converted a quarter million dollars, which was all the IRAs that we had at that time. So, I guess this goes back almost fifteen years now. And the plan for that money originally was well, you know, we’ll have that money income tax-free with no minimum required distributions when we get older, and as fortune should have it, the way that our business is going, it is very possible we will never need that money. In which case, that money might end up going to our daughter, who was three years old at the time that we did that, and it is possible through either second-to-die life insurance or other monies it might end up going to our daughter, that that money will go to a grandchild. Now, we’re talking about a grandchild of somebody who was a daughter of somebody who was three years old. So, we’re talking a very, very long potential time horizon. So, one of the things that you said is you actually…so let’s say that I said alright, P.J., here’s this $250,000 in a Roth, and that’s for much later on, but here’s some other money. Let’s even just talk specifically, what would you look to when you are investing this very long-term Roth IRA money?
P.J.: Well, the Roth IRA, the first thing we would agree on with a client would be what is our strategic asset allocation, just a fancy term for how much in stocks and how much in bonds. For that type of time horizon, we like to start off at a target of 100% in stocks and work backwards, and make a case for maybe we end up at 80% or 70%, but we like to have as much growth as possible. Then we go through the portfolio. Our key decision that we’ve been asking ourselves since 1989 is are we going to manage this money from an active perspective and try and outsmart the stock market, or from an index perspective? And we believe the market is highly efficient, and we would place that into indexed assets.
Jim: All right. And can you be even more specific and say, for example, what type of indexes that you would be thinking of? And you can mention the company or not mention the company, but I’m actually thinking about asset classes right now, at the moment.
P.J.: Yeah, the asset class for the indexes, since we want to index the portfolio, what our next analysis would be, who is the best indexer in our professional opinion in the country, and we feel very strongly in an absolute sense that that would be Dimensional Fund Advisors, DFA. Now, the key would be to diversify the portfolio properly. We want to have exposure to U.S. large stocks, large value, small value, real estate, international large value, international small value and emerging markets.
Jim: All right. Now, will that be pretty similar to what a typical asset allocation might be recommended, say, in Vanguard, or would that be different based on historical evidence of certain classes doing better?
P.J.: You know, Vanguard would be distinctly different by the fact…just to start off with approximately half of Vanguard’s funds or active funds and only half are indexed. So, right at the very beginning at that fork in the road, half of their recommendations are active and only half are indexed.
Jim: All right. I see Hana’s starting to squirm saying “Hey!”
Hana: Yeah, unfortunately, we need to take a quick break, and when we come back, we’ll continue the conversation on investments. I want to remind our listeners out there that we are live tonight, so if you have any questions, give us a call at (412) 333-9385. We’ll be right back with P.J. DiNuzzo and Jim Lange on The Lange Money Hour.
Hana: Hello there, and welcome back to The Lange Money Hour. This is Hana Haatainen Caye, and I’m here with Jim Lange and P.J. DiNuzzo of DiNuzzo Index Advisors.
Jim: P.J., I want to get back to the investing a Roth IRA, let’s call it very long-term money, which, as I understand it, you’re going to actually have a separate account for the Roth IRA and for this longer-term money. And let’s say somebody isn’t hyper-aggressive, but let’s say that that’s the moderately or the most aggressive funds. Can you be more specific in terms of asset allocation and what you would typically recommend?
P.J.: Yeah, Jim. Let’s say, for example, if we’re not at 100% in stocks, the next sweet spot that we like in the market is approximately 70% in stocks and 30% in bonds. The all DFA index portfolio is a 70/30 split, again, 70% stocks and 30% bonds, has outperformed the market the last ten, twenty, thirty-plus years, approximately 1% to 2% a year, but…
Jim: Well, wait. Is that before or after fees?
P.J.: That’s after fees, yeah. After fees.
Jim: Well, wait, wait, hang on a second. So, you’re saying that if somebody was in DFA let’s say the last ten years, just for discussion’s sake, and they had 70% of their money in stocks and 30% of their money…which when I say stocks, what I really mean is index funds, and then they had 30% of their money in bonds, and they were paying a fee of, whether it’s, you know, 1% or 80 basis points or even, let’s assume, some blend, that that has significantly outperformed, let’s say, the S & P with no fees?
P.J.: Yes, that’s correct. Well, the last ten years is even more pronounced, but historically…and what we’ll get into, we were discussing off-mike, was the value premium and small cap, but that 70/30 split is an ideal range for accessing large value stocks, small value stocks, real estate, international large and small or merging markets. What we tell clients is the decision that we generally make is at 70/30, our next decision is, or if we’re going to be more aggressive, we generally would jump up to 100/0. We tell clients if you’re at 80/20 or 90/10, that 10% or 20% in bonds, generally speaking, is just not going to provide you with enough defensive presence to be able to protect that portfolio in a down market. You’re not really going to notice it, but you will materially notice a 70/30 portfolio with the 30% in bonds properly invested, that that will protect you in a down market.
Jim: All right. Now, can you even be more specific of what percentage you might put in large cap, or is that getting a little bit too nitty-gritty?
P.J.: No, that’s very accurate because that’s one of the very common things that we see when we’re talking to prospective clients and investors that we’re having an initial consultation with. We would have, in a 70% stock portfolio, we’d have 14% of that portfolio in U.S. large stocks, we’d have 14% in U.S. large value, 7% in U.S. small cap, 7% U.S. small value, 7% real estate, then we’d have 7% in international large, 3% in international small and small value respectively, and then 7% in emerging markets, and then, of course, the 30% in bonds. But at the end of the day, on the stock side, what it would look like is approximately two-thirds of the equity positions in the U.S., one-third international, about two-thirds in large caps and one-third in small caps. So, this is basically mirroring an institutional-type strategy.
Jim: All right. One thing, we do have a question and I want to get to the question in a minute, but one of the things that occurred to me as you were giving me those very specific percentages, is that is significantly different than what might be recommended in almost any other source that I can think of, in that you’re much higher concentration in small cap stocks than I have typically seen, and also, a higher concentration in value stocks as opposed to growth stocks than I have typically seen. Why is there such a heavy concentration on value and growth? And then, we’re going to take a question from Tom.
P.J.: Yes. The reason why we have the allocation towards value and small cap, there are only three factual premiums. If you were just sitting in a local pub around Pittsburgh and talking to someone who was engaged in this type of conversation and said, “You know, what are the reasons for me investing in the stock market?” There’re only three reasons: there’s the premium for stocks, that stocks make more money than CDs or bonds, etc. There is the premium for value stocks, that value stocks do better than growth, and then the final premium is small stocks, that small stocks do better than large stocks.
Jim: All right. Unfortunately, the caller is a little bit shy and he doesn’t want to come on the air, but he did say what his question was, so I’m going to paraphrase the question to make it a little bit shorter, and basically, he’s saying if he does a Roth IRA conversion, should he do it at the beginning of the year, or at the end of the year? And I’ll take that one, if that’s okay, P.J.? But frankly, it’s going to relate to something that we do together that I think is…we are probably one of the very few firms, or combination of firms, that do this. Tom, I usually prefer doing Roth IRA conversions early in the year, and the reason for that is because I want to reserve the right to undo, or recharacterize, the Roth IRA conversion. So, let’s say that you convert $100,000, or even $20,000, but let’s use $100,000 because it’s a nice, even number, and you do it early in the year. And then, let’s say, later in the year, that the value of that stock takes a significant dip. So now, you’re planning to pay tax on $100,000, and now the fair market value of the stock went down to $60,000 or $70,000. Well, you’re not going to be too happy with that. So, what you might want to do is recharacterize, or undo, that conversion, and then, what you could do, not with the same money, but with a different stock, is you can make another Roth IRA conversion that same year. So, in effect, if you just held onto it, you would have to pay tax on $100,000 with a $70,000 Roth. If you undo it, and then they do another conversion of $100,000, then you’ll have a $100,000 in the Roth. So, in general, I like to do it earlier in the year, and then I like to follow the Roth IRA conversion all the way until October 15th of the year following the year that you made the conversion. Now, P.J., al ready when we have talked about these separate accounts for these different buckets, you know, the Roth bucket, the after-tax bucket, the IRA bucket, I imagine that that is an administrative burden for you, and I would think that it’s even a greater administrative burden to have to track the value of the Roth IRA the day that it was made throughout the year, and then actually after the year, and frankly, that’s something that…I don’t know how many other companies are doing that, and as you know, when people use our joint services, they have reviews with both me and you, and that’s one of the things that we always look to is to see what the performance of the Roth IRA. So, is that something that you will typically do and then always be on the lookout for the possibility of recharacterizing in the event of a downturn?
P.J.: Yeah, that’s correct, Jim. We do track the individual portfolios as well as the Roth conversion and the performance of that portfolio, and that’s one of the benefits that we’ve had from working with your practice, that your firm, from your CPA firm, from tax planning and tax preparation to your law firm, which specializes in estate planning, wills and preparations and all related advice, and especially, which you’ve written a couple of books that have achieved national acclaim from the Roth conversions, the part that we love about working with you and your team at your practice is you’re really experts at areas that we are not experts in, and it’s a great compliment to our practice and to the clients that we’re working on jointly.
Jim: Yeah, and to be fair, I’m going to have to say that there’s even special expertise with one of the CPAs in our office named Steve Kohman. Steve, by the way, is a very happy guy. You know, April 15th, or this year April 17th, so every year on April 17th, he and Glenn, they try to finish everything they need to do, including all the extensions and all the last minute stuff, and they head out of the office around noon and they go play golf. And then, today we had our office party, so I had very limited sips of wine. They did not. But anyway, Steve, when we do reviews on an annual basis, we actually have Steve go through the Roth IRA analysis for people that a Roth IRA is appropriate for, and it really is a terrific thing because, with all due respect, and I’m not going to mention names, but other money managers say, “Hey, that’s too much work to keep track of,” and we could probably spend the rest of the show on the Roth launcher, which is another technique that we use, but there’s too many other things I want to get to. So, we talked about, let’s say, very long-term money that would typically be Roth. What about, let’s say, and we have a lot of clients that have a lot of money in their IRAs and retirement plans. In fact, I would say probably the majority of my clients, and all our mutual clients, have more money in their IRAs and retirement plans than they have outside their IRAs and retirement plans. How would you, maybe typically, invest some IRA and retirement plan money, assuming again, that people have some after-tax dollars also?
P.J.: We would normally bifurcate that, Jim, and in plain language, we would split that. We’d look at that first bucket, or that lower stack of money we refer to as the risk capacity, that’s for the food, clothing, shelter and transportation. That may be as conservative as 20% in stocks. It could be 30%, probably a maximum of 40%. Then we get to the risk tolerance assets. This is paying for the non-essential expenses in retirement. We’d be anywhere from 40% in stocks to 50% or maybe 60% at a maximum in that level.
Jim: Okay. So, again, you know, I hate to do this to you on the spot, but could you give people an idea of what the asset allocation might look like in, say, a 60/40 portfolio? The reason why I’m doing this is because I know that there are people who are do-it-yourselfers, and I know that you’re talking about DFA funds and they would have to make some translation if they’re using Vanguard funds, but I think that that might be helpful for them, and I just don’t want to give general information without giving some specifics.
P.J.: Yeah, that’s good. Would you like to talk about the 60/40 portfolio, Jim?
P.J.: Okay, sure.
Jim: And by the way, I will mention this to everybody. He doesn’t have notes in front of him. This is all off the top of his head. He’s been doing this a long time! And when I asked him, he said, “Oh, don’t worry. You can use any percentage you want!”
P.J.: Yeah, but the 60/40, again, the global concept is we got two-thirds in U.S. equities and one-third international, so if we had 60% in stocks, we’d have 12% U.S. large, 12% U.S. large value, we’d have 6% in U.S. small, 6% in U.S. small value, then 6% in real estate. Then in the international side, we’d have 6% in international large value, and then 3% in international small and small value, respectively, and then 6% in emerging markets, and if we were to ask ourselves, you know, what’s the one area over the balance of our lives that’ll make the most money, it would be that final asset class that I mentioned, emerging markets. If we also use the old phrase, you know, when the market catches a cold, what catches pneumonia? The emerging markets will generally catch pneumonia. So, they’ll make the most amount of money. So, as a rule of thumb, we follow what DFA’s been doing in their pension plans and in their foundations, endowments, Taft-Hartley management, in these enormous portfolios, and we’ll generally maintain a 10% allocation in emerging markets. So, if we had 100% in stocks, we’d have 10% in emerging markets. If we had 60% in stocks, we’d have 60% in emerging markets.
Jim: Okay. 6% I think you mean, right?
Jim: All right, sorry. I didn’t mean to…
Hana: I’m going to interrupt you guys right now because we do have to take another break. Sorry about that! When we come back, we will continue talking about this with Jim Lange on The Lange Money Hour and P.J. DiNuzzo.
Hana: Welcome back to The Lange Money Hour. This is Hana Haatainen Caye, and I’m here with Jim Lange and P.J. DiNuzzo of DiNuzzo Index Advisors.
Jim: P.J., you just gave some specific percentages of what type of asset allocation you would have for, let’s say, a 60/40. That is 60% equity and 40% bondholder. Let’s say that somebody has done that, and for…you know, typically, a reasonable benchmark might be, say, ten years. How has that portfolio, the specific portfolio that you had mentioned, how has that performed, let’s say, against the S&P 500 over, say, the last ten years?
P.J.: Well, the last ten years have really shown the benefits of diversification and the bond allocation to portfolios. Since this has been one of the worst decades in the last 150 years of market experience, the market, the S&P the last ten years has been approximately 2.9%, and of course, that’s an unmanaged index, no fees or expenses, just the index. So, approximately 2.9% versus our 60/40 portfolio, which has been over 6 ½%. I mean, that’s net of all fees and expenses to 60/40.
Jim: All right. Wait, so you’re saying one is about 2.9% and one is more than 6%, even after fees?
P.J.: The last ten years is 60/40, yes.
Jim: That’s a huge percentage. That’s over 3% Delta. Now, is that typical, or is that exceptionally good?
P.J.: Yeah, that’s exceptionally good.
Jim: So, people can expect to beat the market by 3% with a 60/40?
P.J.: Yeah, with a 60/40. Generally, a 60/40 is done to market or slightly better. If we tell clients, the sweet spot that you and I discussed earlier was that 70/30, if we want to try to beat the market, how to outperform the market with high expectations and net of fees and expenses is 70% stock and 30% bond, but the 60/40…what we tell clients is, and a lot of folks who come to us, even they could be highly educated, highly quantitative engineers, actuaries, even CPAs, one of which I am myself and you are…
Jim: Or, you know, I think that you know that I have a, let’s call it, special niche with college professors, and we have over 500 college professors as clients.
P.J.: Yes, highly quantitative individuals, and even a lot of people that are, you know, very highly quantitative, have IQs, multiples, I joke around with them saying multiples higher than mine are, but really, you know, personal finance is really a special and unique discipline, and a lot of individuals, irrespective of their stratospheric IQ, really don’t have a personal finance structure regarding their asset allocations for these various buckets that we discussed earlier, and objectives, and time horizons, the asset allocations, the diversification, the structure of the portfolio, placing probabilities for success on your side by indexes outperforming the active managers over time, and then also rebalancing, and by the time we get to rebalancing, people’s eyes are sort of glazed over, but we add a tremendous amount of value by doing regular rebalancing audits and maintaining our client’s portfolios. At the aggregate level, such as 70/30, but also these various asset classes that we mentioned that are either 14% or 7% or 3 ½%, by keeping them within their desired ranges, as well.
Jim: Yeah. By the way, I’ll tell listeners, I’ve been in the financial industry for a long time, and hardly anybody does that level of detail because it’s additional work. I want to go back for a second because you said some of these people are maybe pretty brilliant in certain areas, but not so brilliant in others. But I’ll tell you what I think a lot of people do understand, which is the risk of running out of money, and the risk of having to make withdrawals after retirement after a market goes down. So, one of the things they don’t want is to have a very risky portfolio, and I know that, typically, risk is measured by standard deviation. Could you talk about the standard deviation of the 60/40 portfolio that you mentioned versus, let’s say, the S&P 500? So, are we getting into maybe a higher return but a riskier situation, or is it a higher return and a safer situation?
P.J.: Yeah, that’s really on a risk-adjusted basis. That’s the main reason, Jim, that if you look at the smartest money on earth, again, these major pension plans, endowments, foundations, etc., their typical portfolios are somewhere between 60/40 and 70/30, and the reason they are, that’s really the sweet spot to maximize the expected rate of return while also minimizing the risk, and one of the benefits we have with the indexes that we work with, our data in the domestic U.S. market goes back to approximately 1926 or 1927, and the power of knowing what the track record of your investments are and have been, the last eighty-plus years through World Wars, regional wars, inflation, deflation, stagflation, presidential assassinations, it provides a lot more comfort than the typical scenario of what people are used to, knowing what their portfolio’s done through ‘08/’09, through 2001/2002, it could be 1994, 1990/1991, especially 1973/1974 when we had another 50% uber bear market, there’s a lot of comfort in taking a look at what these all-index portfolios, especially with the best index manager in the country, Dimensional Fund Advisors, what that performance has been, and we talk as much about what you have been mentioning, the risk side of the portfolio as well as we do the return side of the portfolio.
Jim: All right, well, let’s be even more quantitative. You were good enough to mention what the specific allocations…can you remember what the measured in standard deviation would be for the 60/40 portfolio that you mentioned versus the S&P?
P.J.: Yeah, the 60/40, for example, historically, if we look at the last 75 to 100 years for the market, the market range of returns has been approximately 9%, through some periods, 9 ½% or even close to 10%, but if we looked at the market, we’d say 9%. The standard deviation on a market has been 18%, has been one standard deviation. So, if we have a portfolio, the DFA portfolios with the diversification and with the percentage that’s allocated towards bonds, we’ve eliminated…we brought that standard deviation, the risk in a portfolio, anywhere down from 40% to 45%, in some cases, down to 50% below just a pure stock portfolio. So, the standard deviation in our portfolios would be approximately 12%, in some periods 11%, or even maybe down to 10%, which is significantly less risk in a portfolio.
Jim: All right. So, even specifically, what you’re saying is that, at least in the last ten years, which might be exceptionally good, but that there has been an out-performance by roughly 3%, and a significantly safer portfolio measured in terms of variation and how much it goes up and down, which I think is very important because I have a lot of clients who we know one of their big fears is…let’s say that you decided to retire in 2008, and then, boom! Your portfolio goes way down and now, what do you do? And that might have some implications on the issue of the, let’s call it, the short-term bucket. So, maybe we should talk about that for a little bit, also.
P.J.: Yeah, the short-term bucket…and we agree with you, Jim, again, in a typical scenario, we’re complimenting our client’s withdrawals by money taken out of their taxable portfolio. The taxable portfolio for clients, as we identified earlier, would be in a separately identifiable account, generally somewhere between 30% in stocks or 40% in stocks, so a 30/70, or 40/60…
Jim: So, this is going 30/60 or 40/60 the other way, that is more bonds and fixed income than in equity.
P.J.: More in bonds, yes. As we mentioned earlier, and a lot of times, we’ll take a proportionate withdrawal from that portfolio as we will from the IRA account, and the risk capacity portfolio, as well, but the benefit of the taxable portfolio is there are a lot of different moving parts in that portfolio, and we have tremendous tax-planning advantages by offsetting unrealized gains versus unrealized losses, offsetting various positions, and oftentimes, if clients call and say, “Hey guys, we’ve had an emergency that occurred. We need $10,000, $20,000, $30,000 basically overnight.” We’re able to go into the portfolio and tax manage that to the position and we can withdraw that amount of money without any, not even, in most cases, one penny of negative tax consequences.
Jim: Well, by the way, I will just also mention to our listeners, and I think I mentioned it at the beginning of the program, but I will again: I am morally obligated to tell you that I do have a fee-sharing arrangement with P.J. Most of my guests are national experts that I am completely independent from, but we are both registered investment advisors. We are both, what is called, fiduciary advisors, but we do have a fee-sharing arrangement whereby if somebody comes in to, let’s say, starting with me and I look at, let’s say, certain ‘big picture’ issues, including Roth IRA, estate planning, and now we’re offering will reviews and tax return reviews. So that that is, to be fair, I do have a stake in people using our joint services.
Hana: Okay, Jim…
Jim: And I see Hana…
Hana: We’re going to have to take our final break here.
Jim: All right, last break.
Hana: And when we come back, we’re going to wrap up this conversation on investments. We’ll be right back with P.J. DiNuzzo and Jim Lange on The Lange Money Hour.
Hana: Welcome back to The Lange Money Hour. This is Hana Haatainen Caye, and I’m here with Jim Lange and P.J. DiNuzzo. Jim, you want to wrap this up with P.J.?
Jim: Yeah, we don’t have much time left, but, you know, right now, Warren Buffett is in the news with prostate cancer. Do you have any comments about some of Warren’s philosophies? And I’m not talking about his tax recommendations, but his investment recommendations, and what he, who is maybe the greatest investor of all time, or certainly in the U.S., says about investing?
P.J.: Yeah, Warren Buffett, who most people would consider to be the greatest individual stock picker of our lifetimes, we have literally dozens of quotes by Warren on our website, quoting that the best way to invest in stocks/equities would be to invest in an index fund that charges low fees and low expenses, and the power of that statement is greater than anything we could state ourselves. So, you have the number one stock picker of our lifetimes stating the best way to be in the market to invest in stocks is through indexes, and we would even say anecdotally, if we take a look at how powerful the market is and how efficient the market is, that the market base has been anticipating for a brief period of time and basically hedging itself to ultimately warn retiring, and the premium on his stock, on his Berkshire Hathaway position, has been coming down. So, the premium had been as high as about 50% higher than the underlying stocks that Warren has owned in the portfolio, and it’s been coming down a lot closer to 10% over and above the positions in the portfolio. So, that again would be a tangible example of efficient market theory at work.
Hana: Okay. P.J., I want to thank you for sharing your insights with us tonight. I also want to thank our listeners for joining us for another Lange Money Hour, Where Smart Money Talks. You can access our vast library of past shows on our website at www.paytaxeslater.com. And as always, you can catch a rebroadcast of this show at 9:05 am on Sunday morning right here on KQV. Join us at 7:05 pm on May 2nd when our special guest will be Bruce Steiner.
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.