Episode 131 – Using Nobel Prize Research to Maximize Investment Returns with guest Paul Merriman

Episode: 131
Originally Aired: June 24, 2015
Topic: Using Nobel Prize Research to Maximize Investment Returns with guest Paul Merriman

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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Using Nobel Prize Research to Maximize Investment Returns
James Lange, CPA/Attorney
Guest: Paul Merriman
Episode 131


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  1. Guest Introduction:  Paul Merriman, Retired Financial Advisor & Author
  2. Why is Education Important for the Investing Public?
  3. Resources for the Investor
  4. Comparing Dimensional Fund Advisors to Vanguard
  5. Differences in Portfolio Construction
  6. Diversification within Fixed Income Classes and Bonds
  7. Eugene Fama and the Nobel Prize for Financial Economics

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1. Guest Introduction: Paul Merriman, Retired Financial Advisor & Author

David Bear:  Hello, and welcome to today’s edition of The Lange Money Hour, Where Smart Money Talks.  I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney, and author of “Retire Secure!, The Roth Revolution: Pay Taxes Once and Never Again, and his new book, Retire Secure! For Same-Sex Couples.  Numerous mutual fund companies will help investors manage their money, but there are big differences in the strategies they use and how well they use them.  Most fund firms follow an active method, trying to pick stock portfolios that will beat the market returns.  Others practice an index approach, buying and holding portfolios that mirror the market over the long term.  One index firm, Dimensional Fund Advisors, stands out.

For over thirty years, DFA has been translating compelling academic research into practical investment strategies that have consistently produced superior returns for its clients.  DFA’s active advisory board includes some of the world’s leading financial economists, including two Nobel Prize winners.  To offer some perspectives on Dimensional Fund Advisors, we’re pleased to welcome back investment expert and author Paul Merriman to the show.  Since retiring as an investment advisor, Paul has been passionately committed to educating and empowering individuals to invest wisely and to get the most from their retirement dollars.  With no other agenda, and representing no companies, he donates all proceeds from his work to the Merriman Financial Education Fund, which supports his educational mission.  Paul has written numerous books on personal investing, including the classic, Financial Fitness Forever, and most recently, a series of free eBooks on investing.  Moneymagazine cited his podcast, “Sound Investing for Excellence,” and he’s also a Retire Mentor and regular columnist for The Wall Street Journal’s“MarketWatch” blog.  It’s always interesting when Paul and Jim get together, and listeners, since today’s show is live, you can join the conversation with questions and comments.  The phone number at KQV is (412) 333-9385.  And with that, I’ll say hello, Jim and welcome, Paul.

Jim Lange:  Welcome, Paul.

Paul Merriman:  Great to be with you guys.  Thanks for the nice introduction, David.

David Bear:  You’re welcome.

Paul Merriman:  Jim, it’s been a long time!

Jim Lange:  It has been a while.  I want to tell the listeners, I just got an e-mail from you, and it perfectly typifies, I think, the way you think about things.  You said, “Thanks for having me on.  Let’s change some lives.”

Paul Merriman:  Ah, yes!

Jim Lange:  I mean, that really just tells what you’re all about.

Paul Merriman:  That’s our job.

Jim Lange:  You know, you could be sitting on a beach smoking cigars and, you know, doing anything you want, but instead, you’re writing articles.  I’m going to talk about your amazing website, but you just provide so much great information for so many people.

Paul Merriman:  You know, Jim, the problem is, I never had a hobby.  I mean, this is what I live and breathe, and when I retired, I promised my wife I would never work for money again.  She thought I said, “I would never work again.”  But I’m having a ball, and it is great to be with you and your listeners.

Jim Lange:  Well, you have changed so many lives, both while you were officially working and now.  Certainly, you have changed mine and the lives of many of my clients, because if you recall, I don’t know how many years ago this was, when I was actually on your radio show, you were talking to me after the show and you said, “Jim, for the good of your clients, you have to get them into low-cost index funds, and the best set of funds on the planet is Dimensional Fund Advisors.”  And it took me a while to get it together to do that, but when I did, my business exploded.  My clients’ results were just really wonderful, and the satisfaction level was high.  So, I owe you a huge gratitude of debt.  I really do.

Paul Merriman:  That’s good news!  I’m proud of you and I’m happy for you, Jim.

2. Why is Education Important for the Investing Public?

Jim Lange:  All right.  So, I mean, I kind of think of you as kind of like the Professor Emeritus of financial fitness, because you’ve always been a teacher, you know, even when you were active, and it seems like you had a little bit of a similar marketing style that you just put out great information.  And if people are interested, they maybe gravitated to you.  But why the emphasis on education for the investing public?

Paul Merriman:  Well, I used it when I was building my business.  I don’t think it’s very devious to have this as a strategy, and that was that I was going to teach people how to do everything on their own so they wouldn’t need an investment advisor if they were they type that liked to do things on their own.  But if they were going to do it on their own, they sure better do it right!  So, I would teach them how to do it, and the good news is that a lot of people simply don’t want to do it, and there I was ready to do it for them as a firm.  And I think you’ve always built your business, I think, on education, but when I quit working, and education was always part of my business, but now it’s full-time.  I don’t get any paycheck.  I don’t have to worry about compliance.  See, I know you have this challenge in life, and I used to live with it.  There’s somebody who was always telling me, “Well, Paul, you can say that but you can’t say that,” and “Show me the proof for what you just said.  I want to see it on paper.”  But today, I can simply tell people what I know from all the experience and studying that I’ve done.  No compliance, nobody in the back office, just the best education that I know.  That’s it.

Jim Lange:  Well, I think that’s wonderful, and it puts you in a great position.  So, let me ask you this: one of the things that I always remember about your classes, and I’ve listened to your DVDs, and there’s actually a whole bunch of people in Pittsburgh who know you and know of you and have followed you and actually, you know, were clients at one time, or maybe still are for the successor term.  You always emphasize academic research.  You know, you always say, “Don’t listen to Wall Street.  Don’t listen to Main Street.  Listen to academia peer-reviewed research.”  Why is that?

Paul Merriman:  Well, I call it University Street as opposed to Main Street and Wall Street, and that is because the biggest decision each one of us makes in terms of being an investor is the source of the information.  And in fact, one of the biggest risks that investors take (and they don’t even know this, I don’t think; they certainly don’t know it when they get started) is not knowing that basic source of information.  Why are you doing what you’re doing?  And the only place that I know where not only is it peer-reviewed, but the information is, in fact, in your best interest as opposed to Wall Street is from the academic community.  Wall Street has no choice but to make it first in their best interest because if they don’t make money, they don’t survive.  And they have shareholders they have to answer to and a board of directors they have to answer to, and in that process, a lot of dastardly things happen.  And with the academic community, I feel it is the purest form of good news that I know, and Jim, if you look at what’s cooking today, what really is making people money, giving people peace of mind, almost every one of those products came out of the academic community, obviously including indexing, and target date funds are just a step away from what the academic community has worked on.  So, I think these are the people who have our best interests at heart, and unfortunately, most of us, most investors are behind where they should be, and if they’re going to catch up, they need to make sure what they do next is the right thing, not just something that’s part of a short-term sales pitch, keeping people happy trying to make a commission.

3. Resources for the Investor

Jim Lange:  Well, I think that it’s wonderful, the resources that you have, and what I’d like to do is, I’d like to go with the idea of your comment to me, “Let’s change some lives.”  So, one of the things that I thought was just so wonderful on your website is…and you had it in your book Financial Fitness Forever, which, by the way, I think is a great book…

Paul Merriman:  Thank you.

Jim Lange:  …and even though it’s maybe two years old, I think it’s still a great read.  And one of the things that it has at the end is it has a series of appendices, and it has actual recommendations on, I think then, it was the top fifty funds.  So, if you were with one of the bigger companies, like Walgreen’s…

Paul Merriman:  401(k) plans, yeah.

Jim Lange:  Right, all right.  Well, you actually have a hundred of them on your website.

Paul Merriman:  Just went up, Jim.

Jim Lange:  Well, I was blown away when I saw that because what you can do…so listeners, if you are with one of the bigger companies, and then I’ll tell you for the people who are not, but let’s start with one of the bigger companies, and you’re saying, “Gee, what’s the best asset allocation ?”  “What if I’m moderate?”  “What if I’m conservative?”  “What if I’m aggressive?  And I don’t want all the theory and all the gibberish and everything else.  I just want the answers.  What should I do?”  Paul has, by the way, as much theory as you can stand in all his articles and blogs and everything else, but it has exactly what you should do.  And this is just such a great resource.

Paul Merriman:  Well, here’s the thing now, Jim, because Bayer is on there, FedEx is on there, GlaxoSmithKline, they’re on there.  So, I know there are some firms that are heavy duty employers there in the Pittsburgh area.  I really want people to understand why I recommend what I do.  And so, when you go to that 401(k) site, there are some articles I would really like you to read so that you know why I recommend large, small, value, growth, U.S., international, etc.  And so, it’s not just listening to somebody because you think they had a good story to tell on the radio today, but because you understand all this academic research.  By the way, I don’t get you bogged down in heavy duty formulas and that type of thing, but it is based on what the academic community has taught me and you, Jim.  And so, I’m just trying to make…some of these plans have 200, 300, 400, one of them has over 600 choices.  What is a person supposed to do if they don’t really understand investing?  And, of course, you and I know what a lot of people do.  They buy the target big funds.  They’re not bad.  They’re not bad, but you can probably do another percent to two percent better by putting together just a few more funds and taking advantage of some asset classes that most investors don’t know much about.

Jim Lange:  Well, I’m going to be very specific for the listener.  So, here’s what you do…and by the way, the next part will apply to everybody, but this is for the people that work for the larger companies.  Go to www.paulmerriman.com, and there’s a menu across the top, and there’s a section called ‘Articles.’  And that’s what Paul really wants you to read, and I agree.  But then, after understanding some of the concepts, then you could just go to the ‘401(k) Plans’, which is another subset of the website, and then find the company that you’re working for, and then there’s actual recommendations, and it even differentiates if you’re a conservative, moderate or aggressive investor.  So, that’s great.  The other thing that is on this website that I think is wonderful is if you click on the section that says ‘Recommendations,’ and then it has ‘Mutual Funds,’ and then you have recommendations if somebody is a Fidelity investor, if somebody is a Vanguard investor, I think the other one’s T. Rowe Price.  It’s just really a great resource for a lot of people.

Paul Merriman:  Can I just add one thing there, Jim?

Jim Lange:  Please do.

Paul Merriman:  Because it blows my mind that today, through ETFs, you don’t need a large amount of money to put together a portfolio.  And I’ve got commission-free Vanguard, Schwab, and Fidelity ETF portfolios with, in the case of Schwab, less than $1,000.  In the case of Vanguard, I think it’s $3,000.  In the case of Fidelity, maybe it’s $2,000.  But with a relatively small amount of money, you can put together the portfolio that would’ve taken, in some cases, $100,000 or $200,000 to replicate in the old days.  But today, young investors have so many resources they did not have before.

Jim Lange:  Well, and I know that you are a champion for young investors, and to me, one of the important disciplines for a young investor is to get involved, find out about, let’s say, some of the index funds and some of their investment opportunities.  And as you said, they, particularly with the help of your website, can put together a terrific portfolio that they could not have done ten years ago.

Paul Merriman:  Yeah, and you and I know, Jim, that the big challenge with these young investors is they’ve got it in their mind that what they need to do is to figure out how to get a home run, get one of those ten baggers real soon, and this is the toughest challenge for young investors is getting them to understand that the odds, the probabilities of being able to hit those ten baggers…in fact, those ten baggers lead to a lot of strike outs, unfortunately!  But there is a really great way to invest for the long-term that will give us super return, at least based on history, that doesn’t require them to act like a kind of a poor person who doesn’t have much money.  You get to act like a multi-millionaire from day one, and I think that’s a very big deal for first-time investors.

David Bear:  Well, why don’t we take our first break at this point?


David Bear:  And welcome back to The Lange Money Hour, with Paul Merriman and Jim Lange.

Jim Lange:  Paul, I have a few specific questions for you, because I know…how long have you been in this game?  Is it thirty-five years?

Paul Merriman:  Well, really since the mid-sixties, I’ve been in some end of the financial community.  I’m a little embarrassed, but I was a stock broker for almost three years back in the sixties before I went straight, Jim!

Jim Lange:  Before you saw the light and you converted to index funds!

Paul Merriman:  I’ve seen it all!

4. Comparing Dimensional Fund Advisors to Vanguard

Jim Lange:  All right.  So, over your long career, you’ve certainly seen a lot of mutual funds come and go, you’ve seen index funds and you’ve seen what many people regard as kind of the gold standard, which is Vanguard, and certainly, I imagine, like me, you have the highest regards for John Bogle and what Vanguard has done.

Paul Merriman:  Yes.

Jim Lange:  But there’s also competing index funds, maybe not technically index funds.  One is Dimensional Fund Advisors, and in your book Financial Fitness Forever, you have a pretty in depth head-to-head comparison of Dimensional Fund Advisors to Vanguard.  How would you compare the two sets of funds, realizing that they’re different things?  But I thought that, you know, with the great information that you’ve provided, that you could, let’s say, further educate our listeners.

Paul Merriman:  Well, I’m happy to, Jim, and what I do is every month, I update the last fifteen years because the longer the period of time that we can compare, the more meaningful it is.  And it’s easy to do that with Morningstar.  In fact, I can do that virtually every day if I want to, but there’s no secret here.  There’s no black box.  It isn’t that DFA has something that Vanguard couldn’t have, but they don’t, and I think there’s a good reason for it because DFA works with clients who are much more dependable, much less nervous.  They’re not as anxious.  They don’t want to jump ship all the time.  Even John Bogle complains about how the shareholders at Vanguard are chasing performance.  Well, that doesn’t happen at DFA because almost every client comes through an investment advisor like yourself, Jim, and as you know, in that process, you find out a lot about the investor, and then you can properly match the right amount of equity with the right amount of fixed income and all the things that help to make long-term investing successful.  So, they have a different kind of investor than Vanguard.

Vanguard is the premier supplier of investments to retailed do-it-yourself investors.  I really think they’re great for the do-it-yourselfer.  But at DFA, they’ve built the funds in a different way.  They haven’t built them to be exact copies of asset classes, like the small cap would not look like the Russell 2000.  What you find at DFA is whether we’re talking about big companies or small companies, they’re smaller.  So, if you looked at a large cap value fund at DFA versus a large cap value fund at Vanguard, you would see that the average sized company is somewhat smaller at DFA.  Now, that doesn’t sound like a big deal, but it turns out that it is.  So, if we look at the returns of the last fifteen years of the DFA large cap value fund, it is about 2.5% more per year than the Vanguard large cap value.  And that’s one, because of the size of the company inside of the fund, and how deeply discounted the companies are.  And as the academics discovered, the more deeply discounted the companies are as a group, the better the long-term rate of return.  And this works at the large size and the small size.

For example, if we look at a small cap value fund at DFA, over the last fifteen years, a 12% compound rate of return, the small cap value fund at Vanguard, 10.5%.  And in some cases, Vanguard doesn’t even have a particular asset class.  I know this may sound outrageous to your listeners, but in the emerging markets, there are large companies, there are growth companies, there are small companies and there are value companies.  And if you look at the emerging markets fund at Vanguard, that one has grown at 9.6% a year.  It’s a large cap emerging markets fund.  Well, DFA has one and it did slightly better at 9.8%, but it’s small cap value fund emerging markets compounded at 12.2%.  Its value emerging markets compounded at 11.6%.  And so, all these returns are following what I learned about DFA in about 1993 when the professor said, “Look for better small cap performance.  Look for better value performance.”  And they put their portfolios together so they have much less turnover, fewer trades, because they don’t run them as pure index funds.  One of the problems with index funds is that as the committees change the companies, take some companies off, add other companies to the index, there’s what’s called a ‘reconstitution cost’ to sell and to buy.  But DFA runs it to try to eliminate that reconstitution cost.  It goes on and on and on, but what it’s about, better asset class selection, lower taxes, less turnover.  Oh, and by the way, Jim, the diversification at DFA is about twice the diversification at Vanguard.  And if we could get the same return and have twice the diversification without the extra return, it would still be a good deal because more diversification implies less risk.

Jim Lange:  Well, I know that you are freaking out some Vanguard fans, that they just can’t believe that here is a set of index funds, or, let’s say, a slight variation of index funds, that can be both safer and outperform, even after paying a fee.  But there’s actually good reasons for it, and it’s not like DFA has a bunch of stock pickers and they’re picking better stocks.  It’s that they are defining the type of companies that they want their investors to be in differently and, at least, historically, and of course, we’re required to say past performance is no guarantee of future results, but they have outperformed Vanguard, something that…you know, I have some dyed-in-the-wool Vanguard friends and clients, and they just can’t believe that you could pay an advisor a fee, get all the benefits that an advisor provides, that even…by the way, Jack Bogle just shocked me.  He was on the show, and at the end of the show, I sometimes have kind of like a throw out, and I just said, “So, is there anything that we didn’t talk about that you think might be good information for our listeners?”  With all due respect to John Bogle, I still kind of consider him one of the cheapest guys in America because Vanguard’s fees are so low.  And then, he said all these great things about having an advisor.

Paul Merriman:  Oh, I wish…I have to get a copy of that show!

Jim Lange:  All right.

Paul Merriman:  That’s wonderful!

Jim Lange:  Yeah, it really was.  But anyway, so you get, let’s say, in our case, where we do the Roth conversion analysis, we do the Social Security analysis, the estate planning, the tax loss harvesting, whatever needs to be done in the big picture, and by the way, safe withdrawal rates, and we did a great show before emphasizing safe withdrawal rates, that people can get all that and these great set of index funds through Dimensional Funds that have outperformed Vanguard, all for one percent or less, is actually one of the reasons why our business is doing so well.

Paul Merriman:  Well, you know something?  Jim, I still am a great believer in Vanguard, and I think that, as far as access to indexing, they’re still great.  I will say this: my approach to using Vanguard funds has far out produced the average Vanguard investor because, for fifteen years, I’ve been recommending big cap, small cap, value growth and U.S. international and all this that has performed so well.  But you know, when I just gave those numbers a few minutes ago, about 10% and 12% and etc., we have to remember that during that same period of time, the S&P 500 compounded at less than 5%.  Less than 5%!  And the total market index, the same.  And so, the first challenge I want to make to those Vanguard people, before they make the move to DFA, is get the best you can out of Vanguard to start with, and I’m doing my best to show you how to do that.  But people who are looking at having an advisor or not having an advisor, it goes way beyond returns.  I have an advisor.  I mean, just like everybody else, I’ve got somebody who takes care of my account.  My wife’s got an MBA, but she’s not a professional investor.  And I want somebody, not just to take care of my money, but her money, our money, and to be there, to help me with tax questions.  I call up.  I want to check.  I don’t want to have to figure out which account it should come out of.  The advisor takes care of that for me.  So, I think that too many people, when they think about hiring an advisor, all they’re thinking about is the investment aspect of it, and actually, that’s a small part of the whole process.  You know that because you know that once you get past that investment decision with your clients, you’ve got tons of work to do in the future.

Jim Lange:  Well, yeah, I think a lot of clients, unfortunately, sometimes think of it as a horse race.  So, you know, they’ll either pit two advisors against each other, or they manage some and then they have the advisor, or they’ll compare, let’s say, a pass record, and they think of it purely as a matter of return, and what tends to happen to those investors is they’re chasing returns, so they tend to buy things that just recently did well, which, inevitably, then do badly.  So, they’re buying high, then after it does badly, they get rid of it, so they’re selling low and they really hurt themselves.  By the way, for the do-it-yourselfers (I want to be fair to these Vanguard guys), Paul is right.  If I was a do-it-yourself Vanguard investor, rather than listening to Vanguard in asset allocation within Vanguard, what I would do is, I would go to www.paulmerriman.com, go to ‘Recommendations,’ go to ‘Mutual Funds,’ then click on ‘Vanguard,’ and then take a look at what he has, and then, of course, Paul, being very proper, says, “Don’t just listen to my results.  Listen to my reasoning and read the article section on my website.”  Is that fair?

Paul Merriman:  Well, I hope they do that because the asset allocation advice at Vanguard, I think is very poor.  Now, let me tell you why I think that happens: because I’m not saying that these people at Vanguard don’t know all the stuff I do.  They do know that, but I think they take, what I call, the path of least resistance.  It’s the nature of most organizations in our industry.  They like to put people in the total market U.S., and then the total market international and then a total bond and call that done.  The problem is, there’s too much evidence that says that by adding some other asset classes, that you can increase the return without increasing the risk.  Now, this sounds like magic, but it isn’t.  It’s simply because different asset classes go up and down at different times, I mean, not always at the opposite time, but often at the opposite time, and that modifies the volatility of the entire portfolio.  And the way they give advice at Vanguard, you aren’t getting the advantage of all of that wonderful research that has been around for decades.  Now, John Bogle did his own research and he was right back in 1951, but, in a sense, that was the end of his research.

5. Differences in Portfolio Construction

Jim Lange:  Well, let’s be even more specific.  You talk about emerging markets and all the variations of emerging markets, like emerging markets large and small and value and growth, and you talk about small cap.  And there, there is a difference in portfolio construction.  That is, the DFA model for small cap, for example, would be smaller.  The value would have lower price-earnings ratios.  What are some of the differences, and how does that add to a portfolio, whether you’re a DFA going through an advisor, or a Vanguard person?

Paul Merriman:  Well, I mean, the differences, as I’d mentioned before, you’re facing turnover differences because of the way they construct the portfolio.  You’re facing diversification differences.  And I think this is very smart: when you get into small cap and small cap value and emerging markets and things other than just the S&P 500, you’re in arenas that the individual companies have more risk than the individual companies in the S&P 500.  So, instead of having 500 companies, you might have 5,000 companies in a DFA fund that represents an asset class that’s more risky.  And those asset classes, small cap and value, because they’re not as liquid as AT&T or Microsoft or something, where you can sell a million shares in no time, you then don’t want to be put in a position to have to be liquidating and bailing out all at one time.  And so, as I said before, DFA has a very structured approach, but they also have clients, investors, who, in a sense, are structured in their attitude about investing.  What hurts investors, ALL investors, is their emotional involvement in the process, and Vanguard can’t control their emotions, but DFA can because they’ve got an advisor.  And yes, you get an advisor at Vanguard, but what are the chances that advisor is really going to get to know you, and is going to be there still five years or ten years from now taking care of you?  That just isn’t likely.

Jim Lange:  And I want to point out one more thing about, for example, small cap and emerging markets.  Most of the portfolios that I see are underweighted in those areas, even though historically, those areas have outperformed the larger companies, and I think it’s partly because people are less familiar, and they don’t want to invest in companies that they’ve never heard of, as opposed to AT&T and Verizon.  But you can really add return and reduce volatility by adding these different asset classes.

Paul Merriman:  Well, Jim, I mean, you’ve just opened up a barn door here that is a big deal.  If you look at any portfolio of individual stocks, they’re going to have lousy asset class diversification.  They may have a hundred stocks, but they’re probably all large cap growth-oriented companies, or dividend-oriented companies, because that’s what they know!  And so, the whole thing here is to get your portfolio into things that people don’t know all about because those are the things, as a group, small cap, for instance, and value, out of favor companies, those are the companies that don’t tend to be in the front of people’s minds.  The studies have been done.  The companies that are in the S&P 500 are expected to get lower rates of return than small company or value companies because they’re less risky.  There’s no magic here.  You get a lower return on a CD than you do on the S&P 500 because it’s less risky.  So, the magic, or the good news, for investors is that by putting these really great companies together with the smaller, maybe, value-oriented and international and emerging markets, you end up with a portfolio that’s no more risky than the S&P 500.  And you get about a 1.5% to 2% better return per year.  And a half a percent, I don’t care if you’re retired or you’re building towards retirement (I’m about to do an article on this), a half a percent is a life changer.  It really is a life changer, in terms of what it does to your money over the long-term.

Jim Lange:  Well, I agree with you, and unfortunately, sometimes, you have to wrestle with people who say, “Oh gee, the fee is a half a percent, or eighty basis points, or, maybe at the highest level, at one percent, and I can’t afford that.”  But actually, when you factor in the better returns, the better diversification, and then we haven’t even gotten into the new thing that everybody’s talking about, Alpha or Gamma, which is a lot of the value that is not just the pure horse race, but things like appropriate asset allocation, which assets you spend first, Roth IRA conversions, Social Security, etc., it’s worth it.

Paul Merriman:  But Jim, people are doing so many dumb things to themselves because the industry is telling them it’s the right thing to do.  The big deal these days, alternative investments, that’s where the money is!  Now, I don’t mean that’s where the money is for investors.  I promise you, that’s not where the money is for investors.  That’s where the money is for Wall Street.  But if you see the returns of alternative investments, they are really very subpar.  And when were they able to sell these alternative investments and make 10% to 15% commission just like that, overnight, for doing almost nothing?  Well, they did it right after the S&P 500 and other equity positions lost money.  And so, there’s the salesman right there to take care of you.  “Oh, you want to make some money!  Well, let me put you into something that did well during the last few years.”  Well, I mean, that’s chasing performances.  That’s what’s gotten people and brokers and commission salespeople in trouble forever, is chasing performance.  A good advisor (and I’ve never met a bad DFA advisor, in terms of how they treat the client, I’m sure there’s one out there) keeps you out of the business of chasing performance.  And that will save you a fortune over a lifetime.  And then, they’re afraid to spend half a percent or one percent a year to get you to do the right things.

David Bear:  Well, this is a good time to take that second break.

Paul Merriman:  Let’s do it.


David Bear:  And welcome back to The Lange Money Hour, with Paul Merriman and Jim Lange.

6. Diversification within Fixed Income Classes and Bonds

Jim Lange:  Paul, you have stressed the importance of diversification, and you’ve talked about some of the different classes that a lot of people don’t invest in, such as emerging markets and small and small value, etc., but a lot of people, when they think about diversification, they think about equities and stock.  That is, owning a company as opposed to lending either a company or a government money.  Can you talk a little bit about diversification within fixed income classes and bonds?

Paul Merriman:  Sure, and I think this is a very important topic because what you do with your fixed income can mean a huge difference in the kind of return you’re going to get.  And it’s also a question of why you even have bonds in your portfolio in the first place.  Now, I’m seventy, almost seventy-one, and I’ve got half of my buy and hold portfolio, DFA, in bonds.  Now, I could take more risk than that, but I choose to have 50% in there because I’ve looked at my fine tuning table that you all can look at (it’s one of the best pieces I’ve ever done).  It’s called fine tuning your asset allocation, and it helps people determine how much of their portfolio should be in bonds and how much should be in stocks.  But I’ve got bonds in my portfolio to stabilize the portfolio when the equity portion is going down.  And historically, if you look at what happens during very severe market declines, the best place to be is to be in government bonds or government bond funds.  And, of course, Jim and I would agree, and I hope all you would agree, very low-cost government bond funds, and you should stay short to intermediate.

Now, long-term bonds are much more volatile than short to intermediate term bonds.  And so, for that additional risk, the academics have found that rather than going to long-term bonds, stay short to intermediate, and if you want to take more risk, take the risk in the equity part, not the bond part.  So, that’s for people who want to stabilize a portfolio against the bad times.  But other investors want fixed income for monthly income.  They want the interest.  That’s their main goal.  And for that, I have, on paulmerriman.com, a Vanguard portfolio that’s a combination of everything from intermediate term investment grade, short-term investment grade, GNMA fund, and a high yield bond fund.  Now, that is not built to stabilize the portfolio so much as it is to create some income.  So, part of the process is figuring out who you are, and then figuring out what you should do after you know who you are.  And by the way, Jim, I don’t know about how you work with your clients, but I have the belief that virtually every investor should sit…if they don’t want to hire somebody to manage their money, God bless.  But if they want to have somebody who really understands the ropes, take a look at their situation, that as a minimum, go spend an hour or two, pay them by the hour, to have them look at your portfolio because I think everybody can use some fine tuning.  And fine tuning, if done properly, doesn’t just help you for the next year.  It probably helps you for the rest of your life.

Jim Lange:  Well, Paul, I think that’s a great point, and for whatever it’s worth, the way we do it in our office, if I meet a prospect…and by the way, I have to like them and they have to like me, and if it looks like we might be a fit, one of the ways we start is we take their existing portfolio, and then I run it through Morningstar, and then I do an asset allocation pie chart for them and I show them where they are.

Paul Merriman:  Good.

Jim Lange:  And whether they use my services or not, they often will find out that they are significantly typically overweighted in large growth, and typically underweighted in smaller and value.  And whether they go with me or not, and they get this information, they can be a much better investor either way.

Paul Merriman:  I believe that, and if you’re not charging for that, that’s a home run for anybody who’s in their right mind because that kind of information is so valuable into the decision-making process.  By the way, Jim, you said something earlier about DFA beating Vanguard and that it’s unlikely that Vanguard…well, I don’t know if you said this, but I kind of read between the lines that DFA is really likely to do better than Vanguard.  I want to be fair to Vanguard for a second because I can tell your listeners under what conditions Vanguard will beat DFA.  If large beats small, and if growth beats value for the next twenty years, you’re probably better off in Vanguard than you are DFA.  Fair enough?

Jim Lange:  Well, that’s like saying if it rains backwards and gravity doesn’t reoccur.

Paul Merriman:  You know, I just did a study, and a lot of people in 2000 came to the conclusion that the small cap and the value premiums, that those were dead, that there was no value premium, there was no small cap premium, because there had been a great premium from 1975 through 1989.  But during that ten-year period, the premiums went to growth and to larger companies.  And so, people said, “Well, it’s dead.  Everybody’s figured it out, so it’ll never work again.”  And for the next fifteen years, the small and the value just overwhelmed large cap and growth.  So, these are things that we know can happen, but we have to build a portfolio, and your portfolio doesn’t throw growth out.  You don’t throw large out.  You just have some value and some small in there in case you’re right!  But to put everybody in small and value would be too risky, right?

7. Eugene Fama and the Nobel Prize for Financial Economics

Jim Lange:  Well, I agree completely, and going back to academic research (which I know you’re a big believer in), our friend Eugene Fama, who is a board member of Dimensional Fund Advisors, was just recently awarded the Nobel Prize for financial economics with his Efficient Market Theory.

Paul Merriman:  Yep.

Jim Lange:  Can you comment on what that meant to you personally, and what you think that means to people?  And I’ll give you about three minutes, and…

Paul Merriman:  Okay, well, first of all, that Nobel Prize was due for a long time.  I’ll tell you what it meant to, I think, the DFA advisors and me, because I’ve got most of my money with DFA.  What it means to me is that we’ve got people who are committed to figuring out how to do it better for their investors.  And I don’t know that you ever talk about this on your program, but Dr. Fama and Dr. French, and maybe a couple of other academics, for the last ten years have been studying the impact of profitability in conjunction with value and small cap, etc., and they have recently installed, after ten years of careful research, they have made changes, small changes, that will probably add twenty basis points to fifty basis points a year additional returns in the equity part of the portfolio.  Fifty basis points is a half a percent to people who aren’t in the points world.  But that’s a big deal.  And the idea that there are people who are there working every workday trying to figure out ways to get more, not based on what’s hot in the market and what might happen, but what has happened and what we can do to better manage the risk that our clients and the DFA people are taking.

It is amazing to know that you’ve got those kinds of people on your payroll.  And that’s what I want, that’s what I wanted for my clients when I was in the business and that’s what your clients have, Jim, and that’s what all of us want.  We want competent people who are ethical.  We want them selling competent, ethical products.  We want them working for competent firms.  And that’s what I think DFA and their advisors represent.  I know I talk too loud.  I talk too fast.  I sound like Professor Harold Hill from the Music Man!  But that’s what I believe, and I think it’s proven, and it has been proven, in the results.

Jim Lange:  Well, you have been a passionate advisor and spokesman for good financial planning.  Again, a wonderful resource for our listeners is www.paulmerriman.com.

David Bear:  Well, and thanks again to Paul.

Paul Merriman:  Thank you.

David Bear:  Thanks also to Alex, our KQV in-studio producer, and Lange program coordinator, Amanda Cassady-Schweinsberg.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can always access the audio archive of past shows, including written transcripts, at the Lange Financial Group website, www.paytaxeslater.com.  Finally, please plan to join us on Wednesday, September 17th at 7:05, when we’ll welcome investment advisor P.J. DiNuzzo back for the next new edition of The Lange Money Hour.




jim_photo_smJames Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.