How The Market’s Past Helps Us Prepare For Its Future With Roger Ibbotson

Episode: 205
Originally Aired: November 1, 2017
Topic: How the Market’s Past Helps Us Prepare for its Future with Financial Expert Dr. Roger Ibbotson

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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  1. Introduction of Roger Ibbotson, Investor, Author, and Professor Emeritus at Yale
  2. Premiums Are Stock Payoffs That Essentially Are Permanent
  3. Owning Equities is a Tremendous Way to Build Wealth
  4. Investors Usually Willing to Pay More for Greater Liquidity
  5. Growth Companies are Popular because their Stories Seem Compelling
  6. Don’t Buy the Hot Stocks, Buy the ‘Cool’ Stocks
  7. Fixed-Index Annuities Accumulate Wealth Over Longer Time Period
  8. Annuities Can Be Annuitized Into a Stable Cash Flow for Life
  9. Cost Structures around Some Annuities Have Come Down
  10. Asset Allocation Represents about 50 Perfect of Portfolio’s Performance
  11. Bonds Offer Lower Returns, but the Risks are Lower Too
  12. Mixing Stocks, Bonds, Annuities Tailors Portfolio to Your Needs and Wants

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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 Now get ready to talk smart money.

1. Introduction of Roger Ibbotson, Investor, Author and Professor Emeritus at Yale

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 giant of the industry. We welcome back to the show Dr. Roger Ibbotson. Roger is an emeritus professor of finance at Yale School of Management. He’s also chairman and CIO of Zebra Capital Management, LLC, an equity investment and hedge fund manager. He is founder, advisor and former chairman of Ibbotson Associates, now a MorningStar company. He’s a researcher as well and has written numerous books and articles, including co-authoring Stocks, Bonds, Bills and Inflation, or SBBI, which serves as a standard reference for information in capital market returns. Now, this evening, we’ll be talking about SBBI and what it means to investors as well as the state of the markets here in 2017, and various investment topics on which Roger has done extensive research, including liquidity, investment returns, popularity, mutual funds, valuation, portfolio management and more. So, without further introduction, let’s get right to it as we say good evening to Jim Lange and Roger Ibbotson.

Jim Lange: Welcome to the show, Roger.

Roger Ibbotson: Thank you. It’s great to be here.

Jim Lange: Well, it’s great to have you, but Dan’s introduction doesn’t really do justice to your reputation, in both the academic and financial industries. Some, including me, would say you’re the most famous and well-known knowledgeable expert on asset allocation in the world, seriously! And even outside the area of asset allocation, when the name Ibbotson comes up, every financial advisor knows exactly what we’re talking about. SBBI, that chart, I use that chart practically every day in my work, and I literally buy tablets of them and I give them out like candy. So, anyway, thank you again for agreeing to be on the show.

Roger Ibbotson: I’m happy to be here.

Jim Lange: Well, in prior appearances, you’ve talked about asset allocation, you’ve talked about the importance of appropriate asset allocation, and, very frankly, we could do that whole show again. It would be tremendously valuable. But people can check the archives, by the way, at where we have roughly 200 shows, including a number of shows that Roger’s been on, but I’d like to talk about some of your newer stuff, and I’d like to talk a little bit about premiums, and I’d like to talk about popularity. But before we talk about popularity, could we talk a little bit about what a premium is, and, for example, what an equity premium is, and then maybe talk a little bit about small stock and value, and then get to popularity? But could we start by talking about what an equity premium is in the market?


2. Premiums Are Stock Payoffs That Essentially Are Permanent

Roger Ibbotson: Well, sure, and you know, you did talk about Stocks, Bonds, Bills and Inflation, and the whole purpose of Stocks, Bonds, Bills and Inflation originally was to put the historical data together so we could see what the premiums were like, how large they were and what kind of magnitude they were, because premiums are essentially payoffs that are more or less permanent. I mean, you certainly don’t get them every year, but on average, you do get them. So, some of the major premiums from the market are, like, the equity risk premium, which is how do stocks do compared to bonds, or how do stocks do compared to treasury bills? And obviously, I wanted to find out those sorts of things. So that is a positive number. It turns out to be a substantial number. I mean, historically, stock returns, large caps were 10 percent per year, where long-term government bonds, for example, are 5 ½ percent and treasuries are about 3.4 percent. So, big spreads between stock markets and bond markets. That’s the equity risk premium, and the reason why we call it a premium is because we think it will continue. It isn’t something that goes away. It stays there because people don’t like the risk of stocks and are willing to take it on only if they get an extra return for it.

Jim Lange: All right, so let me understand what you’re saying. At least based on history, that there is, you know, practically a 5 percent difference between a stock investor and an income or bond investor, and even a greater premium, if you will, compared to, say, treasury bonds. So if you are willing to take the risks of the stock market, you’re going to be rewarded enormously, and the difference between, say, 5 percent per year over a number of years is just the difference between being very comfortable in retirement and being barely able to pay rent and have food on the table.


3. Owning Equities is a Tremendous Way to Build Wealth

Roger Ibbotson: I mean, there’s actually an exponential effect to getting double the return has far more than doubled the impact on your wealth because it’s an explosive process. So without being in the equities, you really are not going to participate in big wealth building over time. So, I mean, that’s one of the reasons people love that chart, I guess, because it shows long-term how much stocks do relative to, say, bonds of different types, and it shows you the amount. For example, a dollar grossed over $6,000 in the last 90 years, and even after inflation, it’s about 450 times your money. I realize that’s before taxes and before trading costs and management fees and so forth, but still, there are tremendous ways to make money over time by having patience and ultimately participating in equity markets.

Jim Lange: Right, and by the way, to fill our listeners in, the comparison to your $6,000 number, if you had the money in stocks or large U.S. companies, if you had it instead in bonds or treasury bonds, you’d have $134. So think about that. And basically, we’re talking one lifetime, a long lifetime, granted, but still one lifetime, $134 compared to $6,035 just as your reward for being in the market. Now, you are taking a risk. Could you talk a little bit about what the risk is of being in the market?

Roger Ibbotson: Well, definitely, there’s a risk. I mean, in any given year, actually, I don’t want to talk standard deviations, but you could certainly think of it as a standard deviation of 20 percent, even if the expected return is 10 percent instead of 10 percent plus or minus 20 percent, and that means you can easily have a negative return, and almost a third of the time, we have negative returns in the market. So you certainly have to take the ups and downs here, but essentially, people who invest over the long haul tend to do very well in equity markets.

Jim Lange: Well, would one potential answer to that issue be to, in effect, segment your portfolio — we sometimes call it “buckets” — and have money that you need in the short-term in the more conservative asset-allocation categories like bonds and treasuries, so that if the market goes down, you still have money to meet your expenses, but then have other buckets that are expected to do better in the long-term, and even if there’s a downturn, it doesn’t have an impact on you directly because you’re not going to sell or use that money until, presumably, many years in the future. And then, maybe have a number of buckets.

Roger Ibbotson: You’re talking in behavioral finance, where we have mental accounts, and you can put them in buckets, and yeah, that’s a fine thing to do. It helps us to think about things. I mean, we don’t literally need these buckets, but we need to have some money obviously in bonds and cash to meet our needs. But it helps people to think of it if they think of this money as certain money is for this purpose and certain other money is for some other purpose. Basically, it’s a mechanism, which, in behavioral finance, they call mental accounts, but I guess they can even be more than mental. They can actually literally be buckets that you put in different vehicles.

Jim Lange: Well, for whatever its worth, that’s what we like to do at our practice, using Dimensional Fund Advisor-type funds. So, basically, you’re saying the large cap premium, if you will, and again, depending on your benchmark, is probably 5 percent or more between the difference between stocks and bonds. Could you talk a little bit about the small cap, or the small company, premium?
Matt Schwartz: Correct.


4. Investors Usually Willing to Pay More for Greater Liquidity

Roger Ibbotson: : Well, that’s not as large, but that’s a premium incremental to large cap. So that’s another couple of percent, so that’s not minor. I mean, there actually are different premiums in the market, not only small caps. Small caps do better than large caps. Also, value stocks do better than growth stocks. Less liquid stocks do better than more liquid stocks. We have lots of premiums in the market, and, you know, in some sense, people are thinking there’s almost too many premiums because if you look at historical data, you find different relationships. But I think in order to really have a premium, you have to really identify something that people do not want for some reason. In other words, institutional investors, for example, don’t especially like small caps because once they find a company that looks attractive, they can’t invest very much in it because they start moving the market. They’re less liquid, and we like liquidity. So it’s the things we like that we pay a higher price for, and the things that we don’t like that we will take more of a discount for, and we generally don’t like value stocks so much because usually, the companies, they might not be doing so well, but they’re priced to actually give attractive returns.

Jim Lange: All right, so now, we’re talking about what I see as your new thing, which is popularity, but before we get to that, can we just, let’s say, cover the basics, which are if you are willing to be in the market, you should have, over a long period of time, a substantially higher return. If you have small companies, you will have a higher return, at least for that bucket that I’m calling it, than if you have just large companies if you have value companies that, over time, you could expect to do better than if you have growth companies. Are those all fairly well-documented, accepted premiums?

Roger Ibbotson: Yes, they are, definitely.

Jim Lange: All right.

Roger Ibbotson: But when I talked about popularity, of course, I was actually giving the rationale for these premiums. So, the whole notion of popularity is, why do these premiums exist? Which historical payoffs that we find in the market are likely to continue? And you need a rationale, not just the fact that something happened to work in the past, in order for something to really continue, because what we mean by premium, not calling it a mispricing, we mean something that actually gets an extra return that we actually anticipate will continue over time.

Jim Lange: OK, so let’s say that the big ones that we know are the equity premium, the small cap premium, the value premium, you said that there’s a lot of other premiums. Could you identify maybe the top couple before we then get into the issue of popularity?

Roger Ibbotson: Well, I don’t really want to identify them because I don’t know which ones are really real, I guess. But if I had to name two premiums, they would be a risk premium and a liquidity premium, because I actually see the small cap premium is mostly related to liquidity. In fact, it actually lines up almost perfectly. The smaller the cap, the less liquid the stock is, and that’s why you’re getting the premium. It has to do with people wanting liquidity, and the smaller caps have less liquidity, and so, in fact, that is the rationale for a small cap is primarily a liquidity premium. But it may be some other things, like harder to actually buy big blocks and so forth, but most things are related to liquidity in the small cap.

Jim Lange: Well, would one answer to that be to be buying an index fund of small companies?

Roger Ibbotson: Yes, you can certainly buy an index fund of small companies, and that would be a way to pick up the premium here. One of the things about an index fund is you’re not trying to buy a specific company, and you’re not trying to find an undervalued stock or anything. You’re just trying to buy collectively a group of stocks to get that premium.

Jim Lange: All right. So your explanation for the premium, which is what you have been getting at the whole time, is something that you’re calling popularity, but popularity extends to more than just an explanation of why we are receiving these premiums, doesn’t it?


5. Growth Companies are Popular because their Stories Seem Compelling

Roger Ibbotson: Well, actually, it can even explain mispricing or it can explain all the behavioral types of things. If we like a brand, branding tends to have higher prices, for example. And so, I don’t know that I would call a premium branding, but because it might be temporary, brands lose their power over time. But people chase brands, you know. They also extrapolate the growth company’s earnings, and so they really like those stories associated with growth companies. Ultimately, I guess, the evidence is that people get more stirred up about stories than facts, and value companies are all about facts and what they’re doing now and what they’re accomplishing, and growth companies are all about what they might be able to achieve, and that’s very easy to start exaggerating, and, in fact, all the evidence is that the analysts, for example, way overestimate the earnings projections on growth companies.

Jim Lange: Is that one of the reasons why, over time, value companies can be expected to do better than growth companies?

Roger Ibbotson: Yes, because, in fact, growth companies are actually better companies and are more exciting companies than value companies, but “better companies” does not mean better stocks because you have to overpay for them, effectively, whereas the value companies are the companies that are much more overlooked, and even though the companies may be a bit stodgy, they are attractively priced and they end up to be better stocks.

Jim Lange: So, that’s why, for example, Warren Buffett might buy some railroads that might not sound very sexy compared to Uber, but why he has generated some very good returns because he has historically bought things that were not popular.

Roger Ibbotson: Yes, and I don’t know if he used the terminology, but certainly this is consistent with what Warren Buffett does.

Jim Lange: All right. Well, let’s say that I am a listener, and we’ll talk a little bit about indexes and actively managed companies because I know that you play both sides of the fence, and you say, “OK, what Roger says about popularity makes some sense. How can I take that information and make money on it?” And before I should say anything, I do have to warn you because people listen to different experts and they act on it, and even guys like Jim Cramer, you know, if you listen to Jim Cramer and you did everything that he said, you would have a million dollars today … if you started with 2 million. Sorry about that, Jim! I’m just kidding. But anyway, jokes aside, how can an investor that kind of gets what you’re saying about popularity, how does that turn into action that he could monetize that piece of information?


6. Don’t Buy the Hot Stocks, Buy the ‘Cool’ Stocks

Roger Ibbotson: Well, ultimately, what we’re talking about, and maybe I’ll be a little general at first, we’re going against your natural instinct because our natural instinct is to buy what everybody knows, what people are most familiar with, the most recognizable names, the most highly traded names, but those are the ones that I’m saying not to buy, and you have to obviously look harder here to buy more of the overlooked stocks. And so I’m saying you have to ultimately buy the unpopular stocks, but, of course, our natural instinct is to buy the hot stocks, and actually, by the way, in products that we’ve had and so forth, maybe we’ll talk about this later, but we actually have some insurance products where in order to talk about this with regular people, if you talk about hot stocks, people of course want to buy the hot stocks, but we needed a word to talk about the unpopular stocks because who can tell people to buy unpopular things? So we actually call them the cool stocks. Don’t buy the hot stocks; buy the cool stocks.

Jim Lange: Oh, OK. So, Amazon, for example, might be hot, right?

Roger Ibbotson: Yes.

Jim Lange: And Uber might be hot, but General Motors might be cool.

Roger Ibbotson: Yes, that sort of thing, definitely, because who’s going to get excited about General Motors, right? But it’s not the fact that it has such great growth potential, it’s just more of the fact that it may be priced to sell. I’m not specifically talking about General Motors because I don’t know the price, but yeah, that type of stock definitely actually does better than the hot stocks.

Jim Lange: You said that you are hoping to get into the issue of something that kind of goes against the grain, and honestly, it goes against my grain, which is fixed annuities. So, normally, guys like me, and I’ll call myself maybe a “highbrow” advisor, associated with Dimensional Fund Advisors, and I know that you, at least, were on the board …

Roger Ibbotson: I still am, yes.

Jim Lange: Oh, you still are? OK. So I think that that’s a great set of index funds, you know, with French and Fama, and you reference French and Fama, and they were some of the early identifiers of the value premium, the small premium, and they still actively use those strategies. So that’s, let’s call it, one world. Then, I always associate things like variable annuities and fixed-index annuities, I always associate that, and maybe this isn’t fair, with, let’s say, a different type of advisor, somebody who isn’t quite as highbrow, somebody who is maybe selling to less-educated people, and things that typically pay a very, very high commission, and I can’t tell you I’ve never thought about it, but I consider that going to the dark side. I have not done that. Then, a guy like you, with the highest reputation that you can, and I know that you’re also, in addition to being involved with DFA on the index side, you’re also involved with Zebra Capital, which, I believe, is an actively managed company, but now, apparently, Zebra has a fixed annuity.

Roger Ibbotson: A fixed-index annuity, yes.

Jim Lange: A fixed-index annuity, yeah, fair, and I’m thinking, “Wow, that’s kind of a shocker!” So, with that kind of maybe slightly tainted invitation, could you tell us about the, let’s say, A) fixed-index annuities in general, and B) why you think what you have at Zebra might be different than other choices in the market?


7. Fixed-Index Annuities Accumulate Wealth Over Longer Time Period

Roger Ibbotson: Well, you know, first of all, fixed-index annuities are based on an index, and this already puts it in a lower cost kind of environment when you base it on an index, and I will say, in general, the annuity world, of course, includes all types of players and so forth, and all kinds of commission schedules and all that. So it’s certainly true that some of them can be high cost. Let me start out with saying, though, that there’s a couple of real benefits to fixed-index annuities and annuities in general. Fixed-index annuities have essentially a way of investing in accumulating, you kind of have to lock yourself in for … it depends on eight or 12 years, there’s various different combinations of this, but if you lock yourself in in some form over this period of time, what you’re getting is actually … all your capital gains and your income tend to be deferred during that period of time, and then at some point in time, you can further annuitize it. And usually, the insurance companies are guaranteeing essentially that you are not getting any negative returns over the period. So they take, like, two-year periods or three-year periods, and during that period of time — they’re an insurance company, so that’s their job — they guarantee that your return over this two-year period of time will be, say, some participation in equities and will not go negative, and also, you, of course, as they say, are tax-deferred during that period of time. So in that accumulation stage, it’s actually a pretty attractive investment. I mean, it’s something between stocks and bonds because it’s sort of like an index that is based on an index, but if they’re insured not to go negative, they actually can have some pretty nice features.

Jim Lange: Could you distinguish between a variable and a fixed annuity index?

Roger Ibbotson: Well, I think the big difference is that fixed-index annuities are based on an index, and because of that, they tend to be at a lower cost structure.

Jim Lange: OK, and you’re saying that some of the returns to the individual might even outweigh some of the very high costs that are typically associated with some of these investments?

Roger Ibbotson: Well, I don’t necessarily think they’re high cost in the sense that if you’re locked in for eight years, there’s a front-end commission, which essentially becomes the form of a lower … if you get out early, you have to pay a penalty, essentially, and so that absorbs that commission. But if you stay in the whole time, you effectively don’t pay that penalty. And so the real cost, I guess, is you’re making a commitment when you buy a fixed-index annuity because you’re making, say, an eight-year or a 12-year commitment or some commitment depending on how these are structured. But over that time, you’re not paying taxes on your gains. You only get paid when they actually start coming out to you as cash flows.
Jim Lange: : OK, well, that’s similar to what you were talking about before. In terms of liquidity, if you want to stay liquid, you’re going to have a lower rate of return, and if you’re willing to give up some liquidity, for example, small companies, you should have a premium. So you’re saying that, to some extent, the willingness to give up the liquidity at the expense of a penalty will give you some type of additional return. Is that fair?


8. Annuities Can Be Annuitized Into a Stable Cash Flow for Life

Roger Ibbotson: Yes. I mean, you certainly shouldn’t be buying the products. If you want liquidity, it actually has a positive perspective of it locks you in more over the long run, which is the way, I think, most people should be investing. And they typically have another feature, which is then you can annuitize these into a stable cash flow that pays for the rest of your life, and that’s really what an annuity does. It’s sort of the opposite of life insurance. It pays you all the time you’re alive, and this is called longevity risk. We don’t know how long we’re going to live. Annuities are useful because they actually insure that part of you, so if you die early, you won’t get as much, but if you last a long time and keep on paying, ultimately, it’s satisfying a need, though, because it’s actually paying our income as we need it over the rest of our lives. It’s like Social Security, in a sense, except that this is on the private side.

Jim Lange: Well, for whatever it’s worth, I am a big fan of immediate annuities. Now, an immediate annuity is a simpler product. That’s where, in effect, you give an insurance company a certain amount of money and they promise to pay you a certain amount of return, or a fixed amount, or sometimes it goes up and down depending on the investment, every year for the rest of your life, and they tend to be pretty low-cost and tend to be low commission for the salesperson or representative. I know Jane Bryant Quinn is a big fan of those. I know Jonathan Clements is. But they’re not quite as big a fan on the fixed-index annuity, but what you’re saying, I guess, is that you can use a fixed-index annuity and it has features like an immediate annuity, but you get some tax deferral before you annuitize.

Roger Ibbotson: That’s correct. Think of it as the front end of an immediate annuity because ultimately, you turn into an annuity like that. But in the front end, you’re investing over some period of time you’re insured on the downside, and you’re getting some equity participation, and you’ve got a hold of this period of time, but you’re accumulating things on a tax-deferred basis, and then you end up paying the taxes, of course, once you start cashing out.

Jim Lange: Right. Well, I do see some of the points. For whatever it’s worth, historically, I’ve never sold a fixed or a variable annuity. By the way, I’ve seen commissions as high as 8 percent, 10 percent, 12 percent to the advisor, and by the way, in my, let’s say, business model, I have to work for maybe 20 years to make that kind of money, you know, running the numbers, telling people how much they should do for a Roth, doing at least annual meetings where we’re running the numbers and taking telephone calls and, you know, I would find it more profitable, but I guess I have a hard time with it, but I understand some of your points, but let me ask you this. I assume that one of the reasons that you are interested in talking about this is because Zebra had a product that you think is even better than, let’s say, some of the things offered by some of the big brokerages?

Roger Ibbotson: Well, yes. Zebra has a product. It’s in coalition with the New York Stock Exchange, so it’s the NYSE Zebra Edge Index, and it’s used by Nationwide. They’re the ones who actually insure the returns on this. So, yes, we do have a product, and it is based on popularity, actually. So we’re actually buying the large cap stocks that are less popular, so it’s the same kinds of concepts that I’ve been talking about, but it’s just applied to this large cap universe and then it’s put into the context of an insurance product.

Jim Lange: OK. If some of our listeners were interested, since I will, just by business model, not represent that type of product, could you tell them where they might go to find out about that, or to find out about Zebra, and maybe you could talk a little bit about Zebra also?

Roger Ibbotson: Well, it’s through Nationwide or one of those people affiliated with Nationwide. If you’re not in that set, I don’t think you could distribute this anyway, Jim, so I’m not suggesting that you could distribute it. I will say, though, that in the annuity field, there are wide ranging fee structures and so forth, and actually, Nationwide is a non-profit itself. Like Vanguard’s a non-profit, these are companies that don’t necessarily try to maximize the fee structure here. They do have to have some commissions related to them, of course, because they take some explaining, of course, for somebody that actually purchases this. And I don’t want to speak for Dimensional, but they’ve talked about maybe getting annuity products, too, in the future, I don’t know. There have definitely been those kinds of discussions.

Jim Lange: Well, by the way, this is encouraging, and for whatever it’s worth, I actually am licensed to sell those. If you’re licensed to sell life insurance, which I am, I’m a big believer in life insurance, especially for, let’s say, young couples starting out. I’m very interested in making sure that the couple has some cheap term insurance, so if you’re licensed to sell that, you’re licensed to sell, let’s say, for example, these fixed-index annuity products. But you’re the first guy that I’ve really had a lot of respect for that says, “Hey, there’s a really good product out there, and it’s based on this notion of an index put together on unpopular stocks, and it has relatively low or fair commissions and expenses, and it might be something that an average investor should take a look at.” So I’m trying to be open-minded about this.

Roger Ibbotson: Well, I think everybody should check this out because, yes, there certainly are various fee structures that would be damaging to investors, and ultimately, that’s when they’re going to have to rely on the right kind of registered investment advisor to put them in the right kind of product here, and that’s where it makes a big difference.

Jim Lange: All right. You just mentioned Dimensional Fund Advisors, and earlier, you said that you were on the board. Can you tell our listeners a little bit about that and how that has been, let’s say, consistent with some of the things that you’ve been talking about on premiums?

Roger Ibbotson: Well, certainly, Dimensional Fund Advisors effectively offers premiums in various forms because they usually focus on small caps or value companies, and these are the kind of stocks that historically have had the premiums of the market, and usually, they’re based on a lot of academic research, and particularly, you mentioned Fama and French. So, yes, I’ve been on the board since the start of Dimensional Fund Advisors. Now, that’s how many years? I guess that’s going to be about 37 years or so. It’s quite awhile since the start of the company, but I’ve been on board the whole time as an outside investor, by the way, as somebody who represents the shareholders.

Jim Lange: Well, you know, I don’t want to spend the time being a commercial for Dimensional Funds, but we’re actually big believers in Dimensional Funds, and our clients have seen the benefits of some of those premiums, and hopefully will for years in advance, and what we like to do is to combine the strategies like Roth conversions and gifting and the best estate planning, et cetera, along with the low-cost index investing using Dimensional Funds.

Roger Ibbotson: So, I’ll go back to the annuities for a second.

Jim Lange: OK.


9. Cost Structures around Some Annuities Have Come Down

Roger Ibbotson: You see, the concept of annuities makes a lot of sense, you know. Say if a fixed-income index annuity to essentially ensure your downside and participate in some of the upside of equities, and to ultimately to be able to turn this into a stable income like an immediate annuity. The concepts that make sense, what you’re so worried about is the cost structure, and I understand that. That’s certainly something that everybody should carefully look at because there are going to be a lot of flavors of this and you’re very wary of it. But I encourage you, actually, Jim, to take a look at this because … not necessarily saying our product, but the whole area, because I think the cost structures have come down, and because I think it does actually serve a need for investors to essentially protect their downside during an investment period, to participate in equities, to get a tax deferral, to be able to convert this into stable income over a period of time. I’m saying the concept makes sense. It’s the application that you’re so concerned about, and you should be. You should be very careful what you actually get into here.

Jim Lange: I don’t think it will be fair to our listeners to have, if not the world’s top expert on asset allocation, certainly within the top couple. Can you tell us a little bit about the importance of asset allocation and sticking to a strategy and the difference between rebalancing and timing?


10. Asset Allocation Represents about 50 Percent of Portfolio’s Performance

Roger Ibbotson: Well, you know, there’s lots of measures about how important asset allocation is, and there’s some controversy here because it’s been argued that asset allocation explains 90 percent of performance. I don’t believe that. I think it’s closer to half the performance. When you measure how does my return differ from your return, it’s about half related to our asset allocation and half related to kind of the specific types of things we choose. So that’s been a mis-measure. But overall, whatever it is, asset allocation is kind of a key decision you make as an investor. I mean, certainly whether to be in stocks or bonds or what combination is a key driver of our returns. Now, I think that you need to rebalance from time to time to keep your asset allocation in line because you know that stocks have outperformed bonds. If you let it run, you’re going to end up with an all stock portfolio over time, essentially.

Jim Lange: Which means that you would be vulnerable to a downturn.

Roger Ibbotson: Yes.

Jim Lange: So if all you have is stocks and you have a downturn and you have to sell and the market’s down. So, maybe if you could tell our listeners about rebalancing, the importance of rebalancing, and if there’s any mechanical way that you do it or people might say, “How often should I do it?” or should there be a, let’s say, benchmark, like if I’m off my goals by, say, 3 percent, then I rebalance?

Roger Ibbotson: Well, I don’t have a specific way of doing this because so much depends on the circumstances of what we’re talking about here, but I do think that, essentially yearly, you should be rebalancing your portfolio to be back into the target that you’re really interested in.

Jim Lange: One of the things that I have seen is, you know, people sometimes do it formulaically, whether it’s based on their age or even sometimes their comfort level, and sometimes I have clients that have a pension, and just about everybody, when they’re old enough, has Social Security, and I sometimes say, “OK, if you have a Social Security and a pension that together might total $60,000 to $70,000, and, let’s say, you’re spending $100,000, would you take that into consideration when you consider what your asset allocation should look like?”

Roger Ibbotson: Well, definitely. That’s why being a registered investment advisor is a complex thing because you’re dealing with all types of people. If you have a lot of wealth, I think you can pretty much get whatever asset allocation you want. If you want to take on the risk, it can be all equities, and if it doesn’t affect your lifestyle, you can choose to do that. But most of us essentially are really dependent upon our portfolio to get us through the retirement, and ultimately, as you age, you need to take on less risk.

Jim Lange: Mm-hmm, less volatility.

11. Bonds Offer Lower Returns, but the Risks are Lower Too

Roger Ibbotson: Right, and so you need to be more in bonds. Actually, I have a book on this that actually includes some annuity stuff, a CFA monograph, called Lifetime Investing, but it demonstrates that young people, and really, it’s based on human capital, young people have a lot of human capital, which is bond-like, and so, in other words, that’s the present value of all of the income they’re going to earn in their life, and because they’re essentially getting the wages and the wages are pretty stable, the more you’re getting from wage income, the more aggressively you can take your financial portfolio in order to take the extra risk. But as you said, approaching retirement, you’re not going to get much more from wage income, and therefore, that stable part of your portfolio is diminished, and now you need to lower the risk of the rest of your portfolio, and essentially start trading out of stocks and more into bonds, or, I would say, bonds and annuities, different ways of taking on less risk.

Jim Lange: Right, and by the way, that might be particularly appropriate for people who are in very good health and have long life expectancies. So, for example, my mother was a college professor and she was in the TIAA-CREF system, and the way it worked when she retired, she didn’t have all the choices that people have today. She had to annuitize. So she had to take her accumulations and trade them in for an income stream that lasted the rest of her life. She did this at age 70, and I’m not sure exactly how many years they thought — that is, the annuity company — she would live, but probably somewhere in the ballpark of 15 years. Well, she lived for 25 years, which means that she had a guaranteed income, and because she lived longer than the insurance company thought she was going to live, she never ran out of money, would never run out of money no matter how long she lived, and that was a good solution for her. So I think a lot of people, and particularly people with good genes and a healthy lifestyle, might consider these types of guaranteed investments, whether it’s the annuity that you’re talking about or, probably in my world, I’m still a little bit more comfortable with annuitizing.

Roger Ibbotson: Ultimately, that’s certainly a feature of any annuity, that you can annuitize it, and as you annuitize it, you turn that into stable income, and, of course, as you mentioned, I mean, you want to live long, and you’re happy that your mother lived as long as she did, but it’s a risk if you start running out of money, and so the real purpose of these annuities is to diminish longevity risk.

Jim Lange: Well, I had a similar conversation with a guy named Larry Kotlikoff, who, I suspect, you might be familiar with, from the University of Boston, and we were talking about, OK, what’s the losing side of this risk? Well, you die. So, let’s say my mom died when she was 71 instead of 95. The money that she would have lost was lost to the family, but Larry’s point is dead people don’t have financial problems. So if you’re worried about taking care of yourself and you’re not so worried about your estate, don’t bet on you dying, bet on you living.

Roger Ibbotson: Yeah, the real risk is this longevity risk of actually outliving your assets. As far as if you really need, you can have a bequest. You can definitely have life insurance around this, if you like. If you need to provide for somebody else after your death, you certainly can do that. I guess the whole benefit of this is we can tailor this to what you like or what you need, really.

12. Mixing Stocks, Bonds, Annuities Tailors Portfolio to Your Needs and Wants

Jim Lange: Well, I think that that is the idea, and P.J. DiNuzzo, who is actually the investment person in our team … so, I do the strategies like the Roth and how much you can spend and the estate planning and tax loss harvesting and those types of things, and he’s actually doing the investments and the asset allocation using Dimensional Funds, and then he and I split one fair fee. But his big thing is, everybody’s a snowflake, and you really have to take people’s individual needs, risks, wants, desires, comfort levels, age, et cetera into account.

Roger Ibbotson: Yeah, I certainly agree with that, and if you start looking at a mix of stocks, bonds and annuities, you can essentially tailor a portfolio to each person’s particular needs.

Jim Lange: And desires. So, for example, I have a lot of clients who say, “Hey, I paid for their braces, I paid for their college, I’m at least going through the trouble of thinking about them some, but basically, they’re probably going to get some money when I die anyway. We want to maximize what we can spend during our lifetimes.” And I have other clients, and at the risk of generalizing, maybe even other races who are more multiple-generation oriented.

Roger Ibbotson: Yes, so obviously, you try to deal with everybody individually in some form, and that’s why it’s difficult to “robot” our profession, I guess. And so I think you’re doing the right thing, so I don’t have much to comment on that!

Jim Lange: So, Roger, I’m giving the two-minute warning. Is there anything else that we haven’t talked about that you’d like to impart our listeners with a little bit more of your wisdom? And I’ll leave it open for anything that you’re interested in telling our listeners.

Roger Ibbotson: I’ll just go back to popularity for a second. You know, when we devised this popularity, the actual book that I’m in the midst of writing for the CFA — it’s a CFA monograph — is Popularity: A Bridge Between Classical & Behavioral Finance. The idea here is this is the big picture, and everything’s priced by popularity. All the premiums that we’ve already talked about, they’re just premiums for what you like and they’re priced accordingly, and even the mispricing in the market, and even all the distortions in the market, I’m actually thinking that with the single word “popularity,” you can actually describe all the kinds of pricing that goes on in the expected returns.

Jim Lange: Well, you have been, as usual, a great provider of information. I want to thank you so much for appearing on the show.

Roger Ibbotson: OK, well, I’m always happy to be here, so thank you.

Dan Weinberg: All right, thanks Jim, and, of course, thanks to Roger Ibbotson. Listeners, if you’d like to meet with Jim Lange in person, give the Lange Financial Group a call at (412) 521-2732 and see if you qualify for the Lange Second Opinion service. That’s (412) 521-2732, or connect with Jim’s office through his website at While you’re there, you can also pick up a free digital copy of Jim’s book, The Ultimate Retirement and Estate Plan for Your Million-Dollar IRA, including how to protect your nest egg from the pending death of the stretch IRA legislation. For now, I’m Dan Weinberg. For Jim Lange, thanks so much for listening, and we will see you next time for another edition of The Lange Money Hour, Where Smart Money Talks.