Paul Winkler: Welcome. This is “The Investor Coaching Show.” I am Paul Winkler.
Bad Experiences With Investing
I think educating, providing guidance, and providing discipline are really the big differences between investors doing well — that research shows — versus them self-destructing. The average asset allocation investor according to Dalbar, divides between stocks, bonds, and fixed income, over 30 years, lower than the inflation rate. That’s it.
You look at that and go, “Lower than the inflation?” That’s the average. Okay, so what does that mean? Half are above, half are below.
And what we know is that a lot of people, I talked to some people this weekend, and literally they have just given up on investing. Just, “I have nothing to do with it.”
“I haven’t had any good experiences,” somebody said to me. And they called me because they had been referred by a friend, and the friend said, “Yeah, you got to talk to this guy.” So this guy calls me and I’m talking to him about things. And I’m going, “Yeah, you know why the average investor experience is so bad is because of the things I’m about to tell you.”
So I’m going to do this this way. Imagine that you wanted to make a lot of money on investments. And I’ve joked around with regard to annuities and insurance products this way as well.
Want to make a lot of money? Sell them. Because so much of the sales process with investing is getting you to do things that you shouldn’t do, and buying things that tend to be way more expensive than you think they are.
Even with these fund companies that try to make it look like their expenses are nothing, they’re making money in other ways.
They’re not building these big buildings, running these big ads and commercials and all of that by charging nothing for their investment services or having extremely low management. No, there are a lot of expenses that you’re not even aware of.
The Five-Star Curse
But this isn’t going to be about this. This is going to be how to get you to do something imprudent with your investments and get you to do something that the advisor wants you to do.
And a lot of times, the advisors aren’t even aware that it’s happening. That’s the big problem. They’re not even aware that that’s what they’re doing.
But I’m going to tell you, working for investment firms for as many years as I did, all of us — Evan, Jonathan, Ann, Arlene, Jim, Ira, James, and everybody — have come from that background selling things. And how do you do it? How do you get your advisor to sell things? Well, you’ve got to give them some kind of a story that the client will buy and the client will gravitate toward.
The funny thing is, I learned this, how this was done, back in the early ’90s. I will never forget the first time that I was exposed to this method of selling things when I was actually working with a company in town and working with one of the people that was in the company, one of the employees, the owner’s son, as a matter of fact.
And he was parading before me the things that the advisor was recommending and actually saying, “Hey, your other advisor, Paul, he’s not doing it right. Here’s what you need to be doing.”
Here’s what he did. He pulled out Morningstar Reports.
Now, Morningstar is a company that analyzes all the different investment choices that you have out there — annuities, sub-accounts and annuities, mutual funds, ETFs, everything. They look at it, they report the data on it — what’s it investing in, what kind of companies, what are the biggest holdings, what are all the holdings, as a matter of fact. They have that in there. And then they have star ratings.
And Wall Street Journal has basically said that is one of the worst ways of choosing investments.
They actually called it “the five-star curse” because funds that have really high ratings go on to perform very, very poorly.
And there have been multiple articles since then that have come out basically putting out the same thing. Well, the guy that runs Morningstar basically said, “That’s not the way you choose mutual funds.”
Well, you guys are putting the star ratings on it. What do you mean that’s not the way that you choose mutual funds? You’re the ones doing the star ratings and you know that people associate high star ratings with good investment performance in the future, just as they actually associate good past performance with performance in the future.
Selling on Past Performance
So what happens is if I want to try to get you to buy something, what I would do is go, “Okay, let’s look at…” And I’ve got my most recent, my new book in front of me that actually goes through, it’s called a matrix book, and it goes through returns of various asset categories in recent history.
It looks at one year, five years, 10 years, 15, 20. Now, what I like about this book is that it goes to 50 years and 80 years. That is long-term.
Because what we’re looking for is what returns in the long run, but if we look at all 30-year periods for large U.S. stocks, it’s within a percent of 10% return.
We don’t necessarily have to go 80 years, but the more data you can get, the more you can figure out what is an expected return for this portfolio.
Now, stick with me on this one. Because let’s say I’m trying to sell you something and I look at the portfolio that you’ve got and let’s say you’ve been a listener to this show and you are super, super diversified.
You’ve got large companies, you’ve got small companies, you’ve got large value companies, you got small value, you have international large, international small, international large value, international small value, emerging markets, emerging markets value, emerging markets small. Those would be the asset categories that I want to hold. Let’s say that you’re super well diversified, but I want to try to blow up your portfolio as an advisor trying to sell you something.
What I would do is I would go through and say, “Let’s see what had the highest return over the last year. Let’s see, the S&P 500 was 26% for 2023. Let’s see, small international stocks, they were only up 14. So 26 is a much higher number than 14.”
I would go, “Look at this, you way underperformed. You got this dog in there. It’s just a 14%. It wasn’t terrible, but 14% return versus 26% return.”
Or, “Let’s look at the five-year performance. Good grief.” You’ll look at, let’s say, the S&P was 15% and emerging market stocks were only 4%.
“Why are you going and putting money in emerging market stocks? It’s a 4% return for five years.”
Why You Diversify
In fact, that’s exactly one of the objections that I had in the late ’90s when I was studying under Eugene Fama, the guy that won the Nobel Prize in 2013. And he was pointing out to us as students, “Hey, look guys, you probably ought to have your clients in this asset category.”
It was international small value at the time. He was saying, “You ought to have clients in that asset category.” I’m looking at it going, “Why?”
Large U.S. stocks were knocking it out of the park during that period of time. It was the sky’s the limit for that asset category. You look at the ’90s, let me look at the book right here, because you look at the 1990s and you go up to, let’s say, 1999, the rate of return was 19.2% per year for the S&P 500. That was from 1989, excuse me.
It was 18.2% from 1990 up until the year 2000. You can go to 18% return per year. Wow, that’s great. That’s money doubling in a very, very short period of time.
If you take the rule of 72, it breaks down going above 12% return. But if you take a 12% return, rule of 72, take 72 divided by your rate of return, 12, that means money doubles in six years. That’s money doubling even faster than six years, maybe three or four years.
So you look at that and go, “Whoa, wait a minute. What I want is that.” International small had a five-year return of zero and you go, “Why on earth would I ever do that?”
And you go, “Yeah, why would I do that? That’d be silly to go and put my money in something that, number one, I don’t even know what those companies are. I don’t even know who they are.
“And why would I go and do something like that? Because I like myself too much to do something like that.”
Well, over the next 12 years, U.S. large companies basically lost money. It’s like a negative return.
Whereas international small, that thing that had five years of zero return, had a 14% return per year average annual from 2000 through 2011, and you look at that and go, “Well, wait a minute, what happened?”
That’s why you diversify. You don’t know when this kind of stuff is going to happen.
Buying Low and Selling High
But if I’m just trying to sell you investments, I’m going to go through that list and go, Hey, what had the best performance? That’s what I’ll do. I’ll just show them that. I’ll just show them that, that’s what we’re going to do.
It’s especially enticing when the asset category that had the greatest performance last year was the one that you’re most familiar with because then you’ve got familiarity bias. “I know who these companies are. I shop at these companies and it’s in my country and it’s patriotism.”
There, you can throw that in there, throw that in the mix. “I’m being a patriot. I’m owning companies that are all U.S. companies.”
Then you’ve got a mix for something that really pulls people off the beaten path and causes them to go and break the rule of investing, which is what? Buy low, sell high.
Now, you can’t go and consistently buy low, sell high. That’s timing the market.
But you go and choose investments for your portfolio, which are based on short-term performance — and yes, five and 10 years are shorter-term performance. If you look at large U.S. stocks for 10 years, the rate of return for the S&P year ending 2023 is 12% return. Well, if we look at U.S. small companies, it’s about 8.6%.
And you go, “Well, why on earth would I have owned small companies if we can just put money in large companies and have that kind of return? Why even mess with that?”
Well, the answer to that question is, again, you look back at that period of time that I just talked about, when I’m looking at large U.S. companies having no return, negative return, basically losing money, and you go, “Well, what happened over that same period of time, 2000 through 2012, for small U.S. companies?” We’re still in the U.S.
The rate of return from 2000 through 2011 was just about 14% per year, whereas large U.S. stocks lost money. So that’s just using dimensional U.S. small-cap value index funds, just looking at that particular market segment, at small companies. It’s a different area of the market.
The Drive Toward Pleasure
But if I want to sell you something, I remember to appeal to your desire to go toward pleasure. If I want to sell you on going to a restaurant, I’m going to tell you how great the food is going to be and how wonderful it is, and you’re just going to love this and you’re going to have so much fun.
We are driven to go toward pleasure. Now, if I told you, you may get ptomaine, you’re probably not going to want to show up at the restaurant.
If I tell you that there are going to be asset categories in your investment portfolio that are going to perform poorly, I’m not going to guarantee it, but I’m going to tell you that it’s very likely, then you’re going to go, “Well, I don’t want that. I don’t want anything.”
“I don’t want this meal at the restaurant where I like the potatoes, but the meat is awful and the green beans are okay, but the broccoli is broccoli.” Who likes that? I’m not going to do that because I want to tell you everything on your plate is going to be wonderful.
It’s all going to be great. And the atmosphere is going to be phenomenal. The music’s going to be great in the restaurant. And the waiters and waitresses, they’re all going to be phenomenal, they’re going to be top shelf.
But the problem with investing is that’s not the way it works. Otherwise, we wouldn’t diversify.
If everything in the portfolio were going to do great, then there’s something that isn’t needed.
If you think about it, why have any more than one thing if everything’s going to do great? But that is why investors get pulled in and they get sold something that they shouldn’t be sold.
And as I just went through, you look at that and go, “Five years, small international, no return.” That is a hard pill to swallow.
But then over the next 10 years, it’s out of the park, tripling in value. Whereas large companies, the thing that had done better before, crash — yuck, absolutely awful.
And then what happens is after something does awful like that, I’m going, “Oh, I got to get out of it all the way. I got to get out.”
No, you don’t want to get out of it altogether because the next 10-year period that very well may not be a very good idea. Unless it is a bad thing, unless it’s a bad investment, you may want to get out of it altogether.
But if it’s an asset category that should be in a portfolio and the fund that you own is doing a good job of capturing the return of that asset category, even if it’s zero, even if the small international stock fund had a 0% return in 1999, well, that was asset class returns. It wasn’t a problem with the fund. It just happened to be a bad period of time.
Now, this is a tough pill to swallow. This is why investors get terrible, terrible results, because this is so counter to what I want to hear. I don’t want to hear that there are going to be some things in the portfolio that don’t do well. But that is reality.
Hindsight Bias
Sometimes we have to recognize that reality is the best thing for us to embrace. Matter of fact, if you read the prudent investor rule, the statement in the American Law Institute, they talk about diversification this way.
This is the law as to what constitutes prudent management of a portfolio, and they literally tell people, “This is what’s going to happen. Suck it up. Suck it up, recognize it.” Because if you don’t and you chase returns like the rest of humanity has this tendency to do, you are going to get the same bad results and you are going to be literally chasing your tail for the rest of your life and you may have really high odds of running out of money.
Because what do we see in the Dalbar research, as I started this segment with? We see a 2.85% return in 30 years.
Why are investors getting such bad results? This is what they’re doing. Investment advisors are subject to it.
We see it all the time. I see it all the time. I was subject to it. I remember the first 10 years of my career, this is what I was doing.
And then I had this guy selling against me, and he was pointing out what I had put the client in, “Oh, look at the performance of this.” And, “Look at what he had you in. You should have been in this.”
There’s another big firm in town. I still have their book. And that’s what they would do.
They would look at five-star ratings on funds and they would go, “Look at all the funds you own for the past 10 years. Look how badly they’ve done.”
This is the book that they would put together when they were competing against another investment firm. Then they would take that book and in there they would have the lousy performance.
And they have this little chart on what the performance was in the funds that you owned over the past 10 years. Then on top of that chart, they put a chart of what would your return have been and how much your money would have grown if you were in the things that they’re recommending that you buy from them.
What they didn’t tell you was that they didn’t own those funds during that same period of time. That’s what they’re recommending now.
You talk about disingenuous. Oh my gosh, they did not even own those funds. How do I know that? I know what they were investing in because I researched it and I found that they didn’t own the funds that they were telling somebody and saying, “This is what your performance would’ve been.”
It’s called hindsight bias. We look at it and go, “Well, yeah, in hindsight, that’s what would’ve been great to own.”
Fund Companies Keep Changing
Of course what happened is the fund company, the investment company, the group that I’m talking about, has changed their way of doing things three to four times, even their name, many times over the past 20, 25 years. And they keep changing everything.
The reason is because nothing works that they’re doing. And people catch on to it and they go, “Well, that didn’t work.” And then they change funds.
“Oh yeah, yeah, that fund didn’t work. I should have put you in this one over here.” And then you go do the same. And they show you some past performance of something and then you go do it again.
I just remember buying my first car. It was kind of like that. It was this dog and pony show. And you learn how the car dealerships do it.
“Yeah, we’ve got to bring in my manager. Oh, you’re a really shrewd negotiator, Paul. I’m going to bring my manager in to see if we can agree to this. Oh, did you want this extra feature on your car?
“Oh, yeah, well, that’ll be this much more. Or did you want this extra? Oh yeah, that’ll be this much more. Oh, you know what? Your trade-in.
“I don’t think that we’re going to be able to give you that much for it, but we might be able to get it up a little bit more. I don’t know.” And they go back and forth. And once you learn their little games, then all of a sudden it’s, “Oh my gosh, I am being sold in a big way.”
But the problem is most people don’t know the games of the investment management world. It’s so complicated to them that they don’t get it.
But this is one of the big ones I wanted you to be aware of, using past performance and dogging things in a portfolio that made it diversified but underperformed over the most recent period, not recognizing that past performance is not an indicator of future performance.
That thing that did not do as well may be the very thing that saves your portfolio in the next five to 10 years. But they don’t talk about that because it doesn’t sell.
Episode 2
Paul Winkler: I’m back here on “The Investor Coaching Show.” I’m Paul Winkler, talking money and investing.
Roth IRA Conversions
I just had somebody ask a question and throw it by me. And the question was something in regards to Roth IRA conversions. They heard something and just wanted my thoughts on it. So I thought I’d jump in on this one.
The example was given as this. When we look at Roth IRA conversions, let me just talk about what that is. Let’s say that I have an IRA, it’s a pre-tax IRA or a 401k where I put money in, and I didn’t have to pay taxes on the contribution.
So let’s say that the contribution is $1,000. And instead of taking that income, and let’s say there is such a thing as a 20% tax bracket. There’s not, it’s 22 and 24, but let’s just say 20, just to keep the numbers nice and round.
If I have a 20% tax rate, if I take the income, and I forget social security for a second, but let’s just look at the federal income taxes — the federal income taxes in this particular example would be $200. So I take $1,000, 20% of $1,000 is $200. So I would have money taken out to go to the federal government.
So I look at that and go, “Well, I don’t need the money today. What can I do? Can I put it off to the future and take the income in the future? Can I defer it?”
And the answer is, yeah, with qualified plans, retirement plans, pre-tax plans, yeah, you can defer it.
I can take that income later on down the road when I really do need it, which would be in retirement.
So that’s why these types of qualified plans have always been very, very popular. Now, if I take that income, I’ve got to look at that and go, “Oh gosh, I’ve whittled it down to $800 bucks.”
Ignoring the Time Value of Money
Or let me use $10,000. I’m going to use $10,000. I’m going to just use that as a contribution level.
So it’s $2,000 in taxes that I’d save on a $10,000 accumulation, or on a $10,000 contribution. Now if I don’t put it in my qualified plan, my pre-tax qualified plan, my tax-deductible program, now I only have $8,000 to deal with.
Whereas if I do put it in the pre-tax plan, I have $10,000. Okay? So you with me on that? Okay.
Now here was the thing. The example that was given was that the tax bracket now was let’s say 20%, and in the future, it’s 10%. You still ought to do the Roth IRA conversion. You ought to take the money, or you do the Roth IRA instead as a contribution.
Because if I go and pay the taxes now, there’s only $2,000 in taxes. So you look at that and go, okay, well that’s again, I hate it. I’ve got to pay $2,000 in taxes, but I’ll never be taxed on the money again.
Now, if I had done pre-tax, if I had done tax-deductible, pre-tax, traditional IRA, traditional 401k, the whole $10,000 goes in, but later on, I have to pay taxes on the distribution. And if I’m in a 10% tax bracket and it’s grown to $100,000 — let’s say the $10,000 grew to $100,000 — now I’ve got 10%, $10,000 in taxes.
Well, let’s just pay $2,000 now so that I don’t have to pay $10,000 in the future. That’s five times as much taxes. That doesn’t make sense, does it? You’re ignoring the time value of money.
Money that was paid to the government in the form of taxes could have been earning income for you into the future.
This is what this is ignoring.
Changing Tax Brackets
So let’s use our example. In my example, which is, I’m just making up numbers. I just want you to get the concept.
If I had $10,000 and it grew to $100,000, it’s a 10 times growth, right? It’s tenfold growth — 10 to 100.
Now, if the money was paid to the government in taxes, then it’s gone. It doesn’t earn income for me anymore. Right?
Now, let’s say that it was $2,000 like I had given in the example. It was $2,000 in taxes that you ended up paying.
Well, what if that was multiplied by 10 times? What does that come out to? It comes out to $20,000.
Now, if that money grew to $20,000 and I did pay $10,000 in the future, I’ve got a net 10 growth on that. It did make sense to take the deduction. Now it did make sense not to pay taxes right now at 20%, and that is what you look at.
I’ve found that financial advisors get this confused all the time. I remember back in the ‘90s I was going into this one thing, it was almost like a pilgrimage. These financial advisors were going to these conferences, and the reason that they were going to these conferences is there was this guy who was a guru — supposed guru — and he was teaching people how to sell a whole life insurance policy, and he would often compare it to a Roth IRA.
So that’s why I’m using this example. And he would do this. He would do this kind of thing and we’d be all like, “Oh wow, interesting.”
And I thought, well wait a minute, wait a minute. These advisors are going gaga over this thing. I’m looking at it going, “Are you guys just bad at math? How did you get into this industry?”
This makes no sense if you look at it that way. Now I’m going to give another example to make it a little bit easier.
Let’s say I had $10,000 and I am in a 20% tax bracket right now, and let’s say that money doesn’t grow at all. Because this makes it even easier for you to grasp this concept.
So it is $10,000, it doesn’t grow a dime, I’m the worst investor in the whole world, and then later on I’m in a 10% tax bracket. So 20% now, 10% later.
If I put it away into the pre-tax, I save $2,000 in taxes, 20% of $10,000. Now, if I put it in a post-tax and a Roth IRA, I only have $8,000, right?
Okay, stay with me on that, hopefully. Now the $10,000 doesn’t grow at all. So in the future, I pull the $10,000 out. Now I’m in a 10% tax bracket, I’m going to a lower bracket.
What are my taxes? $1,000. What do I get to spend? I get to spend $9,000, because I got the $10,000 minus the taxes I have to pay, now what do I have to spend? I have $9,000.
Compounding Both Sides of the Ledger
Now let’s look at our ledger again. On the Roth side, let’s say that I have the $8,000 and I’ve multiplied that $8,000 by 10 times. What do I have to spend? I have $8,000.
Now on the pre-tax side, my regular IRA, the $10,000 stayed in the account the whole time. It’s still $10,000. I pay taxes at 10% later on.
Now I have a $1,000 tax bill, and then I’ve got $9,000 to spend. Which number was higher? The $8,000, which was the Roth IRA.
Because remember it grew from $8,000. It just stayed at $8,000, it just didn’t grow. Or the IRA, which didn’t grow, it was $10,000 to $10,000.
But now because the tax rate is lower, when I pull it out, it’s not $2,000 in taxes, it’s $1,000 in taxes. Therefore I have $9,000 to spend. The $9,000 is a bigger number than $8,000.
It’s that simple. And the problem is, what happens is that people don’t get this idea.
You have to compound both sides of the ledger. You can’t just compound one side of the ledger.
But that’s amazing, because I was in this huge room. And it was in Washington, D.C., in May — I guess that was when all of the trees, the cherry trees, all of that was in bloom, I mean it was beautiful.
And we were there for that conference and people lined up, the financial advisors lined up outside the door, and they would line up early in the morning and throw their books on a table so they could get a seat toward the front. It was a pilgrimage.
I was there, I was like a fairly new advisor. I didn’t know a lot, but I was listening to this guy and going, wait a minute, this is just not good math.
But yet, financial people were flocking to it because it helped them sell what they were trying to sell. It gave them a story. And the problem was the clients probably didn’t get it either.
Because they were listening to the person talk with great confidence, the financial advisor. They thought, This person must know what they’re talking about. They’re confident.
When in reality, it was just bad math. This is why we call this “The Investor Coaching Show.” It’s education — educating you, the investor, because you get taken advantage of, and it may not even be on purpose. It may be just because there’s bad math going on.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
