Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking money and investing right here.
So some of the things that I like to discuss here on the show are maybe the news of the week, or sometimes it’s conversations that I have during the course of the week with just folks out there — it’s some of my favorite stuff to do. I love getting into conversations with you all out there because it helps me look at what you’re thinking about, what you’re seeing, and what you have questions about.
Retirement Programs
So I thought I would just give you a couple of things from the conversations that I had this week. I was off at a financial conference, and one of the things I did is I went out to dinner with my son. He likes it when we go out to a place to sit at the bar because he can watch the sports on the TVs right in front of the bar.
It’s fun for me because I like getting into conversations with people that I’ve never met before. And I did that this week. I had some conversations. It was super, super interesting.
Like, one of the conversations was with a lady in the medical field, very accomplished. And we got into a conversation about retirement programs that they had at the hospital. And I talked about the issues that I often discuss here where a lot of these programs are just not nearly as diversified as you think they would be.
One of the things I described, and I don’t think I’ve ever really talked about here because it’s more of a recent phenomenon, is this idea of collars. And I said, “Look at retirement plans at work. And you will hear me if you listen to my show.”
And she was like, “I’m going to be listening to your show.” She may even hear this segment.
But one of the things that you’ll find is that these programs typically focus on a very narrow area of the market because of people’s familiarity with that area of the market. Large U.S. companies, and I talked a little bit about capitalization weighting of portfolios, which is going to focus you more on large companies rather than smaller companies.
And I talked about how when we combine these things, we can significantly reduce the risk of the portfolio. People don’t realize that.
They think, Well, a small company is risky, right? Or, A value company is risky, right? And in isolation, yes, they are riskier, absolutely, but because they don’t move with other types of companies, you can actually significantly reduce the risk of a portfolio.
But you find that these pre-allocated portfolios that people have at work are not that. And even the big fund companies, even when you choose mutual funds with the big fund companies, and let’s say you’re putting together an IRA and you choose their small-cap fund, you don’t even recognize that they are overly focusing typically on the bigger companies because what they can do is they can show lower expenses.
When you manage a portfolio that way, you can actually have lower expenses because you don’t have to do anything as the fund manager. There’s no activity, you’re not actually engaging and making sure that the portfolio is better balanced because you have reconstitution to those types of things, which are way beyond what I’m going to talk about today.
But if we look at large companies right now, they’re selling for a really pretty high price compared to historic norms.
And I was pointing that out to her. “You look at these pre-allocated portfolios,” and she said, “Yeah, that’s probably exactly what I’m doing.”
And I said, “Yeah, you would be normal if that’s what you’re doing in your plan at work or your own personal stuff because that’s what typically advisors will put people in.”
Pre-Allocated Portfolios
When I was working for a big investment firm, we would have these conventions. Let me just digress for just a second and talk about what this was like.
I remember working for a traditional investment firm. Now think about the ones you see advertised on TV and you got it.
So what would happen is I would go there, and you would have these really great workshops. You’d have these great dinners, you’d have great hotel arrangements and all of that stuff. It was all paid for by investment providers.
And then they would have keynote speakers. The speaker — that position was given to the highest payer or the highest bidder for actually speaking at the conference. Because if you got the keynote position, you had the attention of all the financial advisors at the conference. And I would listen intently and went to these things year after year, and it would frustrate me because you would have different people speaking and different funds inside of a fund company performing well.
So you’d have the fund manager for one fund that did really well in one year, and the next year it would be maybe the same fund family, but it would be a different fund inside that fund family. And then the next year would be a different fund manager.
And I was like, “Well, why, if this person was so great the first year, why weren’t they great the second year?” That was the issue that I kept having, right? And I would go to these conferences and it was an exercise in frustration because I would just get confused.
Well, what I would find with the pre-allocated portfolios is they would tend to focus more on bigger companies, and the asset allocation models were very focused on that. And I started to realize why. It was because investors would be more disciplined if their money was moving in tandem with big U.S. companies, which were announced and talked about on the radio and TV programs every day.
And I pointed that out. I said, “That’s really why they do it is for that particular reason.” And I said, “But the problem is that you run into is that when you lose diversification into other asset categories, you can increase your risk significantly, and you can go for long periods of time with little to no return.”
Most people don’t recognize that. They look at recent history, and they look at recent history as far as the past 10, 15 years, and they go, “Oh, everything’s great. Everything’s wonderful.”
Well, that was the same thing that happened in the late ’90s. And it was wonderful until it was terrible, and then all of a sudden things weren’t so great anymore. Well, what happens is that those particular areas of the market, especially those areas of the market like large U.S. companies — it’s very, very inexpensive to manage that area of the market.
It’s very inexpensive to manage a mutual fund portfolio.
So part of your marketing is based on low expenses, like some of the big mutual fund companies, the huge mutual fund companies that advertise that they’re low cost and all of that, and some of those companies are actually raising their fees because they’re starting to have issues with profitability, but they’re still fairly low.
And the reason they’re fairly low is because that area is very inexpensive to manage. But that area, like I said, it can go 10, 20 years with no return. And if an investor’s stuck there, that’s a problem.
Options Contracts
The other issue though that I don’t often talk about is the level of volatility and risk in those areas. And I saw something recently where somebody was talking about collars, and they were talking about how you have options contracts.
So if you’re familiar with options contracts, if you stay up really late at night, you’ll see these things — call options, the options to buy at a certain price or the options to sell at a certain price. And the idea is to protect a position, so to speak.
Now here’s the issue. Let’s say if we look at a put option, we’re trying to protect the downside risk of our portfolio, I would buy a put option or I would buy a call option to make sure I don’t miss out on the upside.
Here is what is going on right now: Those positions are much more expensive to get than historically normal — very expensive.
The commentator that was talking about this was saying that the reason comes down to the level of uncertainty that’s in our future. That’s the point that he was making when it comes to large U.S. Companies, which is what I’ve been saying for quite a while — that area, you just don’t know.
A lot of people are not well diversified outside of it. And what he was talking about is that that is telling us that we could have a huge upside or we could have a huge downside.
Now, whether he’s going to be right about that, nobody knows. I don’t try to predict the future. I don’t ask you to or I encourage you not to, but I encourage you to make sure that you’re really, really well diversified because he could be right. Because that area of the market is selling for a very high premium over the typical book value.
The Election’s Effect on Market Segments
I thought he had a good valid point because anytime you’ve got a close election, you could have all of a sudden it goes one way unexpectedly. Now, that’s not as big of a deal if you don’t have a close election.
If you have an election where one candidate is way above another one, that information will be priced into the stocks right away. It’ll be priced in the stocks right now. But in the particular situation that we’re dealing with right now, it’s fairly close.
So you don’t know. And the policies of the two candidates are very, very different from each other. And the effect of that can be very different in different market segments is the thing that’s really super important to get.
Let’s say that all of a sudden a candidate gets in and they are bad for the U.S. economy and they’re problematic in their stances on things. Because the dollar drops in value, let’s say you could have international companies really, really do well, where the U.S. companies that you’re totally focused on are the ones that really suffer.
And you want to make sure that you’re in those other areas of the market. You want to make sure you have certain policies if you’re trying to target a certain group of companies that may be larger companies, it may be the smaller companies that are the benefactors of that.
For example, you might have, I’ll just throw out something, antitrust legislation, or maybe you are going to be concerned about the competitiveness of a certain area and you want to try to break up the larger companies. That might be an example of something that could happen.
You could have something that effectively hurts one set of companies because of the tax treatment of various programs.
That doesn’t hurt other types of companies. You may have a certain area of the market, like for example, technology, that is harmed.
Whereas value companies, the more stodgy companies — for example, I’m going to still need electricity, I’m still going to need to buy food, I’m still going to need to buy prescriptions or whatever — aren’t affected as negatively when certain policies are put in force. And that is why it is so critical, and this is why I’m always talking about how the thing is about diversification.
Diversifying With Value Companies
It isn’t always popular with investors. I remember reading an article a little while back talking about that very thing. There was a mutual fund company, and it was Vanguard, as a matter of fact.
And they were talking about how this isn’t a popular thing. All I could do is scream at the top of my lungs that yeah, that’s probably why your target date portfolios aren’t very well diversified because you don’t think that people like it, so you don’t do it. It’s a frustration of mine always.
But this is what happens with diversification. Let’s say that we’re looking at the 1990s, just as an example. Large U.S. growth companies were rocking, doing super, super well. With international, small companies, nothing, not much was going on whatsoever.
So an investor looking at different investment options is going to look at their 401k and the choices that they’ve got and go, “Well, this fund has done pretty well, it has a 10-year track record. Well, this fund hasn’t done as well. I think I’ll stay away from that fund.”
Which would be perfectly rational if we’re talking about putting your hand on a stove. Last time I put my hand on the stove, I got burned. I think I’m going to stay away from that.
Well, yeah, I’m going to stay away from this investment choice that has a low 10-year return is kind of the same thing. Instinctively I want to stay away from it.
But what happened over the next 10 years is nothing for large U.S. companies. Matter of fact, they dropped in value by 40% in the first three years, whereas international, which had done nothing, significantly outperformed, going up three to four fold depending on the different areas of international small, and value companies, which for the previous 10 years, even in the U.S., hadn’t done much. So people really weren’t focusing on them.
Now, value companies are more those stodgy companies that I was talking about.
And what ended up happening was over the next 10, well, 20 years, I mean, gee, it really, really significantly did better than everything else. But a lot of investors aren’t terribly well diversified in those areas. And the reason is that it’s more esoteric, more arcane.
Most people, they’re not really familiar with those market segments. They’re not talked about. Nobody talks about the performance of those market segments on radio or on TV. They’re not getting into that.
Being an Educated Investor
Now, why does this matter? Well, literally it’s your retirement and ability to retire, your ability to go out and do the things that you always dreamt of doing. Travel.
I think about my parents. My mother was, matter of fact, one of the reasons that I’m really into the investing world as much as I am is because she and I would listen to educational programs on investing when I was a kid.
So I got a huge head start, but my mother was really into this stuff. She would track the performance of investments. I don’t recommend this, but she would track this stuff every single day.
And she had a notebook, no kidding, I should have kept it. I should have kept it. She literally had daily pricing data on everything that she owned.
And the thing that I picked up from that, and my father being so fastidious on sitting down at the table every month and doing his work, that’s when you balanced checkbooks. But he would sit there, and he would engage in planning every single month.
And my mother was the same way. Now the problem was they worked with a financial planner one time. I will never forget it, this financial planner coming in and sitting at the table, and I listened to this guy. And I’m going to tell you, my parents did make some mistakes.
Now looking back, I fixed their stuff later on in life after I studied under the guy that, the professor that won the Nobel for Economics. I fixed a lot of their investments many, many years before they passed. But I will never forget when this guy came in, sat at the table, and what he had my parents do. He said, “You need to do this, you need to do this.”
And I’m sitting there listening, and my mother’s sitting there listening. And what was really, really interesting is my mother did not act on it. My father did not act on the advice.
The reason was they were so educated about investing that there was no way. “No, this doesn’t make any sense whatsoever.” And I remember them just going, “Yeah, good meeting you. Good to see you. Bye.”
And I thought, That is perfect. That’s exactly the way it ought to be.
The investor ought to be so educated that they know what’s good and what’s not good.
Not that they knew everything. They didn’t have to know everything. Like I said, my parents made their share of mistakes, but they knew enough that they knew what this guy was doing was basically snake oil.
And then later on, I’ll never forget, my going and studying under some of these academics, and I came in and I talked to my father. In fact, you know what, I’ll do, I’ll take a quick break and tell you my story of my father because it was kind of funny how I got him over to investing more prudently, as I say, as I call it, and investing more academically.
It was an interesting story because sometimes the prophet is without honor in their own house. That was certainly the case in my place, and I’ll tell that story right after this.
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.
