Episode 129 – The Importance of Asset Allocation with guest Dr. Roger Ibbotson

Episode: 129
Originally Aired: June 3, 2015
Topic: The Importance of Asset Allocation with guest Dr. Roger Ibbotson

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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The Importance of Asset Allocation
James Lange, CPA/Attorney
Guest: Dr. Roger Ibbotson, Founder, Chairman and Chief Investment Officer of Zebra Capital and Professor in the Practice Emeritus of Finance at the Yale School of Management
Episode 129

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TOPICS COVERED:

1. Guest Introduction: Dr. Roger Ibbotson
2. The Efficient Market
3. Long Term Premiums
4. Alpha and Beta
5. Eugene Fama
6. Making the Best Investments
7. Robert Shiller and Behavioral Science
8. Questions from Listener John about How Much to Invest Where and Dimensional Fund Advisors
9. Asset Allocation

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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. Guest Introduction: Dr. Roger Ibbotson

David Bear:  Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks.  I’m David Bear, here at KQV with James Lange, CPA/Attorney and author of three best-selling books: Retire Secure! The Roth Revolution and now, Retire Secure! For Same-Sex Couples.  When it comes to building retirement portfolios, how big a role does asset allocation really play in performance?  To provide perspective and insight on that issue, we welcome another industry giant back to the show, Dr. Roger Ibbotson.  Long-time professor in the practice of finance at Yale’s University of Management, Dr. Ibbotson is also chairman and CIO of Zebra Capital Management, an equities investment and hedge fund manager.  Founder and former chairman of Ibbotson & Associates (now a Morningstar company), he also serves on numerous boards, including Dimensional Fund Advisors.  A prolific author, he’s written dozens of articles and books, including Stocks, Bonds, Bills and Inflation, which has become a standard reference for information about capital market returns.  And with that, I’ll say hello, Jim and welcome, Dr. Ibbotson.

Jim Lange:  Welcome, Roger.

Roger Ibbotson:  I’m glad to be here.

Jim Lange:  Well, you’ve given us great information in the past, and it’s such an honor to have you on the show.  You know, some of the readers, most of our financial planner listeners probably know of your…well, certainly know of your reputation, and many of our lay listeners also.  But it’s just such an honor to have literally one of the top, if not THE top, asset allocation experts in the world, and the top expert, or one of the top experts, on efficient markets versus inefficient markets.  So, one of the latest pieces that you were involved in was published by the Yale School of Management, “How Does Your Theory of Markets Shape Your Portfolio?”  And this is part of the article where you say, “Questions about market efficiency have driven academic discussions for a long time and remain far from resolved, as evidenced by the 2013 Nobel Prize in Economics, which was awarded to Eugene Fama of the University of Chicago, and then a little bit later, and another one to Robert Shiller for Behavior Science.”  So, where do you stand?  Because you’re kind of an enigma, because you’re both, you know, actively involved with Dimensional Fund Advisors, which is, I guess, more the efficient market theory, and Zebra Capital, where you are trying to profit from market inefficiencies.  So, how do you reconcile those two positions?

2. The Efficient Market

Roger Ibbotson:  Well, of course, the truth is never so absolute, I guess.  The truth is always somewhere in between.  And actually, I’ve had the great experience of…when I wrote my PAC dissertation, my chairman at the time was Gene Fama, and, of course, I’ve been on the Dimensional Fund Advisors board for all this time, which has had a connection with Gene Fama for all these years.  But I’ve also been on the Yale faculty here with Bob Shiller, and, in fact, I’ve even taught a few of his classes at Bob Shiller’s class.  So, he’s my esteemed colleague here at Yale.  So, I guess I’ve gotten to know both of them very well over the years, and I think they’ve both made wonderful contributions and certainly deserve the Nobel Prizes that they have both achieved.  But, I mean, I actually think you could actually believe in both things, to some extent.  And actually, I wrote a very recent article on popularity, “The Dimensions of Popularity,” it’s just about to be published in the Journal of Portfolio Management, and it sort of reconciles these things, to some extent.

Jim Lange:  Well, can you give our listeners a, let’s say, a lay listener summary, or a conclusion?

Roger Ibbotson:  Well, think of this as, of course, if you buy something, if there’s a stock or an asset class that is very popular, it’s going to be high priced, and that means it’s going to have lower returns.  If you have such a category that’s less popular, either it could be a stock, it could be an asset class.  The less popular it is, the lower its price, and in fact, that means the higher the return.  So, that explains the asset classes.  For example, why do stocks have much higher returns than bonds over time?  Well, of course, we all know that stocks are risky, much more risky than bonds, and it’s that, of course, risk is actually very unpopular.  When you have a characteristic like that, like risk, that’s very unpopular, that means that those kinds of assets generally are going to be…the price is going to be lower because of it, and it means that they’re going to have higher returns.  So, you actually get much higher returns on stocks than bonds, but, of course, it’s not free because risk is unpopular and you’ve got to take the extra risk.  We can generalize this though, not just to risk, and I guess if you had to take another category, the second thing that kind of stands out is liquidity.  Everybody wants liquidity.  They want more liquidity, and that’s fine.  It’s great to have liquidity, but that’s something that’s too popular, I guess.  And so, what it means is you get to be so liquid, the price goes up and the returns go down.  So, everybody wants less risk, and they want more liquidity, but what that means is the less risk and the more liquidity you have, that means the higher the valuations and the lower the returns.  And so, this applies across all the basic efficient market theories.  They recognize in efficient markets, they really all recognize that there’s a tie-in here that you should have a risk premium, or you could have a liquidity premium.  You should have a risk premium for the things that are more risky, and you should have a liquidity premium for things that are less liquid, as that’s very consistent with efficient markets.  We can take it further though and actually bring this more into Bob Shiller’s world.

Jim Lange:  All right, well, let’s finish the efficient market before we get into behavioral science, because, like you said, you did your paper under Gene Fama, and I’m sure it was a big thrill for you when he won the Nobel Prize.  Now, Gene Fama is obviously very active with Dimensional Fund Advisors, which you are, which, more or less, although they have certain ways that they are trying to maximize return, are still not “trying to beat the market.”  They’re not looking at individual securities and saying, “Well, we think IBM is going to go up, so we’re going to buy IBM.”  Or “IBM’s going to go down, so we’re going to sell IBM.”  They are trying to enjoy the, let’s say, equity premium and using asset allocation, efficient market theory, etc.  But basically, they’re not trying to beat the market.  Zebra Capital, on the other hand…and you’re on the board of this company, Dimensional Fund Advisors.  Zebra Capital, on the other hand, is trying to beat the market.  So, maybe even just a basic explanation of what trying to beat the market is, what active investing is, might be good for some of our listeners before we delve much further.

Roger Ibbotson:  Well, let’s take the…it’s probably easier to find the passive investing, which certainly recognizes that different types of securities have different expected returns than others.  So, even in a passive world, you recognize that any kind of asset that is more risky should have a higher return.  These are more or less permanent effects.  The same thing with something that’s less liquid.  It should have higher returns.  Or sometimes, we can look at the, say, small cap stocks.  They’re less liquid.  They tend to have these higher returns because they’re less liquid.

Well, these are permanent effects.  I mean, we could tell you all about it and everybody could listen to this radio show and let the secret out that small caps tend to outperform large caps, or value tends to be growth, or stocks tend to be bonds.  You could listen to the show and you could recognize that truth, but even if the whole market recognizes that truth, those kinds of excess returns will not go away.  Those premiums are permanent because they’re sort of intrinsic.  We don’t like risk.  We do like liquidity.  And in the case of value stocks, actually, we don’t like the kind of companies that are value stocks, actually.  They’re not very exciting companies.  There’s usually something wrong with those companies.  They’re distressed, or they basically may have poor management.  There’s something wrong with those companies, and we don’t like them.  And even if we told you all about this and you listen to this show every week, you still wouldn’t like those kind of stocks.  So, you basically have to incentivize people to buy those kinds of stocks, and you have to give them an extra expected return.  This is all consistent with efficient markets.  That’s why Dimensional Fund Advisors, for example, basically buys small cap or microcap stocks, and also buys value stocks.  They believe these premiums are permanent.  They’re not going away.  They’re not going away once they’re discovered.  Now, in contrast, an active manager is looking for much more transitory effects.  They’re looking for characteristics that we might not temporarily like, or we might like too much only in a transitory way, but we would permanently dislike or like something.  So, active management is looking for very short-term effects.  They don’t have to be a day or a week.  They could be a year or two.  But they’re basically not permanent effects like you get in the premiums in the market.  So, efficient markets admit that there are…and Gene Fama always said that efficient markets, there’s two parts to it, that it’s always prices are fair relative to something, say, relative to risk or relative to liquidity.  Prices are fair relative to something in efficient markets.  In inefficient markets, with active management, you have distortions in the prices, but they’re much more transitory in nature.  And that’s the basic difference here, whether you have these transitory mispricings, or whether you have only these long-term premiums in the market.

3. Long Term Premiums

Jim Lange:  Well, let’s talk for a second about the long-term premiums in the market.  So, for example, DFA might have a higher percentage of small cap than some other advisors, or even efficient companies, let’s say, like a Vanguard, and their small might be smaller.  Their value might have a lower price earnings ratio.  Are you basically saying that these are, in effect, permanent advantages?  And that’s why, for example, a DFA will outperform, say, an S&P 500, in terms of long-term results because they are investing in some of these, sometimes, perhaps, less popular areas like small cap where people are a little bit afraid, or other areas where people might be afraid, say, international, etc.?

Roger Ibbotson:  That’s exactly what I am saying, that if you go to the areas of the market where people have some fear, or they just don’t like them for one reason or another, and there’s something intrinsic about it, not just temporary, it’s not just a fad, there’s something intrinsic about it, then they’re likely to have better long-term results.  Now, of course, it’s kind of hard to measure a long-term result because it actually means quite a few years to get a long-term.  They’re not going to win every year, any of these premiums are not going to pay off.  Even the permanent premiums, like the stocks will always need bonds, for example, you can’t count on these things.  The very nature of risk is that you don’t know what the result is going to be.  You can say, on average, that stocks will beat bonds.  So, these are permanent effects, but they only show up for those who have the patience to ride through the long-term.

Jim Lange:  Let’s say that the listener has the patience.  For example, I have a lot of clients, and these are some pretty smart people that I know, that say, “Oh, I don’t like international,” or “Oh, I’ve been burned by international small companies,” or “I have been burned by smaller companies, or small value companies.”  So, they stay away from those companies.  But actually, is what you’re saying that some of those companies in the long-term have outperformed the larger companies, and if you exclude those form your portfolio, that you are, in effect, almost asking for a lower return in the long run?

Roger Ibbotson:  If you give up something that people collectively don’t like, then basically, those are the kinds of securities that are going to get higher returns.  But I’d be a little bit careful about talking about international because who’s the foreigner, I guess?  There’s global markets here and there’s global participants, and what’s international to me might not be international to a German investor or a Japanese investor.

Jim Lange:  Yeah, that’s a really good point.

Roger Ibbotson:  So, it’s not so clear how the international is going to shake out.  It might be that we collectively are a little wary of emerging markets, say, the ones that haven’t yet emerged, but I don’t think we could pick on the category of just being international.

Jim Lange:  Okay, fair enough, because I guess I’m just looking at it from an American investor.  And the other thing that I find is…so, I think what you’re saying is, in general, markets are efficient but that there might be some opportunity to profit, in effect, from some market inefficiencies.  Is that a fair characterization?

Roger Ibbotson:  I think that’s true.  It’s just a question of how efficient markets are.  They’re clearly not perfectly efficient.  But one of the nice things, that is, even in an efficient market, there are these premiums which you can capture by being a long-term investor.  So, by picking up more…in Dimensional’s case, Dimensional Fund Advisor’s case, they’re trying to pick up more value or more small cap stocks and pick up the premiums that way.  Basically, overload your portfolio in these less desirable categories, whereas the typical investor would underinvest in those categories, Dimensional would overinvest in those categories and we get these premiums.  This whole area now, by the way, you’re hearing things like “smart beta”.  It’s very related to that because smart beta’s trying to also pick up the long-term premiums.  It’s beta because it is the beta’s that are putting basically coefficients in front of the premiums.  And so, how much beta you have in such and such a premium is basically your payoff.  And smart beta strategies are trying to load up on those premiums, as well.

4. Alpha and Beta

Jim Lange:  Okay.  Before we go too far, I also feel honor bound to say that I am a Dimensional Fund Advisor, distributor, and my business, or at least a large part of it, is working with Dimensional Fund Advisors.  We have a particular money manager, P.J. DiNuzzo with DiNuzzo Index Investors, and he does the asset allocation, and he does the actual investing using Dimensional Fund Advisor funds.  Our office does tax work, Social Security analysis, Roth IRA conversion analysis, estate planning, etc.  So, when we’re talking about DFA, I have to tell the audience out of fair disclosure that I am not completely independent.  Although frankly, it doesn’t hurt me when you say, “Well, DFA outperforms because of these reasons.”  But anyway, I just wanted to mention that.  All right, so you started to talk about beta, and maybe if you can backtrack one step and just maybe give a basic definition of, say, alpha and beta, and then maybe we can talk a little bit more about where you were going.

David Bear:  Break coming up here, so keep that in mind too.

Jim Lange:  All right.  So, can you give us a…

Roger Ibbotson:  I’ll give you something fast, I guess, with the break coming up.

David Bear:  Yep.

Roger Ibbotson:  So, I’ll say beta’s the coefficient you put in front of a premium.  So, if it’s, say, a high beta, it means you’re buying a lot of that premium.  If it’s a low beta, you’re buying a small amount of that premium.  And there can be multiple betas.  There can be a beta on small caps.  There can be a beta on value, or just a beta on the whole stock market.  And say, we think of betas over one on the stock market as being high beta, and betas less than one on the stock market as being low beta.  But basically, your return is sort of an additive sum of a bunch of premiums with the beta coefficients, I guess… coefficient might be a tricky word, but an additive, just a sum of a bunch of premiums with a number in front of those premiums.

Jim Lange:  Okay.

David Bear:  All right.  Well, that’s something to think about while we take this break.

BREAK ONE

David Bear:  And welcome back to The Lange Money Hour with Jim Lange and Dr. Roger Ibbotson.

5. Eugene Fama

Jim Lange:  Roger, you were talking before about Eugene Fama, that you had literally studied with him and you’ve known him for years and he’s been on the board, and he’s basically an efficient market guy, but he recognizes, let’s say, some of the unpopular areas, for example, small cap or value, and has been able to get premiums by investing in them.  What was new when in the article, it says, “For his groundbreaking work on the efficient market hypothesis.”  What was new that Eugene Fama was presumably awarded a Nobel Prize for, or was he awarded the Nobel Prize for the work he’s been doing all these years?

Roger Ibbotson:  Well, it’s for all those years, but actually, the efficient market hypothesis is…I think he coined the word.  I think he wrote the first paper on the subject.  I mean, there was random walk theory before that, where people were talking about stock prices seem to behave in a random walk.  They didn’t seem to be very predictable, and you couldn’t easily use technical analysis in order to predict their pattern of how they might behave.  But he broadened the idea that prices were fair at all times.  He basically invented the notion of efficient capital markets.  Of course, people talked about very similar things, but he really brought it out into the open and made it concise and gave it a definition and said that efficient markets, you can’t look at it itself.  You have to combine it with something else, like risk.  And then he usually talked about everything in the context of risk premiums.  And so, basically, I think you could call Gene Fama the inventor of the concept of efficient markets.  So, clearly, you know, many, many things afterwards, but he basically invented efficient markets in the late 60s, and then he developed many ways of testing whether markets were efficient too.  And basically, surprisingly, most of these results showed that markets were relatively high efficiency.

Jim Lange:  Well, he’s always been one of my great heroes.  On the other hand, John Bogle is also.  And John Bogle does not necessarily do as much in terms of asset allocation and some of the smaller companies and some of the value-oriented companies, and frankly, DFA, if you follow a recommended DFA portfolio, you have done better than, let’s say, the S&P or even most Vanguard portfolios.  Do you think that this is…and they’re both…I think it’s fair to characterize John Bogle as an efficient market practitioner.  Is it fair to say  that they have a lot in common, but maybe Eugene Fama is going a little bit further with some of the small cap and less popular ideas and value-oriented to get greater returns?

Roger Ibbotson:  Gene Fama and Jack Bogle, obviously, both of their work, both of the things they do are consistent with efficient markets, and Gene Fama, I guess I would say, invented efficient markets.  Jack Bogle was one of the first people to come out with index funds.  And, of course, in Vanguard, they basically have now a pretty very strong, it may be dominating, presence.  They’re the largest mutual fund investor, in fact.  They’re really dominating the index fund space.  So, Jack Bogle…I would say, first of all, Gene Fama is an empiricist but also has developed theories.  Jack Bogle is somebody who has applied these things directly.  Gene Fama applies them through Dimensional Fund Advisors.

Jim Lange:  Umm-hmm.

Roger Ibbotson:  But yes, Gene Fama, in applying efficient markets, has noticed these different premiums, and he didn’t discover these premiums, necessarily, but he has noticed them and advocated these premiums, and he’s usually called these things ‘risk premiums,’ although I think the later results nowadays show that most of them are not necessarily associated with at least the standard definitions of risk, like standard deviations.  But they are premiums, and I’m saying more generally what their premiums are for things people don’t like in some form.

Jim Lange:  Umm-hmm.

Roger Ibbotson:  And, to me, it’s more whether they permanently don’t like it, that’s what makes a premium out of it.  If they only temporarily don’t like it, that just makes something mispriced.

Jim Lange:  Okay.  Well, speaking of things mispriced…and by the way, I’m an efficient market fan.  I think Gene Fama’s work is phenomenal, and I genuinely believe that what he is doing with DFA is probably, for most people, the best choice there is, and if you combine it with some of my tax strategies, Social Security, Roth, etc., that’s what we think is the highest level of service.  But, to be fair, there are people like you who recognize all this as well as anybody, but have companies who are trying to take advantage of some of the inefficiencies.  So, maybe you could tell us a little bit about Zebra Capital and your work there and if that would be appropriate for any of our listeners?

6. Making the Best Investments

Roger Ibbotson:  Yeah, I don’t necessarily think it’s the right thing for your listeners.  I will say our investors are much more institutional, and they can be nimble enough in order to pick up these extra, I guess, inefficiencies.  I want to say upfront here: I think you and your firm (I mean, I don’t know that much about your firm, but at least I know the concepts behind it) and Dimensional Fund Advisors, I think you’re actually providing a great service to certainly the retail investor, especially, by basically avoiding some of the higher fees and in being diversified and reducing your tax burdens and basically structuring portfolios in this particular way.  I think that gets you 90% of the way there.  Whether you want to try to beat the market, that’s another thing, and usually, it’s the institutional investors who have the edge on doing that because the individual investors would not be nimble enough or would have to pay taxes if they were actually doing a lot of trading in order to accomplish that.  So, I’m not necessarily advocating the listeners on this show invest in Zebra Capital because it may not be tax efficient, for example.  But I do think we have the capability of discovering some of the short-term inefficiencies.  And one of the ways we do that is looking at trading value.  If you see a lot of turnover in trading value in a company, that’s a very good indication that people are really interested in that company, and actually, the more it’s traded, the more interested they are in it.  The more popular it is, the more overpriced they get.  People tend to basically want to buy the cocktail party stocks, but those are the worst stocks to buy.  So, if you just leave it to your own devices here, most of the individuals are going to actually move in precisely the wrong direction because they want to buy the most popular stocks.  They want to buy the stocks that everybody else is talking about.  And I’m saying, really the way to have higher returns is to buy a lot of stocks that people have never heard of.

Jim Lange:  Well, first of all, thanks for the very nice compliment.  You also gave me a great testimonial for my book Retire Secure!  But let’s talk about trying to beat the market because, you know, there’s quite a few listeners out there who, to be fair, are maybe not the most sophisticated people.  They don’t have PhDs in finance, and they might read an article, and they do engage, I fear, in cocktail talk, and they read Money magazine or something like that, and they pick their own stocks, and they often don’t really keep track of how well they have done.  And do people like that have much of a chance of beating, say, an efficient market theory, whether it be a Vanguard or a DFA or something like that?  Because there a lot of do-it-yourself listeners out there, and I want to know if it is sound for, let’s call it, a part-time person not well trained, not spending a lot of time on this.  Is that a reasonable thing for him to be actively choosing and buying and selling stocks?

Roger Ibbotson:  Well, the market itself…relative to the market, it’s a zero sum game.  For every one percent of return that beats the market, a dollar return, you’ve got to have the same negative return relative to the market on the other side.  So, beating the market is a zero sum game.  It’s sort of like playing poker.  Clearly, poker is a zero sum game, but it’s actually a negative sum game in the sense that you have to pay commissions.  You have to pay fees and things like that to even try to play the game.  So, again, it is like poker.  If you want to get into a casino poker game, you have to pay some fees to get in.  You have to basically pay the house something to play.  But if you’re a good poker player, you can still come out ahead, and like we know that we’ve watched these TV shows about poker and all that, some of these star poker players actually make a living playing poker.  And so, that’s a zero sum game too.

Now, what you really have to think about though is: would you pay some money to enter a poker game with what you know at the moment, you know?  Most of us would feel we’d be fleeced in that kind of a poker game, playing with a lot of experts.  Well, we have the same sort of danger that we may have playing poker with a bunch of experts trying to beat the market, because we’re trying to beat the market where our competition is a bunch of experts.  We have to pay to play, and ultimately, we’re probably playing against professionals where we’re less apt to know as much about this.  Like they sometimes say about poker, one of the amusing things they might say, is “When you’re in the poker game, who’s the sap in the game here?  If you don’t know who it is, it’s probably you.”  You know, so, here in the market, it’s the same sort of thing.  You can’t just expect to outperform the market with conventional knowledge because you ultimately have to be better than the average expert, effectively.

David Bear:  I think I’ve heard Jim use that same line a few times!

7. Robert Shiller and Behavioral Science

Jim Lange:  I have, actually!  All right, but let’s maybe give Yale some credit too, because it’s not just the University of Chicago who are winning Nobel Prizes.  Yale’s Robert Shiller won a Nobel Prize for his fundamental contributions to behavioral science, which points to the irrationality in inefficiencies in the market.  Could we talk a little bit about Robert Shiller’s work as one of your colleagues?

Roger Ibbotson:  Yeah, well, let me say, just in general, there are all kinds of distortions in the market actually.  It’s not that hard to find, especially after the fact kinds of distortions.  I mean, Bob Shiller was in the technology bubble, basically warning everybody about how stocks were so way overpriced.  Not that it was so easy to take advantage of that, because he recognized that maybe several years early.  But certainly, he recognized that the prices were way out of line and of course, then they collapsed.  The bubble burst and they collapsed.  And then, he came along and recognized the real estate bubble, and he recognized that several years early too.  But basically, when the mortgage bubble collapsed in 2008, he had warned us several years beforehand that the real estate was due for a collapse.  So, he actually has had tremendous foresight in recognizing the two biggest drops we’ve had in the last couple of decades.

Jim Lange:  Now, has he missed?  Because I know Harry Dent likes to brag about the ones that he’s hit, but he has had some pretty famous misses, or maybe not ones that he would want to advertise.  But is it fair to say that Robert Shiller came up with a couple winners and didn’t blow it and just completely missed things?  Or did he just have a couple winners and maybe we should listen to him?

Roger Ibbotson:  He had only a couple…he didn’t really have losers, but I will say it would’ve been difficult to follow the strategy because he would’ve been out of stocks in ’97, ’98, ’99 (three of the best years of the stock market) because he recognized this so early.  In the real estate market, the real estate was actually booming under the Bush administration, under W. Bush’s administration, and basically the real estate was booming in 2003, ’04, ’05, ’06, ’07 before it collapsed.  Bob Shiller was talking about this early in both cases.  So, you would’ve missed out on some very good returns along the way.  So, yes, it’s not that he was wrong, he’s early.  He recognizes things and it takes a while for the market to recognize these distortions, and it’s not so easy to just listen to Bob Shiller and make a lot of money from what he does.  But basically, he has recognized a couple of the major distortions.  He’s got different ways of measuring it, like the CAPE, but it’s basically a ten-year average earnings.  He likes to look at earnings over the cycle.  He’s actually basically one of the real leaders in behavioral finance.  And at the micro level, there’s all sorts of distortions too.  But what I would say about behavioral finance is that basically, they’re recognizing things that get too popular or basically that are unpopular.  The things that get too popular, like technology stocks in the 90s, they recognize that those things are going to collapse, and they do collapse.  It’s just that you can’t exactly pick the time when they do collapse.  And ultimately though, the way to make money in the market, if you want to beat the market, is you have to be a contrarian.  You have to buy the kinds of stocks that other people don’t want.

David Bear:  Well, at this time, we should take our one final break and we’ll come back.  We have a question actually from James from Ohio has written in.

BREAK TWO

8. Questions from Listener John about How Much to Invest Where and Dimensional Fund Advisors

David Bear:  And welcome back to The Lange Money Hour with Dr. Roger Ibbotson and Jim Lange, and as I mentioned, we have a question.  James from Ohio asks Dr. Ibbotson, “Is it prudent for a retiree receiving a federal retirement annuity in Social Security equal to 80% of pre-retirement income to invest 90% of his 401(k) in low-cost index funds?”  And following up, he asks, “Will DFA advisors set up an IRA for a retiree with 90% invested in equity index funds?”

Roger Ibbotson:  Okay.  Well, I can’t speak for what Dimensional Fund Advisors will recommend there exactly, but generally, of course, as you get into retirement, you don’t want to be 100% equities.  The theory would say, in fact, that it really comes from human capital theory.  Actually, another Nobel Prize winner, Gary Becker, was sort of one of the great creators of thinking about human capital.  He was also from the University of Chicago, and, as I say, he just died, I think, in the last couple weeks.  Anyway, Gary Becker basically said, “You’ve got two kinds of assets.  One kind of asset is your human capital, which is all your earning power, and the other kind of asset you have is your financial assets.”  And when you’re young, you don’t have very many financial assets, but you’ve got all this human capital earning power, and if you’ve got a stable job, actually your human capital is relatively low-risk.  And you should be taking a lot of risk in your financial capital.  So, young people should be loading up on, basically, equities, perhaps 100% equities.  But as you get older and into retirement, your human capital has really dissipated, but you’ve got financial capital.  But your financial capital now is not balanced by the lower risk part of your human capital.  That’s gone.  So, you need to be more diversified.  I would say 90% equities is too much in equities for our listeners here, unless you’re quite wealthy and you’re not really dependent on the markets here.  But basically, even though stocks will outperform bonds most likely over the long-term, if you’re really dependent on your wealth here to get you through to retirement, you really want to, especially in the early retirement years, actually protect your retirement base, and 90% is too high.

Jim Lange:  Well, far be it for me to disagree with one of the top asset allocation experts in the world.  The only thing that I would add to that, though, is the question specifically does say he has a federal pension that is presumably guaranteed, and he has Social Security that together add up to most of his…I think the question was 75 or 80%, of his needs.  To me, somebody like that, while I would agree with Roger that maybe 90% in equities would be too high, but that person might have a different asset allocation than somebody that has, say, no pension and a small Social Security.  Is that fair, Roger?

Roger Ibbotson:  Oh, absolutely, and I probably overlooked the part that he’s so heavily covered.  He doesn’t have the human capital anymore, but he has the residual payoff from his Social Security and his pension, and I guess, a defined benefit pension plan that’s protecting him.  And presumably, I don’t know how much wealth he has, but if he’s not so dependent upon the wealth to actually get him though the retirement, then you certainly can take more risk with that wealth.  And of course, the more risk you take, the higher the returns, and actually, of course, in this case, probably more for your beneficiaries.

9. Asset Allocation

Jim Lange:  All right.  Well, let’s talk about asset allocation.  It would be literally a crime to have one of the top asset allocation experts in the world and not talk about asset allocation a little bit more.  I think a lot of people probably understand a little bit about percentages of stocks and bonds and may or may not be appropriately invested in those, but could we talk a little bit about asset allocation and diversification and the different asset classes, say, within a stock portfolio, or the different bond or fixed income categories within a fixed income portfolio?

Roger Ibbotson:  Generally, of course, I would say asset allocation would be the most important decision you want to put together, and of course, that’s what you’re providing for them, those combinations.  You want to get as diversified a portfolio as you can.  Basically, getting diversified, keeping your tax load down, keeping your costs down, and perhaps getting some extra return from beating the market.  Those are the big four, I guess.  But I would say that they’re all very important, but basically, asset allocation is trying to make your portfolio as diversified as possible, and a way to do that is have different kinds of stocks in the portfolio and different kinds of assets in the portfolio.  But within the stock market, you don’t want to be just in one kind of stocks, but you’d like to be in large and small and value with higher return, but presumably, some growth stocks to help you diversify it.  So, combinations of these things, and the bond market, depending on how good your tax status is, you probably would need some municipal bonds.  Or if you want to take some longer horizon risk, you need to probably take some lower grade bonds in the portfolio.  You want to have a mixture of this.  And probably international, both stocks and bonds.  Especially bonds.  With international bonds, basically you’re buying these currencies.  They’re paying off in different currencies, and that diversifies your portfolio.  So, what you’re trying to do in this portfolio is buy a combination of a bunch of different things that particularly are not so correlated with each other, and that’s what gives you that diversification.

Jim Lange:  Yeah, and something you said earlier in response to the listener’s question was, “And sometimes, you should think about maybe the next generation.”  So, I have a lot of clients who, to put it nicely, are not some of the great spenders of the world.  Whether you want to call it a depression era mentality or whatever it might be, they’re just not great spenders relative to the amount of money that they have, and they sometimes don’t think about the next generation.  So, for example, if you have a million dollar portfolio and your Social Security is $30,000 and you’re only spending $60,000 or $70,000, maybe it might be appropriate to have, let’s say, a higher portfolio (that is, a higher percentage of stocks) as opposed to bonds or fixed income.  Is that fair to consider, let’s say, the next or even the next two generations in those decisions on the theory that if you can cover yourself, why not have more money going down to the next two generations?

Roger Ibbotson:  Well, it’s clear that if you buy more…if you’re definitely covered through your retirement, you’re basically generating wealth for the next generations, and, actually, the inheritance tax thresholds are pretty high.  They’re $5,000,000 a person.  A married couple has $10,000,000 thresholds before you’re paying any federal inheritance tax.  You might be paying state inheritance taxes, but you can actually give quite a bit of money to the next generations.  Of course, that gets to be, I guess, a very personal matter as to what you wonder why you…sometimes people, I’ve heard the joke like either you better be flying first class or your kids will be.  So, I’m not saying we all want to spend that money because spending money doesn’t necessarily make us happy.  But you do want to think about what you’re leaving to your next generation, and whether they will be using that money wisely, or actually in some cases, if it may make them less prone to develop their own careers.  They just get lazy and feel they’ve got enough anyway.  So, those are complicated questions when you get the generation shift, but from a pure tax angle, I guess we can answer all these things from a technical perspective, and certainly, we can leave more to the next generation by taking on more risk.  And so, it seems like a reasonable thing to do, but of course, it gets to the individuals involved here as to what the appropriate actions are.

Jim Lange:  And finally, the last question that I have that I think we have about maybe three minutes for, or even two minutes, is: what’s next for Roger Ibbotson?  You know, you’ve been enormously prolific, had this fabulous career, but it’s not like you’re home on the golf course hanging out.  You’re always doing something.  So, what’s next for Roger?

Roger Ibbotson:  Well, I’m definitely building Zebra Capital up ideally into a large money management firm.  I’ll continue on, I guess I teach much less nowadays, but as a Yale professor, it’s been a wonderful experience.  And actually, I’m really excited about this whole field of behavioral finance, I want to say, and the whole idea of popularity and how you can actually try to understand all the different relationships in the market from both perspectives of the premiums in the market and the mispricings.  So, I’m actually trying to understand how the markets work, and I think it has great implications for everybody.  And so, it’s really an amazing field.  I mean, yes, we’re handling money all the time, but it’s also finance and investments are so intellectually stimulating, and discoveries are made all the time, and I’m so happy to be a part of that.

Jim Lange:  And could you give our listeners resources of how they could, say, take a look at Zebra Capital, or even some of the work you’re doing in behavioral finance?

Roger Ibbotson:  Well, I would suggest you go to our website, www.zebracapital.com.

David Bear: Okay, and you want to say it one more time?  And then, we’ll have to leave.

Roger Ibbotson:  Okay, so that’s www.zebracapital.com.  We’re in Connecticut, and we’re a global money manager.

David Bear:  Well, and with that, we’ll say thanks to Dr. Roger Ibbotson.  Thanks to Alex Shackles, our KQV in-studio producer, and Amanda Cassady-Schweinsberg, the Lange Financial Group program coordinator.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can access the audio archive of past shows, including written transcripts, on the Lange Financial Group website, www.paytaxeslater.com.   Finally, please join us for the next edition of The Lange Money Hour on Wednesday, August 20th at 7:05, when we’ll welcome Larry Swedroe back to the show.

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