Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking about the world of money and investing. We talk about whatever financial planning type of things happen to be coming up in the news.
Conversations About Investing
I was having a really interesting conversation with a guy. It was funny because we got to talking about investing and he said, “So what do you do?” I told him what I do — run a registered investment advisory firm. I have all these offices all around Nashville and one in Texas.
You can approach investing from the broker route and work for a big investment firm. This involves working for that company and offering whatever they happen to have.
That’s where I came from. I used to go to work for a company and an investment firm, and I would get an investment list. Then that broker-dealer actually went out of business because somebody had done something really stupid and they were being sued.
The lady who was working in the compliance area said, “Paul, what are you going to do?” And I said, “I don’t know what I’m going to do, Beth. What are you going to do?”
She said, “Well, I got to go work for another broker-dealer.” And I said, “I don’t know what to do.” She said, “You ought to just go set up a registered investment advisory firm because you haven’t sold anything that we sell anyway.”
And I said, “Yeah, I don’t believe in it. That’s why it was really rough for me.” So she said, “Go do that.” And I said, “All right, yeah, I’ll go do that.”
I opened up the company and the rest is history.
I said to the guy I was talking to that I was intrigued by the academic research that was coming out about multi-factor investing and market efficiency. I was just going on and on telling my story, and the guy said, “Oh yeah. You’d be amazed how few people know anything about standard deviation or use standard deviation.”
I looked at him and said, “Why do you know about this? How do you know about this?” He said, “Oh, I like research. I like understanding investing.”
It was just interesting because it was like clockwork for him to talk about using academics and investing.
Expected Return After Inflation
Now, what is standard deviation? Why is that so important?
Let’s say that you’re getting close to retirement, and you’re trying to figure out how much money you’re going to have.
The biggest thing you’re trying to figure out is how much income you can take from your investment portfolio. That is something that is so often overlooked that most investors don’t even know to look at it.
Let’s say you get your 401(k) statement and you see how much income you can take from your investments and what they’re projecting that you can take from that. That’s very dependent on a couple of key factors.
Number one, obviously how much money you have is a big factor.
But another really big factor is the expected return after inflation of your investment portfolio.
If I know what that expected return is, that’s super helpful for telling me how much income I can take.
Now typically we look at return after inflation. That’s what I like to do.
Let’s say that you’re buying CDs right now, and you get a 4% CD and you’re thinking, Yay, I got a 4% CD. Then all of a sudden you look at it and go, “What’s the return after inflation with zero?” You look at that and go, “Wow, basically I’m going to just be running down the portfolio to keep my standard of living up.”
It doesn’t work really well. So that’s one thing that we look at.
Now, we look at a portfolio of stocks and bonds and look at various asset categories. For example, if I look at large US stocks, and go back and look at 30-year periods throughout history, I can see that the rate of return for large US stocks in every 30-year period is right around 10%.
Well, if we look at inflation-adjusted returns for large US stocks, it’s about 7%, and if we look back through history, we see that it’s been about 7%.
Projecting at the Gross Rate of Return
Now, if we’re projecting out at 10%, financial people will say, “Well, at a 12% rate of return, you’re going to …”
And you go, “Well, wait a minute. You’re projecting it out at the gross rate of return.” I’m not going to know what I’m going to be able to purchase with that amount of money in the future. I don’t know how much that will purchase.
I may look at it and go, “Well, I’m going to have millions in the future.” Well, how much purchasing power would that amount of money have? If you project out after-inflation numbers, now you can look at that number and think of it in today’s dollars.
If I had $700,000 today, could I retire? That’s the question you ask yourself.
And now I look at it and go, “Nope. Okay, how much more do I need to put away? Or do I need to adjust my asset mix to change the expected return after inflation?”
If we look at small company stocks, we get to the neighborhood of about a 9% return after inflation and a small value of about 11%. Different asset categories around the world will have different expected returns.
So that’s the first thing we look at. We go, “Okay, how much expected return do I have in the portfolio based on the asset mix?”
You say, “Well, how am I going to know that?”
Well, we can’t project out in the future and know what’s always going to be the case, because you don’t know. Let’s say that all of a sudden the whole world comes to an end and there’s thermonuclear war, and then all bets are off.
But you can look at things and go, “Well, let’s say the world kind of goes the way it always has.” There are going to be ups and downs and there are going to be backs and forth and all of that. If I look at small companies, I know historically in every long period of time, the rate of return has been very, very similar and has been very similar for large companies that they don’t have.
Even when you go back to the Depression up through World War II, you see the rate of return of large US stocks was pretty close to what it’s been in recent history. It’s almost uncanny how close it’s been.
If I know what asset categories I’m exposed to, I can come up with a decent idea of what the expected return is.
Standard Deviation
Well, what is so often ignored is standard deviation, as this guy was talking about.
Standard deviation is how much your portfolio return deviates from the expected return.
So if I have a portfolio with a 10% expected return, it’s pie in the sky to expect that my return will be 10% continuously into the future.
I mean, anybody who has ever watched stock markets before knows that it’s up 15, down five, up 25, up four, down six; it’s back and forth and back and forth. You look at the returns over five-year periods, and it’s in a much narrower range.
I look at all the five-year returns all the way through history, and I go, “What’s the return with the four-year returns?” Let me use that because the math works out really well. Let’s say I have a standard deviation — the return deviates by about 20 — for large US stocks.
So I go, “Okay, I have a 10% return, but 68% of my returns throughout history have been between 10 to 20. I’ve had a 30% return and 10 minus 20, equaling negative 10. That’s a pretty big range — negative 10 to positive 30.”
But if I know that range, I can go, “Okay, well, if it’s a one-year period, can I handle that? Is that going to drive me absolutely batty?” That’s one way that we can look at that, but we can also look at it and go, “Well, if I need this money back in a short period of time, is that negative 10 a deal killer? And negative 30 if we go out to standard deviations.”
So it’s another 20 below that number. But here’s what happens: If I look at four-year periods, I can take that standard deviation of 20 — because remember, that shows me how big of a range it is and how much it’s going to vary — and I can take that 20 and divide it by the standard deviation and the number of years. It comes out to two, and my standard deviation drops to 10.
Well, my hand goes from 20 down to 10. I drop my variation significantly when I go just four years. Now, if I go out nine years, I can drop it down to just below seven, and the longer I can go out, I can actually drop that.
Now I know my length of time and I know how much it varies, and I know how the variance drops as I get further along. If you’re following any of this, you’re going, “Wow, I can get a decent idea of how much money I’ll likely have in the future through knowing this information.”
Why wouldn’t you want to know this stuff? Why would financial advisors not want to know this or understand this stuff? And I found that when I was a broker, they didn’t. They had no clue.
We weren’t taught this in that arena at all. It wasn’t until I got into the academic side of the world that we got into that at all.
Running Out of Shares
Now, why is that important in retirement? It’s way, way important in retirement because when I’m in retirement and I’m taking an income, if I have a portfolio that is varying all over the place and going way up down and back and forth — when it’s way down, I’m having to sell more shares.
Now let me put that in a number example for you. Let’s say something was selling for $25 a share and I needed $100. Well, how many shares do I have to sell? I’ll have to sell four shares to get my $25.
But let’s say the share price drops down to $10. When it was $25, I had to sell four shares. Well, when it’s only $10, I have to sell 10 shares. I have to sell more than twice as many shares in order to get the same $100.
So when the market recovers, I won’t own as many shares. I’m sunk. It’s a problem.
It’s so critical to understand the standard deviation of your portfolio because it tells you the likelihood that you’re going to run yourself out of shares.
Now I could go and say, “Well, this is all too complicated and this is too scary. I’m going to put all my money in CDs.”
Now we’re down to where the rate of return after inflation is zero. And you go, “Well, that’s a bigger problem. I don’t think it’s a really good idea to do that.”
People end up ignoring this critical component of investing. They don’t understand the level of volatility in the portfolio. A lot of times people say, “What’s the likelihood that you’re going to run out?”
And they’re not even talking about this. They’re talking about the investment portfolio return and that’s about it. If they’ve annuitized, they’re going down what many times is a really bad path.
Controlling Risk
This week I got into a conversation about being really active at Trevecca and about gifting. We were talking about raising funds because we’re helping the students and expanding programs, and some of the things that are going on are phenomenal. And we’re like, “Well, what can we do?”
I explained that one of the things you can do is look at estate planning. Because you’d be surprised by how many people own non-qualified annuities in their investment portfolios. It’s an absolutely horrible asset to inherit so many times because of the level of taxation on it.
A lot of times I’m having people think about this: If they own one and they’ve got all this capital tied up in annuities and they have a significant amount of gains in them, it might be one of those things where they let their kids, or general people, or maybe family members, inherit stocks or the non-qualified stock portfolios because they get the step-up in basis. It’s a lot more tax efficient.
With the annuity, so often you have to get the money out in a very, very short period of time — like five years — and you have to pay taxes on all of it. It can be a really nasty asset to actually inherit.
That’s what people are often using as a way to not run out of money.
But the problem that you run into with annuitization is that almost nobody does it, because they don’t like losing control.
Annuitization comes with most of these products with no kind of cost of living increase.
The products that do have cost of living increases have horrible payouts, so in my experience, nobody even recommends them. I’ve seen that the payouts are terribly low if you want to get a cost of living increase inside of your annuity.
So that is typically what you hear talked about. Very rarely do you hear people talk about controlling risk and how critical that is in taking an income from your investment portfolio.
Electric Vehicles
You get on YouTube and every once in a while you’ll see a really popular video pop up. One popped up about Toyota and I was fascinated, but I didn’t really have time to go and look for any articles on it to see what they were talking about specifically. I found a couple that were interesting, but I’ll usually look for something from a really reputable source and I didn’t find stuff that I really jumped all over.
I have talked about this for a long time. This is one of the things I think is really bothersome for a lot of people, not just me. The vehicle world is being driven into electric vehicles — battery only — and people are like, “I don’t want one of those.”
It’s funny because I have kids my son’s age telling me, “I don’t want one of those things.” And you think, “Wow, those would be the ones you’d think would want this technology really badly.” They’re like, “No way.”
We’re looking at different technologies that will be coming down the pike that will be revolutionary, and one of them, of course, is hydrogen. I’ve talked a little bit about the hydrogen vehicles.
We’re not looking at this as being a terribly profitable area.
Electric vehicles require the acquisition of a lot of necessary metals from Russia.
We’re not really excited about that, as you can imagine. Russia, China and different countries that are not necessarily friendly to the United States — we don’t want to be dependent upon them for the materials for the vehicles. So a lot of people are not so happy about that.
People are also not so happy that the range has come in a lot lower than what sellers claimed the cars were supposed to be able to go. The cars are supposed to be able to go for these long ranges and that’s not necessarily happening. That’s one of the issues that people have been lamenting.
Now, the idea of hydrogen is something that is not necessarily with us right now. In some areas it’s been working out okay, so there’s some hope for that. I’ve talked about how we can get some of the technology to be a little bit better. There’s a good shot that we could do something with that.
Technological Innovations
The one innovation that was not on my radar screen that they were talking about in this particular Toyota video was ammonia. The video was talking about how you could actually hit the carbon — the targets — with ammonia. I have no clue how it works or what it does, but they seem to be onto something from what I’m understanding.
Now, if that ends up being the case, I think it’s interesting from a geopolitical standpoint because of the dependence on oil-producing countries. I’ve talked about this before.
You go, “Well, the oil companies are the ones that have been stopping this and making it so it doesn’t happen. They’ve been blocking.” And the oil companies, a lot of them, now they’re actually doing searches for the technology themselves.
But what is really interesting is that so much of the profit comes from things that have nothing to do with making fuel. That was one of the points that was made by Exxon, I think.
They said, “Hey, look, you have plastics, you have roads, you have a lot of things that you use petroleum for that have nothing to do with fueling vehicles and we’ll be fine.”
Now, if that indeed happens and we find some other way of doing things, then maybe the amount of petroleum or the oil that we actually produce in the United States will be plenty to take care of all of our needs in other areas, and then we’ll make everybody happy regarding the environmental stuff that people are so concerned about.
But to me, this is a really hopeful piece of news. I think it’s something that is worth watching and taking a look at. I’m going to be doing some reading about that and I’m going to talk a little bit more about it — what it might lead to and where we might see some changes down the road. That was another topic of conversation I’ve had with so many people here locally.
There’s actually a drone type of vehicle that has been developed called the Jetson or the BlackFly, as I’ve talked about.
There are a lot of different operational vehicles out there — the one that was actually approved by the FAA as well. We’re going to have to deal with these types of things because people are saying, “Well, we needed a train a long time ago.”
Some of those technological innovations that come from flying cars are probably going to be taking us out of traffic problems.
I’m very hopeful about those types of things and looking forward to seeing how that all plays out.
