back to index

Bogleheads University 501 2024 Factor Investing with Paul Merriman in Conversation with Jim Dahle


Chapters

0:0 Introduction of Paul Merriman
2:20 Intro to Factor Investing
4:30 What Factor Are Worth Considering?
5:57 Is It Just Data Mining?
9:6 How Long is the Long Run?
12:55 How Much Should You Tilt Your Portfolio?
17:24 What's In a Name (6 different small cap indexes)?
24:15 What Date Would Convince You To Stop Tilting?
29:50 Risk Story vs. Behavior Story
32:25 Will AI Change Factor Investing?

Whisper Transcript | Transcript Only Page

00:00:00.000 | (audience applauding)
00:00:03.160 | - All right, we've got some time now
00:00:08.320 | with a true giant in the field.
00:00:11.460 | I am excited to participate in this.
00:00:14.440 | Paul and I have been talking back and forth
00:00:17.160 | for the last month or so
00:00:19.600 | about what this is going to look like today.
00:00:22.040 | And we think it's gonna be really good
00:00:24.080 | and really educational and really useful for you.
00:00:26.920 | So let me tell you about Paul, if you don't know.
00:00:31.920 | Paul is a nationally recognized authority on mutual funds,
00:00:37.200 | index investing, and asset allocation.
00:00:40.400 | After retiring in 2012 from Merriman Wealth Management,
00:00:44.040 | which he founded in '83,
00:00:45.920 | he created the Merriman Financial Education Foundation,
00:00:49.320 | dedicated to providing investors of all ages
00:00:51.220 | with free information and tools
00:00:53.320 | to make informed decisions in their own best interest,
00:00:56.040 | and successfully implement the Retirement Savings Program.
00:00:59.520 | He is the author of eight books,
00:01:01.520 | twice as many as I've written,
00:01:03.200 | and writes a regular column
00:01:04.360 | for the Wall Street Journal's MarketWatch.com,
00:01:07.380 | and has a multi-award winning weekly podcast,
00:01:10.840 | Sound Investing, which has been named by Money Magazine
00:01:14.760 | as the best money podcast.
00:01:17.080 | In 2008, which was a really important year,
00:01:21.960 | don't get me wrong.
00:01:24.440 | He has also been given a number of awards,
00:01:26.680 | the American Association of Individual Investors,
00:01:29.080 | James Clunan Award for Excellence in Investment Education,
00:01:32.640 | and as a Distinguished Alumni Award
00:01:36.080 | from Western Washington University School of Economics,
00:01:39.180 | and perhaps most importantly to him,
00:01:41.280 | a founding member of GlobalHelp,
00:01:43.880 | the Board of Directors of GlobalHelp,
00:01:45.440 | which is a non-profit that produces medical publications
00:01:48.840 | and distributes them to doctors
00:01:50.080 | and other healthcare workers in developing nations.
00:01:52.800 | A very, very wonderful life that you've lived so far, Paul.
00:01:57.160 | Come on up here, let's get some more wisdom from Paul.
00:01:59.880 | (audience applauding)
00:02:00.720 | - Great.
00:02:01.560 | Thank you.
00:02:03.680 | I think this is working, yeah.
00:02:07.560 | - All right.
00:02:08.400 | Okay.
00:02:10.360 | Is this one still on?
00:02:11.240 | Keep us both on here.
00:02:12.680 | Please have a seat, Paul. - Okay.
00:02:14.320 | - We're gonna talk about factor investing.
00:02:19.480 | - Wow.
00:02:20.380 | - And that's a pretty awesome topic, right?
00:02:23.720 | Those of you who've followed these discussions
00:02:25.600 | for the last five, 10, 15, 20, 25 years,
00:02:29.760 | know that there's a fair bit of controversy
00:02:31.920 | on the Bogleheads forum these days about factor investing,
00:02:36.040 | which is a very different situation than it was in 2004,
00:02:40.540 | when I walked onto that forum.
00:02:42.400 | And so we're gonna talk a little bit about this,
00:02:44.600 | but let's start, Paul.
00:02:46.420 | Why don't you just tell us what we're talking about
00:02:49.040 | when we're talking about factor investing?
00:02:51.520 | - Well, when I came into the industry in 1966,
00:02:56.520 | the way that they differentiated
00:02:58.560 | between different kinds of investments,
00:03:02.040 | I think mostly were names made up
00:03:04.320 | by the marketing departments of the mutual fund companies,
00:03:08.080 | things like aggressive growth, capital appreciation,
00:03:13.080 | growth and income, dividends.
00:03:16.480 | And then a number of years later,
00:03:18.640 | the academics got involved,
00:03:20.960 | and they looked deeper into the premiums,
00:03:24.960 | the additional returns
00:03:29.160 | that certain kinds of investments get.
00:03:33.300 | And so then we had a whole different way
00:03:36.200 | of looking at the returns on investments
00:03:40.980 | and legitimate ways to compare.
00:03:44.120 | And that kind of factor investing then
00:03:47.240 | is really using these individual kinds of investments
00:03:52.240 | to build a portfolio and to build the portfolio
00:03:57.960 | in the hopes that you will have diversification
00:04:01.200 | of different kinds of investments.
00:04:04.100 | And I'll show you some information
00:04:05.900 | that just blows my mind how different these things can be.
00:04:10.900 | So the idea is to get a better unit of return
00:04:15.040 | per unit of risk by putting these factors
00:04:18.560 | that the academics came up with to use.
00:04:22.240 | - Okay, so let's get more specific.
00:04:23.960 | I mean, when I look at the literature on factor investing,
00:04:26.240 | there's like 800 factors or 4,000 factors
00:04:28.640 | or something that's been identified.
00:04:30.840 | What factors are actually worth considering
00:04:35.000 | for an individual investor like yourself?
00:04:36.280 | - Well, I'm almost 81, and I can only do three.
00:04:42.720 | Value versus growth, size, large versus small.
00:04:47.720 | And of course, the market is a factor itself,
00:04:54.800 | the decision whether you're going to be in the stock market
00:04:57.400 | or you're gonna be in the bond market.
00:04:59.760 | And the other one that's been more recently discovered
00:05:02.560 | and put to use that looks really great is quality
00:05:07.120 | or the financial stability of the companies
00:05:11.640 | that are in the portfolio.
00:05:13.160 | So those are all factors that could then represent companies
00:05:18.160 | from all different industries.
00:05:20.720 | And those are the main ones.
00:05:24.600 | Other ones are oftentimes hard to get to,
00:05:28.040 | expensive to get to.
00:05:29.800 | Tax-wise, they're expensive to own,
00:05:32.320 | but those are the basics that you're going to get
00:05:35.760 | in the ETFs that we have choices from.
00:05:40.800 | - Small value quality.
00:05:42.760 | - Yeah, and the market.
00:05:45.360 | - Okay, and of course, the overall market factor.
00:05:48.080 | Okay, now I promised Rick Ferry
00:05:50.680 | I'd ask you all the hard questions today,
00:05:52.360 | so I'm definitely gonna ask you the hard questions.
00:05:55.200 | Here's the first one.
00:05:56.880 | How do we know this isn't all just data mining
00:05:59.600 | and doesn't really exist in the first place?
00:06:01.240 | We just pulled it out because we looked at a past data set.
00:06:04.600 | - Well, let me see if I can show you some numbers.
00:06:06.880 | Now, by the way, you're gonna see a whole bunch of numbers
00:06:10.840 | that you are not gonna be able to read from where you are.
00:06:13.440 | The good news is we put together a package
00:06:16.680 | so that if you go to paulmerriman.com/bh,
00:06:21.240 | as in Bogleheads, you can see all this stuff
00:06:23.840 | close and up front.
00:06:25.160 | But let me see, in order for me to go forward.
00:06:27.680 | There we go.
00:06:31.000 | All right, all right.
00:06:32.920 | - I want you to pay attention to the colors here.
00:06:35.000 | We know you can't read the numbers on this chart,
00:06:38.880 | but pay attention to the colors.
00:06:40.480 | - I had no idea it would be this small.
00:06:42.640 | The red colors are the S&P 500.
00:06:46.440 | This is going back to 1928.
00:06:49.040 | That basically is large growth.
00:06:52.680 | It's got some value in it,
00:06:54.120 | but large growth drives most of that return.
00:06:58.120 | You can't see it,
00:06:59.120 | but there's an electric blue color up there
00:07:02.580 | that is small cap value.
00:07:05.400 | Now, what we know about the S&P 500
00:07:07.480 | is it's the highest quality asset class amongst this group,
00:07:11.680 | which means it should produce the lowest return.
00:07:15.120 | But what's interesting is to notice
00:07:17.120 | how often the red is at the top.
00:07:20.160 | In other words, there's a lot of the time
00:07:21.680 | that S&P 500 does better than the others.
00:07:26.360 | And the blue, the small cap value
00:07:29.160 | is the most productive asset class,
00:07:31.400 | and yet you're gonna see it at the bottom of these
00:07:35.400 | from 1928 to 2023.
00:07:38.700 | What really blows me away,
00:07:41.840 | this is what factor investing is meant to try to do,
00:07:45.840 | and that is that when you put together a 25% S&P 500,
00:07:51.200 | small cap value, small cap blend, and large cap value,
00:07:54.620 | not only is the compound rate of return
00:07:58.100 | about 2% better than the S&P 500,
00:08:01.240 | but you can't see it very well.
00:08:03.900 | But if you could see the brown or the yellow,
00:08:06.620 | you would find that that four fund strategy
00:08:09.620 | is almost always right in the middle,
00:08:12.880 | never number one, never number four.
00:08:15.460 | And if you wanted to see that
00:08:17.180 | and have a breakdown of what percentage of the time
00:08:22.700 | it ended up in this particular quintiles,
00:08:27.360 | you will see the S&P 500 is the least productive
00:08:30.600 | 41% of the time and the most 28% of the time.
00:08:35.600 | And when you have time, you will be able,
00:08:37.840 | if you are interested in this kind of information,
00:08:41.280 | to compare how they did overall.
00:08:45.160 | And what it leads me to believe
00:08:47.000 | is that putting these factors together
00:08:49.960 | has a great premium and reward for doing that.
00:08:55.320 | You just need to know the funds that you do it with.
00:08:57.960 | - We'll talk about funds here in a minute,
00:09:01.120 | but first we gotta talk about something else.
00:09:03.420 | Paul, I started investing in 2004.
00:09:09.360 | It's now 2024.
00:09:11.080 | I've gone from being broke in 2004
00:09:13.400 | to being financially independent in 2024.
00:09:16.280 | And I've been tilting my portfolio
00:09:19.640 | to small and value factors almost that entire time.
00:09:23.760 | It has not paid off.
00:09:25.840 | I am way behind what I would have been
00:09:27.840 | if I had just used total market funds.
00:09:29.500 | Not only do I have lower performance,
00:09:32.240 | but I had lower tax efficiency.
00:09:34.480 | I have higher expenses.
00:09:35.840 | I mean, when you look at the long-term data,
00:09:39.360 | you see the small cap value is outperformed,
00:09:42.400 | quality's outperformed, et cetera.
00:09:44.780 | But how long is the long run, Paul?
00:09:46.540 | How much longer do I have to wait?
00:09:48.240 | - Well, let me show you, whoops, not that one.
00:09:53.880 | Let me show you this one.
00:09:55.180 | - Yeah, see that really flat one at the end?
00:09:57.800 | That's me, that's my entire investing career.
00:10:01.040 | - Here's the reason that factor investing
00:10:04.300 | will not work for some people.
00:10:06.140 | It really is a legitimate long-term strategy.
00:10:11.980 | As Warren Buffett says,
00:10:13.280 | his favorite holding period is forever.
00:10:16.760 | The idea is to understand that these asset classes
00:10:21.500 | are going to go through ups and downs
00:10:23.720 | for very long periods of time.
00:10:26.400 | And what Jim did was he bought at a time
00:10:32.160 | during which small cap value was kicking butt, remember?
00:10:37.160 | - Oh yeah, I remember.
00:10:38.040 | We were all tilting to small cap value in 2004, 2005, 2006.
00:10:41.680 | - And it had been, as a matter of fact,
00:10:44.240 | over about a 15-year period,
00:10:46.200 | it doubled the return of the S&P 500.
00:10:50.380 | And that's when people get attracted to this kind of thing.
00:10:53.720 | And guess what?
00:10:55.640 | What's the likely outcome of chasing performance?
00:10:59.200 | It doesn't work very well, right?
00:11:01.000 | Anybody agree?
00:11:02.520 | Yeah.
00:11:03.480 | And so the idea is to understand, I think,
00:11:06.980 | that these are asset classes that are meant to be held
00:11:10.060 | forever as a part of a portfolio.
00:11:12.800 | But what this particular telltale chart,
00:11:16.920 | and John Bogle developed, as far as we know,
00:11:19.420 | the telltale chart, and what it allows us to do
00:11:22.360 | is to compare the relative return of the S&P 500,
00:11:26.520 | in this case, to small cap value.
00:11:28.720 | And what do we find out?
00:11:31.120 | Over the entire period, it's true that small cap value
00:11:35.160 | made about 12 times as much as the S&P 500.
00:11:39.520 | That's the good news.
00:11:41.560 | The bad news is that 80% of the time
00:11:46.040 | it wasn't adding any value.
00:11:49.160 | And so it is a type of an investment
00:11:52.760 | that you must have the ability to wait out that return.
00:11:57.760 | And unfortunately, as this is a business of faith,
00:12:02.640 | the investment business is faith-based,
00:12:06.440 | where we all have our portfolios believing
00:12:10.600 | that they're gonna be okay, right?
00:12:13.280 | Well, we believe that small cap value
00:12:16.840 | will add performance over time.
00:12:20.400 | But you don't know.
00:12:21.480 | As a matter of fact, from 1975 to '99,
00:12:24.840 | the S&P 500 compounds at 17%,
00:12:28.160 | and since then, it has compounded at about 7.5%.
00:12:33.160 | So that's the reality of being an investor.
00:12:37.400 | And proper diversification is what you got,
00:12:40.560 | is that if you are properly diversified,
00:12:42.720 | there are gonna be periods that you're not happy
00:12:45.940 | with some part of your portfolio.
00:12:47.640 | And I am sorry.
00:12:49.240 | (audience laughing)
00:12:52.200 | - I'm not blaming you, Paul, for certain.
00:12:54.120 | - That's good.
00:12:54.960 | - But okay, let's talk about this.
00:12:56.880 | Somebody's still convinced.
00:12:57.960 | They're like, "Oh yeah, man, I'm 25.
00:12:59.960 | "I can hold on for the long run.
00:13:02.160 | "This is gonna pay off eventually.
00:13:03.680 | "I'm really impressed with the data."
00:13:06.040 | How much should you tilt your portfolio?
00:13:08.280 | How much should go into small value
00:13:11.240 | versus the overall market?
00:13:13.240 | - Well, in all of these, in that paulmerriman.com/bh,
00:13:18.240 | there are about 200 tables there you can look at
00:13:22.780 | in charts and graphs and whatnot.
00:13:24.700 | This is part of a page of one of 'em.
00:13:27.340 | And what it shows here is the,
00:13:30.700 | this goes from 1970 through 2023.
00:13:35.340 | The rest of the page shows the annual returns.
00:13:38.260 | This is the cumulative impact.
00:13:42.000 | And on the far left, we have the S&P 500
00:13:46.160 | compounding at 10.7%, 100% S&P 500.
00:13:51.160 | When you add 10% small cap value,
00:13:54.420 | the return goes from 10.7 to 11.
00:13:58.240 | This is not life-changing, but it's in the right direction.
00:14:02.220 | And when you look at the worst six months, 12 months,
00:14:04.700 | 36, 60 months, the worst drawdown,
00:14:07.740 | you will see that the risk of loss
00:14:10.020 | is almost the same as being 100% in the S&P 500.
00:14:15.020 | As you move across that page,
00:14:18.040 | it keeps getting better and better
00:14:21.060 | and at a slow pace for the combination
00:14:24.940 | and the additional risk.
00:14:26.340 | For example, if we look at 50/50,
00:14:29.060 | it looks to me like the worst 12 months
00:14:31.140 | is a loss of 46% versus 43% with 100% S&P 500.
00:14:36.140 | Really not much difference.
00:14:39.820 | And yet the return goes from 10.7 to 12.4.
00:14:44.820 | Now the challenge we have is there is no risk in the past.
00:14:50.180 | We always know what we should have done, right?
00:14:54.900 | This is what we should have done,
00:14:57.220 | but we can't know that it will produce
00:14:59.540 | that same kind of additional return in the future.
00:15:04.300 | But this table is our effort to show people
00:15:07.660 | what are the implications of adding small amounts
00:15:11.980 | of small cap value, for example.
00:15:16.300 | And we do the same with the four fund strategy
00:15:20.140 | or a three fund strategy.
00:15:21.980 | The idea is to look at different strategies,
00:15:24.460 | different combinations and the risk and return historically.
00:15:29.460 | - You know what I've always said when people ask me
00:15:31.580 | how much should I tilt my portfolio?
00:15:34.380 | I tell them don't tilt more than you believe.
00:15:37.900 | You know, if you don't believe very strongly
00:15:40.580 | that this is going to outperform in the long run,
00:15:42.780 | don't make a big huge tilt.
00:15:44.660 | If you believe very strongly,
00:15:45.940 | you can probably tolerate a larger tilt.
00:15:47.900 | It's a little bit like the price is right, right?
00:15:49.820 | When you're setting your stock to bond ratio.
00:15:52.080 | You want to get as close without going over
00:15:54.900 | your risk tolerance as you can.
00:15:57.180 | And I suppose it's the same way with small cap.
00:15:59.900 | - I totally agree.
00:16:01.100 | As a matter of fact, my own portfolio, equity portfolio,
00:16:06.100 | and I'm 50/50 stocks and bonds, my wife and I are,
00:16:10.540 | but I'm half small cap and half large.
00:16:13.280 | I'm half value and little more than half value
00:16:19.220 | and little less than half growth.
00:16:21.520 | I'm half US, I'm half international.
00:16:24.520 | And so I have not played any favorites.
00:16:28.420 | I have spread it across all of these
00:16:31.780 | major equity asset classes.
00:16:34.700 | And the only difference really here is that
00:16:37.300 | typically people build portfolios based on cap weighting,
00:16:41.740 | like the total market index or the S&P 500.
00:16:45.580 | We've been, we have learned from the academics
00:16:49.340 | that it is very important to also diversify
00:16:53.760 | amongst equity asset classes.
00:16:56.780 | That's what they teach.
00:16:58.420 | I didn't create any of this information.
00:17:00.940 | All I've done is learn from others
00:17:03.000 | and try to pass it along.
00:17:04.660 | - What if they're wrong, Paul?
00:17:07.940 | What if you're wrong?
00:17:08.780 | What if, what data could come out
00:17:12.300 | that would suggest this is a bad idea?
00:17:15.700 | That would cause you to bail on this tilt you put in there?
00:17:18.780 | - Well, let me see if I can show you here.
00:17:22.280 | I jumped that one.
00:17:24.460 | I love this table.
00:17:27.580 | This table are the results of 15 years of performance
00:17:32.580 | from six different small cap value indexes.
00:17:36.340 | Morningstar and S&P and the MS, Morgan Stanley,
00:17:41.340 | six major small cap value indexes.
00:17:47.300 | And the difference each year
00:17:48.820 | between the best and the worst is huge.
00:17:51.420 | It averages about 3%.
00:17:54.440 | From the top to the bottom.
00:17:56.660 | What that tells us is these people
00:17:59.360 | are not doing what they do with the S&P 500
00:18:02.560 | where the difference between the best and the worst
00:18:04.860 | will simply be the expense that is charged.
00:18:08.620 | And so you might have a 1/10 of 1% difference
00:18:12.260 | for the S&P 500.
00:18:13.780 | So you can count on that depending on the expenses.
00:18:18.780 | That is not true.
00:18:20.860 | It is not true with small cap value.
00:18:24.380 | Or small cap blend.
00:18:26.140 | People, companies have developed their own
00:18:30.160 | and the question you need if you're gonna do this,
00:18:33.020 | how do you make sure that you get your money
00:18:35.860 | into the small cap value fund
00:18:38.780 | that is likely to perform the best?
00:18:40.940 | I know, for example, the Russell 2000 value,
00:18:44.060 | it's a lousy, lousy small cap value index.
00:18:49.060 | And we know why it isn't very good.
00:18:53.240 | Because it has a lot of companies that are not very stable.
00:18:57.340 | They are companies in financial trouble.
00:19:01.500 | On the other hand, there are indexes
00:19:03.440 | where they have eliminated that part of the portfolio
00:19:07.580 | and tilted, another tilt, towards the profitability,
00:19:11.540 | towards the quality.
00:19:14.180 | And what difference might,
00:19:15.980 | well I can tell you the last five years,
00:19:18.940 | AVUV, a fund that we happen to think highly of,
00:19:23.260 | had about twice the return,
00:19:26.000 | about 88% versus about 34% with a Russell 2000 index.
00:19:31.000 | They are about the same size companies.
00:19:36.440 | Everything else about them is very similar
00:19:38.520 | except for one thing, the quality of the portfolio.
00:19:42.680 | So that's why I think the quality is important
00:19:45.800 | and size and the value orientation is going to be important.
00:19:51.800 | And so what we want you to do is,
00:19:55.200 | if you're going to do this,
00:19:56.560 | just be sure that you're getting into those ETFs
00:20:01.560 | that represent what we hope, and we can't know,
00:20:05.500 | will be the better performers.
00:20:07.240 | - I'm not sure you answered the question I asked,
00:20:10.360 | but you answered one I meant to ask.
00:20:12.400 | So let's dive into this a little more
00:20:14.200 | and then we're gonna go back to the question I asked.
00:20:16.880 | You're suggesting Avantis is doing a pretty good job
00:20:21.560 | with these factor funds.
00:20:24.360 | Avantis, of course, those who aren't aware,
00:20:26.960 | Avantis is a bunch of DFA break-offs
00:20:29.200 | that went over there and started doing
00:20:30.400 | a bunch of small value ETFs
00:20:32.800 | 'cause the DFA folks apparently didn't want to.
00:20:34.840 | Well, now there's DFA ETFs too.
00:20:37.040 | So Avantis you list as, if you wanna do this,
00:20:40.840 | that's a pretty good place to go.
00:20:42.280 | You're paying 25 or 35 basis points.
00:20:45.120 | - 25, at DFA you're paying 31.
00:20:48.400 | - Yeah, and so what else?
00:20:51.260 | What about the Vanguard small value funds?
00:20:54.600 | - Well, the challenge, what you get with Vanguard
00:20:57.720 | is you get a very low expense ratio.
00:21:00.040 | And what you get from these other organizations
00:21:04.320 | like Avantis and DFA is you are getting strategies
00:21:09.320 | that require more work and they must charge more for it.
00:21:15.640 | For example, the Russell 2000 Index,
00:21:20.860 | they rebalance basically or reconstitute that once a year.
00:21:25.860 | And when it's reconstituted,
00:21:29.360 | there's a cost to the shareholders
00:21:31.220 | of getting out of the companies they gotta get out of
00:21:34.080 | and getting into the new companies they need to get into.
00:21:37.760 | Now, what Avantis does is they reconstitute
00:21:41.800 | during the year one stock at a time.
00:21:46.800 | And so they don't wait around for a year
00:21:49.660 | and they also are not being burdened with the expense
00:21:53.500 | when everybody tries to rush in
00:21:55.500 | or everybody tries to rush out.
00:21:57.640 | It is being done at a cost that you're gonna pay more.
00:22:03.020 | But when you see the difference in return over the years,
00:22:07.580 | I think most people would agree
00:22:10.180 | that it is worth the price of admission.
00:22:13.380 | And so this is always, if you're talking about the S&P 500,
00:22:20.020 | obviously, that's an easy decision to make the lowest fee.
00:22:25.020 | But let's be honest, we can all go to Fidelity
00:22:29.020 | and we can buy the S&P 500 without any expense at all, right?
00:22:34.020 | We can, but we don't because we honor
00:22:37.860 | the man that started this.
00:22:39.540 | Which means that there is an emotional part
00:22:44.220 | of the decision that we make.
00:22:46.260 | It's sometimes about who we trust
00:22:48.820 | and who we want to do business with.
00:22:50.700 | I can just tell you from my knowledge
00:22:53.620 | of the people at Advantis and DFA,
00:22:56.380 | if you wanna go someplace and get an education,
00:22:59.260 | their websites are a great place to get an education
00:23:02.860 | about factor investing.
00:23:05.240 | - You know, it wasn't that long ago
00:23:09.720 | that we thought 20 basis points
00:23:11.280 | was a great price for a mutual fund.
00:23:13.500 | And now it's four, three, zero at Fidelity
00:23:18.380 | that we can, investing has basically become free
00:23:22.140 | for the masses now.
00:23:23.060 | And so we don't wanna pay anything for it,
00:23:24.660 | even though not that long ago,
00:23:25.860 | 20 basis points seemed pretty awesome.
00:23:28.060 | - I will note that if people go to our website
00:23:33.060 | and take our recommendations, it's free.
00:23:37.400 | So we're a Vanguard fan through and through.
00:23:42.900 | We're trying to bring it as low cost as we can
00:23:46.300 | for what we're doing.
00:23:48.520 | And what you gotta do, I hope, is check us out
00:23:51.360 | to see if we know what we're talking about.
00:23:53.600 | And all we're doing is bringing what we've learned
00:23:55.880 | from the academic community.
00:23:57.960 | And it shows up in these tables
00:23:59.760 | that either we make or other people make
00:24:02.840 | to help you make a decision.
00:24:04.440 | - Okay, now we're gonna go back to that question.
00:24:08.080 | - Yes, what was that question?
00:24:09.780 | - I mean, a lot of this we get from looking back
00:24:13.380 | at 100 years of data and we say small value outperformed
00:24:16.520 | over that 100 years.
00:24:17.620 | What kind of data would convince you
00:24:21.200 | to stop tilting your portfolio to factors?
00:24:23.700 | What if it was so poor for another 20 years
00:24:27.800 | that it's now underperforming large growth over 120 years?
00:24:32.800 | Would that be enough or what would dissuade you
00:24:36.640 | from being a factor investor?
00:24:38.120 | - This is gonna shock you, but I'm not thinking 120 years.
00:24:41.460 | (audience laughing)
00:24:43.840 | I do not think.
00:24:45.880 | What would it take for me to decide
00:24:49.440 | that there is not a small cap premium
00:24:52.640 | or a small cap value premium or a large cap value premium?
00:24:56.780 | You would have to turn the way people believe
00:25:01.900 | that investing works upside down to conclude that.
00:25:05.740 | Because if we can conclude that,
00:25:09.000 | we could conclude that bonds are better than stocks.
00:25:12.480 | Now you may think that is crazy, but in 1925,
00:25:16.240 | people believed that bonds were investments
00:25:18.680 | and stocks were nothing but speculations.
00:25:20.980 | They did not believe that stocks were a good investment
00:25:24.500 | for the long term.
00:25:25.620 | And they were wrong from what we know
00:25:28.800 | about the rest of that story.
00:25:31.040 | But small cap is more risky.
00:25:33.680 | Value is more risky.
00:25:36.340 | There's a reason that they sell
00:25:38.480 | for half the P/E ratio of growth.
00:25:42.560 | And so the question is, if they are more risky,
00:25:47.440 | will they have to pay a premium
00:25:49.920 | for people to put money in those companies?
00:25:52.840 | And yes, they will have to, at least as a group,
00:25:56.960 | or people will make the decision to get out of them,
00:26:00.040 | at which point they'll go down in value
00:26:02.060 | and then they'll work.
00:26:03.320 | But in the long run, it's the way,
00:26:07.360 | from everything we know,
00:26:08.920 | when we look at this other thing I showed you
00:26:12.840 | with all those, the quilt chart back to 1928,
00:26:17.760 | they all did what they said they were gonna do.
00:26:20.560 | The S&P 500 had the lowest return.
00:26:23.540 | Small cap value had the highest.
00:26:27.680 | Large cap value was second from the bottom.
00:26:32.680 | And the small cap blend was next.
00:26:35.640 | And if you go back and look at the years,
00:26:37.480 | what you're gonna find this kind of fun,
00:26:40.600 | at least my idea of fun,
00:26:42.880 | is you're gonna look at a year and say,
00:26:44.360 | wait a minute, look at this.
00:26:46.080 | Small value and large value did the best that year.
00:26:51.080 | Large blend and small blend didn't do well.
00:26:54.920 | And sometimes there's a 10, 15, 20, even 30% difference
00:26:59.320 | from the top to the bottom.
00:27:01.200 | Other years, small cap value and small cap blender
00:27:06.120 | at the top, but large value and large blender at the bottom.
00:27:10.840 | Obviously, for some reason,
00:27:12.520 | investors decided to buy more of the small companies
00:27:17.520 | than the growth and value too.
00:27:22.000 | And so you can see every year,
00:27:24.160 | and you can make up a story about how investors felt
00:27:28.320 | about these different asset classes.
00:27:30.840 | And what I believe personally,
00:27:33.680 | and I don't know if anybody else,
00:27:35.280 | 'cause this is a judgment
00:27:37.680 | that I think many people would disagree with.
00:27:40.360 | I believe the future will look just like the past.
00:27:45.360 | Now, when I say just like the past,
00:27:49.500 | that there will be all these years
00:27:51.000 | with all these different configurations.
00:27:53.200 | Like last year, the S&P 500 was up 26%.
00:27:58.200 | It's been up 25 to 30% many, many times before.
00:28:03.600 | There's nothing new about that.
00:28:05.480 | It's just the market continues to reproduce returns
00:28:12.400 | as it has in the past.
00:28:14.360 | Not exactly, but close enough to say,
00:28:17.240 | well, I guess it does.
00:28:19.000 | The problem is it's the sequence of returns.
00:28:25.280 | I don't have any idea
00:28:27.360 | what the sequence of returns is gonna be.
00:28:30.840 | I just know that the returns are gonna flip-flop around.
00:28:33.960 | As a matter of fact, you probably know this,
00:28:36.640 | but from 1929 to 1938,
00:28:39.800 | the S&P 500 had a better return
00:28:44.800 | than from 2000 to 2009.
00:28:47.400 | They looked almost the same,
00:28:50.480 | except it was more volatile back in the '30s
00:28:54.120 | because there was less money in the market.
00:28:57.680 | And so the little bit of money
00:28:58.960 | pushed the market around quickly either way,
00:29:01.560 | which today there's a lot more liquidity than we had then.
00:29:04.960 | But the total 10-year period,
00:29:07.440 | it looked worse 2000 through 2009.
00:29:11.240 | We didn't see suplines.
00:29:13.920 | We didn't see the impact of it,
00:29:15.680 | but we saw the numbers.
00:29:18.520 | And I just believe the numbers are gonna be there again.
00:29:21.960 | I just don't know when,
00:29:25.480 | which makes that worthless information,
00:29:28.640 | except that maybe if you believed all of that,
00:29:33.400 | you would say, "Ah, I will have some in small,
00:29:35.720 | "and I will have some in value,"
00:29:38.280 | because it will all come over time.
00:29:40.880 | - All right, I've got one more topic
00:29:45.360 | I wanna discuss with you.
00:29:46.400 | But those collecting questions,
00:29:48.040 | if you can bring those up, that'd be great.
00:29:50.280 | So it sounds like you mostly believe it's a risk story.
00:29:54.520 | That's why the outperformance is there.
00:29:56.560 | How much can be attributed to behavior,
00:29:58.560 | that people just wanna own the invidias of the world?
00:30:01.360 | - John Bogle, I just got out my old copy,
00:30:05.200 | in fact, not the old copy,
00:30:06.600 | the updated copy from 2017
00:30:09.640 | of "The Little Book of Common Sense Investing."
00:30:13.200 | And what he says, he differentiates
00:30:15.800 | between investment return and speculative return.
00:30:19.960 | And one of the things I find fascinating,
00:30:23.560 | I had forgotten about this,
00:30:25.640 | is that we could be right on all the economics
00:30:30.640 | and the country could make a certain amount of money.
00:30:35.480 | And we don't know what premium people
00:30:41.200 | are gonna be willing to pay for securities.
00:30:43.920 | For example, in his study in the book,
00:30:46.680 | in 1980s and '90s, people paid over 7% a year
00:30:52.240 | what he calls speculative return.
00:30:54.440 | It did not have to do with the economics of the firms.
00:30:57.960 | It had to do with what people were willing to pay
00:31:01.400 | to get to pay to play, if you wanna look at it that way.
00:31:04.640 | Other years, like the '70s, people weigh underpaid.
00:31:11.040 | And the problem we have is not only can we not know
00:31:16.680 | what kinds of returns are gonna follow,
00:31:18.920 | what kind of returns,
00:31:20.560 | but we have no idea what that speculative aspect
00:31:24.480 | is going to be.
00:31:25.480 | But here's what he says in the book.
00:31:27.760 | His study shows that 9.5% of that 10% that people got
00:31:33.880 | from 1928 to whatever time this book was updated,
00:31:39.920 | 9.5% was from economics.
00:31:44.080 | One half of 1% came from speculation.
00:31:50.080 | Which says that, by God, when people are paying 7% more
00:31:55.080 | a year for the earnings of companies,
00:31:59.200 | and they do that over a 20 year period,
00:32:03.040 | you got a heck of a lot of risk looking at you there.
00:32:06.720 | And did we see it?
00:32:08.520 | Yes, we saw it from 2000 through 2009,
00:32:11.960 | because we lost money for 10 years
00:32:14.200 | after having 20 years of being over,
00:32:16.800 | of people willing to be overpaying for the earnings
00:32:20.560 | that these companies produce.
00:32:22.360 | - Okay, let's take a question from the audience.
00:32:25.720 | Academic research shows that machine learning models
00:32:30.400 | outperform Fama-French three factors,
00:32:33.520 | even Fama-French five factor models.
00:32:36.360 | Do you think AI machine learning
00:32:38.200 | will change the factor investing radically?
00:32:43.720 | - Well, I do believe that whether it will or will not,
00:32:48.720 | that it will convince people
00:32:51.920 | and everybody will have a market timing system based on AI.
00:32:56.920 | Everybody will have a, now when I say market timing,
00:33:01.320 | it could be just a numbers based,
00:33:04.240 | trend following kind of market timing system.
00:33:06.960 | It could be a system based on economic factors,
00:33:10.000 | inflation, et cetera.
00:33:13.120 | But people are going to be able to look
00:33:15.800 | at the past more carefully.
00:33:17.680 | I mean, look how far we've already come.
00:33:19.680 | We've come in the last 30, 40 years
00:33:23.120 | from not knowing that there was a small cap premium
00:33:27.440 | or a value premium and just really the last 10 or 15,
00:33:31.600 | I think quality became something that was been recognized.
00:33:35.080 | So there's no reason to think it won't find more.
00:33:40.520 | The question is how will we control the emotions
00:33:43.720 | of the people that follow all this?
00:33:46.480 | And the bottom line is we've come a long way.
00:33:49.040 | This room is filled with people
00:33:50.640 | who really do believe in index funds.
00:33:54.360 | And you're not alone.
00:33:56.080 | It's just a lot of other people
00:33:57.480 | have something else going on this weekend.
00:34:00.080 | But the fact is the society now believes in index funds
00:34:08.720 | and that changes the scope of investing
00:34:10.920 | because it means in theory, if I'm an investor,
00:34:13.920 | I just keep investing in my 401(k)
00:34:16.640 | and I trust that it's gonna be okay.
00:34:18.520 | So I don't stop investing when the market goes down
00:34:21.320 | because I own an index fund
00:34:23.040 | and index funds are to be trusted under all conditions.
00:34:27.600 | It may be that argument will work
00:34:29.880 | and people will stay the course.
00:34:31.880 | That changes things.
00:34:35.160 | I don't know exactly how,
00:34:37.220 | but I do know it means that more people
00:34:39.160 | are buying whatever the company is and holding it.
00:34:43.340 | Now, it also implies to me,
00:34:46.480 | it's the kind of thing that's,
00:34:48.040 | I'm a catastrophic thinker.
00:34:50.160 | My wife brings up any topic
00:34:51.960 | and I immediately think of all the reasons
00:34:53.880 | that's a scary thing to do.
00:34:56.200 | Just where my mind goes.
00:34:58.120 | My mind goes when I think of everybody investing
00:35:01.800 | and believing that we should buy and hold,
00:35:04.320 | I think what the heck happens
00:35:06.780 | when that is a tipping point and they stop believing that.
00:35:11.680 | And what a lot of you may not know in the '60s,
00:35:17.000 | there were times when people wanted to sell 100 shares
00:35:22.000 | of an over-the-counter stock,
00:35:24.940 | not on one of the big exchanges,
00:35:28.560 | they wanted to sell 100 shares and there was no bid.
00:35:33.520 | It was called WO, workout.
00:35:36.560 | We'll sell you 100 shares for 12,
00:35:39.060 | but we will not quote you a price
00:35:41.400 | to buy that 100 shares from you.
00:35:44.040 | So you don't know that today.
00:35:45.440 | You think you have this liquidity
00:35:47.320 | that we can always get out with a little tiny spread
00:35:50.600 | between the bid and ask.
00:35:52.520 | I don't know what it's gonna be like
00:35:54.320 | when everybody heads for the door at the same time.
00:35:59.220 | And like most of us, we plan on the society going straight
00:36:04.220 | and starting to live within our means after we die.
00:36:08.380 | Okay?
00:36:11.480 | Our kids have to take care of that.
00:36:13.580 | I guess I'm like everybody else.
00:36:15.220 | I feel that's gonna happen someday, but I'm gonna be dead.
00:36:18.340 | - Paul, our time is now gone,
00:36:22.540 | but thank you so much for coming and sharing with us.
00:36:25.400 | (audience applauding)
00:36:27.020 | - Thanks, Jim.
00:36:27.940 | (audience applauding)
00:36:31.100 | [BLANK_AUDIO]