(audience applauding) - All right, we've got some time now with a true giant in the field. I am excited to participate in this. Paul and I have been talking back and forth for the last month or so about what this is going to look like today. And we think it's gonna be really good and really educational and really useful for you.

So let me tell you about Paul, if you don't know. Paul is a nationally recognized authority on mutual funds, index investing, and asset allocation. After retiring in 2012 from Merriman Wealth Management, which he founded in '83, he created the Merriman Financial Education Foundation, dedicated to providing investors of all ages with free information and tools to make informed decisions in their own best interest, and successfully implement the Retirement Savings Program.

He is the author of eight books, twice as many as I've written, and writes a regular column for the Wall Street Journal's MarketWatch.com, and has a multi-award winning weekly podcast, Sound Investing, which has been named by Money Magazine as the best money podcast. In 2008, which was a really important year, don't get me wrong.

He has also been given a number of awards, the American Association of Individual Investors, James Clunan Award for Excellence in Investment Education, and as a Distinguished Alumni Award from Western Washington University School of Economics, and perhaps most importantly to him, a founding member of GlobalHelp, the Board of Directors of GlobalHelp, which is a non-profit that produces medical publications and distributes them to doctors and other healthcare workers in developing nations.

A very, very wonderful life that you've lived so far, Paul. Come on up here, let's get some more wisdom from Paul. (audience applauding) - Great. Thank you. I think this is working, yeah. - All right. Okay. Is this one still on? Keep us both on here. Please have a seat, Paul.

- Okay. - We're gonna talk about factor investing. - Wow. - And that's a pretty awesome topic, right? Those of you who've followed these discussions for the last five, 10, 15, 20, 25 years, know that there's a fair bit of controversy on the Bogleheads forum these days about factor investing, which is a very different situation than it was in 2004, when I walked onto that forum.

And so we're gonna talk a little bit about this, but let's start, Paul. Why don't you just tell us what we're talking about when we're talking about factor investing? - Well, when I came into the industry in 1966, the way that they differentiated between different kinds of investments, I think mostly were names made up by the marketing departments of the mutual fund companies, things like aggressive growth, capital appreciation, growth and income, dividends.

And then a number of years later, the academics got involved, and they looked deeper into the premiums, the additional returns that certain kinds of investments get. And so then we had a whole different way of looking at the returns on investments and legitimate ways to compare. And that kind of factor investing then is really using these individual kinds of investments to build a portfolio and to build the portfolio in the hopes that you will have diversification of different kinds of investments.

And I'll show you some information that just blows my mind how different these things can be. So the idea is to get a better unit of return per unit of risk by putting these factors that the academics came up with to use. - Okay, so let's get more specific.

I mean, when I look at the literature on factor investing, there's like 800 factors or 4,000 factors or something that's been identified. What factors are actually worth considering for an individual investor like yourself? - Well, I'm almost 81, and I can only do three. Value versus growth, size, large versus small.

And of course, the market is a factor itself, the decision whether you're going to be in the stock market or you're gonna be in the bond market. And the other one that's been more recently discovered and put to use that looks really great is quality or the financial stability of the companies that are in the portfolio.

So those are all factors that could then represent companies from all different industries. And those are the main ones. Other ones are oftentimes hard to get to, expensive to get to. Tax-wise, they're expensive to own, but those are the basics that you're going to get in the ETFs that we have choices from.

- Small value quality. - Yeah, and the market. - Okay, and of course, the overall market factor. Okay, now I promised Rick Ferry I'd ask you all the hard questions today, so I'm definitely gonna ask you the hard questions. Here's the first one. How do we know this isn't all just data mining and doesn't really exist in the first place?

We just pulled it out because we looked at a past data set. - Well, let me see if I can show you some numbers. Now, by the way, you're gonna see a whole bunch of numbers that you are not gonna be able to read from where you are. The good news is we put together a package so that if you go to paulmerriman.com/bh, as in Bogleheads, you can see all this stuff close and up front.

But let me see, in order for me to go forward. There we go. All right, all right. - I want you to pay attention to the colors here. We know you can't read the numbers on this chart, but pay attention to the colors. - I had no idea it would be this small.

The red colors are the S&P 500. This is going back to 1928. That basically is large growth. It's got some value in it, but large growth drives most of that return. You can't see it, but there's an electric blue color up there that is small cap value. Now, what we know about the S&P 500 is it's the highest quality asset class amongst this group, which means it should produce the lowest return.

But what's interesting is to notice how often the red is at the top. In other words, there's a lot of the time that S&P 500 does better than the others. And the blue, the small cap value is the most productive asset class, and yet you're gonna see it at the bottom of these from 1928 to 2023.

What really blows me away, this is what factor investing is meant to try to do, and that is that when you put together a 25% S&P 500, small cap value, small cap blend, and large cap value, not only is the compound rate of return about 2% better than the S&P 500, but you can't see it very well.

But if you could see the brown or the yellow, you would find that that four fund strategy is almost always right in the middle, never number one, never number four. And if you wanted to see that and have a breakdown of what percentage of the time it ended up in this particular quintiles, you will see the S&P 500 is the least productive 41% of the time and the most 28% of the time.

And when you have time, you will be able, if you are interested in this kind of information, to compare how they did overall. And what it leads me to believe is that putting these factors together has a great premium and reward for doing that. You just need to know the funds that you do it with.

- We'll talk about funds here in a minute, but first we gotta talk about something else. Paul, I started investing in 2004. It's now 2024. I've gone from being broke in 2004 to being financially independent in 2024. And I've been tilting my portfolio to small and value factors almost that entire time.

It has not paid off. I am way behind what I would have been if I had just used total market funds. Not only do I have lower performance, but I had lower tax efficiency. I have higher expenses. I mean, when you look at the long-term data, you see the small cap value is outperformed, quality's outperformed, et cetera.

But how long is the long run, Paul? How much longer do I have to wait? - Well, let me show you, whoops, not that one. Let me show you this one. - Yeah, see that really flat one at the end? That's me, that's my entire investing career. - Here's the reason that factor investing will not work for some people.

It really is a legitimate long-term strategy. As Warren Buffett says, his favorite holding period is forever. The idea is to understand that these asset classes are going to go through ups and downs for very long periods of time. And what Jim did was he bought at a time during which small cap value was kicking butt, remember?

- Oh yeah, I remember. We were all tilting to small cap value in 2004, 2005, 2006. - And it had been, as a matter of fact, over about a 15-year period, it doubled the return of the S&P 500. And that's when people get attracted to this kind of thing.

And guess what? What's the likely outcome of chasing performance? It doesn't work very well, right? Anybody agree? Yeah. And so the idea is to understand, I think, that these are asset classes that are meant to be held forever as a part of a portfolio. But what this particular telltale chart, and John Bogle developed, as far as we know, the telltale chart, and what it allows us to do is to compare the relative return of the S&P 500, in this case, to small cap value.

And what do we find out? Over the entire period, it's true that small cap value made about 12 times as much as the S&P 500. That's the good news. The bad news is that 80% of the time it wasn't adding any value. And so it is a type of an investment that you must have the ability to wait out that return.

And unfortunately, as this is a business of faith, the investment business is faith-based, where we all have our portfolios believing that they're gonna be okay, right? Well, we believe that small cap value will add performance over time. But you don't know. As a matter of fact, from 1975 to '99, the S&P 500 compounds at 17%, and since then, it has compounded at about 7.5%.

So that's the reality of being an investor. And proper diversification is what you got, is that if you are properly diversified, there are gonna be periods that you're not happy with some part of your portfolio. And I am sorry. (audience laughing) - I'm not blaming you, Paul, for certain.

- That's good. - But okay, let's talk about this. Somebody's still convinced. They're like, "Oh yeah, man, I'm 25. "I can hold on for the long run. "This is gonna pay off eventually. "I'm really impressed with the data." How much should you tilt your portfolio? How much should go into small value versus the overall market?

- Well, in all of these, in that paulmerriman.com/bh, there are about 200 tables there you can look at in charts and graphs and whatnot. This is part of a page of one of 'em. And what it shows here is the, this goes from 1970 through 2023. The rest of the page shows the annual returns.

This is the cumulative impact. And on the far left, we have the S&P 500 compounding at 10.7%, 100% S&P 500. When you add 10% small cap value, the return goes from 10.7 to 11. This is not life-changing, but it's in the right direction. And when you look at the worst six months, 12 months, 36, 60 months, the worst drawdown, you will see that the risk of loss is almost the same as being 100% in the S&P 500.

As you move across that page, it keeps getting better and better and at a slow pace for the combination and the additional risk. For example, if we look at 50/50, it looks to me like the worst 12 months is a loss of 46% versus 43% with 100% S&P 500.

Really not much difference. And yet the return goes from 10.7 to 12.4. Now the challenge we have is there is no risk in the past. We always know what we should have done, right? This is what we should have done, but we can't know that it will produce that same kind of additional return in the future.

But this table is our effort to show people what are the implications of adding small amounts of small cap value, for example. And we do the same with the four fund strategy or a three fund strategy. The idea is to look at different strategies, different combinations and the risk and return historically.

- You know what I've always said when people ask me how much should I tilt my portfolio? I tell them don't tilt more than you believe. You know, if you don't believe very strongly that this is going to outperform in the long run, don't make a big huge tilt.

If you believe very strongly, you can probably tolerate a larger tilt. It's a little bit like the price is right, right? When you're setting your stock to bond ratio. You want to get as close without going over your risk tolerance as you can. And I suppose it's the same way with small cap.

- I totally agree. As a matter of fact, my own portfolio, equity portfolio, and I'm 50/50 stocks and bonds, my wife and I are, but I'm half small cap and half large. I'm half value and little more than half value and little less than half growth. I'm half US, I'm half international.

And so I have not played any favorites. I have spread it across all of these major equity asset classes. And the only difference really here is that typically people build portfolios based on cap weighting, like the total market index or the S&P 500. We've been, we have learned from the academics that it is very important to also diversify amongst equity asset classes.

That's what they teach. I didn't create any of this information. All I've done is learn from others and try to pass it along. - What if they're wrong, Paul? What if you're wrong? What if, what data could come out that would suggest this is a bad idea? That would cause you to bail on this tilt you put in there?

- Well, let me see if I can show you here. I jumped that one. I love this table. This table are the results of 15 years of performance from six different small cap value indexes. Morningstar and S&P and the MS, Morgan Stanley, six major small cap value indexes. And the difference each year between the best and the worst is huge.

It averages about 3%. From the top to the bottom. What that tells us is these people are not doing what they do with the S&P 500 where the difference between the best and the worst will simply be the expense that is charged. And so you might have a 1/10 of 1% difference for the S&P 500.

So you can count on that depending on the expenses. That is not true. It is not true with small cap value. Or small cap blend. People, companies have developed their own and the question you need if you're gonna do this, how do you make sure that you get your money into the small cap value fund that is likely to perform the best?

I know, for example, the Russell 2000 value, it's a lousy, lousy small cap value index. And we know why it isn't very good. Because it has a lot of companies that are not very stable. They are companies in financial trouble. On the other hand, there are indexes where they have eliminated that part of the portfolio and tilted, another tilt, towards the profitability, towards the quality.

And what difference might, well I can tell you the last five years, AVUV, a fund that we happen to think highly of, had about twice the return, about 88% versus about 34% with a Russell 2000 index. They are about the same size companies. Everything else about them is very similar except for one thing, the quality of the portfolio.

So that's why I think the quality is important and size and the value orientation is going to be important. And so what we want you to do is, if you're going to do this, just be sure that you're getting into those ETFs that represent what we hope, and we can't know, will be the better performers.

- I'm not sure you answered the question I asked, but you answered one I meant to ask. So let's dive into this a little more and then we're gonna go back to the question I asked. You're suggesting Avantis is doing a pretty good job with these factor funds. Avantis, of course, those who aren't aware, Avantis is a bunch of DFA break-offs that went over there and started doing a bunch of small value ETFs 'cause the DFA folks apparently didn't want to.

Well, now there's DFA ETFs too. So Avantis you list as, if you wanna do this, that's a pretty good place to go. You're paying 25 or 35 basis points. - 25, at DFA you're paying 31. - Yeah, and so what else? What about the Vanguard small value funds? - Well, the challenge, what you get with Vanguard is you get a very low expense ratio.

And what you get from these other organizations like Avantis and DFA is you are getting strategies that require more work and they must charge more for it. For example, the Russell 2000 Index, they rebalance basically or reconstitute that once a year. And when it's reconstituted, there's a cost to the shareholders of getting out of the companies they gotta get out of and getting into the new companies they need to get into.

Now, what Avantis does is they reconstitute during the year one stock at a time. And so they don't wait around for a year and they also are not being burdened with the expense when everybody tries to rush in or everybody tries to rush out. It is being done at a cost that you're gonna pay more.

But when you see the difference in return over the years, I think most people would agree that it is worth the price of admission. And so this is always, if you're talking about the S&P 500, obviously, that's an easy decision to make the lowest fee. But let's be honest, we can all go to Fidelity and we can buy the S&P 500 without any expense at all, right?

We can, but we don't because we honor the man that started this. Which means that there is an emotional part of the decision that we make. It's sometimes about who we trust and who we want to do business with. I can just tell you from my knowledge of the people at Advantis and DFA, if you wanna go someplace and get an education, their websites are a great place to get an education about factor investing.

- You know, it wasn't that long ago that we thought 20 basis points was a great price for a mutual fund. And now it's four, three, zero at Fidelity that we can, investing has basically become free for the masses now. And so we don't wanna pay anything for it, even though not that long ago, 20 basis points seemed pretty awesome.

- I will note that if people go to our website and take our recommendations, it's free. So we're a Vanguard fan through and through. We're trying to bring it as low cost as we can for what we're doing. And what you gotta do, I hope, is check us out to see if we know what we're talking about.

And all we're doing is bringing what we've learned from the academic community. And it shows up in these tables that either we make or other people make to help you make a decision. - Okay, now we're gonna go back to that question. - Yes, what was that question? - I mean, a lot of this we get from looking back at 100 years of data and we say small value outperformed over that 100 years.

What kind of data would convince you to stop tilting your portfolio to factors? What if it was so poor for another 20 years that it's now underperforming large growth over 120 years? Would that be enough or what would dissuade you from being a factor investor? - This is gonna shock you, but I'm not thinking 120 years.

(audience laughing) I do not think. What would it take for me to decide that there is not a small cap premium or a small cap value premium or a large cap value premium? You would have to turn the way people believe that investing works upside down to conclude that.

Because if we can conclude that, we could conclude that bonds are better than stocks. Now you may think that is crazy, but in 1925, people believed that bonds were investments and stocks were nothing but speculations. They did not believe that stocks were a good investment for the long term.

And they were wrong from what we know about the rest of that story. But small cap is more risky. Value is more risky. There's a reason that they sell for half the P/E ratio of growth. And so the question is, if they are more risky, will they have to pay a premium for people to put money in those companies?

And yes, they will have to, at least as a group, or people will make the decision to get out of them, at which point they'll go down in value and then they'll work. But in the long run, it's the way, from everything we know, when we look at this other thing I showed you with all those, the quilt chart back to 1928, they all did what they said they were gonna do.

The S&P 500 had the lowest return. Small cap value had the highest. Large cap value was second from the bottom. And the small cap blend was next. And if you go back and look at the years, what you're gonna find this kind of fun, at least my idea of fun, is you're gonna look at a year and say, wait a minute, look at this.

Small value and large value did the best that year. Large blend and small blend didn't do well. And sometimes there's a 10, 15, 20, even 30% difference from the top to the bottom. Other years, small cap value and small cap blender at the top, but large value and large blender at the bottom.

Obviously, for some reason, investors decided to buy more of the small companies than the growth and value too. And so you can see every year, and you can make up a story about how investors felt about these different asset classes. And what I believe personally, and I don't know if anybody else, 'cause this is a judgment that I think many people would disagree with.

I believe the future will look just like the past. Now, when I say just like the past, that there will be all these years with all these different configurations. Like last year, the S&P 500 was up 26%. It's been up 25 to 30% many, many times before. There's nothing new about that.

It's just the market continues to reproduce returns as it has in the past. Not exactly, but close enough to say, well, I guess it does. The problem is it's the sequence of returns. I don't have any idea what the sequence of returns is gonna be. I just know that the returns are gonna flip-flop around.

As a matter of fact, you probably know this, but from 1929 to 1938, the S&P 500 had a better return than from 2000 to 2009. They looked almost the same, except it was more volatile back in the '30s because there was less money in the market. And so the little bit of money pushed the market around quickly either way, which today there's a lot more liquidity than we had then.

But the total 10-year period, it looked worse 2000 through 2009. We didn't see suplines. We didn't see the impact of it, but we saw the numbers. And I just believe the numbers are gonna be there again. I just don't know when, which makes that worthless information, except that maybe if you believed all of that, you would say, "Ah, I will have some in small, "and I will have some in value," because it will all come over time.

- All right, I've got one more topic I wanna discuss with you. But those collecting questions, if you can bring those up, that'd be great. So it sounds like you mostly believe it's a risk story. That's why the outperformance is there. How much can be attributed to behavior, that people just wanna own the invidias of the world?

- John Bogle, I just got out my old copy, in fact, not the old copy, the updated copy from 2017 of "The Little Book of Common Sense Investing." And what he says, he differentiates between investment return and speculative return. And one of the things I find fascinating, I had forgotten about this, is that we could be right on all the economics and the country could make a certain amount of money.

And we don't know what premium people are gonna be willing to pay for securities. For example, in his study in the book, in 1980s and '90s, people paid over 7% a year what he calls speculative return. It did not have to do with the economics of the firms. It had to do with what people were willing to pay to get to pay to play, if you wanna look at it that way.

Other years, like the '70s, people weigh underpaid. And the problem we have is not only can we not know what kinds of returns are gonna follow, what kind of returns, but we have no idea what that speculative aspect is going to be. But here's what he says in the book.

His study shows that 9.5% of that 10% that people got from 1928 to whatever time this book was updated, 9.5% was from economics. One half of 1% came from speculation. Which says that, by God, when people are paying 7% more a year for the earnings of companies, and they do that over a 20 year period, you got a heck of a lot of risk looking at you there.

And did we see it? Yes, we saw it from 2000 through 2009, because we lost money for 10 years after having 20 years of being over, of people willing to be overpaying for the earnings that these companies produce. - Okay, let's take a question from the audience. Academic research shows that machine learning models outperform Fama-French three factors, even Fama-French five factor models.

Do you think AI machine learning will change the factor investing radically? - Well, I do believe that whether it will or will not, that it will convince people and everybody will have a market timing system based on AI. Everybody will have a, now when I say market timing, it could be just a numbers based, trend following kind of market timing system.

It could be a system based on economic factors, inflation, et cetera. But people are going to be able to look at the past more carefully. I mean, look how far we've already come. We've come in the last 30, 40 years from not knowing that there was a small cap premium or a value premium and just really the last 10 or 15, I think quality became something that was been recognized.

So there's no reason to think it won't find more. The question is how will we control the emotions of the people that follow all this? And the bottom line is we've come a long way. This room is filled with people who really do believe in index funds. And you're not alone.

It's just a lot of other people have something else going on this weekend. But the fact is the society now believes in index funds and that changes the scope of investing because it means in theory, if I'm an investor, I just keep investing in my 401(k) and I trust that it's gonna be okay.

So I don't stop investing when the market goes down because I own an index fund and index funds are to be trusted under all conditions. It may be that argument will work and people will stay the course. That changes things. I don't know exactly how, but I do know it means that more people are buying whatever the company is and holding it.

Now, it also implies to me, it's the kind of thing that's, I'm a catastrophic thinker. My wife brings up any topic and I immediately think of all the reasons that's a scary thing to do. Just where my mind goes. My mind goes when I think of everybody investing and believing that we should buy and hold, I think what the heck happens when that is a tipping point and they stop believing that.

And what a lot of you may not know in the '60s, there were times when people wanted to sell 100 shares of an over-the-counter stock, not on one of the big exchanges, they wanted to sell 100 shares and there was no bid. It was called WO, workout. We'll sell you 100 shares for 12, but we will not quote you a price to buy that 100 shares from you.

So you don't know that today. You think you have this liquidity that we can always get out with a little tiny spread between the bid and ask. I don't know what it's gonna be like when everybody heads for the door at the same time. And like most of us, we plan on the society going straight and starting to live within our means after we die.

Okay? Our kids have to take care of that. I guess I'm like everybody else. I feel that's gonna happen someday, but I'm gonna be dead. - Paul, our time is now gone, but thank you so much for coming and sharing with us. (audience applauding) - Thanks, Jim. (audience applauding)