Afford Anything - The Two-Fund Investment Portfolio, with Paul Merriman

Episode Date: February 9, 2021

#300: Here’s the deal: Target Date Retirement Funds are simple, automated, easy. The problem? What’s simple might not be optimal. Investment expert Paul Merriman joins us to discuss the two-fund portfolio, a mix of one target date fund and one small cap value fund. He describes why this could be the ultimate portfolio for buy-and-hold investors who want to boost their returns, without excessive complexity or risk. If you’re wondering what to do with your 401k, tune in. For more information, visit the show notes at https://affordanything.com/episode300 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every choice that you make is a trade-off against something else, and that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention. Any limited resource that you need to manage. Saying yes to something means that you're saying no to other opportunities. And that opens up two questions. First, what matters most in your life?

And second, how do you align your daily, weekly, monthly, yearly decisions to reflect that? Answering those two questions is a lifetime practice. And that's what this podcast is here to explore. My name is Paula Pant. I am the host of the Afford Anything podcast. And today, Paul Merriman joins us to discuss the two-fund portfolio. Paul Merriman is a nationally recognized authority on index fund investing, asset allocation, and both buy-and-hold and active management investing strategies.

Back in the 1960s, Paul was a broker at a big Wall Street firm, and he concluded that he wasn't into it. Wall Street was, in his view, burdened by too many conflicts. of interest, and he decided instead to move towards helping small companies raise venture capital. In 1979, he became the president and chairman of a public manufacturing company that's in the Pacific Northwest. Fast forward to 2012, he wrote and published the How to Invest series. He's also the author of a total of five books on personal investing. His latest book is called We're Talking Millions, but he's written four previous books as well. And he has a weekly podcast called

sound investing, which was named by Money Magazine as the Best Money podcast. I will pretend, I'll pretend not to be offended. But no, no, in all seriousness, it is a well-deserved honor. So I am proud and happy to have the host of the Best Money podcast right here as a guest on this one. He has also, just to go through some other amazing things that he's done in his life, he's been a featured guest speaker at Harvard University at their investor psychology conference. He's done that twice. And one of the things that I'm jealous of the most is he actually knew John Bogle. For anybody who's wondering who that is, John Bogle is the founder of Vanguard, which is a low-cost brokerage, and John Bogle is the inventor of index funds. Let me emphasize

that. Index fund investing, passively managed index fund investing, exists because of John Bogle. One of my big regrets as a podcaster is that I was never able to interview John Bogle before he passed away. So Paul in this upcoming interview discusses his meetings with John Bogle, discusses conversations that they've had about index fund investing and specifically also about the two fund portfolio model and target date funds. They discuss what you are about to hear. So I'm going to lay that as the groundwork for this upcoming conversation. And there's one more thing that I'm just going to lay down as a little bit of background, particularly for the benefit of anybody who is new to this podcast. If you're a beginner, if you're unfamiliar with the world of investing, here's a little background that's going to help you understand this upcoming conversation. So index funds are classified based on size, geography, and style.

So an example of size would be small, mid, and large. Small cap index funds represent the smallest companies that are publicly traded. Well, technically, if you want to be very specific, there are some companies that are publicly traded that are even smaller than small cap, but that's not pertinent to the discussion that we're about to have. So for the sake of this upcoming interview, think of small cap as small. Large cap represent the largest companies that are publicly traded, such as Apple, Amazon, Tesla. And midcap, of course, is in the middle. So classifying funds based on their size, that's one of three ways that funds are classified. Another way that funds are classified is based on geography. And in the United States, since we're very U.S. centric, we regard that as U.S. versus international. You can get more geographically specific. You can get Latin America or Europe or developed markets or emerging markets. But broadly speaking, U.S. versus international are the two broad categories of funds classified based on geography. And then finally, funds are also classified based on style, meaning value versus growth.

Value funds are funds that seem to be in the discount bin, they seem to be those undervalued gems that are trading for less than what the company is actually worth. So if your investment style is a deal hunter, value funds could appeal to you. By contrast, growth funds are funds that are seen as likely to grow rapidly. So those three classifications, size, geography, and style, those are different ways that we classify index funds. And with that being said, with that established, here is our interview with Paul Merriman, in which he discusses a two fund portfolio. Hi, Paul. Hi, Paula.

How are you? You know, I'm doing great. This is really an exciting opportunity for me. And so thank you so much for the invitation. Of course. Paul, you wrote a book in which you talked about a two-fund portfolio. I won't give away what it is, but at the risk of asking too broad of a question, explain the premise behind having a two-fund portfolio. Well, let me talk about the one fund portfolio, if I might, because it is the part that I think everybody will probably relate to. And that is fund number one is a target date fund. And I think that a target date fund is probably the best investment ever offered to the public, to people particularly who are not interested in taking care of their investments.

So as we all know, the Target Date Fund does that all for you, literally from the you could start at age 20 and go to age 90 and never have to make any kind of decision about what's going on within your portfolio because it's being taken care of by professionals and not professionals who charge 1%, but professionals who charge maybe 1 tenth of 1%. So that's the starting point. And of course, I'm an advocate of using index funds and low expenses and all those things that I know you advise investors to do. but here's the problem with the target date fund as a stand-alone investment.

It does not give access to some important asset classes that have historically made a lot more than the large cap, blend, basic portfolio that you find in target date funds. Now, yes, they have a little small cap and some value, but based on what, what we've learned from the academics, not very much. So what we do in this portfolio, and I did not develop this, this is the work of Chris Pedersen, who is our director of research and our foundation. He studied for months coming up with a combination of the Target Date Fund and a second fund, making it two funds for life, and a formula that you combine the second fund in a way

that it automatically, almost automatically, adjust to your risk tolerance over life. And that second fund is oftentimes small-cap value. And why small-cap value? Because those small and value are two asset classes that are underrepresented, according to the academic community, in the target date fund.

Right. And that makes sense. With a target date fund, typically has its equities portion represented through a broad market index fund, such as VTSAX, and by its very construction, that broad market fund is overrepresented with large cap stocks. And then the key, the challenge, is how much do you put into small cap value? Or, by the way, it could be large cap value if you wanted to be more conservative. And what we have wanted to do in our work is not just tell people what funds to be in,

but how much you should be in at different points in your life. So the formula that Chris created was so simple. You just simply take your age 20, let's say, and you multiply it by 1.5. Now you've got 30. That is the percentage that would be in the target date fund. Then as you age and you continue every year, every five years, whatever is most comfortable, you multiply that 1.5 again. So at age 30, you're now 45% in the target date fund and 55% in small cap value.

And that continues through until theoretically by the time you're 65, 66 years old, you've eliminated the small cap value and ended up with. with a very conservative retirement portfolio. Of course, we show people how to be a little more aggressive than that when they retire, but some people, that will probably be the appropriate thing to do. Why would there be a modification to a target date fund? Given the fact that target date funds are, by definition, designed to be a one-stop shop that carries an individual investor from age 20 through age

100, you know, age 20 through retirement. Given that that is the intent of a target date fund, why would there need to be a modification? And I suppose that's another way of asking, what are some of the shortcomings of target date funds? Well, in fact, when I had the opportunity to spend 90 minutes with John Bogle in his office, the one question I was nervous about asking him was, how can Vanguard put 10% of a 20-year-old's investments into a bond fund and even at 30, maybe even at 40? And the reason being is because my book and a lot of the work that we do on our website is about finding every way that we can that you might make an extra half of 1%. and what we know about 10% in bonds is that it is going to likely reduce your compound rate of return by one half of 1%. So why would we penalize a young investor who, in fact, should celebrate a bear market?

I mean, first of all, how much protection does 10% in bonds give you when you're young? Well, none if you want to look at it in reality because, oh, yeah, you're going to lose a little bit less than you would if you were 100%. But it's a meaningless amount. And the other side of that is when you're a young investor, we must encourage young investors to celebrate a bear market, celebrate the opportunity to buy investments when they're going down as opposed to being afraid or being worried about losing everything. if you're broadly diversified, that historically should not be a concern. So his answer was so wonderful because it explains everything about the attitude of Vanguard and the way they build that portfolio. He totally agreed that that was going to reduce the likely return. But they feel it is important for the first-time investor,

and that's who they're serving when someone, is starting out, should, in fact, understand that bonds are an important part of the long-term strategy and that it is not about trying to protect against a huge bear market because it doesn't. And so it's just part of a long-term relationship with a portfolio. And he made another point that means a lot to me. He said, I'm not in this business. and I'm paraphrasing, I'm not in this business to make people wealthy. I am here so that people will have enough.

And so, yes, that 10% in bonds reduces the potential return. But it doesn't reduce it so much that if you continue to invest and you trust that investment and stay the course, dollar cost averaging in, that you're probably going to have enough. And that's an interesting philosophical approach where I'm stuck in a whole other world. I'm trying to figure out what steps can we take that are prudent steps and maximize the return that we make over a lifetime. And my book is basically about those steps because you could make more money if you took more risk than my book recommends, but I can tell you that you might likely be taking risk that will encourage you to stop, to motivate you to stop taking those risks

because the pain is just too great. In a moment, I'm going to ask you about what some of those hypothetical moves are that could result in greater rewards, but also have a trigger greater loss aversion. We'll ask about that in a moment, but first, tell me more about this conversation with John Bogle. What else, you were with him for 90 minutes. What else did you discuss? Well, we had talked for years on a radio show that we had in Seattle. He was an annual guest. And over the years, when we would interview him, we would tease him a little bit about his position on internationals and his position on small caps and value.

and over the years he actually did change a lot of his beliefs, not necessarily because he didn't still feel that you should have all your money in the U.S. I think that that's what deep down he wanted, but he also understood that there was a cry for further diversification in adding the internationals. So he learned to compromise and start saying, okay, it's all right if you put 10 or 20%, but I wouldn't go any more than 20%. But he talked about his history, things that I had read before that he had written, and there were no secrets that he shared, but that he actually was willing to admit that he was

just damn lucky. Because if you think about it, he started an index. fund at the start of a 25-year period that the S&P 500 compounded at about 17% a year. And that was about as lucky as you can get when you're starting a strategy and the underlying asset class takes off like a rocket. Had he started that same portfolio in 2000 for the next 12, plus years, his compound rate of return would have been around 6%. And he would not have been seen as the hero that he became. We talked a lot about the active end of the industry and how they get away

with, what they get away with, and all the myths, I don't mean all the myths, but the myths that people continue to hold because they want to believe that smart people can do better than somebody who doesn't have a lot of information. And of course, John was obviously a believer in all indexing. In fact, I recently saw one of his old videos where he said what we should be doing is putting our investment in an envelope, close the envelope, and 50 years later, open it up and find out what it's worth because he said you will be amazed. Well, of course, my response to that is, well, you won't be amazed if you don't put the right thing in the envelope in the beginning.

I had heard he was a little bit on the gruff side. In fact, the meeting was scheduled for 60 minutes. He was an absolute teddy bear. And his room, his office was filled with stuffed teddy bears. And one of the worst things that happened to me in my career is I recorded that on my cell phone. And then I came back and forgot it that I had it on my cell phone and upgraded and lost that interview. Oh, no. Which was a killer.

But, no, I've done things just as stupid many times. But it was marvelous. He is, and this comes through not just in his words, but his. the look on his face. He was in this business to change the lives of, what I call them, small investors, people of less means that didn't have the ability to build great fortunes. He never talked about the large investors who use Vanguard. He was always focused in that conversation on the small investor. We all should be grateful that that was his focus because That focus led to the rest of the industry having to come to his level, not him having to go to their level of what was right for the investors.

So whether you own an index fund or not, you still need to thank John Pogel for what he did because the expenses would be much higher today without his work. And by the way, we shouldn't overlook Charles Schwab because at the same, time that Bogle was making his impact and being laughed at, Chuck Schwab was coming out with his discounted commissions that really was hard on the industry, and they didn't want that happening for sure. Right. Wow, that's a fascinating detail about the teddy bears in John Bogle's office. But back to index funds in honor of John Bogle, back to the portfolio.

So we were discussing the shortcomings of target date funds. Yeah. One of those shortcomings being that it overrepresents large-cap equities and under-represents small-cap equities. Another shortcoming being that it is, by definition, a balanced fund with both growth and value stocks rather than a value-oriented fund. I'm not sure that that's a good idea. When I say not a good idea, a person could be, in fact, we have portfolios on our website for all value. The risk there is that the investor does not understand the long periods, the expected long periods of underperformance that comes along with owning an all-value portfolio. Here's what we know from our studies.

If you go back to 1928 and you build a portfolio, not of large-cap blend basically only, but equal parts, large-cap value, small-cap blend, small-cap value, and the S&P 500, you actually have a portfolio that, in terms of not day by day or year by year, but if we look at five or ten years at a time,

is much less volatile than the S&P 500 on its own, but adds about a 2% compound rate of return for over 90 years. And my book is talking about if I could only find you an extra half or 1%, which, by the way, for a young investor, translates into over a million dollars in extra money he'll or she will have to take out or to leave to the family or to the charities that they love. And so if there's a possibility that you could have a portfolio that is balanced between the big and the small and the value and the growth, then add 2%, or I said and, I should say and add 2%, you're a talking about a major change in what you're likely to be worth and what you leave to others. And I'm not talking about be worth because we want to have huge piles of money.

I'm talking about having the ability two things. One is to take out a percentage of a higher number. And if I could easily get 20 or 30 percent more from my investments by the time I'm 65 or 70, just even 20 or 30% more, that's a big deal if I'm taking out 4%, but the other part that first-time investors probably don't understand is if you accumulate a bigger pile of investments at retirement, you can likely take out not 4%, but 5%, in some cases even 6% without facing the risk of running out of money before you run out of life. And then you leave more to children and charities. So that extra half a percent is a big deal. But now we're talking about 2% for only doing basically one thing. But that one thing is adding a small cap value component to a target date fund.

So constructing that two fund portfolio that has a target date fund plus a small cap value component, Doesn't that indicate that one of the shortcomings of only holding target date alone would be insufficient exposure to value-oriented equities? Yes. At least historically, that's all we have to go on. Even if all you did, forget the two funds for life with the formula that Chris came up with, just take 10% of what you're going to put in the target date fund and put it into a small cap, value fund or 20%. It's not like you're putting your life on the line. It's a relatively small part of the portfolio. But when one asset class is compounding at 9 to 10 and the other is compounding at 11 to 12, even a 10% piece is meaningful. So we show, of course, we go much deeper elsewhere than in

that book because that book is built for somebody who we're not trying to turn them into a masterclass investor. We are trying to help the person that doesn't want to get very involved and make sure they do a few things that are in fact in their best interest and get on with their life. We'll come back to this episode after this word from our sponsors. Fifth Third Bank's commercial payments are fast and efficient, but they're not just fast. and efficient, they're also powered by the latest in payments technology built to evolve with your business. Fifth Third Bank has the big bank muscle to handle payments for businesses of any size. But they also have the FinTech Hustle that got them named one of America's most innovative

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Deals, head to Wayfair.com now to shop Wayfair's Black Friday deals for up to 70% off. That's W-A-Y-F-A-I-R.com. Sale ends December 7th. How did you come up with the formula for the allocation that goes to a target date fund as compared to the allocation that goes to the Small-Cap Value Fund? Why, you know, 1.5 your age equals target date exposure with the rest in small-cap value? Well, here's what we know. We know that when investors are young, that they are built to take more risk. This is one of the things I don't particularly care for in target date funds.

If you look at the Vanguard funds, they're going to have in the equity portion, whether it's 30% in equities, which would be what they would do with me at my age, or whether you're 90% in equities, the balance of equities are exactly the same. same. So much U.S., so much international, all basically large cap blend. And the fact is, is that they have small cap value in a target, I shouldn't say an S&P 500, but if you get a total market index, you are going to get a little bit of small cap value. It's not like Vanguard doesn't believe that small cap value isn't a legitimate asset class. They do believe it is. But you should have more of that when you're young.

That's the time. In fact, that's the time if small cap value does this dastardly thing to you that it will from time to time, it will go down and it will go down more than the S&P 500. That's what happens. And when you're young, remember I said earlier, celebrate the bear market. Take advantage of a great asset class when it's when it's, when it's, down on its knees because you're buying more shares. Right. But why specifically that formula? Why 1.5 rather than 1.75 or 1.25? Well, because what Chris did was he looked at all sorts of combinations. In fact, he has a book coming out later this year in which he shows some different

formulas. In the desire to keep this book simple, we showed a basic strategy that we would be comfortable with anybody using. But yes, you could be more aggressive than that, or you can be less aggressive. The way you become more aggressive is use a slightly more aggressive percentage approach, but the other way is to use less risky, like I mentioned, large cap value instead of small cap value. So there's no magic to this. We just are trying to figure out. Well, and in fact, let me tell you about another formula that people can use. Chris developed, and that's on our website, he developed a strategy from birth, from birth to death, what he thinks that a newborn child should have and what you would do with that newborn

child. And in the early years, you're all in small cap value. That's where you should be if you believe the past. and he makes the investment more aggressive throughout the whole life of that person. So there's no magic here. It is simply that philosophically, and also in terms of the implications of the early years of investing, that is the point at which we have decades to work. We are worth a lot to the world in those decades that we're working and adding value to our society.

but then you get to my age or a lot younger and you're not so much value to now you really have to have the savings because your your capital value has gone down and so you need to be more conservative theoretically when you get older i believe by the way paula that those people who learn how to invest and invest right from their twenties on when they get to be 65 or 70 they're not going to be overly conservative because they're going to learn what it feels like to be in equities when they're going up. That's the good part. And they're going to understand when they're going down. And they're going to have some fixed income in their portfolio, but not as much as the people who haven't had that experience. Speaking of fixed income, if a person were to embrace the two fund portfolio, what overall bond allocation or fixed income allocation? could they expect to have, and how would they calculate that?

Well, what they're going to see, I mean, I can't give you an easy formula right here, but obviously they're going to, and this is good news, because they've added this large position of equities, I don't care what kind of equities it might be, but a large position in equities. They are going to have added the equities to a portfolio that holds bonds that we don't want them to hold. But by adding the equity, you are redacted,

reducing the exposure to bonds. So that, that's good. And that's in the early years. The years that we need to be more careful of is later on when it would be appropriate to start adding more bonds. And you do, with the Target Date Fund, have a lot of bonds as you get into your 50s and your 60s. But remember, at that time, the small cap value is being reduced to having very small impact. on your portfolio. When you are 60 years old, you're 90% in the target date fund, which is probably 50% in fixed income, and you're 10% in the small cap value, which is going to mean a little more

equities to your portfolio. But, you know, once you've lived with that for a long period of time, my sense is you're going to be very comfortable. In fact, you may find yourself not cashing totally out of small cap value, but letting it ride if you want to. I'm 77. My buy and hold equity portfolio is half in stocks and half in bonds. So I'm not being overly aggressive, but I'm also not going to sit at 30% in equities, as they would recommend at Vanguard. But in that 50% I have in equities, half of it is in small.

by the way, it's also an international small as well as U.S. small. And it has partly small blend and partly small value. And we show people how to build these portfolios, which we're trying to get away from in this book. Because again, once you start talking about all of these different pieces that you could put in a portfolio, which is what I used to do for a living when I was, an investment advisor, but the many you go there, people's eyes glaze over, and they want it to be

simple. So we're trying to make it simple, but give them the ability to get as close to the return and the unit of risk that you take as you would have in one of these massively diversified portfolios. On the topic of international funds, the two-fund portfolio is overweighted to towards domestic equities. If a person wanted greater exposure to international equities, should they make adjustments to this plan? For example, should they go into a three-fund portfolio with the third fund being a total international or total world equity fund? Well, actually in the target date fund at Vanguard, and in most target date funds,

they have about a 70% exposure to U.S. and 30% exposure to international. Again, it's all basically large cap, these kind of total market index kinds of portfolios. So what you could do is we have a four-fund strategy that is a balance of these major assets. classes. One of them includes international along with U.S., but all you need are four funds. You could use that four fund strategy along with the target date fund, or you could make that a three fund strategy because you're already getting the large cap blend inside the target date fund. There are a lot of ways to kind of slice and dice these things to make them potentially better. And then we're talking not about a half of one percent, but maybe a tenth of one percent,

or maybe two-tenths of one percent. And I don't want to make light of a tenth of one percent. But how simple, and the more complex it gets, this is where, I mean, John Bogle, he literally wagged his finger at me. I felt like I was being taken out behind the woodshed, but he was very, he was kind about it. But he said, you cannot expect people to be able to manage. these portfolios of 10 different mutual funds like you're recommending. It needs to be simple. And so we've tried to eliminate as many of the moving parts without giving up return. And that's what makes it hopeful to me that we're talking about truly changing people's financial future, but not scaring their pants off because that's what happens to people when they get into things.

they don't understand. With regard to the international exposure, how advisable is it to diversify some of that exposure among developed nations as compared with emerging markets? Is that something, particularly for younger investors, is that something that we ought to be thinking about more? Or does that add so much complexity that, from a behavioral percentage, that from a behavioral perspective, it decreases our likelihood of follow through. Well, that's the big challenge is behavior.

And in fact, in a total market index internationally, you will pick up a fairly good-sized piece of emerging markets. But I have for years, probably 20 years, talked about what I call the ultimate buy-and-hold strategy. And it's so simple. It's 10% each of large-cap U.S. blend, U.S. large cap value, small cap blend, small cap value, reets. And then still going 10% each, international large cap blend, large cap value, small cap blend, small cap value, and emerging

markets. So you have massive diversification. You have currency diversification. And one of the things that people don't understand about using non-correlated assets is that during the period of distributions in retirement, those non-correlated asset classes can have a huge impact on how long your money last. Because remember back in that 2000 through 2009 period when the S&P 500 and the total market index U.S. lost money for 10 years. Well, if that was the basis of your equity exposure and you were taking distributions, that was not only painful, but may have caused a lot of people to stop with the equity exposure. On the other hand, if you had a combination of U.S. and international, large and small and value and growth and that slice of emerging markets and the slice of reeds,

you came through like a champion and you stayed the course, hopefully. So it, and by the way, it's important for people to understand something that, talking about the psychology of investing, and that's something I think you do a great job in educating people about that aspect. Thank you. But you're young enough that you may not know what it's. felt like to live through the 90s when the S&P 500 was glorious, amazing, in fact, from 95 to 99, it compounded at 28 and a half percent. Amazing. And when people were interviewed as to what their

expectations were for the next decade, the public thought, well, somewhere between 20 and 30 percent. Well, this obviously was a trap, and we understand why they believed 20 to 30 percent, because they just got it. But what they got for the next decade was actually a loss instead of a gain. Nothing. You came out, well, by the way, if you dollar cost averaged in, you were okay, but if you were in a lump sum environment, you got hammered, particularly if you were taking money out on top of everything else. But the industry pretended like that was normal. It wasn't normal.

But boy, was it profitable for the industry? And it was profitable for some investors. But for a lot of people, it was that sucker trap one more time. And it's painful. It's painful to families and what we believe. And I think what you're teaching young people, This is way more impactful than one might understand if we get young people today to do the right thing and to be comfortable with money as opposed to so many people who are not comfortable with investments and don't like to talk about it. They will then have families where their children are likely to hear the right story.

One, they're not going to hear the story about how dangerous it is to be in the stock market and how you lose all your money in the stock market. because there are people who still believe that. You're going to learn from your parents that the market is a long-term situation. You don't do it to try to make money fast. You do it to make money relatively slowly and that you have to be ready to ride the waves to get there. If we teach that to the next generation, then I personally believe that your work and my work is more than just about teaching today. Potentially, it's for a much longer term.

In fact, I'm 77. If I get five more years of being able to teach like this, I will feel blessed. And I will not see my work. I will not see what happened to all the people I help learn about the 10 fund or the four fund or the two fund. But we will have an impact on a slice of America. And so are you.

Thank you. And I think I'm envious. I'm not envious of wealth. I am envious of youth that have taken the time to understand the problems of whatever particular aspect of society that they're trying to help with. And that's something that I wish I could do again. Among people in your age group who have lived through both periods of an incredible market growth and economic growth, as well as periods of incredible retraction or stagnation, what dominant feelings do you observe with regard to trust in the market, trust in the overall economy,

comfort with investing, even now at 77. Are there those who have been burned too badly or those who are still irrationally exuberant? What do you see? Well, I've been around the business since 1963, and that's a valuable period of the market to be able to kind of look back and see what happened. What happened in 73 and 74 was devastating to people. They had learned to trust the market. That's not the first time that that had happened to people. In a sense, that's what happened in the 20s. There was a book that came out in the 20s of Dr. Smith wrote a book that made the case to the retail public that stocks were a better place to have money for the long term than bonds.

And it's interesting to note that the public didn't know that. So the public decided to invest in the stock market. Now, not all of the public because I think in 1929 during the crash, only about 10% of America was invested in the stock market. but it was way more than what was there before. Those people in many cases did not invest in the stock market again in their life. In fact, in the 60s, the Ford Foundation came out with a paper that chastise the pension funds for not investing in equities. And why weren't they invested in equities?

Because the trustees of those pensions were people old enough to have lived. through the depression. And they never wanted to do that to somebody again. And they were trying to be prudent and protect the people who were putting their money away for retirement and trusting the trustees. They didn't want to take that risk again. And in the mid-50s, people wouldn't invest in stocks unless they at least paid a dividend that was as much as they could get in a bond because they knew there was a good

chance they were going to lose their money in the stock. But if they just got the dividend, it would be worth holding on. Well, if you got out of the market in the mid-50s because dividends were not paying as much as bonds, you've yet to get back in or just getting back in. So history is just ripe with these huge mistakes. So in the late 70s, for example, the famous article, the death of equities on the front page of a national magazine. was because people believed that the equities market was in fact dead and was not going to be a place to put your money for the long term. But today is different. I do a piece about how investing has never been better, never been more productive.

In fact, even if we get a lower rate of return, like for example on the S&P 500, we are probably going to make as much as it has in the not because the S&P 500 made it for you, but because we didn't pay those expenses that we paid in the past. In the 60s, a load fund was 8.5%. Actually, 9.3, if you look at it, the right way. Active management was the only way because there was no indexing. And commissions were sky high. I mean, it's amazing.

I was a broker for two years back in the 60s. I got in and out after about two years. It was obvious that it was an industry, I thought, that was difficult to be honorable. And I don't mean that everybody who's in it is dishonorable, but it's built as built in conflicts of interest. But I would sell 100 shares of, let's say IBM, very popular stock to somebody. And I don't remember, but I think I got about $175 commission for 100 shares. And if I sold them a thousand shares, I got $1,750. What do you pay for a thousand shares of IBM stock today?

Nothing if you go to the right place. So that's money that stays in your pocket. Expenses in mutual funds stay in your pocket if you do it right. Taxes, if you take advantage of the things we have available to us with IRAs and 401Ks, stay in our pocket and Roths, oh my God. I mean, we have a chance to be tax-free for life, in theory. And we didn't have that. So when you look at all the money that was being taken out of our pockets by not only Uncle Sam,

but by the brokerage industry, and you keep it in yours, this is what John Bogle was all about. he didn't do anything special, but help keep more money in your pocket. He did not add any value to the investment. He added value to what your return would be because if you've been left to it or with the help of a broker probably would have made a heck of a lot less. And then he gave reduced expenses. He didn't come out of the gate giving reduced expenses significantly. In fact, his mutual fund was eventually a load fund, was, I'm sorry, originally a load fund.

And after about a year, they dropped the load. So there's a lot that we keep in our pocket. And I'm just trying to help investors make sure at a weak moment, they don't decide that rather than investing in the stock market, that they loan money to their pal Joe. And there are things that historically, the odds are not very good that you're going to come out ahead. We'll return to the show in just a moment. You mentioned it's never been a better time for equities and for investing. There are many people right now who are concerned that the market is far too high,

that we have been in a bull run since 2009. There was a minor disruption in March of 2020, but then it came roaring back. So with the exception of a little March 2020 blip, we've been in a steady bull run for a decade. And valuations are incredibly high, particularly for tech stocks. But those stocks comprise some of the biggest companies in the S&P 500. And so anyone who buys VTSAX, for example, would be holding a double. large portion of some fairly high PE ratio stocks. What is your thought on the objection or the reluctance to get into equities now given the perception of high valuations? Are you a market

timer or are you a buy and holder? What are you? Because if you don't know who you are in that regard, I can't guarantee you'll become a market timer, but a lot of people who claim that they believe in buy and hold become market timers when the pain gets too great, which means when the loss is more than they're willing to sustain, which means they probably didn't give any consideration to what their loss limit would be. My portfolio was built for an amount of money that my wife and I agreed to lose on a short-term basis. and every portfolio is built with a certain exposure to loss. And if you don't know what your portfolio is,

maybe you ought to be asking yourself what it is and what it's going to be for somebody who's, let's say, 90% in equities, are you ready to lose 40% of your money? Because if you're not, you shouldn't be 90% in equities. But that fork in the road, a buy and hold, and or a market timer. And by the way, you know, most everybody says, oh, market timing doesn't work, but most people use it unsuccessfully. The beauty of buy and hold is you don't worry about list A, the good news, and list B, the bad news.

They both exist at all moments of time. And so when you don't have to worry about that, you don't have to decide. like so many people did, and I don't blame them. In March of 2009, they cashed out. And many of those people are still waiting to get back in because they had no plan of when to get out, except that they were using what we call the I can't stand it anymore strategy, where they just are overwhelmed. By the way, that strategy is, in a sense, the same thing when it's the fear of missing out,

the FOMO, that same emotion. It's not about intellect. It's about emotion. And when it comes to sex, food, and money, we do not make decisions intellectually unless we somehow create a mechanical way to deal with what otherwise takes control of our mind and our body. The bottom line is that if you decide to be a market timer, if that's what you believe in, then act like it. And And if you believe in market timing, well, okay, what market timing system do you believe it? Oh, you believe in the market timing system that says to get out of things that are overpriced and get into things that are underpriced. Well, what could that be?

Well, if you follow Ben Carlson, one of my favorite writers, bloggers, I include the list in my article. You should be in energy, financials, you should be in value. I mean, you should be in European and Japanese stocks, things that are relatively undervalued. Now, he believes in active management. I don't believe in that kind of active management. But for most people, I think if you can just stay the course with buy and hold, the odds are hugely in your favor to stay the course, but you always must have a defensive position.

even if your position is, I believe to be, I should be 100% in stocks. That's a very aggressive position. Now I want to know how many. You say one. Ooh, I don't like that. I know, according to the academics, that the expected rate of return of 1,000 growth stocks for the next 10 years is the average return of all 1,000 companies. but many of those companies will fail.

And it could be that one stock you believe in so, could be one of those that failed or did not make the grade and got the, didn't even get the average return. Dr. Bessam Binder studies show that going back to 1926, over half of U.S. public companies, from the time they started until they, until they finished, didn't make a positive rate of return from what they originally came to the public. And the other half made people rich.

We always know, we always know about the Amazon's and the Teslas. We always know about them afterwards. And the challenge is that our minds and, Again, this is that psychological stuff, but the bias is we think linearly. If something's been going up, we think that's going to continue. So we know where the bubble likely is, and it's not likely in value. It's likely in the Teslas of the world. And young people will tell me, ah, you're just an old fogey.

You don't understand. It's a new world in these things. There were 1,700 times earnings because they don't have it. any earnings and someday when they have earnings, you're going to be amazed. And I may be dead. And they will try to find me and say, see? Well, you need to take the steps if, unless you really believe that you are a kind of a Warren Buffett kind of person somehow and not, and Warren Buffett, by the way, didn't invest in the Teslas of the world. But he tells us the S&P 500 is probably the best investment for not only all amateur investors, but professionals as well.

And I don't understand why he doesn't say the total market index, except maybe he knows what a lot of us know, is the return of the total market index and the S&P 500 for the last 90 plus years is virtually the same except the S&P 500 has done a little bit better. I just want people to go beyond and pick up a couple of other asset classes and then close their eyes, knowing they have the right amount of fixed income at the right time. I don't want to be yelled at for having convinced somebody to be in equities all the way all the time. Excellent. Well, we're coming to the end of our time. Are there any final thoughts that you would like to share with this audience?

Well, I think the final thought, Paula, is that there's a circle of knowledge. And within that circle, everything's in there. Everything that ever happened having to do with stocks and bonds and all that, it's in there. And each one of us needs to imagine the size of the piece of pie that represents what we know we know. And then the size of the piece of pie that represents what we know, we don't know. and probably the major thing that we don't know is the future. We can't know that. Most of what we know we know is about the past.

Maybe that's true of all we know. But then there's a piece that represents what we don't know, we don't know. And we need to understand that whatever's in that pie, we have no idea that that risk, let's think in terms of risk for a second, is even there for us to face. It's not like we're in the middle of the first pandemic that ever happened, but I think most people would admit that we didn't have that on our list of risks in our financial future a little over a year ago. And it could be that what we don't know, we don't know is exactly the thing that's going to bring us to our knees. But then there's still another piece of pie.

And it's what we know we know. I mean, we really know it, but we're wrong. and that is very common. I'm working on a list of 200 myths. People believe, believe that active management is going to produce a higher return. But then there's another piece of pie yet, and it's what we know we know, but we don't do anything about it. And my job, and I think your job, is to expand the piece of pie that represents what we know we know. And then somehow, even though we are not their personal advisor, give them enough information.

It motivates them to do something about it. I loved being an investment advisor. I loved the first hour and a half, particularly. It's when I got to find out a whole bunch of stuff about somebody. And I'd make a long list as I was listening to them. And I would turn that piece of paper over. And I would say, let me see if I understand what it is that you want to do. And my memory was good enough.

I could remember the list I had just written for at least 10 minutes. And I would repeat back what I heard and what I concluded they needed. And then they could either go do it on their own because I didn't charge them for those hour and a half meetings. Or they could ask us to take care of it for them. Now that I'm just a teacher, all I can do is try to share information I know. that is some maybe is so overwhelming in terms of evidence to people. And that by the way, I don't have one original thought. This is all stuff that other people have taught me.

You know, Chris Pedersen has had some original thoughts, not I. And it will motivate you to do the right thing, knowing full well that it might not work. I hate that thought. I hate it because it means, I could, you could, any of us who have folks who believe in us, could tell you to do something that's not in your best interest. But I will tell you this. If you read through those 12 recommended steps to take,

I will have explained almost everything I know of significance that gives you defense, defense, defense, and the opportunity to get enough offense out of it that you will lead a great retirement. That's what I believe, and that's what I hope happens. And we believe so much in this, we give teachers. Teachers who are in the financial literacy arena, I want them to have a copy of our book free.

They just email me, Paul at paulmerman.com, and they could just want a free book, okay? But I want to share this information with teachers who are in, in having some impact on other people, young people. Happy to do that. I don't make a penny. I've not made a penny for myself in 12 years. When I started this foundation,

I promised my wife I would not work for money ever again. What I did not tell her that she still holds against me is she thought I meant I would not work ever again. I've never worked so hard. I have never had so much fun. And thank you so much, Paul, for having me on because you have a very loyal following, and it's really, it's a pleasure to be here with you and with them. Thank you so much, Paul. What are some of the key takeaways that we got from this conversation?

Here are five. Number one, if you are looking for a combination of simplicity and efficacy, consider a two-fund portfolio. A two-fund portfolio is comprised of a target date retirement fund and a small cap value fund. Now, here's the reason why. A target date retirement fund, by its design, is meant to be a one-stop shop. It's meant to expose you to a mix of equities and bonds that is appropriate for your age and your timeline to retirement. And inside of that target date fund, it represents its equities portion through a broad market index fund like VTSAX and also a total international fund. It does that with equities and it does that with bonds.

However, broad market index funds are overrepresented by large-cap stocks, large-cap blend. And in addition to that, target date funds arguably overexposed investors, particularly young investors, to bonds. And so in order to capture the simplicity and the automation of a target date approach, while also layering in one more fund that could lead to greater upside, Paul suggests a two-fund portfolio. Here's the problem with the Target Date Fund as a stand-alone investment. It does not give access to some important asset classes that have historically made a lot more than the large-cap, blend, basic portfolio that you find in Target-date funds. Now, yes, they have a little small cap and some value, but based on what we've learned from the academics, not very much.

Paul's position is that target date funds overexposed people in their 20s, 30s, and 40s into bond funds. He says that 10% in bonds is likely, according to historic data, to reduce your compound rate of return by one half of 1%. And this is what exposure to target date funds may do. And so, according to his research and the research of Chris Petter, a simple two-fund portfolio in which you put your age multiplied by 1.5 as the percentage in a target date fund and the rest in small-cap value funds may enhance your returns without adding too much undue complexity. And so that is key takeaway number one. It's the core message of the interview. He introduced the notion of a two-fund portfolio and explained the research and the

justification behind this strategy. And so that's the first key takeaway number two. Adding a mix of diversified index funds into your portfolio might simultaneously boost returns and decrease volatility. The simple answer to portfolio management, of course, as we just discussed, is to put everything in a target date fund. That's the one-stop shop, set it, and forget-it approach. Alternatively, a different approach is to follow the J.L. Collins philosophy of splitting everything up between one total stock market index fund and one total bond market index fund. And if you're looking for simplicity, those are both simple approaches. And we know from mountains of behavioral science research that the more simple the approach,

the more likely the follow-through. But what's simple and what is behaviorally optimized is not necessarily mathematically optimized. And according to Paul, a slight uptick in complexity, meaning layering just a few additional funds into a portfolio, could simultaneously smooth the volatility while enhancing the long-term aggregate returns. If you go back to 1928 and you build a portfolio, not of large-cap blend basically only, but equal parts, large-cap value, small-cap blend, small-cap value, and the S&P 500, you actually have. a portfolio that in terms of not day by day or year by year, but if we look at five or ten

years at a time, is much less volatile than the S&P 500 on its own, but adds about a 2% compound rate of return for over 90 years. When investors are young, particularly investors under 40, we're able to take on more risk. And so Paul's suggestion of adding a small-cap value component into a portfolio into a target-date-centric portfolio adds a slightly more volatile asset class into that portfolio, while also reducing the bond exposure that comes from an all-target date strategy alone. And yes, a small-cap value index fund will have greater swings, at least according to historic data, but based on historic data could also be likely to lead to higher long-term aggregate returns. And so that is key takeaway number two. Key takeaway number three, let's discuss Paul's ultimate buy and hold strategy. During this interview, Paul introduces a variety of strategies,

and the one that might be a good fit for you depends on, among other things, the level of complexity that you're looking for. So during the interview, Paul discusses a two-fund strategy, a three-fund strategy, a four-fund strategy, and even a ten-fund strategy. So if you're really eager for complexity, Paul describes his ultimate buy-in-hold strategy of creating a 10-fund portfolio. Here's how that plays out.

It's 10% each of large-cap, U.S. blend, U.S. large-cap value, small-cap blend, small-cap value, reets, and then still going 10% each, international large-cap blend, large-cap value, small cap blend, small cap value, and emerging markets. The purpose of a two-fund portfolio is to offer something to investors who want to get the bulk of the benefit of a target date fund, meaning the benefits of automation and simplicity, while also adding in just one additional fund to try to increase optimization and increase lifetime returns without making the portfolio too complex. because there are many people who believe that once you get to greater than two funds, once you get to three or four or ten, the portfolio becomes so complex that from a behavioral perspective, it's unlikely that you're going to manage it, it's unlikely that you're going to stick with it and truly buy and hold it.

John Bogle had these words for Paul Merriman. John Bogle, he literally wagged his finger at me. I felt like I was being taken out behind the woodshed. He was kind about it. But he said, you cannot expect people to be able to manage these portfolios of 10 different mutual funds like you're recommending. It needs to be simple. And so we've tried to eliminate as many of the moving parts without giving up return. So the purpose of the 10 fund portfolio is to add a heck of a lot more complexity, but also hopefully, based on historic data, lead to higher. returns. But as Paul describes, if you don't want the complexity of 10 funds, if you want to eliminate 80% of this 10 fund portfolio and focus on the most important 20%, well, now we've reduced

10 funds down to two funds, and that is the basis of that two fund portfolio that he kicks off the episode introducing. And so when you think about how to apply this to your life, first ask yourself the question, how many funds do you want to hold in your portfolio? Do you want the hassle of managing 10 funds, or would you prefer only holding two? It might be the case that you love managing your portfolio and you'd be happy to manage 10 funds. Or it might be the case that that sounds like the worst way to spend a Friday night. So think about where you want to fall within that spectrum of a two-fund portfolio to a 10-fund portfolio. And remember that, as Paul says, there is plenty of support for the notion of managing a two-fund portfolio. And remember that, as Paul says, there is plenty of

support for the notion of managing a two-fund portfolio without giving up a significant level of returns. Truly 80-20ing it. And so that is key takeaway number three. Key takeaway number four, know your loss limit, know how much downside you can stomach. Every portfolio is built with a certain exposure to loss. You might wake up and log into your account and see that it has tanked. How strong of a stomach do you have for that? How much money are you willing to temporarily lose during a market crash. A lot of people who claim that they believe in buy and hold become market timers when the pain gets too great, which means when the loss is more than they're willing to sustain,

which means they probably didn't give any consideration to what their loss limit would be. If you say that you're a buy and hold investor, you need to know how much money you're okay with losing because people who think that their buy and hold. investors end up becoming accidental market timers when they take on too much risk. So if you're 90% in equities, are you ready to lose 40% of your money? Are you ready to wake up and look at your portfolio and see that loss on the screen of your smartphone staring back at you? If you are genuinely okay with that, then you might truly be a buy and hold investor. But unfortunately, a lot of buy and hold investors, they go into

what Paul describes as the I can't stand it anymore strategy, in which they think that they're buy and hold, but then they end up cashing out when the going gets tough. They sell in March of 2009 because they can't stand the loss anymore. And then they refrain from buying back into the market until 2014, 2015, 2016, after the run-up because they can't stand sitting on the sidelines anymore. It's a FOMO-based method of investing. And this type of emotional whiplash is not a sound investing strategy. So if you're going to buy and hold, then buy and hold. But that means tuning out the noise, tuning out the news, and knowing how much money you are willing to lose. That is key takeaway number four. Finally, key takeaway number five, have a defensive position. Paul says that the expected

rate of return of a thousand growth stocks for the next 10 years is the average return of all thousand companies. But within that mix, there are many companies that will fail. Dr. Bessam Binder studies show that going back to 1926, over half of U.S. public companies from the time they started until they, until they finished, didn't make a positive rate of return from what they originally came to the public. And the other half made people rich. When we think about companies that have become runaway successes, we experience what's called hindsight bias,

meaning that with a benefit of hindsight, we can look back on the Amazon's and on the Teslas, on the stocks that have skyrocketed, and we tend to forget the Blockbuster videos, the companies like Blockbuster that once were synonymous, That brand name Blockbuster was synonymous with an adjective for it's a Blockbuster hit. It's a runaway hit. It cannot be thrown off its pedestal.

And yet that's what happened with companies like Blockbuster Video. And because we don't hear about those in the financial news, those companies don't have salience. And so the availability heuristic, recall bias, those don't easily come to mind. And so we tend to overlook them. We tend to discount them, even though they are part of the mosaic of the overreact, overall market, or they were while they lasted. And so having that defensive position, knowing what your loss limit is, as we discussed in the previous key takeaway, investing in index funds that represent the overall market rather than

choosing individual stocks, those are examples of how you can protect against the downside of a company completely going belly up. And so those are five key takeaways from this interview, which is a number. Paul Merriman. Thank you so much for tuning in. If you learned from today's podcast, please do two things. One, subscribe to the show notes. Show notes are available at afford anything.com slash show notes,

and we will send you weekly a synopsis of that week's episode. Number two, share it with a friend or a family member. Once you're subscribed to the show notes, you can just forward those show notes onto them. That's one of the easiest ways to share this podcast with the people that you about and the people that you want to extend this learning to. We also have a 31-day challenge for a strong year ahead. It's February, but a lot of people's January resolutions kind of sort of fizzled out. So if you want to have a strong February, if you want to have a strong 2020, it's not too late to get a really strong start to the year. And we have a 31-day challenge

where every day for 31 days, we send you one idea, one question, and one action that you can take. It's completely free, and you can sign up at affordanything.com slash 31 day challenge. That's afford anything.com slash 31 day challenge. Thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast. Make sure that you are subscribed to this podcast so that you don't miss any of our enlightening educational upcoming interviews. Just hit the subscribe button or the follow button in whatever app you're using to listen to this show. And while you're there, leave us a review. Congratulations to the whole community for episode 300. This is an incredible milestone. So I am beside myself that 300 episodes and so many more to go.

So congrats to everyone, whether this is your first time listening or whether you've been part of this community since the beginning. Thank you for coming along on the journey. Thank you for helping to be part of the community that builds afford anything to what it is. so awesome that we are celebrating episode 300. I am thrilled that we could celebrate it with this interview with Paul Merriman, and I will catch you in the next episode in episode 301. See you then.