Thanks. So, I know we’ve been jumping around a lot in some of the questions in the chat and just a lot of them are also covering some of the same material. So let me know if this is something that we you’ve kind of flogged or fully answered at least. Frederick asked, “Do you have any opinions that we may have hyperinflation similar to what happened in Venezuela or Germany in the 1920s?”
Yeah. Well, I’ll give you a short answer. The most important thing for investors to learn is there are no good forecasters. That’s what the academic research proves, and that’s why the active management generally fails. It’s not that the people aren’t smart, but the collective wisdom of the market is a very difficult competitor. And then you have to add the trading costs. But what smart people know is that you make a forecast (you have to forecast like we do for what expected equity returns are), but we make it not based upon our judgment or any forecast, we look at equity valuations, and we look at something called the earnings yield, which is the inverse of the PE ratio because the evidence shows over the long term, that’s the best predictor we have of stock returns. So just as a simple example, if we were looking at U.S. stocks, the current PE is about 20, just to round it.
So, the earnings yield would be 5%. So, we would expect on what’s called the unconditional forecast, meaning I don’t care if you’re asking me one-year, three-year, five-year, 10, or 20, equities are going to provide a 5% expected real return. And then you would add your expectation for inflation to get that.
If the PE, like it is on small value stocks is 10, well I’m going to forecast the 10% expected return. And by the way, those are roughly the numbers of today of the small value funds that we own. So, we expect small value stocks to have much higher return. That doesn’t mean they’re a better investment. It means their market thinks they’re riskier. Pricing for that, and so you get the higher expected returns. So, if you sit down with Adam, he doesn’t tell you that your return—let’s say of a diversified portfolio stocks and bonds—is going to get 6% in a deterministic way.
He’s going to show you the outcome of what’s called the Monte Carlo simulation, which looks at 3,000 possible scenarios based upon historical evidence of returns and volatilities and correlations. It gets a little bit complex, but it will show you, and I’ll make this up, but let’s say 6% was the mean expected return. That means 1,500 of those runs had less and 1,500 had more. Maybe 20% chance you might have less than a 2% return and 20% chance you might have more than eight. And there’s a 5% chance you’re going to have a loss on the portfolio per annum out for the next 10 years and 5% chance you have really a higher return. So, what I would say in the answer to that question, “I think that we have learned enough that the risk of hyperinflation, which destroys societies is so great that you have to bite the bullet and take actions ahead of time to fight that.” So, I wouldn’t rule it out, countries have gone through them.
I think the odds are much greater that the federal reserve would step in quickly and really drive real interest rates to a sufficient level. I think we would enact fiscal policies that would be more conservative. I think that is by far the more likely outcome, but I wouldn’t rule it out that it is an impossibility. I would never do that. One of the worst mistakes investors make is they treat the unlikely as impossible. And just to give you an example of why that’s a really dumb thing to do—but people do it all the time—I’ll just use a geopolitical event. Germany made the bet that if it integrated Russia into the global economic system, they’re not going to cut us off. We can rely on Russian gas and energy, and they have 90% or 80% reliance on Russian gas when Russia was always at risk for something. And they treated the unlikely as if it was impossible.
That’s a mistake in my opinion, that only fools make, and Germany made it. Italy did it. And that’s a mistake. We don’t do that when we build investment plans. We are always looking at that left tail risk for stocks and bonds and making sure your plan can address it, and what are the actions (what we call a Plan B) you’re going to take if that left tail risk would happen to show up.
I’m going to just piggyback a little bit on Larry and address maybe a couple questions that came through the chat in the context of what he said. Again, what we’re trying to do is put the odds in your favor. And those of you who are on this—that are about 90 now—we know we’re not a fit for all of you. So hopefully those of you who want to continue to do this yourself, there are a couple takeaways here. So, one question came through and it said, “Are high fees and alternatives worth it?” What we tend to use are as low cost of funds that we could find that still fit what we want to do. And by that, I mean Larry mentioned a Bridgeway fund. If you compare the Bridgeway fund we use, which is small-cap value to maybe a Vanguard fund, or IWN, the Russell 2000 index you’ll find the cost is significantly higher.
It might be 50 basis points higher. I know many of you understand the Morningstar style box. If you look at the makeup, you will see it is the smallest of small, and it has a low PE or lower PE and lower price to book. We’re willing to pay for those characteristics because of the higher expected return. Plus, you don’t have people moving in and out of this all day long really mucking with your portfolio. So, we feel that excess price is worth it. Same with some of these alternatives. Are they single-digit basis points? Absolutely not. I think Larry mentioned one and a half percent. But we’re buying those types of funds that fit for us. Remember we’re fiduciaries, so we’re not buying these upfront 8% commissions non-traded REITs or any of those things. So, the short answer is yes, we think it’s worth it.
The second thing Larry is talking about a lot (understandably) is about portfolio construction. And again, there was a question in the chat about a long-term charitable planning. And what I would say is in the context of goal planning, the real value to be found, whether we do it for you or you do it on yourself is understanding asset location, which Jim brought up earlier. And I’m sure because you’re all disciples of Jim, you understand that the IRA is the worst asset to leave to your kids if they’re in a higher bracket. So, what would we do? We would say give those IRA dollars to charity, if you’re going to leave them at death, or maybe a charitable remainder trust or something.
And again, all of you on here understand that you could certainly give appreciated assets now, either to the charity or create a donor-advised fund, but I would caution you to do this. Don’t merely look at this year’s tax return, look out over the next 20 years (actually look out over the next generation). At Buckingham, we’re focused on keeping taxes down, not just today, but over your children’s lives. And I would encourage you to do that too when you’re looking at portfolio construction and or legacy planning.
Yeah. Let me just add as a good example to this point is what I find is too many people bite their nose to spite their face, because they focus solely on costs instead of value added. So, I know Jim, did you have children?
I do. I have one daughter.
Yeah. Did she play any sports, for example, traveling or anything?
Adam, do you?
So, when you’re out traveling with your kids, you might take your daughter out to the local Lone Star restaurant or someplace not too expensive, eating out with the kids. Would you take your wife on your 10th anniversary or 20th or whatever there? You wouldn’t do that. Not if you wanted to continue to stay married, right?
Hoss’ buffet person.
There you go. So, what we think about in that example is value added and that’s what we do. We have no incentive to choose a high-cost fund because it means you have less assets if they don’t added value and we earn lower fees, because our fees are based upon your assets. So, we’re only going to recommend something: 1) if we think it adds value and 2) every one of us invests our own personal money in the very same vehicles that we recommend to our clients. So, we’re putting our money where our mouth is. But let me give you a very specific example of what I think is this foolishness of focusing only on expenses. Expenses should matter only when you are comparing pure commodities, and then it’s the only thing that should matter because they’re identical. So, you’re going to buy an S&P 500 index fund, they’re identical except for the expense ratios, so choose the cheapest one.
As Adam said, Bridgeway fund, I think their current expense ratio is in the forties versus say 10 for a Vanguard small value fund. But we think the Bridgeway fund has, after those additional expenses, about a 1% or so higher expected return because it’s much smaller and more valuing. I’m willing to pay 40 to get another hundred or 30 to get another hundred. In the case I mentioned earlier, Vanguard’s high yield fund, I don’t know what that expense ratio is. Maybe it’s 15 or 20 basis points, maybe it’s even 10. And the Cliffwater fund is 150. Well, that’s a big difference. But the yield on the Vanguard fund is 3.8. The yield after expenses is 7.3 on the fund. It’s got less credit risk and it’s got much less inflation risk. So, all I’m concerned about is buying the best vehicle.
Do I wish Cliffwater was less? Yeah, but there isn’t anything better or we would choose it. We’re going to choose vehicles that add the most value to your portfolio. And you should ask the question, “What am I getting for that extra fee? Is it worth it?” And if we can’t justify it, you shouldn’t invest. But we wouldn’t recommend it if we didn’t think the value far exceeded the additional costs because costs are certain and expected returns are uncertain. So as an example, if we thought something would deliver 20 basis points more return for 10 basis points more expensive, we probably wouldn’t do it unless it was a virtual certainty, and there are very few of those in investing. So hopefully that answers your question.
Let me add one other point. I do want to add one other point here I just thought of that is important. If you’re buying a Vanguard fund, basically, if you will, robots are running that fund. It’s a computer that just tells you which securities to buy in the index, so it could be done very cheaply.
If you’re using this reinsurance fund, there is no public securities to just go buy. There has to be contracts that need to be negotiated with insurance companies that share their book of business, what those fees look like, the terms, and everything. In effect, in this case a company called Stoneridge, is running a reinsurance company for you. You can’t compare the two. And in fact, the returns on equity in the Stoneridge funds we think are very comparable to the returns on equity if you’re an investor in those companies for that insurance risk. We actually run the numbers and can show you that. So again, don’t bite your nose off to spite your face. Don’t make the mistake of focusing only on expenses. They are important and should be considered, but they shouldn’t be the only consideration.