>> Okay, in alphabetical order, I'd like to introduce the panel members. You all have the long bios in your welcome kit, but at the same time, I'm going to do just short introductions. First of all, our first panelist is co-founder of Efficient Frontier Advisors and author of several successful titles on finance and economic history.

Please welcome our real vocal and favorite, Dr. Bill Bernstein. Our next panelist is the founder of the low-cost investment management firm, Portfolio Solutions, author of six investment-related books, Forbes.com columnist, and a Wall Street Journal Experts contributor. Please welcome Rick Ferry. Our next panelist is the founder of WealthLogic. He's an author, and he writes for CBS Money Watch and other publications.

Please welcome Alan Roth. Our final panel, our next panelist is a retired former chief investment officer at Vanguard. He now serves as a senior consultant to Vanguard. Please welcome Gus Salter. And our final panelist is -- who's not on the agenda, but is going to join us, is none other than the founder of Vanguard, Mr.

Jack Bogle. -This is my day to listen instead of talk. And they kind of conned me into being part of the panel, which I'm happy to do if they want. I think you will find probably quite a bit of silence from me. Quite a bit of silence from me.

Can you hear me back there? Quite a bit of silence from me. That doesn't mean I'm not interested in what's going on. This is a terrific panel, and Gus has just been a huge asset ever since, I guess, September of 1987, and a good friend of mine. One of the best people around, as well as being a brilliant guy to run the index fund.

A man filled with ideas, filled with convictions, filled with passion about the work he's doing. So I salute you, Gus, again for the job you did this morning. I actually wanted to be up here to make a quick announcement. I just haven't been able to get up since I sat down.

That's why I'm on the panel. But a couple of things. One, I'm reminded of a story they tell about John Quincy Adams of his aging years, sick in bed. And a friend comes to see him, and he says, "How is John Quincy Adams today?" John Quincy Adams looks at him and says, "John Quincy Adams has never been better in his entire life.

Things are wonderful. He's at the top of his game." However, the house to John Quincy Adams is falling down. And that's the way I feel now. 'Cause everything seems to be going wrong. I have to get out of here and get a CAT scan on my shoulder to see if there's something going on down there nobody knows about.

So I will not be able to be here for the other panel. But I did want to just take this opportunity to thank you all so very much. I've had so many nice compliments. You're thanking me for things that any ordinary person would have done in the course of a long career.

And I put myself in the ordinary category, but I did have a couple of good ideas. And it turns out, world-changing ideas. In fact, just as Gus said, indexing is changing the world of investing. And so I feel very good to have been a part of that and even a leader.

And on that point, by the way, I think it's okay for me to say this. I mentioned the other morning that I had written a letter to the editor of the "Wall Street Journal" telling him that the real Nobel laureate that influenced me was Paul Samuelson. But I'd never heard of Gene Fama.

At that time, at that time. And that Gene Fama's conviction was so great that he started his own-- was that formation the inspiration for a fund group, but not an index fund group. He's a DFA guy. He believes that the markets, despite the efficient market hypothesis, please have permanent, persistent inefficiencies.

So I had a little note from the guy. It's a long, long letter to the editor, very long. Most of them are 150, 200 words. This is almost 500. And when I got back to the office yesterday, I think I was there sometime-- my yesterday was quite a-- I got back home from New York.

You can probably see that safely. But they're going to publish it tomorrow. Or they say they are. Count on nothing. I mean, this is well-intentioned. Funny things happen on the way to the-- getting on to the journal op-ed page. And so we'll see if they publish it. But that's just a clue.

I'll put it on the Global Heads website on Monday, because this weekend, I'm not going to work. Two more things to say. I want us to thank Kevin for his loyalty over all those years. Couldn't have done it better, Kev. I see you back there. I know you're hiding.

More than worthy, since you're dead. To Kevin. And we have kind of a good time around the office. I come in-- as I come in, you know, it's like the teacher coming into the classroom. And there are Mike and Sarah and Emily chatting up a storm and laughing. I come in, silence.

Here he comes. And finally, if I can just say something that struck me about Bill Bernstein's remarks yesterday. And that is that I love some of the Jewish language expressions. I have a lot of very good friends, many from New York, who use these expressions all the time. So I talk about, like, the self-evident Jewish expression.

Everybody-- you don't have to be told what it means when someone says, "He's a real schmuck." Right? The first time I was called a mensch, which Bill called me the other day, I had no idea what he was talking about. He said, "It means something better than a schmuck." So thank you all.

And that's probably the last you'll hear from me, so have a safe trip back. And I'll be on my way before the next panel takes place. So thank you again. One of the things we like to do, just in case you don't know it, is the panel members pay their own way, just like everybody else does.

So one of the things we do, it's a non-commercial event, but we still let them plug the latest thing that they're doing. So I'd like to give everybody a chance to let us and the audience know what you're up to. Do you have a new book coming out? Have you done any papers?

And Gus, I'm sure we'd love to hear what you're doing since you retired and how retirement life is agreeing with you. Can we go down the line? Rick, I heard you got a new book out, and I heard you recently did a white paper. So do you want to tell the people about those items?

Sure. I published a white paper, if those of you who are interested, on my website, rickferry.com. And the white paper had to do with a case for index fund portfolios. We always look at index funds in each category of investing, and we look at the performance of an index fund, let's say an S&P 500, relative to large cap actively managed funds.

We look at the performance of the Vanguard total bond market in relation to actively managed bond funds, and so forth in each category. And Vanguard does an excellent job with a white paper every year called "A Case for Index Funds" or "The Case for Index Funds," where they look at each of these categories.

But I thought it would be interesting to take multiple index funds from multiple categories and put them together in a portfolio, and then measure the performance of a portfolio of index funds relative to a portfolio or 5,000 randomly selected portfolios of actively managed funds in the same categories. So this study looks at the dynamics of how putting multiple index funds in a portfolio act relative to the individual asset classes and also how well the portfolio performs relative to a portfolio of randomly selected active funds.

And some interesting things take place, which I can share later if you want or go through it now, but basically you get a-- we call it a "portfolio multiplier." Things happen in a portfolio when you have all index funds that actually the probability of the portfolio outperforming actively managed funds actually increases to a fairly significant level depending on how many asset classes you put in over and above what each of the individual asset classes show.

So it's kind of interesting work. I wanted to take indexing-- at least the study of indexing-- to a portfolio level, which has not really been looked at yet. In addition to that, right now I'm writing a book. And I started it last year, if some of you who are here remember.

But it never materialized because I was having difficulty writing it, so I changed the name of the book and approached it from a different way. And you're all going to recognize this, but the title of the book is called "The Three-Fund Portfolio." And what it is, though, it begins with what I'll briefly discuss here for a second, is we all have the same philosophy as Bogleheads.

Everyone here in this room has the same philosophy. However, there are maybe 200 people in this room. I guarantee you none of us have the same portfolio. We all have different strategies. And your strategy is right for you. My strategy is right for me. I'm using the three-fund portfolio as the beginning strategy for everybody in the book.

And the final part of being a successful passive investor is having the discipline to follow the strategy. And the only way you're going to have the discipline to follow the strategy is if you have the Boglehead philosophy. So that's what's going to be in the book. That's what I'm working on.

I would say retirement doesn't feel like retirement so far. Not what I thought retirement was. But actually, I think I'm just moving on to doing something new for a change. At the end of last year, the very last thing I did at Viagra was to convince the firm to change equity benchmarks and then took off out the door and said, "You know, good luck implementing this." So actually, I was retained to consult on that implementation process during the first five months of this year.

I am continuing to do consulting for Vanguard, primarily speaking to clients and at symposiums. In addition to that, I'm talking with the university and will be picking up a role at a university that has not yet announced it probably about March or April of next year. So I've been in 68 airplanes this year, so I've been fairly busy.

I've pretty much achieved my life's goal, which is to be able to stay in my bathroom until 2 p.m. and play with my grandchildren perfectly after I get out of my bathroom. And Jack gave me the opportunity to plug my e-book, so I'm not going to do that. The e-book that I've written and I'm proudest of is an article that was in FAJ called "The Paradox of Wealth." The bad news is you can't get it unless you have a subscription to FAJ, but the good news is there's a much better working version of it available, "The Paradox of Wealth," on Larry Siegel's website, LarrySiegel.org.

Just Google it. You'll find it. It's easy enough. It's a much better version because FAJ cut the heck out of these. It's called "The Paradox of Wealth," and it's on Larry Siegel's website, LarrySiegel.org, I think. It's easy to find. If you can't find it, just e-mail me on wbinnovationprojector.com.

And I'm casting around for new things to write about. I haven't really settled on anything yet. I may do another finance book. I may do another big-picture history book. I have no idea, but I'm sure having fun figuring it out. Like Bill, I've met my goal of being on a panel with these guys.

I'll pay $500 for a picture, and we'll take our picture. Aside from my normal writing in "CBS Money Watch" and "Financial Planning Magazine" and "The Wall Street Journal Total Return Blog," I've written a couple of important pieces coming out early next year in "AARP Magazine." And the one I'm most proud of really has little to do with investing.

It's called "When the Numbers Stop Making Sense." How we protect ourselves later on in life if we no longer have our full thinking capacity, cognitive abilities, and can be tricked by other people. So certain things that we can do. And it ends up--it may be inevitable. Even the mind games, you know, Sudoku, crossword puzzles, may not slow things down.

All right, well, we'll start with the Q&A, and Jack, it's good that you're here. Probably the most requested--the number one, the most questions I got was on a subject that's very controversial on the board of its own, and that's treating Social Security as a bond. So I'd like to--Jack has already touched on that yesterday, so I would like to get the panelists--the members to share their thoughts on treating Social Security as a bond and increasing their equity allocation as a result.

Can we start with Alan, please? I think the mathematical answer is that Social Security is a bond, but we're not mathematical beings. We're emotional beings. So therefore, what I tend to do is look at the cash flow for a client that they need above and beyond Social Security and then design the portfolio that not only matches their willingness to take risk, but even more important, their need to take risk.

Since we can't take the money with us when they leave, we may not even be on the efficient frontier. We may be on what minimizes the probability of outliving their money. You can do one of two things. You can either capitalize the Social Security as a bond, but then you can't include your Social Security payments in-- or you have to include your--so you have to include-- you can't include the stream in your living expenses.

So if you're making $30,000 a year from Social Security and you need $70,000 a year to live, you cannot say, "I only need $40,000 a year," and capitalize it. You have to do one or the other. You either have to say, "I can capitalize it," and then you have $70,000 a year in living expenses, or you can say, "I have $40,000 a year of residual living expenses after the Social Security comes in," but then you can't capitalize the Social Security.

One or the other can't include that spending. So I guess this presumes we're going to be able to collect Social Security. You know, it's very much like a defined benefit plan, and I think Bill and Alan covered it. It's very similar to someone who receives deferred compensation, and I think with deferred comp, you need to figure out how that's invested and invest around it.

So I think including it in your portfolio is the appropriate way to think about it. Social Security I treat as though you're--as pay. Just like a pension, it's pay. It doesn't really have a net present value because you can't sell it. You can't cash it in. You can't go to the Social Security office and say, "Well, the net present value of my Social Security is $300,000.

Give me a check." It is like getting paid without working. When you die, it goes away. Your spouse doesn't get it. With Social Security, there are some partial payments. So I don't treat it as a bond. I look at it the way Bill described it actually a couple of years ago, and Alan described it a little bit earlier.

You look at it as pay, and anything above that that you need to pay your expenses has to come from your portfolio, and then you do an asset allocation on your portfolio to give you that extra income. So that's the way I look at it. Thank you. We have a question from Lady Geek for Bill Barnstein and Rick Ferry.

Although the risk of bonds and stocks are very different, investors sometimes associate a high-yield bond with an equivalent equity portfolio. What is the role of high-yield bonds in a portfolio? A brief introduction for new investors would be appreciated. That was from Bill Barnstein and Rick Ferry. Go ahead, Bill.

I will, yes. A high-yield bond you can think of as being a mix of mostly high-quality bonds and a little bit of stock. So the only thing I would say about high-yield bonds is don't count on it when the excrement hits the ventilating system because you're going to have to take a haircut.

That's why I really, except in very exceptional circumstances, don't like high-yield bonds because I believe that they're risky assets, they're safe assets. Don't confuse the two. The high-yield bond is halfway in between. There's a correlation with that, and I just find it very aesthetically displeasing for that reason. If you want to own high-yield bonds, own T-bills, own a little bit of stocks.

You've got the same thing, plus you'll sleep better at night. I disagree. Okay, so a high-yield bond market wouldn't exist if it was inefficient, and the argument is a high-yield is inefficient. It acts like equity. It's like a bond. It's an inefficient market. It shouldn't exist, yet it keeps getting bigger and bigger and bigger every year, and the issuance of high-yield bonds keeps getting absorbed.

I did a lot of work in separating the credit risk of high-yield bonds from the default risk. With corporate bonds, investment-grade corporate bonds, you have credit risk, and what that is is the possibility of the bond credit degrading down to high yield. When you get to high yield, you can actually separate out the credit risk from another type of risk that only shows up in high yield, and that's the default risk.

I actually stripped out default risk from credit risk, and then I did a correlation of the default risk to equity risk to see if, in fact, default risk and equity risk are the exact same risk. The answer is, at times it is, and at times it isn't. So the default risk is actually a unique risk to high-yield bonds.

To the extent that I look at portfolio management as a diversification of risks, if I have this unique risk in high-yield bonds, and it's a big market out there, and it's a relatively efficient market, I want to include at least a slice of that in my clients' portfolios to actually make the portfolio a little bit more efficient as a portfolio.

So I just look at it a little differently. Well, I'd like to add, too, that while a question may be directed to a specific individual or two individuals, as in this case, that after they address the question, if the other panelists have any thoughts they'd like to add, please do.

If I could just add one thing, and I do agree with Bill on this one. You could make the argument that variable annuities and hedge-funded funds wouldn't exist if there weren't a market for it, but they're sold. It doesn't mean that it's inefficient. And I think you take your risk with equities, and you want your fixed income to be the shock absorber, the ballast.

I'm not even in agreement with over-weighting investment-grade corporate in a total bond portfolio with BND. You know, I mentioned earlier that I like thinking of theory first and figuring out how that applies in practice. Theoretically, a stock is essentially a call option, and the strike price is the value of the bond.

So it's a call on the value of the firm, but the strike price is the value of all fixed income assets. And so whether it's a high yield or creditworthy, it is the strike price. And note that the strike price there is almost by definition a little bit closer to the edge than it would be for a high-credit quality bond.

So I guess I've always kind of thought of it as a little bit of a hybrid. I tend to think of things linearly, I guess. If I think of this as the value of the firm, and this is the strike price or the value of the bonds, and this is the value of the equity, in a high-yield bond or high-yield situation, the strike price is closer to the edge of the value of the firm, and therefore I think does take on some characteristics of the equity market as well.

It's kind of a hybrid between fixed income and equity. If you look at the performance of the Vanguard high-yield corporate bond fund over the last five years, it has outperformed both bonds and equity. How can it do that if it's a hybrid between bonds and equity? I don't understand.

But I'll just leave it there. We can go to the next question now. Well, because it's basically a low-beta equity combination, and when you go through a very significant bear market, it doesn't take the same degree of hit that the -- it wasn't down 55% the way the equity market was.

Let me just add one more thing. Whatever one thinks about the general principle, don't make the mistake of thinking high-yield bonds are a commodity. They're all alike. There are staggering differences in quality. Vanguard, because of our policy and low cost, we can deliver the same yields that somebody that wants to deliver extra yield with a high expense ratio, has to have a much lower -- a much riskier portfolio.

So there's a big selection risk in high-yield bond funds, but you want to be very, very careful in that. They're all different. This next question is very interesting, and, Jack, I think we'll start with you on this, and we'll go straight down the line. It says, "Question for all the panelists.

What was or is your most humbling investment experience, and what have you learned from it?" Well, when I was young and out of college, just out of college, maybe the first five, seven years, many of my friends were in the brokerage business, and they always had a great stock for me.

And I don't know how to differentiate. I would say every single one of the damn things was a humbling experience. And one of them was in the original Windsor fund run by a guy named Bob Kenmore, and I can't remember the name of it, some kind of computer thing.

And Kenmore loved it. He had it in the fund. So he talked me into buying it when I did stocks. I haven't done stocks for, I guess, 40 years, something like that. And I did, and, of course, that failed like all the rest of them. So the humility you get by not just buying stocks, by buying stocks that are recommended with all due deference, but that are recommended by brokers, is just, is this thing hazardous duty squared.

Okay, I'll give you two. One of them was when I was in the Marine Corps, and I finally started to accumulate some money. And I bought a very popular financial magazine that you all know, but I won't mention the name. And in there I recommended three great stocks for the future.

And I bought $500 worth of each of these three stocks. And within two years, all three were bankrupt. The second one was I was on vacation again in the Marine Corps with a young family, and I walked into an art shop in Honolulu, Hawaii. And I saw these dolly prints on the wall.

And I just thought that, and I was talked into the fact that these are the greatest investments in sliced bread. And so I bought one. That was my other second worst investment, because it turned out to be a fake dolly. I guess I'll give two quick ones as well.

Back in 1983, I was at a conference. I started a gold mining company. I put a venture capital deal together to start a gold mining company. And so I was at an investment conference, and Milton Friedman was talking at that conference. Well, Milton Friedman had a student named Colin Campbell who was a professor of mine.

So I went up to him and asked, "Do you still keep in touch with Colin Campbell?" And so he said, "You know Colin?" He said, "Yeah, he's a professor of mine." He said, "Oh, you're my grandson." So he's yelling out to people, "He's my grandson." So he asked me, he said, "So what do you do now?" I said, "Well, I put a venture capital deal together to start a gold mine." He says, "Oh, so you're unemployed." The other one was, I think you may remember this one.

I was actually going out for my interview with Vanguard in September of 1987. I was interviewing with Jeremy Duffield, who actually ended up hiring me. Jeremy said, "It was a Saturday." He said, "So come in, kind of golf attire, something casual but reasonable." And so it turned out that Friday the day before, I was with my wife.

Her company was doing an outing, and so I was with them. I was wearing, actually, basketball shoes. I was in the airplane. I went right from there to the airplane. I was in the airplane flying out here for the interview. I realized the only shoes I had were basketball shoes.

And it was 10 o'clock at night by the time I got here. So I interviewed with Jack wearing basketball shoes. I'm not sure I noticed. Well, before I was 40, I probably made every dumb mistake that everyone else in this room has made. But I think that the biggest mistake I've made in my professional life was not understanding what Warren Buffett has understood most of his life, which is the only safe asset in this world are short-term treasury securities.

And during the crisis, that really didn't come home to me. And I realized that even short-term corporates, even short-term municipal bonds, are going to incur a haircut if you want to cash them in to live on or buy even cheaper stocks. I used to be much smarter than I am now.

I took my college graduation money in 1979, about a year later, and put it in gold. Gold had fallen back from $8.50 to $6.64 an ounce, and I was absolutely sure it was going to double every year. Now, obviously, it hasn't even kept up to inflation. If I had discovered the Jack Bogle and put it in an index fund, I would have had a whole heck of a lot more money.

It taught me I wasn't as smart as I thought I was. And my only excuse is Richard Thaler had not invented behavioral finance, so I did not know I was following him. It's not your fault. Innocent victim here. You're a victim. Well, since it's true confession time, I'll throw mine in, too.

I started investing in the late '60s, and every magazine article that I read about a fund, I never met a fund that I didn't like and didn't buy. And I was really reminded a couple of years ago, well, in 2006, we sold our home, and in the attic was boxes of all the funds that I used to own back in the days before down Vanguard and investing in that.

So I was really reminded of the things that we all go through, or most of us go through, early in our investing career, and that's we just follow all the hot funds, we do performance chasing, we do everything wrong. Hopefully the forum helps a lot of people from making those same mistakes that we make.

So that's one of the reasons we all do what we do, to try to keep people from making the same mistakes that we make. Here's a question for Alan. With the interest rates at an all-time low, where does one get income? Hmm. How do you go box? Oh, I'm sorry, I spoke out of turn.

I'll go with Rick. Let's make it feel good. You know, I reject the fact that rates are near an all-time low now. If we go back to 1981, you could earn 12% on a CD, which meant that after taxes, rates were much higher than you got, about 8%. Inflation was as high as 15%, so you were 7 percentage points worse off.

It felt good because you got to see the statement increase. So, you know, I tell people that, I tell my clients, our portfolio is stored energy that allows us to do what we want with our life, and you can't take it with you, and it's okay to spend down the principle, quit looking for income.

Everyone in this room, for one reason or another, was programmed to put money away, to be accumulators, and it's very difficult to give yourself permission to spend it down. So I don't know what rates are going to do, and there may be a reversion to the mean, and I use certain CDs that have easy early withdrawal penalties as a put, the right to sell it back to the bank if interest rates do increase, but quit chasing income would be my number one recommendation.

And by the way, stocks are yielding 5.1%, 3.1% in terms of a stock buyback, which is absolutely returning cash to shareholders, and another 2% in dividends. So the income really needs to come from the equity portion of your portfolio. I mean, return is return. It doesn't matter whether it comes from capital return or dividends.

To me, the whole thing of looking for investment income to live on is an oxymoron. And I'll second what Alan says, is you're accumulators. Don't be afraid to spend a little of that capital and maybe fly first class once in a while. And that's actually Vanguard's position as well, that we think of total return investing as opposed to thinking of yield.

It's really what is the total return, and then you use whatever you need to in capital in addition to the yield. So we talked earlier about high dividend yielding stocks. Let's say you get a 4% dividend yielding equity, and just for hypothetical reasons say, well, you're going to get 6% capital appreciation.

Is that any better than a 2% yielding equity with an 8% capital appreciation? In fact, you could argue that it depends on the tax environment, but it could be worse. In the old days when dividends were taxed at ordinary rates, you'd actually rather get capital gains. But the advantage of thinking total return is you end up with a more broadly diversified portfolio, and you're not taking the factor bets that you might with a high dividend yielding portfolio.

I'm just going to agree with Bill and Alan. I do like Alan's idea of that a buyback yield is a real cash yield. They're using the cash instead of the pay you. In a cash dividend, they're using the cash to buy back stocks, so why not sell that portion of the stock market, that 3% or so, that's the buyback yield.

You could take that as income as well. So I'm on board with everybody so far that it's the total return of the portfolio that matters. We have a question for Gus. You mentioned that PE is the best predictor of equity returns. You also hammered that beta timing is a fool's game.

Should investors shift or tilt their equity on exposure based on current PE ratios? Gus mentioned that PE is the best predictor of equity returns. He also said that beta timing is a fool's game. Should investors shift or tilt their equity bond exposure based on current PE ratios? Well, I think PE ratios are actually pretty fair right now.

I mentioned earlier, Vanguard's econometric model is predicting 6 to 9% equity returns, which I think is a fine return if we should get a return in that segment. I think if you look at Shiller PEs, people say, "Well, Shiller PEs are still quite high." I think in normal times, Shiller PEs are fine.

I think today's Shiller PEs are distorted. They're backward looking. We know that the market's forward looking. A Shiller PE usually works okay. It's just a way to normalize earnings. It's going to produce a higher PE ratio than you would using, say, the last 12 months of forward looking. You just have to calibrate it and recognize it's, on average, going to be higher and compare it to its longer term average.

Right now, it's distorted because of the last 10 years. We've just seen earnings do crazy things over the last 10 years. Actually using last 12 months would be better than a Shiller PE, and actually forward looking PEs are better than last 12 months because the market's clearly forward looking.

From that standpoint, I think things are fair. Maybe we're slightly above long term average. That's typically not where bull markets end. But if you look out over 10 years, you should get a reasonable rate of return, maybe a little bit less than historical averages. As I indicated in my one presentation, even though I think there will be reasonable returns in the equity market, I still question the idea of throwing caution to the wind and over-investing in equities because you are taking greater risk.

Bonds are there to moderate your portfolio risk. I believe what I showed with the efficient frontier and the utility curves, with lower expected returns both in equities and bonds, even though equities are reasonable, it still looks like a static asset allocation, not necessarily a shift to a new asset allocation.

I wouldn't necessarily say move to equities. I think staying with your long term strategic asset allocation makes a lot of sense. Gus, could I just ask you, do you use operating earnings or reported earnings to calculate your PE? Do you look at the past 12 months or the next 12 months?

Typically we look at the next 12 months and look at operating earnings. Isn't that kind of a cop out? Fifteen years ago, when Jeff was running the ship, I would have said, yeah, it's a cop out. It's just a way of calibrating things. Because then you compare things historically.

The important thing is comparing apples to apples. So Shiller is okay if you compare Shiller to Shiller. You wouldn't compare Shiller and say, well, Shiller's PE ratio is 20 times and the long term average is 15. It's just important to compare apples to apples. I think that the best long term work on this has been done by Dimson, Marsh, and Staunton.

And you can get it for free. It's $710 for Triumph of the Optimist. But their Credit Suisse yearbooks are available online for free. I know they discussed on the board. And what we're really talking about here is torquing around your equity allocation based on the valuation. And in just about all 20 countries they looked at over the course of the 20th century, that was a monk's game.

You did not gain any risk adjusted returns by doing that. However, what they found was that by adjusting your internal allocations among nations, depending upon which countries were cheap, that did improve risk adjusted returns. So how do you apply that now? Well, as you look around the world today, I think that U.S.

equities are probably the most expensive. I think developed market equities are probably a little less expensive. And for a very good reason I know that. And emerging markets of late have perhaps even become cheaper than developed market stocks, as I think someone mentioned last night. So, you know, you can take that for what it's worth.

And if you want to play that game, you can play that game. But if you don't want to, you'll do just fine as well. I knew that was the reason I was overweighted in emerging markets. That's it. That's not advice. I think sticking with an asset allocation is more important than picking it right in the first place.

We've seen all sorts of data presented last night throughout that the dollar-weighted returns way underperform fund-weighted returns. We have all of these sophisticated reasons to change our asset allocation, and they typically lead to lower returns. So sell equities because equities are up to get back to your target allocation.

So you're not going to be coming out with the Allen Roth under fund flow ETF? Now that got turned down by Gus. I think that valuations are important as you're getting close to retirement, as the amount of money that you have accumulated reaches your goal, and you're going to be doing an asset allocation shift down anyway because you've accumulated the amount of money that you need for retirement, and the risk then is to lose it.

So you don't need to take as much risk. The question is when do you actually make this shift? If it's 2008, early 2009, and the P/E of the market is down around 10, I just wouldn't recommend making the shift then. I would wait until the market came back to 15 P/E or so.

On the other hand, if the market is trading at 35 times earnings or 30 times earnings like it was in 1999, and you've made a lot of money because of the increase in the speculative premium, as Jack would call it in his books, and you've made a lot of money and you're at your goal, then you might want to do an asset allocation shift a little early.

But that's probably the only time. If you're 25, 30 years old and your time horizon on taking your money is 20, 30 years out, I don't think you need to worry about valuations. I will say one more thing, and that is that Bill made the comment that we should perhaps look at the valuations of different countries.

And I think that if you divide your portfolio up among U.S. equities, developed markets, and emerging markets and have a fixed allocation and then do a rebalancing, say, once a year, that you're actually going to take advantage of what Bill was talking about and not have to work too much on it.

The next question is for everyone. Bonds, it's about bonds. What do you do with dollars set to go into bond index funds? I guess this is a nervous investor who is afraid to put the money that's allocated for bond funds to invest it at this time. The question is, what do you do with it?

What do you do with it? You invest it. Again, the role bonds play, it's never been what we think is the workhorse in a portfolio. It has a role as a diversifier to moderate the volatility that we experience in our portfolio. And that role hasn't changed. The good news is if interest rates start to rise, the equity portion of your portfolio is likely to perform pretty well.

My view of the way things unfold is that the economy starts to get a little bit stronger, the Fed backs off, it tapers, interest rates rise, but the equity market does pretty well in that environment. There's a difference between tapering and tightening. So, like Rick, I'd say stick with your strategic asset allocation and go ahead and make the investment and just recognize that it's there for a reason.

I mean, you know, what if an accident happens? I mean, what if Congress does something crazy? Imagine that right now. Well, I guess the follow-up question on that would be, do you lump sum it or dollar a cost average when you're a real nervous investor? I'd say just do it.

I think there's a lot of arrogance in the belief that, you know, common wisdom is that quantitative easing has to end, which is going to cause rates to go up. I think there's arrogance in saying the market didn't know that we couldn't buy back our treasuries indefinitely, and we don't know what's going to happen to rates.

The top economists have been directionally correct on longer-term rates, far less than a coin flip. So just do it, in my opinion. This one's for Rick and others. We've already heard from Gus and Jack spoke briefly on this. But, Rick and the others, what are your thoughts on smart beta?

Oh, okay. So, lowly investment advisor, I don't know these things, so I called up the--or actually emailed the experts. I got an opinion from Bill Sharp, Nobel laureate Bill Sharp. I got an opinion from now Nobel laureate Gene Fama. I got an opinion from Ken French. And I got an opinion from my friend Rob Arnott, who is a friend of mine, by the way.

Okay, so three out of four of them said there is no such thing as smart beta. And guess which one said there was? Yeah, so basically, I think that Gene Fama summed it up the best. He basically said that if you look at value versus growth and small cap versus large cap, and you do regressions on these returns, the regressions are positive, which means you could call it a beta, and some people do.

He doesn't call it a beta. Fama doesn't call it a beta. Bill Sharp doesn't call it a beta. He says, but some people in academics mathematically would call that excess return premium that we've seen in the market a beta. And therefore, if you put additional betas in your portfolio in addition to the market, it becomes a multi-factor portfolio.

But there is no such thing as smart beta. It's silly to call it smart beta. Beta is just beta. But you could call it additional betas. So that's the right term to use, additional betas. The most difficult piece I've ever had to write is about a five, six hundred word piece for a financial planning magazine in the current issue where I had to give the Portfolio Innovator Award to Rob Arnott.

And it is an innovation. It's certainly the small cap value tilting, and I tend to get small cap value tilting from my client by buying a total stock index and a little bit of a small cap value vanguard index. But it's an innovation when you capture 100 million one way or the other.

I believe it's more of a marketing innovation. And it is a new way, as Rick Perry pointed out, of allowing individuals to capture that small cap beta directly outside of DFA, which you have to go through advisors. It's a buzz word. It's like fundamental indexing. I don't believe I'm going after dumb beta.

That was the biggest thing, by the way. I really took offense to what Rob was calling. I did not come up with the term smart beta. Somebody else came up with it, but he just embraced it. He patented it anyway. I was at a conference last week, and Rob was speaking, and the presentation of his speech was smart beta.

And he must have said the term 100 times in 40 minutes. It was just driving me crazy. But I think the thing that really turns me about smart beta that I don't like is it infers that all of us market investors are investing in dumb beta, which makes us all dumb.

And that's what I really don't like about it. Jack, how do you feel about that? I agree. I actually think it's misleading. The ads say this has outperformed the S&P 500. Why in the world would you compare a mid-cap value portfolio to the S&P 500? I mean, our mid-cap value index fund has outperformed the S&P 500, but we don't market that.

So I think it's potentially drawing people into an investment without really realizing what they're getting. Gus, this next one's for you. It said, "Could you please explain how you managed to keep the index fund returns so close to the benchmark returns despite transaction costs and cash drag?" Is it all about securities lending?

What is your secret sauce exactly? What is your secret of secret sauce? I see Karen D'Amato over there. You know, indexing is a lot of blocking and tackling. It's about this much intellectual property and a ton of blocking and tackling. And I think we've got the best traders in the industry.

They've been with us for as long as--the first one who joined me in 1989 is there today. They're phenomenal at what they do. They identify, I'll say, micro-inefficiencies and can add some value. One thing we have is an advantage of size. And continually going into the marketplace, we can find opportunities that, you know, if you're not continually going into the marketplace, you don't have the opportunity to take advantage of it.

So, you know, a lot of it is just being great traders, minimizing transaction costs, and looking for these micro-opportunities. In some funds--the question is also, is it securities lending? In some funds, they are enhanced by securities lending. In the small cap fund or an international fund, in any given year, it may be as high as 10 basis points of additional return.

In a lot of funds, though, it's a basis point. In the S&P 500 large cap segment, it's negligible. It's not even measurable. So it's mostly the skill and expertise of our index team. So Rick Edelman isn't right about hiding 2% in trading costs. Actually, you underperform the index by less than the expense ratio, which I think is-- Phenomenal.

--yeah, absolutely amazing what you've done for shareholders. You really have. It's amazing. Thank you. Okay, let's move to tips now. We have a couple of questions. The first one is from Victoria. Please discuss at what level of fixed rates it will become advantageous to start buying tips again. And the follow-up question or associated question is, what are the panel's views on tips and their role in a portfolio in the current interest rate and inflation environment?

So can we cover the broad tips market then, please? Well, I always have tips in a portfolio because of the reason they exist, and that is as a hedge against unanticipated inflation. And since unanticipated inflation is a risk in the portfolio, then I always want to have a small portion of my bond portfolio in tips, and my allocation has always been 20%, and it's worked out fine for me.

I've been nervous about tips the last several years because real rates have gone negative. Historically, real rates on, say, a 10-year tip is 175 basis points, one and three-quarters percent. They actually went negative, and right now they're still very, very low. It turns out that the duration on a tips bond, the real rate duration is actually quite high, like eight years.

So if the real rate reverted back to, say, the longer-term average of one and three-quarters percent, that's a backup of, let's say, 150 basis points from here, you could lose 12% in principle trying to capture an inflation premium. I think this is a point in time where tips really kind of scare me.

With regard to inflation, I've been saying ever since the global financial crisis, inflation isn't going to happen. A lot of people are worried that the Fed's balance sheet has just ballooned, and they're talking about the money supply exploding. The money supply is not exploding. The Fed's balance sheet is expanding.

The money multiplier has collapsed. If you look at the broader aggregates of money supply, they're growing at 5% a year. That's basically nominal GDP growth, and you need money supply to grow at that level. If you don't, you're going to start choking off your economy. So obviously there's so much slack in the economy right now.

I personally just am not worried. I think Rick's right that tips guard against unanticipated inflation, against some sort of oil shock or something like that. If it's anticipated inflation, like you get in the mid-'80s, actually, mid-'70s, actually equities are a great inflation hedge in that type of environment. Equities performed great in the second half of the '70s.

Tips are good for unanticipated inflation. I just think they have some risks at this point. I think those are all very interesting features of tips, and I agree with what Rick and Gus said. I see tips as the ultimate liability matching element in everybody's portfolio. We all have a stream of real liabilities in the future in terms of our retirement, and a tips ladder that is adjusted and aimed at that is probably the safest asset that you can have.

I think it will ensure your retirement the best. Having said that, I'll also agree with Gus. This ain't the time to be buying. The natural rate of the long tips is probably in excess or at least in the vicinity of 2%. Shorter tips, 1 to 2%, depending upon the duration.

And at the shorter end, you're still looking at negative yields. I wouldn't be in a rush to buy them right now. I'm a hypocrite. I time the market when it comes to tips quite a bit. I say tips are the lowest risk asset out there because it's the real return that matters, and of course the U.S.

would never default on it. By the way, they say that Congress has a 5% approval rating. I've never met one of those 5%. They work for Congress. But anyways, tips are far more volatile than treasuries. In 2008, when stocks plunged, people ran to traditional treasuries, not to tips, and those yields were 3.5%.

That was a wonderful time to get into tips. I still believe that tips need to be part of the portfolio. They give some protection against inflation, not as much as stocks, but they are a part of the portfolio. I just want to mention one more time that if tips are a strategic allocation, a certain percentage of your bond portfolio, and you're doing rebalancing, then when they go to 3.5%, you're going to be buying, and when they go to a deep negative, you're going to be selling because the values have gone up.

So you are capturing a portfolio benefit by just having a fixed allocation in your portfolio. Gus, if you're scared, I mean, you know investors are worried about tips too, would you recommend cutting back on tips or just holding for somebody who's got 30%, 40%, 50% of their bond allocation, a retiree who is worried about inflation and that's the reason they have the enlarged allocation to tips, would you recommend they cut back on tips?

The tips are down right now, Vanguard's tips fund is down about 6%, 9% this year, so you would be selling in a down market. Would you cut back? Yeah, I think, you know, to Bill's comment that you're kind of immunizing your future liabilities, I mean, there's a reason it's called fixed income, it's generally fixed income, but it's inflation-protected fixed income, so if you can live off of the income itself and you don't really care what's happening to the principal, a lot of people don't really think that way, I mean, you know, all of a sudden you lose money in bonds and people sell like mad, I mean, go back to the beginning of 1987, there was a collapse in the muni market place, so if you have discipline and you're living off of the income, it's going to be inflation-adjusted income, which should take care of you, I think it's okay.

If you are at all concerned about the principal, I'm nervous. Well, obviously, it's very volatile, that's for sure. Yeah, and I'd be nervous having 40 or 50% in tips. We have tips in some managed payout funds, but it's a moderate amount, I mean, it's 10%. Actually, two of the managed payout funds don't have it, and one did.

Gus, this one's probably for you. Why did Vanguard buy a market-neutral fund? It almost seems like something interesting to keep the quants from getting bored. Now, I was actually hired to develop the active quant equity program and was given the indexing side as well. I mean, if you do active quant, you can do passive quant.

So I built the active quant equity team, and it's been kind of my pet project, my love. I find it very intellectually stimulating. The reason I like active quantitative investing is, I think that I mentioned earlier, there are inefficiencies in the marketplace, and my belief is those efficiencies arise because we all act irrationally.

I mean, you know, we do irrational stuff all the time, so why should we be rational when we invest? And that's true with a traditional manager as well. They're going to make irrational decisions at times, and I like a quantitative form of investing because you create a model based on theory.

You test it to make sure that it worked, and then you just rigorously apply it. You do not let your emotions take over. You just use what you think is the right theory. And in my view, that maximizes the chances that you'll actually be able to add value or find alpha.

And I think if you look at our active quant group, we've had mixed success over the years. We've had some really good periods and some dramatic underperformance on average. I think we've added a little bit of value. And the way I think of a long/short market neutral fund is it's really a volatile money market fund.

It's a money market fund. The expected return on it should be money market rate of return plus any alpha, which could be minus alpha if you don't have skills. So, you know, I would hope that over time we'll be able to actually get a return that is greater than a money market rate of return, obviously with volatility that you don't experience in money markets.

Phil, this is for you. Regarding residual living expenses, what do you mean by residual? Just to go back to the example I had before, which is that if your living expenses are $70,000 a year, you're getting $30,000 in Social Security, then you've got $40,000 a year of residual expenses.

And just to amplify that a little bit, you should probably have, if you're going to retire, 25 times your residual living expenses. So that's a million bucks. This is a question that comes up every time we have a volatile situation. I've heard the expression many times over the years, "It's different this time." I've never believed that to be true for a long-term investor.

The current investing environment does seem somewhat unusual with both stock and bond markets hosting significant risk. My question is, is it really different this time? No, no, and no. New paradigms, and this time it's different, will kill you. And then second of all, I wrote a piece on data that Wilshire provided, the myth of market volatility.

Markets are no more volatile today than they've been over the last 40 years. In 2008 and 2009, it was an exception, and there are lots of reasons why we think it's more volatile today. One of those are that the index values are so much higher that a 1% change today is a lot of points.

30 years ago, it was much smaller. So markets are no more volatile today, and this time it's different, will kill you. The only black swans are the history you haven't read. I don't think the laws of economics change, and therefore things can't be different this time. Your borrowing costs have to be below your return on equity.

Your GDP is basically related to population growth and increases in productivity. These universal laws of economics don't change. So even though the markets may be volatile, it's not different this time. All right, we're coming up to the close. Rick has to catch a flight. We're on schedule. We're going to take a break.

I'd like to thank all the panel members who are with us. Jack has one final message for us. In my little litany of thanks to everybody, I have, shockingly and embarrassingly, I didn't mention Mel's leadership, and so I'd like to express my own appreciation for Mel's leadership. I know you all feel the same way.

The ball stops somewhere, right now and right here. It's Mel.