Bogleheads University 501 2023 - The Case for Factor Investing with Paul Merriman
00:00:00.000 | (audience applauds)
00:00:03.000 | You're gonna get Paul Merriman,
00:00:07.560 | because Paul Merriman is here, and I'm excited about that.
00:00:09.960 | He's a nationally recognized authority
00:00:12.280 | on mutual funds, index investing, and asset allocation.
00:00:15.520 | He retired in 2012 from Merriman Wealth Management,
00:00:18.780 | which he founded in 1983,
00:00:20.920 | and basically dedicated himself at that point
00:00:23.720 | to just educating as many people as he possibly could
00:00:26.240 | for free about financial literacy.
00:00:29.280 | He's the author of eight books.
00:00:30.840 | He writes a regular column for MarketWatch,
00:00:33.360 | and produces a multi-award-winning weekly podcast,
00:00:36.460 | Sound Investing, and he's got over 30,000 subscribers
00:00:40.720 | to his twice-monthly newsletter.
00:00:43.520 | More recently, he has made a massive donation
00:00:46.480 | to boosting financial literacy at a university in his state.
00:00:51.000 | So thank you for that, Paul, and congratulations on that.
00:00:54.560 | - I really am excited to be here.
00:00:57.240 | This is on my bucket list.
00:00:59.400 | Some people want to go to other parts of the world
00:01:01.840 | when they retire.
00:01:03.200 | I've been waiting to be here for 10 years.
00:01:06.000 | So I am, I, yeah. (audience applauds)
00:01:10.040 | It's really, it's very exciting,
00:01:12.780 | and I am not here, really, to debate Rick Ferry.
00:01:17.300 | I really am here to share some information
00:01:20.740 | that I think could help you make more money
00:01:23.840 | with your portfolios, nothing more than that.
00:01:26.840 | We are simply a nonprofit organization
00:01:30.000 | feeding people information that we hope
00:01:33.120 | will help them understand ways to combine
00:01:35.880 | different kinds of equity asset classes.
00:01:39.880 | We are not investment advisors.
00:01:42.320 | We are not financial planners.
00:01:44.960 | We are teachers, and that is all we are.
00:01:48.920 | So as your teacher for a few minutes here today,
00:01:53.240 | I want to make the case for small-cap value
00:01:56.880 | as a factor in your portfolio,
00:02:00.480 | and I want to make it based on information that I trust,
00:02:03.400 | and I mention that because I ran into a gentleman last night,
00:02:07.160 | a friend from many, many years ago.
00:02:10.400 | He doesn't believe in small-cap value.
00:02:12.640 | It was not Rick. (audience laughs)
00:02:15.880 | And I wanted to know why,
00:02:17.920 | because there's so much great information.
00:02:20.560 | He doesn't trust the path, the returns,
00:02:24.520 | or the studies that have been done,
00:02:27.200 | and we are in a faith-based industry, like it or not,
00:02:32.040 | and since that's the way it is,
00:02:34.520 | if he doesn't trust those numbers,
00:02:36.800 | then I understand that he shouldn't be using small-cap value.
00:02:41.300 | I use numbers that I'll share with you,
00:02:43.540 | many more than many people like,
00:02:45.420 | that make me trust it, that come from people
00:02:49.860 | that I trust have developed the numbers from the past
00:02:53.700 | that I can recommend, in a sense, to other people.
00:02:56.680 | So let me talk about the truth of small-cap value,
00:03:01.680 | the good, the bad, and the ugly, and let me tell you,
00:03:05.520 | the ugly is about as ugly as it can get,
00:03:08.800 | and if a person's not ready for that ugliness,
00:03:11.820 | then they shouldn't be in it,
00:03:13.280 | and by the way, that could be true
00:03:14.600 | of the stock market as well.
00:03:16.480 | It all starts with this simple table
00:03:18.840 | that shows the long-term return
00:03:21.400 | for the four major U.S. equity asset classes.
00:03:25.200 | I started making this table in 1995,
00:03:28.780 | and every year, we update it,
00:03:30.680 | and what it shows is that large-cap blend,
00:03:34.080 | or the S&P 500, is compounded at about 9.8%,
00:03:39.080 | large-cap value higher, small-cap blend higher,
00:03:43.280 | small-cap value at 13.2.
00:03:46.640 | Now, what's fascinating to me is
00:03:48.760 | a lot of people don't trust that 13.2,
00:03:52.840 | because if you trusted it,
00:03:54.160 | wouldn't you wanna have some of it
00:03:56.160 | if it didn't take your risk over the top,
00:03:58.680 | which, of course, is the big question.
00:04:00.880 | So, if we could believe that short-term bonds
00:04:05.880 | make less than intermediate bonds, or long-term bonds,
00:04:10.560 | or governments make less than corporate,
00:04:14.560 | or junk bonds make more than high-grade,
00:04:17.760 | if we could believe all of those things,
00:04:19.260 | why is this such a big leap of faith?
00:04:23.700 | So, I'm going with what I'm seeing here,
00:04:26.960 | and I want some of that 13.2.
00:04:29.600 | I want it for my portfolio,
00:04:32.000 | and I've got a brand-new granddaughter.
00:04:33.980 | We gave her money last November when she was born,
00:04:38.200 | half in S&P 500, half in small-cap value
00:04:41.560 | for the rest of her life.
00:04:44.120 | And if you wanna know why half in S&P 500,
00:04:47.880 | I don't have time.
00:04:49.040 | This is one of the greatest teaching tools I've ever seen.
00:04:55.120 | Daryl Balls is our director of analytics,
00:04:59.160 | total volunteer, as is Chris Patterson,
00:05:04.400 | who also works with me on this project.
00:05:07.360 | What this shows is the rate of return.
00:05:09.240 | I know it's too small.
00:05:10.560 | Many of you don't have your computers,
00:05:12.280 | but let me just tell you what it shows.
00:05:14.400 | One year at a time since 1928,
00:05:17.320 | how did the S&P 500 do?
00:05:19.040 | How did small-cap value do?
00:05:20.400 | How did large-cap value do?
00:05:22.400 | How did all of the major asset classes do?
00:05:26.440 | And he color-coded them for us.
00:05:28.800 | So, when you get home and you pull up the PDF on this,
00:05:33.300 | you can look at these,
00:05:34.800 | and you're gonna be able to look at 90-plus years of returns
00:05:40.480 | and see how wild and crazy it is.
00:05:43.080 | I mean, there's nothing low-risk about the S&P 500.
00:05:46.200 | It's at the top, it's at the bottom.
00:05:47.800 | I mean, it's all over the place.
00:05:49.520 | So is small-cap value.
00:05:52.120 | And so, one of the things this does,
00:05:53.780 | because the green is the S&P 500,
00:05:56.680 | by the way, the green is supposed to give us
00:05:59.320 | the lowest rate of return.
00:06:01.360 | Why?
00:06:02.180 | Because it's the highest quality of the four.
00:06:05.080 | But Daryl surprised me.
00:06:06.320 | He's always got a surprise in a new table.
00:06:09.280 | He threw in the four-fund strategy.
00:06:11.880 | What would happen if you put those four asset classes,
00:06:15.680 | including the small-cap value,
00:06:18.400 | if you put them together in one portfolio,
00:06:21.160 | and you rebalanced them every year?
00:06:23.520 | How much more risky would that be than the S&P 500?
00:06:26.920 | That is the pink.
00:06:28.960 | And where is the pink?
00:06:30.420 | The pink is in the middle.
00:06:32.880 | Why is it in the middle?
00:06:34.340 | Because it picks up some of the value of all four,
00:06:37.800 | but it's never the best and it's never the worst.
00:06:41.080 | So if you had a portfolio that was 25% small-cap value,
00:06:44.860 | that's a lot, and 75% these other three assets,
00:06:49.860 | and you were running around the middle all the time,
00:06:52.520 | if the rate of return was better than the S&P 500,
00:06:56.160 | would it not be a better investment?
00:06:58.680 | Anybody vote for yes?
00:07:01.560 | Not enough.
00:07:06.160 | So then a couple years later, he does another table,
00:07:08.680 | but this time, and I'm just giving you the results,
00:07:11.600 | so you'll see why I think this is so powerful.
00:07:14.480 | Here, what we have at the top,
00:07:16.240 | we have U.S. small-cap value, 13.4%
00:07:20.720 | over that whole period of time.
00:07:22.560 | At the bottom, we have the S&P 500.
00:07:25.280 | I want you to notice something here.
00:07:27.520 | Those two are normally at the top or at the bottom
00:07:30.920 | because the other three are combinations
00:07:33.860 | of these major asset classes.
00:07:37.000 | What I love is the S&P 500 is 10.2.
00:07:41.660 | The two-fund strategy that my granddaughter
00:07:44.060 | is going to retire on is 12.2.
00:07:48.860 | Every half a percent would mean at least
00:07:52.820 | a couple million more dollars to her, that difference.
00:07:56.620 | And so I think that's a slam dunk
00:07:58.980 | because that too, it doesn't end up at the top,
00:08:02.280 | it doesn't end up at the bottom.
00:08:03.700 | The two-fund strategy, that's what we're looking for.
00:08:07.620 | Less volatility, better returns.
00:08:11.260 | I call that Ben Felix.
00:08:12.480 | I think one of the finest educators,
00:08:15.180 | could we agree on that?
00:08:16.460 | Ben Felix is the finest, one of the finest educators,
00:08:22.380 | I'm talking about YouTube pieces, on investing.
00:08:24.780 | How many follow Ben out of curiosity?
00:08:26.620 | Yes, and I just think he does a marvelous job.
00:08:29.860 | I called Ben, I said, "Ben, I've gotta face Rick.
00:08:34.320 | "Give me something I could bring here
00:08:36.140 | "that Rick isn't prepared for."
00:08:38.820 | And he gave me something that's just marvelous.
00:08:43.180 | He gave me a study he was working on that showed,
00:08:45.940 | remember the lost decade from 2000 to 2009?
00:08:49.020 | That was a big surprise.
00:08:50.040 | That kind of stuff doesn't happen very often.
00:08:52.420 | He went back to 1927.
00:08:54.140 | He looked at every 120 month consecutively
00:08:59.420 | to call those all decades.
00:09:01.100 | He found out that there were 145 lost decades
00:09:05.700 | for the S&P 500 over that period of time.
00:09:09.560 | So lost decades are not uncommon.
00:09:12.660 | And by the way, there's a lot of repeats there
00:09:14.860 | because you're going one month at a time
00:09:16.580 | to start a new period of time.
00:09:18.540 | But here's what I like.
00:09:20.700 | Even if small cap value does not make you a lot richer,
00:09:25.320 | we do at least know this, that looking backward,
00:09:27.860 | if we looked at the 145 lost decades for the S&P 500,
00:09:32.140 | how did small cap value do for those same periods?
00:09:37.100 | And it turns out in 78, 74%, 108 of the 145,
00:09:42.100 | small cap value made money.
00:09:48.640 | And that if you looked at every one of those 145 decades
00:09:52.660 | that the S&P 500 on average lost 2.3,
00:09:57.020 | small cap value made 6.45.
00:10:00.660 | And I'm thinking, I mean, I can't tell you
00:10:03.420 | that every little number that was ever added up
00:10:05.880 | in all of these studies is exactly right.
00:10:08.740 | I'm a salesperson.
00:10:09.900 | We don't focus on details, right?
00:10:13.860 | The bottom line is this tells me
00:10:15.940 | there is something there worth, oh, and I love this.
00:10:19.580 | We have over 200 tables that kind of look like this.
00:10:25.500 | So they aren't for today, and I understand that.
00:10:28.580 | But I wanted to give you something
00:10:30.020 | that where you'd have a piece of paper,
00:10:31.780 | you could compare small cap value in the S&P 500.
00:10:36.020 | You could look at it one year at a time.
00:10:37.900 | You could look at it all small cap, all S&P,
00:10:41.380 | 50, 50, 40, 60, 60, 40, 80, 20, you got it?
00:10:44.580 | Every combination here, all those years going from 1970,
00:10:49.580 | I'm sorry, yeah, 1970s through 2022,
00:10:55.020 | and we can find out how did they each do.
00:10:57.660 | And then we could even pretend we invested in them.
00:11:00.980 | And here's what I like.
00:11:03.140 | I mean, this really, I think, is mind-bending.
00:11:06.840 | By adding 10%, on the far left, we have the S&P 500.
00:11:11.640 | You can't see it, it's 10.4%.
00:11:14.100 | That was the compound rate of return.
00:11:15.720 | The worst 12 months was a loss of 43.3.
00:11:18.860 | The worst drawdown was a loss of 51.
00:11:22.500 | If you were adventuresome enough
00:11:24.580 | to put 10% into that portfolio,
00:11:27.420 | instead of 10.4, you have gotten 10.8.
00:11:30.780 | Instead of, oh, well, of course,
00:11:31.980 | now you're gonna have bigger losses.
00:11:33.600 | Yeah, 6/10 to 1% in both cases.
00:11:37.460 | Standard deviation is still the same.
00:11:40.540 | In fact, personally, I don't mind moving
00:11:42.980 | further over to the right and saying,
00:11:45.260 | look, this is not taking big risk.
00:11:48.100 | This is not like cryptocurrency.
00:11:52.220 | In fact, what we're doing, if you think about it,
00:11:55.100 | if we add it to the S&P 500,
00:11:57.220 | we go from having 500 stocks
00:11:59.300 | to maybe having 2,000 or 1,500.
00:12:02.820 | And yeah, one by one, they aren't great quality,
00:12:05.940 | but not are all the S&P 500 companies.
00:12:09.140 | Hey, are you keeping time?
00:12:15.460 | By the way, I have no idea.
00:12:16.980 | I wanna look at it two ways,
00:12:20.380 | 'cause I'm not gonna get through all the slides.
00:12:21.880 | By the way, if you do look at the PDF
00:12:23.940 | that we provided to the folks here,
00:12:27.220 | it not only has these slides,
00:12:29.160 | but two nights ago, I made a 45-minute presentation
00:12:32.100 | about this to AAII.
00:12:34.380 | All the slides are in the PDF,
00:12:36.460 | and there are some killer slides I can't show you today.
00:12:39.320 | Here we have the S&P 500 on one side,
00:12:44.800 | small-cap value on the other.
00:12:46.260 | Same thing, except we put money to work.
00:12:48.700 | Starting in 1970, $1,000.
00:12:51.900 | This is something your grandkids
00:12:53.180 | or your kids need to know about.
00:12:55.460 | And you put away monthly, $83.33,
00:12:59.340 | and then every year, you up that by 3% a year
00:13:02.220 | so that you were kind of replicating
00:13:03.820 | what inflation might have been.
00:13:05.960 | And then what happened is you put it into the S&P 500 only.
00:13:11.300 | That's the far left-hand column.
00:13:13.380 | And at the end of that period, I don't read well,
00:13:16.180 | but I think it's around three-plus million dollars.
00:13:20.460 | Well, I do read well, but not from this distance.
00:13:23.780 | If I look at the small-cap value,
00:13:25.700 | it's a holy moly, it looks like well over 20.
00:13:30.700 | - Can you actually read that?
00:13:33.080 | - Yes, I can.
00:13:34.400 | Of course, I sleep with this, understand?
00:13:36.500 | But every time you add a 10% small-cap value,
00:13:41.940 | you can see what happens to the bottom line.
00:13:44.900 | It goes up by about $500,000 a year, I mean, per column.
00:13:49.900 | That's important, and that's good.
00:13:54.380 | But if you think that's good,
00:13:55.600 | I wanna talk to any fire movement.
00:13:57.620 | Is Brad Barrett here today by chance?
00:14:00.220 | And no fire movement people here?
00:14:02.900 | Well, let me tell you, they're standing behind you
00:14:06.220 | because they're trying to learn how to invest
00:14:08.380 | like you're investing, but they're young
00:14:10.860 | and they wanna retire at 40, 45, or 50.
00:14:14.940 | This next chart, table I'm gonna show you,
00:14:18.200 | instead of being a accumulation table,
00:14:21.140 | it's gonna be more aligned to what we might be thinking,
00:14:23.500 | and that is distributions in retirement.
00:14:27.400 | Now, yes, this is all equity on this page,
00:14:30.340 | but please understand that I'm having this replicate
00:14:34.700 | the equity portion of your portfolio, okay?
00:14:38.660 | So you may only have 20% in equity,
00:14:40.820 | but I want you to see what happens here.
00:14:43.820 | And what we have with the S&P 500,
00:14:45.820 | starting with a million dollars, taking out $40,000,
00:14:48.700 | increasing that by real inflation every year
00:14:51.820 | over this period of time,
00:14:53.600 | you would have taken out about $8.5 million
00:14:56.380 | over that 53-year period,
00:14:58.540 | and at the end of that period with the S&P 500,
00:15:02.300 | you would have been left with about $9 million.
00:15:04.980 | I do not know anybody I've ever met
00:15:07.340 | that would say that was not a good outcome.
00:15:11.800 | Now, it's all equity, so I'm not recommending
00:15:14.000 | we go put all of our money in equity for retirement,
00:15:17.400 | but that shows in the equity part.
00:15:19.800 | But I just wanna go one tiny step to the right
00:15:23.520 | and add 10% small-cap value.
00:15:28.240 | And when I first saw this, I actually didn't believe it.
00:15:31.660 | I said, "Daryl, there's something wrong."
00:15:34.520 | And then he went through the whole thing,
00:15:35.960 | line item by line item, confirmed everything was right.
00:15:39.320 | Instead of $9 million, it's about $25 million.
00:15:42.360 | Because that's that impact of that 4/10 of 1%,
00:15:49.000 | and I'll tell you what else it is,
00:15:50.320 | and this is why I love adding other asset classes
00:15:53.920 | to the S&P 500,
00:15:56.640 | that when we look at that period, 2000 through 2009,
00:16:00.600 | what we know is that was not good for the S&P 500.
00:16:07.480 | And so you actually, over that period of time,
00:16:09.840 | you went from about, let's say,
00:16:10.960 | $6 million down to about $3.7 million.
00:16:14.520 | Over in the, let's take the 50-50,
00:16:16.800 | you were at $22 million in the beginning,
00:16:18.960 | and you ended at $31.
00:16:20.560 | How can the S&P 500 be dropping like a rock?
00:16:25.560 | Oh, I didn't see your fingers.
00:16:27.000 | Mike, I've got five.
00:16:27.840 | - [Mike] We're running out of time.
00:16:29.600 | - Okay.
00:16:30.440 | Look at the table.
00:16:33.940 | (audience laughing)
00:16:35.440 | And I am out of time, but I want you to see this,
00:16:37.540 | and look at the PDF.
00:16:39.080 | Here is why people can shy away from small-cap value.
00:16:43.500 | Every time you see a green area,
00:16:45.120 | small-cap value's doing well,
00:16:46.560 | but every time you see it moving sideways
00:16:48.560 | next to the S&P 500,
00:16:50.360 | it means it's not doing better than the S&P 500,
00:16:53.400 | which means over half of the time,
00:16:55.040 | you were not doing any better than the S&P 500.
00:16:58.340 | And if you're an advisor, and you're advising clients,
00:17:03.720 | and you're not doing well,
00:17:05.520 | and they're looking at that,
00:17:06.340 | what's that small-cap value in there for?
00:17:09.600 | And it's because they don't wanna hold it
00:17:11.840 | for 17 years to get the premium.
00:17:14.140 | It is not easy.
00:17:15.640 | And then I'm gonna go forward here and just show one more.
00:17:18.840 | And that is, Avantos did this study.
00:17:22.800 | We're gonna write it up.
00:17:23.720 | I think it's a beautiful study.
00:17:25.260 | Show the return of six different small-cap value indexes,
00:17:29.600 | six different small-cap growth indexes,
00:17:32.160 | six different small-cap blend indexes.
00:17:35.920 | And the difference between the best index over 15 years
00:17:40.560 | and the worst was about 2 1/2%.
00:17:44.160 | I mean, you could be in growth or small-cap or core,
00:17:47.840 | small in an index, and simply be in the wrong index,
00:17:52.280 | which it means that we need to understand
00:17:55.160 | how indexes are being constructed
00:17:57.280 | if we're gonna be an index investor.
00:18:01.800 | That's Boot Camp on our website.
00:18:04.300 | That's me teaching classes.
00:18:06.460 | These are free books.
00:18:07.920 | My time is up.
00:18:08.920 | Thank you, Jim, and thank you all.
00:18:10.600 | (audience applauding)
00:18:13.760 | (upbeat music)
00:18:16.340 | [BLANK_AUDIO]