The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney

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Investing Mistakes with Guest Larry Swedroe, MBA
Jim Lange, CPA/Attorney
Guest: Larry Swedroe, MBA
Episode 81

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TOPICS COVERED:

  1. Introduction of Guest - Larry Swedroe, MBA
  2. Common Mistake: Buying High and Selling Low
  3. Avoid Mistakes With A Well Thought Out Plan
  4. Tailor Your Portfolio to Your Unique Situation
  5. Confusing The Familiar With The Safe
  6. Integrate An Overall Financial Plan
  7. Understanding Indexing

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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.


1. Introduction of Guest - Larry Swedroe, MBA

David:  Hello, and welcome to this week’s edition of The Lange Money Hour, Where Smart Money Talks.  I’m your host, David Bear, here in the studio with Jim Lange, CPA/Attorney and author of two best-selling books, “Retire Secure!” and “The Roth Revolution: Pay Taxes Once and Never Again.”  Joining us by phone from St. Louis is Larry Swedroe.  Larry is a principal and director of research at a multi-billion dollar firm that works primarily with index funds.  He’s the author of ten books on finance and writes the blog “Wise Investing” for CBS’s personal finance website MoneyWatch.  Larry’s earned a well-deserved reputation for evidence-based investing and exposing misinformation, sometimes flat-out lies, spoken by Wall Street and, too often, echoed by Main Street financial media.  They’ll discuss Larry’s Book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them” that demonstrates how difficult it is for individuals to outperform the market.  Since the show is live, Jim and Larry can also answer your questions.  To join the conversation, please call KQV at (412) 333-9385.  Hello, Jim and welcome, Larry!

Larry:  Hi there, guys.  Glad to be with you.

Jim:  Well, it’s great to have you, Larry.  I’ll tell the audience that the biggest problem of having you on the show is that you have so many interesting things to say, and you are so articulate in so many areas that the burden of the person picking the questions, in this case, me, is overwhelming because there’s so much great material.  So, in a way, it’s easy, but in a way, it’s really hard.

Larry:  Thank you very much for the compliment.

Jim:  And I mean that, and you know, and you were on the show before, and I guess we covered maybe six or seven common mistakes, and I was thinking ‘Boy, I could have him on every week for years.’  But unfortunately, we don’t have that much time, but we do have some time.  One of the things that I wanted to talk about, and we didn’t talk about it last time because it probably wasn’t as appropriate last time as it is this time, but in your book, you have part one, which is called “Understanding and Controlling Human Behavior is Important for Investment Success.”  So, now, we’re getting into, maybe, some of the psychological implications of investing, and I really don’t necessarily want it to be a touchy-feely show, but some of the mistakes that you make are…I think a lot of people, if not more than 50% are making, and right now, I think, you know, particularly people are saying, “Oh my goodness, the economy,” and I’ll tell you what’s kind of interesting about people’s pessimistic views right now is I have a lot of college professors as clients and most of them are liberal Democrats, and I have a lot of engineers and they’re conservative Republicans, and the liberal Democrats are saying, “Oh my God, if Romney wins, our economy’s just…we’re really in big trouble.”  And, of course, the engineers say “Oh my goodness, another four years of Obama, we’re really in trouble.”  And then, you add to that, you know, what’s going on in Europe, and there’s a lot of people who are really not thinking very highly of our future.  So, one of the mistakes, in fact, the second mistake that you list is do you project recent trends indefinitely into the future?  And I thought that’d be a good place to start.


2. Common Mistake: Buying High and Selling Low

Larry:  Yeah.  So here’s the problem: investors we know make this mistake of what I’d call driving forward as if they’re watching their rear view mirror, and so when stocks have done well in the recent past, they watch that, and then they buy after stocks have gone up and they tend to buy high, and then when stocks do poorly, then they watch them go down, and then after they’ve already gone down sharply, then they sell, and when you do that, what you’re doing, of course, is buying high and selling low, which is not exactly a prescription for investment success.  They tend to project whatever has happened in the last six months, year or two years out indefinitely into the future, when, of course, that’s not likely to be the case.  If there’s anything we know about investing is that over the long term, although there’s not a guarantee, returns tend to revert to a mean, which means that then prices go way up, they’re already so high, it’s impossible for them to continue to generate those kind of returns, and earnings have to catch up, and then those asset classes that have done well tend to do more poorly going forward and the reverse is true.  So, let me give you a great example of that: when the bear market bottomed out in 2009 through today, the individual investor has pulled out about $350,000,000,000 out of the stock market for the kinds of reasons you mentioned, and of course, we have been through the worst bear market since the Depression.  And since that time, on March 9th when the market bottomed out, the S&P 500 has returned more than 100%, and investors, most of them, or many of them, missed out entirely on the rally, and even if they had a perfectly clear crystal ball, Jim, I would venture to say they would’ve gotten out of the market because what’s happened?  The unemployment rate’s soared to ten.  We’re still in, you know, a very slow, maybe the weakest recovery in post-war history.  We have all these problems of the fiscal cliff.  The government almost defaulted on its debt, and we have the downgrade of the U.S. Treasury debt from AAA.  We’ve had all these problems in Europe.  We got the uncertainty of tax rates jumping, and yet, despite all of that, U.S. stocks have returned over 100%, and that’s because the market had gotten so depressed that it was priced as if the world was going to come to an end.  It didn’t.  Things did not turn out well, but they just didn’t turn out as bad as people had expected.   

Jim:  Well, I would agree with that, and I think that that actually relates very closely to another mistake, mistake 45 if anybody is keeping track, and by the way, I can’t speak highly enough of your book because…and I’ll mention the title, it’s “Investment Mistakes Even Smart Investors Make.”  Now, again, I know you’ve written about eleven books and one subsequent to the one that we’re talking about now, and knowing you, it’s probably very good, but frankly, I will actually give a very good plug to a book that I know.  But the mistake 45 that relates to this is do you believe that this time it’s different?  Because you just gave a whole litany of problems, and then, you know, let’s add political uncertainty to the mix, and you have Europe, and you have the threat of terrorism, and you have all of these things.  So, a lot of people genuinely believe that this time it’s really different and that we are in a new cycle that history doesn’t matter, or we can’t rely on history.  Is that right, or do you just think that we’re just in a time like any other time that things are going to go up and down, and maybe it’s down for a while, but it’ll go back up just like it did in 2009?

Larry:  Well, there’s a lot in your question that we could probably spend an hour just addressing this question, but I’ll try to touch on a few points.  First of all, this time is different.  I think we could relate, for example, to the Facebook IPO, which was, you know, super-hyped.  Everyone wanted to get in on it, and people had forgotten that, you know, exactly the same thing had happened in the late ‘90s, only then it was the dot com instead of social media era.  They drove prices to crazy levels.  Some of these IPOs skyrocketed, but eventually crashed.  But everyone had forgotten that, mostly, and you know, it’s only thirteen years later and what happened?  We had this big rush into social media, Facebook stock got driven to incredibly absurd PE ratios that could not be justified by almost any reasonable expectation of growth, and then, you know, people wonder why the stock dropped, and then they get disillusioned and say, “Oh, it’s a rigged game and I don’t want to invest.”  Well, they simply forgot their investment history, which is…one of my favorite sayings is that the only things you don’t know about investing are the investment history you don’t know.  So, that’s an example.  This time is different.  Social media is different than the dot com era, which was different than…people were saying then the electronics era, the sixties, then we had the same kind of bubble, and I pointed that out at that time.  Any stock that had the ending ‘-tronics’ on it was trading at PEs that were over 100, which, of course, ended up with stock prices crashing.  So that’s the first thing.  The second thing I would say is history can be a guide, for example, to what’s going to happen or what may happen, but it’s not a forecast.  You cannot rely on the fact that markets recovered in the past, that that means they will recover.  There’s no certainty.  All we need to do is look at Japan, for example, you know, that to disprove this idea that stocks are safe if your horizon is long enough, which was the premise of Jeremy Seigel’s best-selling book “Stocks for the Long Run,” and people got the wrong impression.  Stocks are risky.  I don’t care whether your horizon is a week, a month, a year, twenty years or thirty years or fifty.  That must be true, and the perfect example is in 1990, the Japanese stock market was trading at about 40,000.  It’s now more than 22 years later, and the Japanese Nikkei index is trading at about 8,600, down about 80% from where it was not counting, you know, returns from dividends.  That means it’s lost roughly 3% a year compounded for 22 years.  So, we don’t know what’s going to happen, which is why we have to focus on trying to manage returns, not try to manage returns because we can’t control them.  All we could do is control the amount of risk we take, make sure we diversify those risks, you know, as much as possible.  So, Japanese investors who diversified around the world and own U.S. stocks and other countries stocks did much better than those who concentrated solely in Japan, and if they invested in safe bonds in the right amounts, then their portfolio risk was dampened as well.  The problem that most people have is they end up jumping from whatever did well, they go in and rush and buy high.  Now, they’re buying things like high-dividend paying stocks or MLPs or whatever else has been doing well lately, but they forget that they’re buying high, which virtually dooms them with almost 100% certainty.  It’s a very poor return going forward.  They’d be much better served by simply either following Warren Buffett’s advice, and he said “Don’t try to time the market, but if you do, at least buy when everyone else is panic-selling because then you’re buying when prices are low and expected returns are high, and sell when everyone else is greedy because you’ll sell when prices are high and expected returns are low.  But I think the right strategy is simply to have an investment plan, what we call an investment policy statement that lists the amount of money you’re going to have in stocks and whichever asset classes you’re invested in, how much U.S., how much international, how much in saved bonds, and then make sure every quarter, you check and simply rebalance your portfolio, restoring it to your target, because what that forces you to do is what most people simply cannot do otherwise.  It forces you when stocks go down, so you were 60% stocks, we get a bear market, you’re 50, you have to buy stocks to get it back to 60, so you’re buying just when Buffett tells you to buy, when there’s blood on the street, and then if stocks have a rally and you go up from 60 to 70, you’re selling high, not because you’re projecting bad markets going forward, but you’re just restoring your risk profile.  I believe that’s the simple strategy.  It’s just very difficult for most people to do it on their own because emotions like fear and panic and bear markets and greed and envy and full markets get in the way, and that’s where a good advisor can really add value by providing that discipline and getting the investor to act like the postage stamp, which does only one thing but it does it well.  It sticks to its letter until it reaches its destination.

David:  Well, do you think that that is a reactive strategy or a proactive strategy?

Larry:  I would say it this way: one, it’s proactive in the sense that you are establishing the amount of risk you want to take that’s appropriate for, what I call, your ability, willingness and need to take risk.  I wrote a book to help people figure that out.  It’s called “The Only Guide You’ll Ever Need for the Right Financial Plan,” and it’s proactive.  It’s taking control over your portfolio risk, not letting the market dictate it.  If you do nothing, then the market moves you in a bear market from 60% stocks down to 50 or 40 or whatever the number is, and that means you’ll have less risk in the portfolio than you would like to have, and in bull markets, it could drive you from 60% up to 80%, and now you’re taking more risk than you want.  So, actually, by being active, you’re actually taking back control away from the market and restoring it to yourself. 

David:  That makes sense, yeah.

Larry:  So, I would say it’s proactive, but in another sense, it’s a passive strategy as opposed to active, active meaning we’re trying to time the market and guess when the market’s going to go up or down.  Here, we’re saying we don’t make projections, I don’t know, but I want to control the amount of risk I’m taking.

David:  Right.  That makes good sense.  Okay, this is probably a good place to take a break.  When we return, Jim and Larry will continue the conversation, so listeners, remember, we’re live.  Call us with questions at (412) 333-9385.

BREAK ONE

David:  And welcome back.  I’m David Bear here with Jim Lange and Larry Swedroe.  If you have a question for any of us, call (412) 333-9385.

Jim:  And Larry, I know that your general thinking is you like well-diversified portfolios using low-cost index passive investing, which, by the way, is exactly the subject of the workshop, so you might be interested that we’re on the same wavelength and actually presenting information with dimensional funds.

Larry:  Well, that’s great because all of the evidence is on your side.  It’s just opinions on the other side of the argument, not facts.


3. Avoid Mistakes With A Well Thought Out Plan

Jim:  Yeah.  The other thing is that I thought was kind of interesting, when we talked about mistake #45 (do you believe this time it’s different?), a lot of those engineers will tell you that during the Cuban missile crisis and right before that, that they would actually go to work during the day, and then they would come home, and instead of joining their wives and spending time with their families and their children, that they were literally in the back yard digging out a bomb shelter.  And now, of course, that seems kind of silly, but I guess the idea is that we think that oh, this is the most intense time that this countries ever had, but in reality, we have been through many wars, many threats of wars, threats of terrorism, etc., and the market’s still, with words of caution, in the long run, done very well. 

Larry:  With lots of volatility in between that you had to be able to stay the course, or you panicked and sold at the bottom, and then once you do that, I believe you’re virtually doomed to fail because you will never see a green light that you’re waiting for.  As we mentioned, from March 2009 when the market bottomed out, the S&P was 666.  It’s almost 1,400 again, and there was all this horrible news since then.  I mean, there’s almost nothing that’s been good, and yet the market more than doubled.  So, if you were waiting for that green light to tell you it was safe and that you could get back in, it never came on.  And so, the only way, I think, you have a good chance of achieving your goal is you must have a plan that’s well thought out, written down, and make sure you don’t take more risk than you have the ability, willingness or need to take because when that bear market shows up, and I wrote a piece, I do a speech that talks about sixteen crises we’ve had, major ones, just in the last forty years.  That’s one every two-and-a-half years.  So, these kinds of markets are actually normal where there’s all this volatility, and so if you don’t have a well thought out plan that takes too much risk, you’re almost certainly going to fail.  You will panic and sell, and then you’re virtually doomed to fail.


4. Tailor Your Portfolio to Your Unique Situation

Jim:  Right, and then it also works the other way, which is I have a lot of clients who are so conservative, and they are so risk-averse, that they have a very large percentage of their portfolio in fixed income, and perhaps are not taking into consideration the long-term, and they’re also not taking into consideration the possibility of the loss of purchasing power if we do have an inflation. 

Larry:  Yeah.  I’ll just comment briefly on that.  Having a very conservative portfolio may be perfectly appropriate, especially if you’ve already, what I call, won the game, meaning we use a general rule in our business that someone who’s 65 or less, if you have 25 times your annual spending pattern of, say, $100,000 a year, so you’d need $2 ½ million.  If you have that amount or more, there’s a pretty good chance you will be perfectly fine if you withdraw just 4% of your assets a year, so 4% of $2 ½ million, that’s your $100,000.  If you want to be very conservative, you could make it 30 times.  So, if you’ve already got that amount, than I would say it’s a very good argument for being very conservative.  You probably still want the whole 20% to 30% equities because there are periods when stocks do well and bonds do poorly, and we may be set to enter one of those periods since it’s unlikely interest rates can fall very much.  On the other hand, there are many people who simply cannot reach their goals, having equity allocations that are very low and with bond yields very low, and the only alternatives are either you’re going to have to save a lot more and cut your current spending, lower your desired goal so you won’t spend that much in the future, or you just have to accept more equity risk.  Those are your choices.  You can’t get to your goal with very low equity allocations in many cases.  And that’s a real dilemma for people.

Jim:  And I think that makes sense.  The only caution that I would have is I think people sometimes are a little bit too strict about this 50/50, 60/40, 70/30 or whatever the appropriate asset allocation is because I’ll give you an example: we have, although certainly not as many as, say, ten or fifteen years ago, but we have a lot of retirees who have some kind of pension, and sometimes the pensions are very significant, you know, what I would consider significant, $50,000, $60,000, $70,000 a year, and then, on top of that, they get Social Security, and if they’re married, sometimes two Social Securities, and I sometimes say, “Well, gee, let’s just say that your pensions are $50,000 and you Social Securities combined are $80,000, you know, that’s kind of like a several million dollar bond that’s throwing off a fixed income.”  So, there is an argument that the other monies that you would have, let’s say that, by nature, you’re a 50/50 investor.  It shouldn’t be at 50/50.  If anything, it should be closer to 100% stock on the theory that your guaranteed income is already accounted for and that you can invest some of the rest for long-term and growth.

Larry:  All right.  So, let me address that.  That’s a great point.  I agree your analysis may be the correct one.  It depends upon, for example, you may have someone who has a desire to leave money for his grandchildren or his favorite charity, his church, whatever it may be, and if he can live on the $80,000 comfortably, that’s fine.  On the other hand, you could imagine somebody who just says, “Look, I’ve got enough money with a bond portfolio.  I don’t spend more than $80,000 or $100,000 a year anyway.  I want to sleep well and not worry about the markets,” and yes, your point was you have the ability to take more risk because you have this bond-like portfolio that’s not on your balance sheet, but it’s going to generate cash coming in.  So, it gives you the ability to take the risk, but you may not have any need to take the risk, and you just want to sleep well.  And then, I would argue that you would be better off with a low-equity allocation.  So, the answer is that a good advisor plays devil’s advocate, works with their client to figure out what’s important to them about their money, and then designs a portfolio that’s uniquely appropriate to help them reach their best goal, you know, their goals and what’s important to them.  So, there shouldn’t be cookie cutter solutions, which I think was your point.  You really need to tailor your portfolio to your unique situation.

Jim:  Yeah, that was actually exactly my point, and I think sometimes that investors don’t take into consideration the totality of all of their resources and needs, and then also different needs with family, children and grandchildren.                

Larry:  Yeah.  Let me give you another great example where, I think, most even financial advisors, and I go around the country training other advisors, and if you go to even Vanguard’s services, they never ask their advisory services.  They don’t ask these kinds of questions, which I address in that book I mentioned earlier, “The Only Guide You’ll Need for the Right Financial Plan.”  But let’s say we have two people in exactly the same situation except for one thing.  One of them is either a tenured professor, or he’s a doctor or a CPA, very stable income and he’s 40 years old, and the other person’s also 40 years old, but he’s maybe an automobile salesman, a construction worker, a mechanic at a GM, or whatever.  What I try to teach people is to make sure you’re also asking yourself ‘Am I a stock or a bond?’  So, the tenured professor, the doctor, the CPA, their income is very stable.  It probably doesn’t change much with the economy.  You know, in 2008, they probably saw their income pretty much unchanged.  So, if you’re like a bond with your labor capital, you can take more equity risk than if you’re the automobile salesman or the construction worker, or maybe, you know, he had no overtime or worse yet, he got fired or laid off because his company shut down or had a shrink, and he saw his labor capital deteriorate maybe even to zero in that market.  Well, he’s a stock himself.  His labor capital correlates more with stock returns, and therefore, he probably should own less stocks and more bonds.  So, really, it’s important to work, if you’re going to seek an advisor, or if you’re going to do it yourself, learn how to think about these things in their totality and not just think about how much risk I could take by some risk survey that somebody did.

Jim:  Well, I think that’s a really good point, and I like the idea that you’re taking your own career, your own needs, and sometimes some of these rules like oh, you should have one year of cash on hand might be different, for example, for a tenured professor that has a paid off house, whose kids are out of the home, and he loves his job and it looks like he’s going to be there for the, let’s say, the next twenty years, than somebody who has a much more volatile profession who would need more cash and the professor would need less. 

Larry:  Exactly.

5. Confusing The Familiar With The Safe

Jim:  I think that makes a lot of sense, and that probably relates to mistake number 13, which is ‘Do you confuse the familiar with the safe?’ 

Larry:  This is one of my favorites.  It amuses me all the time when I hear this stuff.

Jim:  I think all of them are one of your favorites because…

David:  78 of your favorites!

Larry:  This one is certainly one of the most common ones, and it gets to Peter Lynch, who is obviously a pretty smart guy, most people know him as one of the great mutual fund managers who ran Fidel and Magellan, and his motto for people was ‘buy what you know.’  And to me, that was one of the dumbest comments I’ve ever heard about investing.  Just because you know something doesn’t tell you anything about whether it’s safe or not, and as investors and as human beings, we tend to confuse the familiar with the safe, and there are lots of good studies on this.  A great example is U.S. investors.  Even though the U.S. is only about 40% of the global equity market, on average, U.S. investors only own 10% of their money internationally and 90% U.S. because they think U.S. stocks are not only safer, but they project them generally to have higher returns than international investments, which of course is completely inconsistent.  You can’t project something to be safer and also project higher returns.  Obviously, we know that risk and return, or at least expected returns, are related.  The more risky something is, the higher the expected return.  But this phenomenon is true everywhere in the world we look: Japanese investors put 80% to 90% of their money in Japan, French investors do the same thing in France and U.K. investors do the same thing in England.  It can’t possibly be that every country is the safest, and what we have seen is that the good citizens of Atlanta (this is one of my favorite stories), you know, I’m sure you guys can guess which stock the citizens of Atlanta own a disproportionate share of.

David:  I’ll have a Coca-Cola, please.

Larry:  Coca-Cola, exactly!  Now, clearly, Jim, it’s no safer to own Coca-Cola if you live in Atlanta or you live in Pittsburgh, right?  And it’s no safer to own Anheuser-Busch, or was when it was a public company, if you live in St. Louis than it is in Atlanta, and yet people in St. Louis overloaded on Anheuser-Busch.  Now, maybe you get lucky if you live in Seattle and you ended up buying a lot of Microsoft.  But we know people in Houston overloaded on Enron and got wiped out.  People in New York City overloaded on Bear Stearns and Lehman Brothers.  They got wiped out.  People in Rochester, New York loaded up on Kodak and Xerox and they got wiped out, and all over the world, people invest heavily in their own companies they work for because they confuse the familiar with the safe, when that’s completely contrary to any economic theory.  If you have a job with a company, you’re now playing a game of double jeopardy if you also invest your financial asset there because your labor capital is tied to how well the company does.  So, these are mistakes that I see is probably the most consistent one, I don’t want to invest in risky, you know, emerging markets, or risky Germany or Japan or whatever.  U.S. is safer, or whatever the question might be related to that. 

Jim:  I think that’s a really good point.  It’s also interesting to me that so far, you have quoted two of perhaps the greatest active money managers of our time, Peter Lynch and Warren Buffett, and interestingly enough, both of them, you know, Peter Lynch managing Magellan and Warren Buffett, of course, Berkshire Hathaway, both of them have said that for the average investor, low-cost index funds are actually probably the best way to go.

Larry:  Yeah.  You could add to that list David Swensen, who is a famous manager of Yale’s endowment fund.  He recommends exactly the same strategy as you and I recommend, and that’s because they know the evidence is very clear that if you invest using index funds, and very importantly, you stay disciplined to a plan and don’t try to time the market and jump all over the place, you’re virtually guaranteed to outperform the vast majority of individual investors, pension plans, hedge funds, venture capital, I mean all of these things where supposedly the sophisticated investors have an advantage. 

Jim:  Well, that’s actually what the workshop that we’re having on August 25th is all about, and I’m afraid that we have to take a commercial break right now.

David:  Well, and it’s a commercial break about that workshop.  So, Jim and Larry will continue the conversation when we return.  Since the show is live, if you have a question, there’s still time to call at (412) 333-9385. 

BREAK TWO

David:  And welcome back to The Lange Money Hour with Jim Lange and attorney Larry…not attorney, Larry Swedroe!

Jim:  No, he’s way too good to be an attorney!

Larry:  The world already has too many attorneys!

David:  Absolutely. 

Jim:  It’s hard for me to agree with that seeing as I am one, and seeing that I think I’m one of those that actually adds value to the world, and particularly in the areas of retirement and estate planning.  But one of the differences in our office is that we actually use numbers as attorneys, so we don’t just mechanically draft wills.  We actually think about the human interaction, and we actually think about the numbers involved.


6. Integrate An Overall Financial Plan

Larry:  Well, Jim, if I could just touch on that.  Sorry for interrupting, but I think it’s a really important point.  It’s one I touch on in my books, is that too many people, when they develop an investment plan, focus on only the investment side.  What they really need to do is develop an overall financial plan integrating, as you noted, estate planning and, what I call, the term risk management, meaning all kinds of insurance, because financial plans can blow up for reasons that have nothing to do with investing.  I always point out, for example, you may have a teenager, they get in a car accident and maim, or worse, kill somebody, and you don’t have an umbrella policy.  I’ve seen many people pay top, high-powered attorneys to draw up all kinds of trusts, and then they don’t get funded properly, or the wrong types of assets are put in them.  And we could go on and on with these kinds of mistakes, including putting the wrong beneficiaries on IRAs, or failing to change the beneficiary when you get a divorce.  And so, it’s absolutely critical, I think, to work with an advisor who acts as a quarterback on a financial services team and integrates overall financial planning and doesn’t just focus on the investment side.

Jim:  Well, Larry, the way we have handled that problem in our office is my area of expertise is probably closer to the strategy how much money can people spend, should they do a Roth IRA conversion, what’s going on with the family, should they set aside a certain amount of money for various contingencies, should they consider life insurance, that type of thing, and that’s the area that I’ve written and spoken about for many years.

Larry:  Lots of those things have nothing to do with investing, right?

Jim:  That’s correct, and then, I’ve known, for example, about dimensional funds for years, and actually, at one point, wanted to represent them to my clients and I went to dimensional funds and I said, “Hey can I be a DFA advisor?”  And they said “No.”  And I said, “No??”  And they said, “Yeah, that’s because you also have a relationship with an active money manager.”  So, I kind of shrugged and said, “Okay,” and then, maybe about a year-and-a-half ago, I was in California.  I was talking with a DFA advisor, and I was actually a little bit jealous because he was offering his clients these wonderful index funds at very low cost with really wonderful returns, and he said, “Well, why don’t you become a DFA advisor?”  And I said, “Well, you know, I’d probably like to, but they said ‘no’,” and he said, “Are you kidding??  You know, with three best-sellers, and you run around the country teaching this stuff.”  He said, “Here, call my buddy at DFA and then see if they’ll let you in.”  And then I eventually did, and very frankly, I thought, “Uh-oh, that means that I wouldn’t be doing what I love, which is the strategy part,” and then I looked at a number of alternatives, very frankly, including your firm, and who knows what’s going to happen in the future, but I looked at areas where somebody else could be doing the investment analysis using low-cost dimensional funds advisors, and me supplying the strategy and the clients actually paying one low fee of, depending on how much is investing, let’s say 1% of the high side, and maybe 50%, or in some cases 40% basis points on the low side.  So, that’s actually the way we do our business, and that way, I think clients get the best of both.  They get the good strategies…

Larry:  I couldn’t agree more.  We work with about 135 firms across the country where we act and provide them with the intellectual capital on the investment side.  Actually, also, we build individual bond portfolios for them so they can avoid the cost of a mutual fund, and then the advisor adds the great value with their local presence and their knowledge of all of these other areas.  So, that’s exactly what you’re doing.

Jim:  Yeah, and by the way, I’ll put in, you know, we have a lot of financial advisors throughout the country who are listening, and we didn’t actually mention, so why don’t you just, maybe in one minute, tell them a little bit about what your firm does because I actually think it’s very…if I hadn’t found such an excellent advisor locally, because I think P.J. DiNuzzo is a wonderful advisor and we’ve been doing really well together, your firm was clearly in high contention for, let’s call it, a business or joint venture partner. 

Larry:  Well, just briefly, we actually run two businesses.  We have our own registered investment advisory firm where we provide the advice tailored to our clients.  We manage about $3.6 billion of assets there, and then we have a second business where we provide the intellectual capital, a lot of technology training, best practices, and we run study groups so we learn from each other.  So, we have a network of 135 firms pooling their intellectual capital to deal with client’s situations.  And so that allows these registered investment advisors to do exactly what you’re doing, focusing on where they could add the most value working with their specific clients with their specific issues, and leaving the investment strategy to us, and we have a team of eight people on our investment policy committee that review all the academic research to make sure we’re providing the best alternatives, and we’ve actually helped both the DFA and other fund families develop better products, either more tax efficient or help them introduce concepts such as something called a core fund, and we’ve helped the firm called Bridgeway develop, we think, the best currently available small value mutual fund, and it’s actually only available to our clients because we want to keep it a small fund because if it gets too big, it will lose some of its ability to transact easily. 

David:  Do you want to just give names to your firms?

Larry:  It’s Buckingham Asset Management and that’s part of BAM Advisor Services is the second business that’s all part of the Buckingham family of financial services.

David:  Great, great.


7. Understanding Indexing

Jim:  All right.  If we could go back to another common mistake, is I sometimes see clients, particularly clients who are still working, and they have a lot of money in…even if they kind of buy into the index concept.  So, you see clients who have, let’s say, some significant exposure to the S&P 500, maybe it’s Vanguard, maybe it’s another S&P fund through work, and they think, “Oh, okay, well, I’m an index.  This is going to lower my risk and over the long run, you know, the index funds have shown to outperform the vast majority of active money managers.  I’m okay and I’m kind of safe because I’m in the S&P, these very large U.S. companies.”  Do you think that they can potentially confuse what indexing is really about with just having an S&P index fund?

Larry:  Yeah, they’re not mutually exclusive, and that’s the problem.  The academic research is very clear on a few things.  One of them is that you want to diversify as much of your risk as possible, and if you own only an S&P 500 index fund, number one, you’re limiting your diversification, or the way I like to say it is, you have all of your eggs in one risk basket, is basically a group of 500 large U.S. companies, and that means you’re, one, not diversifying internationally in developed countries.  A simple way to do that would be to own the MSc IEC index of developed countries, and you’re not gaining exposure to emerging markets either.  So, you could own an emerging market fund also.  That would be at least diversifying geographically and diversifying your geopolitical and economic risks.  But we also know, thanks to the research, that there are other ways to diversify besides geographically.  If you own an S&P 500 fund, you own basically mostly U.S. large companies with a tendency for them to be large, more growth-oriented companies, and the research shows that small companies tend to perform differently than large companies.  They’re riskier and should therefore provide higher returns over the very long term.  They’ve done that by about 2% a year.  But there are periods like the 70s and early 80s when small stocks did much better.  I believe small stocks have outperformed also in the last ten years, and then there are periods when large stocks do better, and what you want to do is own…well, let me say it this way: since we can’t predict when small caps will do well and when large caps will do well, it’s better to own some of all of them, and the same thing is true on the growth vs. value side.  Value stocks are more risky than growth stocks.  They have higher expected returns.  Of course, they also tend to do poorly in bad economic times like 2008.  That’s the risk you’re taking.  But there are periods when they do much better, and so you can also own an index of not only large and small stocks, but you can own indexes of large value and small value stocks, and you can expand that to include an index of real estate investment trusts.  You can even add…some people believe, as I do, that it’s worth considering adding exposure to commodities, not that it will get you higher returns, but commodities tend to do well when bonds are doing very poorly, and they tend to do well but not always when stocks are doing poorly.  So, they provide some diversification benefit.  So, you know, you can believe in indexing and take an index approach and own ten different index funds, and that would be a much more diversified portfolio with various risk buckets, if you will, than if you own just an S&P 500 index fund, or even an S&P and a total international fund.

Jim:  Well, one of the things that I like about what you’re saying is you’re saying, “Hey, we look at the research.  You know, we’re not going to listen to Wall Street.  We’re not even going to listen to Main Street.  We’re going to listen to Academic Avenue and what the objective research has said,” which is, I think, kind of the core of dimensional funds, it is founded by, and still run by people in the academic community, many of whom have Nobel prizes in economics.

Larry:  Yeah.  So, here’s the analogy I like to use, Jim.  If you went to a doctor because you weren’t feeling well, the job of the doctor is to diagnose and prescribe.  So, you tell him what’s wrong, he then puts you through an hour exam, tests and everything, and then he sits you down at the front of his desk and turns around and pulls out Ladies Home Journal, Redbook, TV Guide, maybe Men’s Health, and, you know, so you don’t feel very good about that.  So, then you decide I’d better get a second opinion.  You go to another doctor, he puts you through tests, but when he’s done, he turns around and pulls out the New England Journal of Medicine and explains to you, “This is what I found, and here’s what the New England Journal of Medicine says is the proper diagnosis and treatment.”  Now you feel a lot better.  In our world, the equivalent of Redbook and Ladies Home Journal is Barron’s and Investors Business Daily and CNBC, and the equivalent of the New England Journal of Medicine is the Journal of Finance, the Journal of Portfolio Management, and we base all of our advice on the evidence from peer-reviewed academic journals, not what I would call the investment hype and hyperbole from Wall Street and the media.

Jim:  Well, I’m a big believer in peer review.  I have my material peer reviewed whenever possible, and certainly in the Roth IRA and the retirement and estate planning areas, and I think it’s a great thing to do with your money, and one of the other issues, and I’m afraid we have about four minutes left, so you can maybe make this the last question, and you’ll have some time guideline.  Many of the investors that I work with kind of pick a strategy, sometimes let it float, and they might say, “Oh, I’m doing pretty good” and they’ll name a certain percentage, but they don’t compare their performance with the appropriate benchmarks, and I wonder if you’ve had some experience with investors who have done that, and if you have a remedy for that problem of failing to compare your investments or your overall performance with the appropriate benchmarks?

Larry:  Right.  So, just very briefly, you see this a lot, for example, in the venture capital world.  Venture capitalists will say, “Well, we earned 13% and the S&P earned 11%.”  Well, that’s a horrible comparison.  That’s like saying you earned 7% on some junk bonds and you would’ve earned 5% on a bank CD.  They’re not equivalent.  You’re taking much more risk and you need to adjust for that risk.  So, in the case of a venture capital fund that maybe earned 13% while the S&P 500 earned 11%, what you might look at is more similar risky, say small value stocks, and one study I’m particularly thinking of, in that period for 20 years, the S&P earned about 11%, venture capital about 13%, but small value stocks earned 16%.  So, while you took all the risk of venture capital, gave up liquidity, daily pricing and lack of diversification, the DFA small value fund that you probably invested your client’s money in, you know, owns hundreds and hundreds of stocks, much more diversified than any venture capitalist, and yet, if you compared it to that benchmark, it clearly underperformed.  So, what academics do is they try to make sure you’re comparing apples to apples.  So, if you invest in an emerging market fund, that you should be compared to an emerging market index, not to an S&P 500.  If you invest in small caps to a small cap index, and that’s the proper way.  You want to make sure you’re comparing apples to apples, and not apples to oranges.

David:  Well, I think we should probably start wrapping it up here, and I wanted to say thanks for listening to this edition of The Lange Money Hour, Where Smart Money Talks, and thanks to Larry Swedroe, author of “Investment Mistakes Even Smart Investors Make and How to Avoid Them.”  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can always access the archive of past shows, including written transcripts, on the Lange Financial Group website, www.retiresecure.com.  Please join us for our next Lange Money Hour on Wednesday, August 15th at 7:05 pm when we’ll be speaking with Roy Williams, a financial expert from California, who’ll have tips on talking to your heirs so they’ll be well prepared for your estate and know what to do with it.  So, welcome back, and I’m David Bear.

END

 

James Lange, CPA/Attorney

Jim is a nationally-recognized tax, retirement and estate planning attorney 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, will and trust preparation 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.

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