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Breaking with Bogle

March 27, 2015
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Eric Nelson is one of the most highly regarded investing bloggers in the US. His firm, Servō Wealth Management, based in Oklahoma City, takes what it calls an “asset class” approach. Eric has particularly attracted attention in evidence-based investing circles for being critical of Vanguard founder Jack Bogle. But when we caught up with him recently, he was keen to point out that it’s possible to disagree with Bogle and still have the utmost respect for him.

SITV: Eric, thank you for your time. How important is it that people use a financial planner? And how should they go about choosing one?

EN: I think the vast majority of investors should use one, and if they are getting the right kind of help, they will almost certainly be better off net of the additional fees they pay for advice.

In trying to find one, I think there are 4 things they should look for:

(1)  BUSINESS: In the US, an investor should ask, Is the firm a Registered Investment Advisor (RIA), are they a fee-only firm (i.e. don’t accept commissions), and do they operate in a fiduciary capacity to always put their client’s best interests first?

(2)  ADVICE: Does the planner approach a client’s situation holistically? What I mean by that is, will they give advice on retirement, minimising taxes, how to insure against risks they can’t avoid and any estate concerns they maybe facing as well as managing a goal-focused investment portfolio? If not, you may be leaving some important stones unturned and I’d suggest you keep looking.

(3)  INVESTING: When it comes to investing, does the adviser have a “beat-the-markets” approach or a “get-the-markets-return” approach? This is the classic “active vs. passive” argument and I am of the opinion that you should never take advice from someone who is trying to outguess markets through timing or security selection - even with part of their portfolio. There is no room for these “fence sitters” as my friend Jeff Troutner calls them. If the adviser is an “active manager” you simply cannot afford the risks or all of the costs.

(4)  PERSONAL: How does the adviser invest their own money? If they are recommending a passive investment approach to you, but aren’t “eating their own cooking,” this is a red flag that they might not stick to their advice when times get tough. If they are telling you that you need a growth-oriented portfolio (with more stocks than bonds) to sustain a multi-decade retirement of rising prices, but then you find they have 60%, 70% or 80% of their own money in bonds, you might want to understand why they are so risk-averse with their own funds. It can’t just be “do as I say,” it should also be “do as I do”.

SITV: You describe your approach as an “asset class” approach. What do you mean by that? And why do you believe in it?

EN: At its core, asset class investing starts with the belief that it is very difficult to bet against the market by picking individual securities or trying to time the market. The results from these “active” efforts are typically lower returns, higher risk, and greater investor anxiety, so it’s not worth it to try.

Instead, investors should begin by diversifying broadly across thousands of stocks and bonds in domestic and international markets, according to their long-term goals for growth. An indexer would say that is where things end. Asset class investing goes one step further, recognising that not all stocks and bonds have the same risk and returns. Smaller and more value-oriented stocks have higher expected returns than larger and more growth-oriented stocks. Longer-term and lower-quality bonds have higher expected returns than short-term and high quality bonds. In every case, the higher expected returns come from higher (and different) risks.

So asset class portfolios hold diversified and deliberate weights in a balanced mix of large/small and growth/value stocks globally. The result over time is expected to be higher returns with a smoother ride, making it easier for investors to reach their long-term goals compared to a basic index approach. You saw this play out during the “lost decade” from 2000-2009, while broad global stock markets went 10 years with negative returns net of inflation, smaller and more value- oriented stocks had returns of almost 5% to over 11% per year, a tremendous boost to an otherwise static portfolio.

SITV: You’re also a strong believer in the importance of sticking to an investment plan. Why is discipline so crucial?

EN: Because the impact of bad behaviour on their portfolios is the single largest cost that investors pay. By chasing performance or selling in a panic, they wind up buying high and selling low. Research from Morningstar, the Federal Reserve and John Bogle (just to name a few) finds that making emotional decisions (out of fear and greed) results in a “behaviour gap” between investment returns and investor results of 2% or more per year over time.

And it’s also the thing we have the most control over as investors. We cannot make the stock market go up. We may not be able to save as much as we’d like to. But we can all make a conscious decision to stick with our plans, even when times get tough. And if we simply cannot muster the strength to do it ourselves, consistency and discipline are one of the most valuable but overlooked services that a financial planner can provide for you.

SITV: You’ve taken issue with several things Jack Bogle has said over the last few months. What in particular do you disagree with him about?

I have a lot of respect for John Bogle and think the company he founded,Vanguard, is an excellent firm - one of the few “good guys.” And he is responsible, of course, for creating the first index fund for retail investors, which has changed the way we all invest.

But with great power comes great responsibility. And I think some of his guidance lately might lead investors astray or at least confuse them.

First, he’s never been a big believer in international stock diversification, and I just don’t think concentrating all of one’s assets in their home country is a smart decision. Ask Japanese investors how that’s worked out for the last 25 years (their stock market still trades below its 1989 level while the rest of the world has excelled). I don’t think US investors need 50% to 60% in non-US stocks to align with the world market, but something like 30% is far better than 0%.

Second, he seems to be agnostic about rebalancing a portfolio. But the whole idea behind an asset allocation is that you want to achieve a specific return goal and are willing to accept a certain amount of volatility to get it, and when you are diversified you know different holdings will do well/ poorly at different times. Bogle claims that sometimes rebalanced portfolios do better and sometimes they don’t, but that’s not the point. The point of a rebalanced portfolio is to keep the amount of risk within a fairly confined range, and you have to rebalance periodically to achieve this result. Just “letting it ride” will result in a very different portfolio profile depending on whether we’ve recently experienced a bull or bear market. Rebalancing is not about return enhancement, as Bogle tries to argue. If you want higher returns, you simply hold a different (rebalanced) asset allocation—more stocks, more small/ value companies, or both.

Finally, he’s never come out and acknowledged the higher long-term returns of value and small cap stocks, despite Nobel Prize-winning research to the contrary. He’s in the camp that says all stocks and all bonds have the same long-term returns and until recently, said everyone should pretty much just hold “total” stock and bond indexes. Even in the late 1990s after a period of remarkable growth for the large growth stocks that dominate traditional indexes, his only council was to consider swapping the S&P 500 for a total stock index, which are virtually identical large cap indexes—there was no mention of including more meaningful exposure to other parts of the market that even Vanguard offered index funds for.

But recently, he’s taken issue with total bond indexes due to their large allocation to government debt, and his solution has been to shift more to corporate bonds. Well, now we are talking about taking more (bond) risk in pursuit of higher returns, and that’s in direct defiance of his “total markets” approach, not to mention it begs the question — is more risk in what should be the safe part of your portfolio (bonds) the best way to assemble a portfolio? Or are you better off keeping bonds safe and allocating more to stocks or even more to smaller and more value-oriented companies?

I think this opens a line of thinking that Bogle has been opposed to for so long, he’s reluctant to take it to it’s logical conclusion. And maybe I’ve missed it, but he’s failed to also mention the risk that comes along with lower-quality corporate bonds. Higher yields are not a free lunch. Risk and return are so inextricably intertwined in investing, you can’t even consider the later without the former.

I don’t mean to be critical of Bogle, it’s just that he is such an influential figure with such a wide following, he has a responsibility to get these things right. Global diversification, disciplined rebalancing, and an appreciation for the tradeoff in stock and bond risk and return are the foundations of a successful investment experience and we can’t afford to overlook them. 

SITV: Advisory firms like yours which broadly share our philosophy tend to use either Vanguard funds or Dimensional funds, or else a combination of the two. We’re guessing you prefer Dimensional? 

I think Vanguard and DFA are the two best investment management companies in the business. But if you have an asset class approach to investing, Vanguard just doesn’t provide the tools necessary to do the best job possible.

Vanguard, like John Bogle, comes at the capital markets from a “one-dimensional” perspective, meaning they think about asset allocation mostly in terms of stocks and bonds. They don’t really believe in higher-expected returns for small cap or value stocks nor do they appreciate the diversification benefits of a multi-asset class portfolio (you see this when you look under the hood of their Target Date and Asset Allocation funds - they are all Total Stock and Total Bond Indexes). So their best funds tend to be S&P 500 and Total Stock and Bond Indexes. They have small cap and value strategies too, but they aren’t very small and they aren’t very value-oriented, and since inception going back to the 1990s, that has cost them 1% to 2% per year in lower returns compared to DFA’s value and small cap asset class funds.

Next, Vanguard has some major holes in its lineup, which is hard to imagine with 100 funds and ETFs, but there’s a lot of overlap there. It doesn’t offer any index funds that own international large and small value stocks, which are the best compliments to a US-stock portfolio. And all of their bond funds except two are focused only on US fixed income, with the two non-US bond funds they offer having greater credit risk and longer maturity profiles than we are comfortable with.

The bottom line with DFA’s funds is that they allow us to build our ideal asset allocations, so we aren’t forced to cobble together portfolios with our second or third best strategies. What’s more, DFA’s approach is transparent and predictable and time tested over many decades, which lines up very well with our own philosophy and the investment principles we try to instil in our clients. But if someone wants to make all their own financial decisions and manage their own money, I’d be the first one to send them to Vanguard.

SITV: 2014 was a terrible year for active managers. Few people expect them to do quite as badly again this year, but do you think the tide has turned against them, at least in the US? 

The tide has never been with active management, and the asset flows out of active and into passive are finally starting to reflect this. If you believe active management works, you cannot do simple math. The reason is, all active managers collectively own all the stocks, bonds and cash in the market, so how can they outperform an index of all of the same securities? They can’t. In the aggregate, they get the return of all the available stocks, bonds and cash, but charge 1% to 2% in management fees and trade more frequently, racking up more commissions and taxable distributions. There are so many managers out there that of course a few dozen at any point in time will hold a better-performing subset of the global market. But the key is, we don’t see really any persistence in the performance of winning managers from one period to the next. Today’s superstars are just as likely to be tomorrow’s schlubs.

The fact is, the comparisons between active managers and indexes is not always perfect. For example, large cap managers are often benchmarked to the S&P 500, despite the fact that they hold slightly smaller and more value-oriented stocks. So in a year like 2014, where small and value underperformed, they’ll look terrible compared to the S&P 500. In a year like 2013, where small and value stocks did far better than the S&P 500, they’ll look a little better. The key is, however, over time, even though small and value stocks have done better, active managers haven’t been able to capitalise on this. Only about 50% of US stock active managers who were in business 10 years ago still operate today, and of those survivors, less than 20% have beaten their index. Those odds are worse than going to Vegas.

SITV: If you could give first-time investors just one piece of advice, what would it be? 

Trust that the global stock market is a great long-term investment and will be around long after you or I are. It goes up and down quite a bit in the short run but as a long-term investor, this shouldn’t matter at all to you.

A few more thoughts I think matter a lot: save as much as you can and invest in regularly and consistently in a diversified portfolio of stocks. Don’t worry about trying to pick winning stocks or sectors, or when to get into or out of the market—none of that really matters much or can be done very well. Realize that investing isn’t supposed to be entertaining. If you are spending a lot of time doing research or monitoring performance, you’ll almost certainly wind up costing yourself from bad decisions. And, finally, when you have saved up a good amount of money and your retirement goals are getting closer, one of the best investments you can make is to partner with a fee-only financial advisor who will help you fine tune your plan and address all the other financial issues that have or will eventually surface.

SITV: Finally, if you could give investors who have retired or are about to retire just one piece of advice, what would it be?

If I were forced to tell them just one thing, it would be to not underestimate how long they’ll probably live and how much more expensive their lifestyle will be over the next few decades. A 62-year old couple today has a joint-life expectancy of almost 30 years, and at just 3% annual inflation, you need $2.50 just to buy the same things in 3 decades as you do with $1.00 today. At 4% annual inflation, which is more reasonable for many of the things retirees spend money on, you will need over $3.20.

Beyond that one thing, I’ll add that this clearly has important ramifications for all older investors. First, you cannot afford to keep most of your investment portfolio in low-returning bonds. Sure, they don’t lose much in bear markets, but they also won’t earn nearly enough to support what could be 3 decades of reasonable ongoing portfolio withdrawals adjusted for inflation. With all- bond or “age-in-bond” asset allocations, you could be on your way to going broke by your 80s.

Second, you really need to consider investing in stocks outside of the biggest blue chip companies in the S&P 500 and EAFE Indexes. Whether it’s 1965-1981 or 2000-2011, these stocks have had a tendency to go long stretches where they produce little or no returns after inflation—a real problem for someone trying to produce a rising income stream over several decades. And this is where asset class investing can be a real help; at the very time that large cap, growth-oriented stocks have languished, smaller and more value-oriented companies have seen their best relative results. Going into a multi-decade retirement without a multi-asset class portfolio is one of the riskiest things you can do.

Finally, realize that bad behaviour has become the single biggest cost to investors and even 1 or 2 bad decisions could spoil your retirement prospects. If you went all-in to the NASDAQ Index or a US Total Stock Index (from a diversified portfolio) in 1999, or bailed out of stocks completely in March of 2009, it’s likely that you’ve cost yourself a sum of money you will never be able to recoup. And, like I said before, behaviour is the one thing in investing you really can control, so you need to focus as much of your effort on it as possible. A decent portfolio, consistently held, will always beat the best portfolio that is abandoned when sentiment inevitably shifts against it.

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Comments

JN

Rebalancing does not makes sense if somebody just needs a fixed amount of safe investments in their portfolio, rather than a fixed percentage. Over long periods, stocks have the best returns so it is better to let them appreciate and not rebalance. Who cares if you allocation goes from 60% to 70% if you just care about needing a fixed amount safe?

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