Paul Winkler: Welcome to “The Investor Coaching Show.” I am Paul Winkler, talking about money and investing. I am educating because, well, nobody else seems to be doing it (or very few people).
The voices that you hear the most are people who are educating you on things they want you to know so that you’ll buy what they’re selling. And that is not the way we work around here, because I think the educated investor does not get pulled astray. There are all kinds of ways to get pulled astray.
Avoiding Risk
There was an article that I wanted to talk about here that was in MarketWatch, and it was “Beyond the S&P 500: How to supercharge your diversification” by Paul A. Merriman.
You get a lot of lip service in the finance industry for diversifying your portfolio. Don’t put all your eggs in one basket. Especially when dealing with times of calamity, a lot of times our desire is to go away from diversification. I want to go toward safety.
And when I go toward safety — like fixed-income investments, annuities and things that I think are safe — I’m actually increasing risk. Because if you think about it, we actually live in a world where currencies are not tied to any kind of commodity anymore. There are all kinds of reasons for that that I won’t get into. But you have flat currencies, which in other words, are not backed by anything.
Therefore, what happens is you’re depending upon the currency actually maintaining value, and we call that inflation when it doesn’t maintain value. And that is, of course, a big problem with those types of investments.
Protection against inflation is non-existent, historically.
It can be a huge problem. So what we do is we say, “Well, maybe I shouldn’t do that.”
The way I look at it is we get some semblance of security in our lives by spreading things out like crazy.
Think about your career or think about, let’s say, whatever you do for a living. What if all of a sudden what you do for a living becomes obsolete? Maybe you do something that is really in demand, but what if it all of a sudden becomes obsolete? What if you’re that person who makes horse buggy whips or something like that, or you’re involved in something that is being supplanted by something else?
Preparing for Changes
There are all kinds of articles about how that’s happening right now with AI and so on and so forth. But just think about it. What do we do to protect ourselves from that eventuality? Well, what we do is we make sure that we’re constantly learning, constantly reinventing ourselves, constantly picking up new skills, constantly doing something, anything to make sure that we don’t become a statistic and that we’re not all of a sudden no longer needed in the economy.
That is something that changes all the time. Look at the jobs and the careers of the ’70s, the careers of the ’80s and the ’90s, and how things have changed over the years. We’ve had to keep up. When you think about it with diversification, with investing, you don’t know what’s going to be happening out there.
What are going to be the new technologies? What are going to be the new things that come along? What are the changes in the economic marketplace? What are the geopolitical changes that are going to happen, and how are they going to affect markets?
Diversification is just absolutely critical.
It’s one of the things that we talk about as a basic tenet of investing. A lot of people think they’re way more diversified than they are because they own a total stock market fund or something like that, until you explain to them that they almost own nothing in small companies in those portfolios because of the way those portfolios are weighted. They overweight big companies.
And that goes with our biases. When we talk about how people end up getting taken down the wrong path, it’s our biases that actually drive so much of our behavior. I am familiar with certain things that have done better in the recent past history, and I’m driven by that.
People are driven by thinking that they’re more of an expert than they are, because maybe they’re really good in their field. They think, Oh wow, I’m really great at this. I’m really smart. That means I can do anything, and that investing is easy for me as well.
Some of the worst investing mistakes have been made historically by some of the smartest people. So that’s just not true.
60/40 Portfolio
This article is talking about beyond the S&P 500, which I think is smart, because right now, the S&P has been on a run. Those are the 500 largest companies in the United States.
I like a few things about this article. A few things I disagree with, but I’ll point those out because that’s part of what I do here: point out things that are being taught that aren’t necessarily right.
What’s beyond the S&P 500? What’s the first thing that they bring up? Well, they bring up bonds.
There is another article someplace else talking about how the 60/40 portfolio has just failed miserably and I would agree, because the way most people implement that — 60% stocks, 40% bonds — is just backward. They own types of bonds that are longer bonds in these 60/40 portfolios. In other words, it’s going to be a long time before they mature.
You lend money, let’s say to a company or to a government, and you’re not going to actually get your money back for maybe 10, 15, 20, or 30 years. That’s a long bond. And what happens is that in the interim between when you lend the money and you get the money back, you’re going to get interest payments.
Well, if interest rates go up, then all of a sudden, those bonds become worth less and less and less and less. When interest rates go up — causing corporate expenses to go up because corporations pay interest on debt — your stocks go down and your bonds go down together.
60/40 doesn’t work anymore.
It doesn’t if you implement it that way.
I laugh because this is stuff I’ve talked about for 20 years, and the academic research has been out on it for a long, long time, 22 years now. The academic research has been out, but it gets ignored.
Stock Versus Bond Mix
I was talking to a friend of mine the other day, and we got into talking about how frustrated he was. And I laughed. I was like, I feel your pain.
He says more people search for black holes than they do any of the research on modern portfolio theory or multifactor, or any of the academic research. They just don’t realize what a big deal it is. He says the most reliable thing here is to own bonds in addition to equities, and I agree.
That’s what I always tell people.
This is the first thing that we look at when we put together a portfolio: What’s the stock versus bond mix?
That’s number one. The reason is that stocks and bonds historically don’t tend to move with each other.
I don’t like to go with the long ones because they can, as I just described, move a lot together and really decimate you, because all of a sudden they both move down, and you’re trying to draw an income, and you’re going, “Well, which one do I sell low? I’ve heard that the golden rule of investing is buy low, sell high. And now I have to sell low. Which one?”
And that’s why we want shorter and high-grade types of bonds in the portfolio, as I’ve talked about many times here.
I want to have something that I can draw income from to buy time for, because historically, equities always recover. I mean, you look at it, and it’s up and down. It’s just normal that they go back and forth like that.
But what people do is they go, “Let’s just have this big repository of fixed-income investments, and let’s do the bucket approach. Let’s draw from that until it’s depleted, and then we’ll pull from equities.”
And I go, “No, no, no. That makes no sense.” And that’s something I’ve taught elsewhere. It makes no sense, because what you’re doing is you’re depleting it.
Then once you’ve depleted it, what if stocks are down in that year? You’re sunk, man. You are done. What if the inflation has kicked up, and all of a sudden your interest rates have gone off and your bonds have dropped down in value?
And you’re doing that, you’re selling that into a low. There are a lot of reasons that just doesn’t make sense, but I won’t get into them right here. But that’s the first thing: the bonds, in addition to stocks.
Diversifying Your Equities
The article says, “Once your overall risk is under control, you’re likely to get the greatest long-term benefit from diversifying your equities.” This is something I don’t see enough. I hear people talk about equity stocks, and they talk about bonds, but they don’t talk about types of equities, and I think that’s a huge, huge mistake.
The article talks about what to do if the stocks are pretty similar. Having more of them may not help much. And I think that is a really good point. This is true.
Owning all 500 stocks in the S&P 500 essentially eliminates the chance that any single corporate disaster will take you down. However, the index is heavily weighted to stocks of giant companies, as I’ve said many times in the show. This MarketWatch article is nailing it.
Now the article says, “However, the index is heavily weighted. … These stocks mostly tend to move up and down together.” As I’ve talked about here on the show before, you can go 20 years, pretty much — or the recent period where we went 12 to 13 years — with no return, which means negative returns after inflation.
Now the article says, how do you do that? Well, you can diversify amongst groups of stocks. And then Merriman says, “Don’t recommend sector funds.” Again, nailed it.
Too often, people will go, “Oh, tech, it’s really hot, right?” I just saw in an email I got that this person set up this tech fund or these tech stocks with insurance on them. And I’m going, “Well, okay, you’ve taken a certain type of stock with a potential return that might be high in some periods of time, and you basically watered it down by insuring it.”
When you take away risk, you take away return.
I mean, it’s just the way it works.
Having Options
When you have these options — traits and futures and things like that — you’re actually, with the annuities, guaranteed you can’t lose. And those types of things, they’re using options to guarantee your downside.
They’ll have municipal bonds that are insured. Well, I don’t like municipal bonds. I can’t remember the last time I’ve ever recommended using that in somebody’s investment portfolio because, again, what’s the purpose? My bonds are to protect against risk.
With the municipalities, you end up with risk.
I’ve talked about that before too. I won’t go there right now.
But anyway, what happens is that with these options, contracts and insurance, you’re dragging down return because you have an expense that you have incurred to do that. There was a guy from a big investment platform with all kinds of commercials from this platform saying, “Hey, you can do your trades here, you can do it more cheaply, blah, blah, blah,” and all the beautiful things. He was being interviewed, and they said, “What’s going on right now?”
He said, “Well, we’re not making as much money on stock trades, and you’re not doing as much stock trading right now.” And I’m going, “Yeah, because people are getting killed doing it, right?” So since they’ve been bitten so badly, they’re not doing it anymore.
They said, “Which one do you make more money on?” He said, “Options. We make a lot more money on that.”
Wall Street: Whatever you want, they will give you. They’re just big enablers.
It’s like the parent that wants to be a really good friend to their child and just lets them do whatever they want, doesn’t give them any kind of boundaries whatsoever. And the kid goes wayward and everything falls apart and they wonder what happened.
Well, that’s the same thing. You have this enabling going on from Wall Street and then people end up losing and then they go, “What happened?” Maybe we just let you do whatever you wanted to do and you shot yourself in the foot and we made a bunch of money.
Mid-Cap Stocks
Merriman talks about diversifying across asset classes. Where have you heard that before? That’s what I talk about all the time — diversifying across asset classes. In the example here, they use the asset categories of small value and large value.
Notice something missing from that. Something that’s always missing when I teach is mid-caps. Why? Because you have something called the goalpost effect where you find that your greatest diversification is in companies that are more different from each other.
Medium-sized companies are more similar to other areas. Why is this so important? Again, when I’m taking income in retirement, if I have something that’s going down, I don’t want to sell into the downturn.
I don’t want to keep selling at lower and lower prices, because when it recovers, I won’t have any shares left.
That’s the problem you run into.
The article says, “You’ll see year-by-year returns going back to 1928 for each of these four asset classes, along with the results of combining all four into one.” They have a chart showing what happens if you believe the S&P is all you need. Look at the chart and notice how many times that you end up in the bottom if you only have large US stocks: It’s a lot of times.
Sometimes these years continued and continued and you’re sitting there going, “When is this thing going to recover?” And then you finally give up and then it recovers after you give up, right? Isn’t that classic?
So what happens is that you take a look, and they show all these different periods all the way through history that I’ve talked about before, so I won’t belabor that. A lot of times in the last 100 years, you’ve seen these downturns in the S&P go on and on and on and on. And what happens is that in the period shown, the return to the S&P switched 34 times from positive to negative.
I mean, it’s a lot. That’s not a recipe for peace of mind. And I think that’s a really, really good point.
What can we do about this? I would make sure that I have international stocks too. If you look at international stocks right now, international is selling for way lower than us for every dollar of earnings and for every dollar of book value for the assets. It’s because that’s been out of favor for a while.
So do you go, “Oh, well, it’s been out of favor for a while. I’m just not going to own any of that”?
Well, you know what? US large was out of favor up until about eight or nine years ago, and then all of a sudden it did better than everything else. Does it make sense that now after it’s done so well for so long, we just load up on it?
Well, most people are loaded up on it, and they don’t even realize they’re loaded up on it. They don’t realize that target date funds are primarily that asset category. They don’t even realize it because they don’t even know what they’re looking at. They don’t even know what they’ve got.
Indexing the Portfolio
In the article, Merriman talks about indexing the portfolio. And the thing is, you can buy an index fund for large US stocks, and you can buy an index fund for small US stocks.
Well, here’s the problem with that dissimilar price movement. For example, if you look at last year, the Russell 2000 went down over 20%. If you look at the asset category, yes, it was down, but it was down a lot less than 12 — which, if you look at this 8% spread, is a pretty big deal. Then you look at small companies with a small-value index fund.
The Russell 2000 value index would be a small-cap index, and that’s what index funds would actually be looking at. A lot of index funds are going to actually mirror that. Well, it went down almost 15%. That’s a big, big difference.
Now, in an up year, like the year before where you had, let’s say, small stocks, the Russell 2000 went up about 14%. Well, small caps, as I would define them, would not be capitalization weighting it like an index fund does for micro caps up over 30% to 33%. Well, that’s a pretty big difference. Up 14 versus up 33.
You look at that and go, “Wow, that can be a big, big, big difference.” Small-value stocks are up 28, and the asset category, as I would hold it, is up over 39.
Beyond what I can get in this segment? I’ll give you a couple of things.
Number one, don’t do strict capitalization weighting — weighting based on the size of the company. Make sure that the portfolio doesn’t fluctuate because index funds are reconstituted every so often, usually about once a year.
What happens is that those indexes will look like small-cap indexes for a little while until they drift, and then they will drift for an entire year, and they will become more of a mid-cap index.
Then you’ll have how the portfolio is traded. You’ll have the criteria for what we determine as value versus growth. For a lot of reasons, indexing is not a solution that I recommend, but overall I give “Beyond the S&P 500: how to supercharge your diversification” a pretty good grade for an article like that. I think it’s good in general, what it teaches.
Employee Changes in Companies
If we look at companies, companies of course have lots of different areas of expense. One of them would be the cost of goods sold. They have to buy parts and things like that to make whatever they make. They have infrastructure costs — maybe it’s the intellectual capital that they have to buy or whatever software.
So you got your costs — you’ve got your operating expenses, your lights, your heat and air, and then of course you have telephone and communications and computers, and your employee costs are going to be a big part of that.
One of the things that has been happening is we have had these demographic changes — I’ve talked about this before — where in certain countries around the world — Japan, France, and Germany — you have an aging of populations, and we’re not necessarily seeing a lot of replacement of those populations through births for all kinds of reasons. That’s not my kind of show, so I’m not getting into that right now.
But there are things going on where, all of a sudden, now we’re not seeing the growth in the population. And of course, we need employees. Well, what’s happening?
According to an article by the Wall Street Journal titled, “I Just Wasn’t in the Mood to Work: American Employees Reinvent the Sick Day,” the bar for taking a sick day is getting lower, and some bosses say that it’s a problem.
They’re finding that US workers have long viewed an unwillingness to take sick days as a badge of honor. But the number of sick days Americans take annually has soared since the pandemic, employee payroll data shows. So now we have lower birth rates and now we have more people taking sick days. That’ll probably start to change in a little bit.
But think about it.
What is a company to do when this kind of change in behavior takes place?
You go, “Well, what’s going on? This guy, he’s taking a picture with his son, and they’re off at a football game, on his sick day.” Well, he was too sick to go into work, but he wasn’t too sick to go and take a selfie at a football game. And you go, “Whoa, okay.”
The article said the younger generations are in front. Younger workers used to follow the examples of their older peers and come in even when under the weather. And what they’re finding is that that is changing.
Companies Adapting
I think that there was another article in the Wall Street Journal that explains what happens when companies do these kinds of things. It was entitled “Amazon Introducing Warehouse Overhaul with Robotics to Speed Deliveries.” I think that’s what we’re going to start to see more and more.
We’ve all been talking about robotics for many, many years, right? Well, now what’s happening is you have AI-equipped sortation machines and robotic arms, and now they’re starting to take the intellectual type of duties that employees are engaging in or have engaged in. That’s what I’ve talked about here on the show before, is to look at the Industrial Revolution. That was taking physical labor and replacing it with mechanized labor.
Now with AI, we’re starting to see intellectual labor being mechanized. Because companies are going to figure out some way to do this. And it is always a question of which costs more.
Does the employee cost more, or does the machine? Because machines are expensive. Which one is more expensive? And what is happening is we’re starting to look at that and go, “Well, in some cases, if we start to lose the work ethic, that is going to be what ends up happening.”
It’s either that or do without. And then all of a sudden, things become more expensive because they become more expensive to produce. Then all of a sudden, people regain their work ethic, because if they want anything, they better work. And of course, that changes the pressure.
This is something Alan Greenspan talked about 20-plus years ago — immigration and how to do it more smartly. We don’t just let anybody into the country, but we look for types of people that we need and that we want and that will adapt to our way of life and so on and so forth, and that’s the type of person that we let into a country.
The reality of it is, there has been like a 1.3 million person increase in the population in the United States in the last calendar year, and 1 million of it was immigration — illegal or legal, I don’t know, they didn’t give the breakdown on that. But that’s a pretty small growth in population from birth. If we’re not going to have that growth in the population from that source, we’re going to have to get it from another source. But what has always happened, and what continues to happen, is finding ways to replace labor and mechanizing it if we don’t have it.
Why am I talking about this? Because this is why I like owning companies.
Companies typically will adapt and do whatever they’ve got to do to get to profitability.
And that is a perfect example of how they do just that. They will figure out some way. If it’s going to be reducing expenses, if we can increase sales someplace, yeah, great, we’re going to increase sales someplace, but we’re going to reduce expenses if we can’t do that.
Historically, stock markets typically go up more than they go down even in recessions because you have the ability to do that to increase profitability, even in a down economic time. That’s just another good example of how that happens.
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.
