Originally Aired: April 29, 2016
Topic: Asset Allocation to Maximize Returns and Minimize Risk with Dr. Roger Ibbotson
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Guest Introduction: Roger Ibbotson
- Diversification Is Key to Reducing Investor Risk
- Index Funds vs. Active Funds
- Behavioral Finance: Thinking Inside the Bucket
- Liquidity, Risk and Taxes Impact Return on Investment
- Mixing Assets Maximizes Tax Efficiency
- Buffett and Apple: Why Did He Buy Such a Popular Stock?
- Don’t Assume You Have an Edge
- Zebra Capital: ‘We’re Always Going Against the Grain’
- Momentum Premium and Profitability Premium
- Embrace Emerging Markets, Even Later in Life
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. Guest Introduction: Roger Ibbotson
Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg along with CPA and attorney Jim Lange, and this week, we’re going to talk investing with another industry giant. We welcome back to the show Dr. Roger Ibbotson. He’s an emeritus professor in the practice of finance at Yale University, and he’s also chairman and CIO of Zebra Capital Management, LLC, an equity investment and hedge-fund manager. Dr. Ibbotson is also a prolific author, having written dozens of articles and books, including Stocks, Bonds, Bills and Inflation, which has become a standard reference for information about capital-market returns. Over the course of this next hour, Jim and Roger will discuss topics like liquidity, efficient markets, how to allocate your assets to maximize long-term profits, and they’ll compare the risks and returns across different classes of assets. Our show is live, so please feel free to give us a call with your questions. The number here in the studio is (412) 333-9385. And now, let’s say good evening to Jim Lange and Roger Ibbotson.
Jim Lange: Welcome, Roger.
Roger Ibbotson: Welcome to you, too! I’m glad to be here.
Jim Lange: Well, it’s a pleasure to have you, and I hope our listeners understand that you are, if not the top asset-allocation expert in the world, certainly in the top two or three, and since asset allocation is certainly the most important to mention of investing, really, who could be better to help our listeners get a good clue on investing than you? So, it is wonderful to have you here.
Roger Ibbotson: Well, again, I appreciate the chance to be on your show.
Jim Lange: So, you have been here multiple times like you mentioned, and you have consistently recommended a well-diversified portfolio, meaning that you have investments in U.S. and U.S. large and U.S. small and value and growth and international and small-value growth and emerging markets, et cetera, et cetera. And that you always talk about the benefits of diversification, and I think that a lot of our listeners have heard that before, but, unfortunately, for those of the listeners and for other investors who have listened to that well-diversified portfolio argument, in the last couple years, they have not done as well as their friends who might’ve been in a plain old S&P 500. So, first of all, why have these well-diversified portfolios, in effect, underperformed what many might consider the benchmark?
2. Diversification Is Key to Reducing Investor Risk
Roger Ibbotson: Well, you know, in any race, there’s going to be a winner, and it happened that the S&P 500 was essentially the winner over the last couple of years. But that doesn’t mean you should abandon all the other kinds of investments because the winner of this race isn’t going to be the winner of the next race, and if you knew which one to take, of course, that would be great, but we don’t really know which part of the market is going to do best in the future, and that’s why you diversify, essentially, because what it does in the end is, it reduces your risk. If I knew which one was going to be better, of course, I’d tell you to invest in that one, but essentially, I don’t know. Even I don’t know, I guess! And I don’t say that even because very few of us can really know, and since we don’t know, we have to buy a bundle of things, and then part of the portfolio, of course, would include the S&P 500, and that part would’ve done well, but even better than some of the other parts.
Jim Lange: You know, I sometimes hear people say, ‘Oh, look what’s going on in China. I certainly don’t want to invest internationally now,’ or they’ll read an article about, let’s say, a particular asset class and say, ‘Oh, I really don’t feel like being in there now,’ or ‘Oh my goodness, look at what’s going on politically. You know, we don’t like either candidate on the Republican or the Democratic side,’ or ‘The United States is going to be in a rough tailspin.’ And they try to, let’s say, in effect, outguess the market. Do you think that that’s a wise strategy, or do you think that that is really pretty risky?
Roger Ibbotson: I think it’s risky to go in and out of the market, and since we really don’t know, and some of these things, like China, for example, we all know that things are volatile in China, but often, that’s the best time to buy because when everybody else is afraid to buy, that’s when the prices are the best. And by the way, we just had, like, small caps, for example, they haven’t done as well lately. But that just means that the prices are more attractive, and so they might give you better returns in the future. So, you don’t want to chase, essentially, last year’s performance. That’s the worst thing you could do. In fact, if anything, there is some tendency to reverse, and you’d like to chase the ones that didn’t do as well.
Jim Lange: All right. If you are, let’s say, mechanically rebalancing, that is, to keep it simple, let’s say you had 10 asset classes and you had 10 percent of your investments in each class, and then one went to 12 percent and one went to eight percent, and you mechanically sold two percent of the one that went to 12 percent, and you mechanically purchased two percent of the one that went to eight percent, which we would call rebalancing. Is that similar to what you have in mind when you say buy something that isn’t in favor, or sell something that is?
Roger Ibbotson: That’s certainly one way to accomplish it because if you buy something after it’s gone up, then that’s what you’d be doing in this case with the S&P 500. It’s better to buy something after it’s gone down, and mechanical rebalancing is one way to accomplish that, yes.
3. Index Funds vs. Active Funds
Jim Lange: One of the things that we sometimes like to do, and I think that it’s easy to do it if you have … and we’re believers in index funds, and we’ll talk about that because I know you sometimes play on both sides of that fence, index or active. But in our office, most of the money is invested using low-cost index funds with a group that you’re affiliated with called Dimensional Fund Advisors, and we would actually, let’s say, diversify across probably all major asset classes using index funds, and then with rebalancing. But I guess the point that I was going to get to is that certain classes of assets; for example, small companies, or even international small, that might be a little bit more volatile. We would put that in a portfolio that we’re not planning to touch for a long time, and, let’s say, things like cash and CDs and bonds and things like that that we are planning on using in a shorter period. So, we would literally have different tranches, or buckets, if you will. Is that one way of having asset allocation, but at the same time still providing for short-term needs in the event that the market does go down?
Roger Ibbotson: I think that’s a very common way. In behavioral financing, in fact, they call it mental accounting, where you have different accounts for different purposes. Now, of course, you could just sell off your stock to use for your cash-flow needs. But there’s more trading costs involved in doing that. And so it’s easier for your liquidity needs to use the most liquid parts of your portfolio, use cash in and out. So, that’s a very reasonable way of managing your money, and particularly, it really has to do with liquidity more than anything else because the less liquid parts of the portfolio, you don’t want to churn them so much because your trading costs are going to be higher. So, of course, international stocks are going to be less liquid than domestic stocks, and stocks are going to be less liquid than cash. So, just as we would use money out of our checking account to pay our bills instead of our stock-market account, you’re really doing that in a little more liberal method here. But certainly, it makes sense to think of different accounts with different liquidity and use them in different ways.
4. Behavioral Finance: Thinking Inside the Bucket
Jim Lange: Well, you used the term ‘behavioral finance,’ and I know that you have done a lot of work in that area, and what we have found is if you literally have separate portfolios with different asset classes, even if you, in effect, mushed them all together, they might represent something like a more traditional well-diversified portfolio. But just the fact that you have, in effect, several tranches or buckets, people seem to like that idea, and that might maybe be more, let’s say, a happier circumstance for investors. And I don’t know if you would tie that in to behavioral finance in a way that it would make it more comfortable for people to have some more volatile stocks and index funds in their portfolio. Is that fair?
Roger Ibbotson: It is behavioral finance, and it just makes it easier for us to consider all the things that we have to invest in if you put them in different buckets like that. So, yes, it’s easier for us to think about things in those buckets. Of course, if you’re just a pure rational economist, you can put it all into one big bucket and assess everything, but most of us have more limited information and a limited capacity to think about things, and we don’t want to be thinking all the time about our investments, and in fact, putting things in various categories like that actually gives you a discipline that you might not have had on your own, because what I do certainly recommend, for most of us, is that we are long-term investors and we’re not moving things around, and in just having things in these different accounts and different buckets is a way to stabilize what we do and give us a discipline.
5. Liquidity, Risk and Taxes Impact Return on Investment
Jim Lange: Yeah, in fact, it’s maybe a little bit like a Christmas club fund, or a wedding fund or something, where you are specifically setting aside money for one particular purpose, and I think people do like that idea.
You mentioned another concept, and I know that you are doing some really cutting-edge work on it, so I wanted to bring that up and perhaps you could share your interest in … and you mentioned the word ‘liquidity’ for investments. In fact, you’ve even gone as far as to say that liquidity should be considered almost a separate asset class in itself. And feel free to talk for as long as you want about this, because I know that this is one of your pet areas. You’re very well-published in this area and, I think, probably one of the world’s leading experts in it. Could you tell us a little bit about liquidity and how you see liquidity that might be a little bit different than the average investor might think about it?
Roger Ibbotson: Yes. Well, actually, I’d like to even broaden it out further and talk about a concept called popularity here, and that’s part of behavioral finance, that essentially, people want to buy what’s popular, but the higher returns are going to be associated with the types of securities that are less popular, because the more popular a security is, the higher the price is going to be, and the less popular it is, the lower the price. But the lower the price, you get the higher returns. Now, if you think of what’s really popular, one of the most popular things you can think of is liquidity. If you ask somebody ‘Do you want more or less liquidity in your portfolio?’ they would all say, ‘I want more liquidity.’ Another thing that’s popular is low risk. If you ask somebody ‘Do you want more or less risk in your portfolio?’ they would say, ‘I want less risk and more liquidity.’ That’s what they want. Now, what they don’t realize is you have to pay for this. By not being willing to take on risk, you’re giving up returns, and by not being willing to give up some liquidity, you give up returns. Basically, liquidity has a high price and avoiding risk has a high price. So, in both instances, you have to, in fact, buy what’s unpopular to get the lower prices and the higher returns, and I would say there’s three things that really drive what’s popular in our practices. The three most important things on an asset-allocation perspective are risk and return (you’re going to get higher returns by taking more risk), then there’s liquidity in return (you’re going to get more return by giving up some liquidity), and the third thing is, of course, taxation, and here, it’s a perhaps even more complicated subject, but you want to make sure that you buy things that are really taxable in an IRA non-taxable account, and you want to make sure to get your tax advantages where you need them most, when you’re in the highest bracket. So, we basically have to match our desires with our needs here, and we have kind of false desires because we just think of everything as free, but just as it’s obvious that a municipal bond and a corporate bond have totally different yields because they’re taxed differently, so it’s also true that securities that are very liquid versus securities that are not as liquid have totally different yields and bond markets and have totally different returns in stock and bond markets. So, I guess that’s sort of a general message here. You have to essentially buy what other people don’t want if you want to get the best returns here, and other people tend to want too much liquidity, more than they need, and people are too afraid to take risk, and if you’re willing to take on some of that risk, you’re going to get the higher returns.
Jim Lange: Well, I think that’s a great point, and by the way, that might be a point that promotes the bucket analysis that we had talked about earlier, that let’s say that you do require a certain amount of liquidity because maybe you are retired and your pension and Social Security don’t cover your costs of living and you have to go into your portfolio, and if that portfolio that you’re planning to go into for the next six months, or a year or maybe two years, is relatively liquid, and then, let’s say, some of the money that you’re not going to touch for 10 or 15 years doesn’t require that liquidity, maybe you could, in effect, get the best of both, which is to have a liquid portion of your portfolio that you plan to spend in the near term and give up liquidity. Maybe also give up risk; that is, take on a greater amount of risk knowing that, even after it comes down, if it’s invested long enough, that it is likely to come back up. Is that a fair analysis?
Roger Ibbotson: Yes, that is. And again, of course, we could design portfolios where everything was all in one bucket and do this, but it’s easier to think about if they are in different buckets, and it’s easier to discipline ourselves to say, ‘All right, I’ve got this horizon, I need to spend money over the next one or two years, I need a piece that’s very liquid, but there’s other pieces that I don’t need to be so liquid and I can take more risk.’ So, it’s very reasonable to separate out your investments into these different parts, and this makes it easier for us, basically as investors, to think about our investments.
6. Mixing Assets Maximizes Tax Efficiency
Jim Lange: Well, you also talked about taxation, which, I think, is very important. So, I know Dimensional Fund Advisors are the underlying index funds that we use, and I know that you are associated with DFA also, and I know that there are different choices even in similar asset classes. One might be taxed advantaged that would go in, what I would call, after-tax dollars, and then let’s say DFA has the luxury of not having to worry about taxes, and that could be held in an IRA or a Roth IRA, and the construction of those portfolios are different, even if it’s in a similar asset class. Is that one of the ways to become, in effect, a more efficient investor to literally have different investments in the … I’m just using IRAs and Roth IRAs, but there’s certainly other tax-free accounts. Is that one way of, let’s say, increasing after-tax returns by investing your taxable investments and your tax-deferred or tax-free investments differently?
Roger Ibbotson: It isn’t even behavioral. It just makes pure economic sense. Anything that throws off a lot of ordinary income, like a corporate bond, for example, or fund investments in corporate bonds, especially lower-grade bonds that have higher yields. This could more fit into an IRA where those returns are not going to be taxed, and ultimately will be taxed when you distribute them, but they won’t be taxed according to the income that’s earned. So, in general, though, taxation is a very important part of your portfolio. By the way, and I think you mentioned it, for full disclosure, I’m on the board representing the investors for Dimensional Fund Advisors, and so I’m independent, so I’m not really representing Dimensional, but I’m certainly aware of all their funds, and, in general, I’ll say their funds are really most tax efficient anyway because there’s not very much turnover in these portfolios. They’re portfolios that are held for a long time. Yes, they get inflows and they have outflows, but they’re not a big part of the portfolio. So, most of those portfolios that you might get through Dimensional are actually relatively tax efficient. The portfolios that are not as tax efficient, by the way, are portfolios that have a lot of trading in them, and I will say, you know, we manage hedge funds and many of the hedge funds are actually bought by institutional investors and pension funds. They’re not necessarily tax efficient to be in a taxable portfolio because they may have turnover rates that are too high.
Jim Lange: Right, but presumably, if it’s in a pension fund or an IRA or a Roth IRA, the taxation shouldn’t matter, and the only, in effect, downside of the trading would just be the trading cost itself. Is that right?
Roger Ibbotson: That’s right, and that’s why the natural … I will say the natural customer base for us is going to be in IRA accounts or pension accounts, and a lot of them are institutional accounts, of course. So, they’re not concerned about the taxes. We can really go after the alpha, the excess returns here, because we don’t have to worry so much about the taxation. But I must say, for the individuals, most of your clients, I imagine, most of the people listening today are individuals. They have a complicated set of problems, and certainly one big part of it is taxation. So, the kind of investment that’s best for them is not necessarily the kind of investment that’s best for a pension fund.
7. Buffett and Apple: Why Did He Buy Such a Popular Stock?
Jim Lange: Roger, when you were talking about liquidity, and you were talking about stocks in favor, that is, the more liquid something is, the higher the cost, the more in favor it is, the higher the cost, and then Berkshire Hathaway just invested a billion dollars in Apple, which kind of goes against what I think of as Warren Buffett’s classic investing. I mean, certainly, they’re smart people. They recognize this. Are they so bullish on Apple that they actually think that it’s going to overcompensate for, let’s say, liquidity and stocks that are currently in favor?
Roger Ibbotson: I really have trouble justifying that one, and of course Warren Buffett may know a lot about Apple, I guess, because when you go in big into something like Warren Buffett does, you have, I won’t call it inside information because that’s not quite the right term, but I’m sure he has a lot of private information. I’m sure he knows a lot about what that company’s up to before he would make such a huge investment at Apple, but just as an outsider, you know, it’s a very popular stock. One of the interesting things is, he’s going into it of course when it’s starting to have some difficulties. In that sense, this might be the right time to go in because when it’s having difficulties is when, I guess, the time you might pick up a bargain in Apple, and so maybe he knows something about the fact that the difficulties are temporary. But I would say, just in general, a company like Apple, it’s had so much success over the years. It’s very hard to keep replicating that success and keep on being so successful. I mean, if you look historically, there are companies like IBM that always was the largest company in the market by far, but it can’t sustain that forever, you know. It ultimately just cannot always be at the top of the heap.
Jim Lange: Well, I think you’re right. Like, who would’ve thought that Sears and Kmart would be out of business, or, at least, floundering horribly, and everybody now assumes that even Walmart is impenetrable and will be here a hundred years from now, but that’s not what history would say.
So, getting back to Warren Buffett for a minute, because Warren is, even though probably one of the greatest living active-management investors, although he might have some competition at Zebra Capital, and I want to get to that also, but here we have a guy who has, over a long period of years, beat the indexes, and he himself is saying, ‘No, for the average investor, they are better off with a well-diversified portfolio of index funds.’ On the other hand, for his own investors, he obviously is still actively investing. And for you, you know, you’re representing the investors for Dimensional Fund Advisors, which is, let’s call it, an enhanced index fund, but you’re also the CIO and founder of Zebra Capital, which is, as I understand it, an actively managed fund. So, which side of the fence are you on, Roger? Or do you play on both sides?
8. Don’t Assume You Have an Edge
Roger Ibbotson: I definitely play on both sides of the fence, but it really has to do with what your edge is and where your edge is and where you can apply it. So, if you think of most of our listeners, they’re not really going to have an edge. When they buy something, they always have to think, ‘When I’m buying a particular stock, somebody else is selling it.’ And that’s why, in fact, you’re far better off typically relying on some investment manager like Dimensional to help you manage that money, because do you know more than the person selling it when you buy something, and do you know more than the person buying it when you’re selling something? You know, those are questions that you always have to ask, and most of us do not. So, when you don’t have that edge, the best thing of all is to in fact buy an index fund, or buy more of a passive investment because think of it as a poker game, I guess. In a poker game, of course, a poker game is a zero-sum game, we would say, so that whoever loses money, someone else wins money. The winnings equal the losings and they can’t all win at the game. So, that means that when you’re at the poker game, you have to ask yourself, ‘Who am I playing with?’ And often, they say, you know, if you look around the table and you don’t know who the chump is, it’s you, you know? So, you don’t want to get in poker games where you’re below average as a player. Of course, if you can get in poker games where you’re an above average player, you’re going to do quite well. And so, the key is to know yourself here, really, and recognize what your real talent is and what your specialties are, and if you have some special edges, of course, you can use those edges. But don’t assume you have an edge. You’re only going to have an edge in special circumstances. So, I would say Warren Buffett, over the years, has had a lot of edges in different things, and the fact that he has done so well, it doesn’t mean that the rest of us can necessarily replicate that. I will say also, though, that Warren Buffet with his bigger and bigger pieces of money here and so forth, he probably has much less of an edge today than he would’ve had 10 or 20 years ago. So, I wouldn’t necessarily think he can keep on doing this, and even, I think, Warren Buffett knows it’s harder and harder and harder for him to accomplish what he did in the past. Now actually, we have an advantage at Zebra Capital because we have a little less than a billion dollars under management, and so we’re not impacting the market. If we can really take advantage of our edge …Warren Buffett has tremendous edge, but I don’t think he can very easily take advantage of it at this stage of his life.
9. Zebra Capital: ‘We’re Always Going Against the Grain’
Jim Lange: Well, let’s talk about Zebra Capital for a minute, because we certainly have a local audience of people who are in Pittsburgh. We have both, let’s say, the evening commuters and then it replays Sunday. So, we actually have a large proportion of what I would call the ‘driving to church’ crowd, but we also have a national following, and there’s a lot of people literally from all over the country, both investors and also financial advisers who are looking for an edge. I tend to not look for an edge. I tend to be very happy with well-diversified portfolios in Dimensional Funds. But let’s talk about some of these people that are looking for an edge. Could you tell us a little bit about your activity with Zebra Capital, who that would be appropriate for and where people could get additional information? Because, to me, here you are, one of the top asset-allocation experts in the world, generally known as an index guy, but if you’re saying, ‘Hey, it’s not easy to get an edge, and particularly these days, it’s even tougher to get an edge, but I think I have an edge, at least in certain areas,’ I think that there are some people who are taking you pretty seriously. So, could you tell us a little bit about your activity with Zebra Capital?
Roger Ibbotson: Well, I guess if they want to actually reach us, they can go to our website at www.zebracapital.com and look at us in more detail. In general, though, we’re going to be primarily an institutional manager, and yes, we do have some individual investors. Usually, there’s a million-dollar minimum, so that’s going to cut out a big chunk of investors. So, I mean, even if you have a million dollars to invest, we’re not saying you should invest with us because we don’t want you to put most of your money in our fund. We want you to be diversified. I think it makes sense that all of us should be diversified. So, I mean, if you have five or 10 million dollars to invest, then you might be a potential investor for Zebra Capital. And again, the biggest pieces, the biggest investments, in fact, in our funds are either offshore or actually some major U.S. pension funds invest in Zebra Capital. So, yeah, I can’t even say that necessarily we’re targeting the investment advisers here because we don’t want you to be not diversified. We believe in diversification, and so we only want to be a part of your investments. We don’t want to be the majority of your investments. Now, with Dimensional, of course, they’ve got all kinds of different funds, and so you could be almost all in Dimensional and be very diversified. But we only want to be a part of somebody’s investment.
Jim Lange: Okay. Do you have one overriding theme, like you’re particularly strong in this one segment of the market? So, maybe somebody with 10 million dollars would put a million dollars with you, and then they would underweight the rest of their portfolio so that their entire portfolio would be well-diversified?
Roger Ibbotson: Okay. Our major theme here is popularity, again. We’re basically buying the unpopular stocks. We do have long-short funds, so we actually take short positions, so that the other side of this is we’re shorting the hot stocks. I guess if you’re watching the Jim Cramer TV show instead of this show, we’re likely to be short at the stocks he talks about, and so we take long positions in the stocks that people have heard less about, basically. So, the stocks that everybody talks about were likely to be short. The stocks that everybody kind of ignores are the ones more likely to be long. So, we’re buying the unpopular. The overlooked stocks are, in fact, the stocks that are underpriced, and we’re shorting the hot stocks. Like if you went to a cocktail party and heard stocks, that would probably be a bunch of stocks that we might be short. So, the kind of stocks that people gossip about are likely the ones that we’re not invested in, or if we have long-short portfolios that were short. So, that’s our basic theme, that’s how we approach this, and it works because we’re always going against the grain. We’re going against what other people want.
Jim Lange: And if I could just ask one more time for somebody who is interested, could you please repeat the website or how they could find out information about Zebra Capital?
Roger Ibbotson: Yeah, I think the best place would be the website, which is www.zebracapital.com. That’ll certainly be the way you can access us. We won’t be hard to find if you just go to www.zebracapital.com.
10. Momentum Premium and Profitability Premium
Jim Lange: Okay. And you had mentioned Jim Cramer because you said that Zebra Capital does …
Roger Ibbotson: I probably shouldn’t have said that, I guess, a particular person like that!
Jim Lange: Well, I mean, actually, if you had been following Jim Cramer’s advice, you would have one million dollars today, assuming you started with two million. All right, so we won’t rag on Jim Cramer anymore! And getting back to a little bit about Warren Buffett, Larry Swedroe wrote a book, actually more than one book, about investing like Warren Buffett, and he said that Warren Buffett was one of the very early guys to recognize and take into account, in his investment choices, two areas that I’d love to have your opinion on. One is what he called the ‘momentum premium,’ and two, something called the ‘profitability premium.’ And I know that DFA is taking those premiums into account. Could you tell our listeners a little bit about what is the momentum premium and what is the profitability premium and how they might utilize those premiums to increase their returns?
Roger Ibbotson: Well, momentum is merely basically following trends. So, typically, it’s looking at how stocks have done over the last year, and the stocks that have done the best over the last year, there’s some tendency for them to continue, and the stocks that have done the worst the last year, there’s some tendency for them to continue doing the worst. That’s the definition of momentum, although I will say that momentum has worked much better in the past than I think it works currently now. It’s currently more erratic. I guess, in some sense, Warren Buffett may have discovered it decades ago, but the real academic work was done by (Narasimhan) Jegadeesh. I’m not going to spell that name, but essentially Jegadeesh came out with academic work showing that just buying stocks that went up in the last one year … particularly, you usually look at the period two to 12 months because there’s a tendency if they’ve gone up very recently to reverse. So, I usually look at that two- to 12-month measure for momentum. Now, the profitability measure is a gross-profit measure. It’s pretty close to a cash flow, essentially. How much gross profits before a lot of the other expenses are taken out, like the depreciation and so forth, before you count some of those other costs, but it’s not that different than even a … these are not magic measures or anything. But generally, it’s as strong fundamentals here. So, stocks that have strong fundamentals tend to do well. Stocks that have been going up tend to keep on going up, and there have actually been some studies which show that Warren Buffett, if he’d just followed some simple strategies like momentum and value effectively, that you could pretty closely replicate some of Warren Buffett’s returns, at least historically, that just doing simple things could’ve gotten you very good returns. But I think Warren Buffett’s gone beyond that, and these simple measures explain a lot of his returns, but, of course, Warren Buffett’s been so exceptional that I think he has returns above and beyond momentum and profitability, or, more generally, value.
Jim Lange: Are there funds, or is this something that investors should take into account either with individual securities or funds that might include some of these premiums, as opposed to a, let’s say, more mechanical fund like the S&P 500?
Roger Ibbotson: Nowadays, there’s a lot of talk about what’s called ‘smart beta.’ And basically, you want to buy funds that are sensitive to momentum or sensitive to value, and you could buy them relatively cheaply. In some sense, Dimensional already offers things like that because they do include value. Effectively, they’re buying value stocks in their portfolios. But nowadays, there’s a lot of competition. It used to be Dimensional was more by itself at these things, but now, there’s lots of competitions with … there’s so much competition that it’s been given a name, which has typically been smart beta, a way to get relatively low-cost access to a lot of these premiums. The bad news is it gets back to the popularity concept that I talked about, is once these premiums become so popular, their prices are up and the returns are lower. So, these premiums worked because they were unpopular, not because they were popular. And so, for example, value has been generally unpopular over the years because the growth companies are very exciting companies. The value companies are, you know, there’s usually something wrong with those companies, and so people didn’t want to invest in them. But if value becomes popular, you can forget the value premium.
11. Embrace Emerging Markets, Even Later in Life
Jim Lange: All right, and I think that we’ve seen that in the last couple of years that value didn’t do as well, and, let’s say, using some of the thinking that you’ve talked about tonight, now might be a better time because it isn’t popular right now, because at the moment, the large U.S. companies are very popular, and the value companies, and we just had Burton Malkiel on who gave a price-earnings ratio argument for even some of the emerging-market companies, again, somewhat consistent with your popular and unpopular theory, if that is fair.
Roger Ibbotson: Yeah, that is fair. In fact, I probably should have answered this when you asked me that first question at the beginning of the program. The fact that emerging markets have done poorly, the fact that value has done poorly in recent years means that the prices are more attractive, not less attractive. It means that they basically have become unpopular, and that’s the best time to buy them.
Jim Lange: Well, I know that sometimes you work in the world of large pension funds and people who have 10 million dollars, but let’s maybe cut our scale a little bit, and let’s talk about … I don’t know if you want to call it the average Joe, but let’s say somebody that has maybe a $500,000 to a couple-million-dollar portfolio, and they are, let’s say, at or near retirement, and they’re trying to figure out what their asset allocation is, and I’ve heard from these folks and they’re saying, ‘Well, gee, I’m really kind of uncomfortable with international, and, in particular, emerging markets because I might not have the time horizon to withstand a drop in the market,’ and they tend to maybe be pretty conservative in terms of the percentage of cash and fixed-income investments, perhaps more conservative than I might want. How would you address somebody who was like that? Let’s say that they understand about asset allocation, so it’s not like they’re total naïve, but at the same time, they have their own emotions and they are getting older and they have a little bit of an aversion to risk, and let’s say that you, as a fiduciary adviser, would like to see them in some areas that might not be as popular. Let’s use emerging markets for an example. How would you communicate to somebody like that, and what should they be thinking about in terms of changing asset allocation as they age?
Roger Ibbotson: Well, I’ll start out by saying as you age, you should actually be taking less risk, because I’ve written on this subject, we talk about human capital, but people have human capital and they have financial capital. Human capital is your earnings power. Now, as you age, you have less and less future earning power, and so you’re really left with your financial capital. Now, your human capital tends to be a little more like bond markets. Usually, your earning power is more stable, and therefore, and when you’re young, because you’ve got a lot of earning power ahead of you, you can take a lot of risk in your financial portfolio. You can take a lot of risk in it, but it’s not a very big part of your wealth, because, when you’re young, most of your wealth is human capital, the future earnings that you’re going to make. But as you age, your financial capital becomes the bulk of your capital, and you should be taking less risk. So, for starters, I guess I would encourage them to take less risk. But that still doesn’t mean that they shouldn’t diversify, and, in fact, when you do take some risk in that portfolio, because they shouldn’t be out of stocks, certainly. Even as you get to age 65 or so, with the kind of portfolio you’re talking about, stocks should be close to half the portfolio, and, now it’s important to have that portfolio be diversified, and diversified means buying lots of different types of stocks. And so, that means buying international, buying emerging markets, buy small caps, buy value, buy large caps, buy a whole set of things, and you started out the program by asking, well, ‘Large caps did better than these other categories.’ Well, that’s true, they did. But that actually makes it less likely to do better in the future. So, I would encourage them to take less risk, but in the risking ‘bucket,’ I guess, that we’ve been talking about here, they should still be very diversified.
Jim Lange: Well, I think that that really helps because I think a lot of clients, and particularly, I think maybe people who listen to the media maybe a little bit more than they should are just so worried, and they are so afraid of stocks, and, in particular, international stocks, and here you are … you know, again, I don’t think anybody could be a higher authority, and you’re saying even people in their mid-60s, and maybe even older, should own at least a certain percentage of what might be out of favor in terms of international and emerging markets, and that they should have, in effect, a whole bucket … or maybe not bucket, but a whole variety of different types of investments, and that they are therefore ultimately reducing their risk by not having all their eggs in one basket.
Roger Ibbotson: That’s right. That’s what diversification does. It’s one way to really cut most leeway because we don’t know which one’s going to win, and the worst thing I guess we could do is bet on what won last year all the time. All the evidence is that chasing the winners is the worst kind of thing to do and the worst performance. But unfortunately, individuals have a tendency to do that, and actually, that’s why individuals tend to actually underperform institutions because individuals have a stronger tendency to chase what worked best last year.
Jim Lange: Roger, I hate to ask you this with only one minute left, but, to me, you’re always an interesting guy doing a million different things. So, could you give us the one-minute version of ‘What’s next’ for Roger Ibbotson?
Roger Ibbotson: Well, there’s always a lot of ‘What’s next?’ But I am giving a talk actually at a conference next week on a paper about the long-term drivers of investments, and it has to do with, really, ultimately, it’s the economy and the cash flows that companies produce, because those cash flows ultimately … I mean, we see stocks fluctuate so much over the short run, but over the long time, ultimately, companies have to pay what the economy and the companies have to supply of returns. They’re the ones who supply what’s going on. And so, I’m doing a long-term study of this of actually over the last, I guess, would be almost 150 years of looking at data on what are the drivers. But the driver is the economy, and the driver is the cash flows that companies actually produce.
Dan Weinberg: Okay. Well, Roger, thank you so much for being our guest, and thank you as always to Jim. Special thanks as always to the Lange Financial Group’s marketing director, Amanda Cassady-Schweinsberg, and to KQV’s Alexandria Chaklos, handling the controls for us.