Retirement Investing #4: Taking Action & Investing in Stocks
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm wrapping up our four-part series on investing in the stock market by talking about implementation. My goal is to help retirement savers just like you build a sound investment portfolio or nudge their financial advisor to make some important tweaks based on decades of academic research. I'm going to be talking about how to invest in the stock market by talking about how to

I'm going to be sharing what to look for, pitfalls to avoid, and exactly how to go and take action. Also, a special guest drops by to share some tips with us. So if you've been throwing your money in plain vanilla index funds and you finally want to make some improvements, you are going to love today's episode. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 84.

Okay, really quick. The implementation phase of all of this can feel daunting. Even if you have a financial advisor that's helping you, it can be confusing to know what suggestions to make, what to bring to the table, and what questions to ask based on everything that you've learned. So to help, I put together a list of publicly traded funds that meet a lot of the criteria that I've discussed this month. And if you're interested in learning more about the criteria,

These funds are not trying to beat the market through active trading or predictions about the future. These funds take a systematic approach to provide exposure to the different dimensions of returns that we've talked about. These dimensions of returns are also known as factors or premiums.

I also put together a sample asset allocation for how these funds might come together in a portfolio. And I packaged all of this up for you in a nice PDF. So if you'd like a copy, here's all you have to do. Leave an honest written review of this podcast in the Apple podcast app.

Take a screenshot of your review and email it to me at podcast at youstaywealthy.com. And if you don't have an iPhone or an iPad, borrow one from your friend or neighbor. Of course, just make sure you sanitize it first.

This show is free. You guys know this. And my ask here is just an easy way to give back and support the growth of the podcast. As I've shared in the past, the podcasting world is still very much the wild, wild west and finding high quality shows that aren't hosted by a celebrity can be difficult. So your help is always appreciated.

Again, all you need to do is leave an honest written review in the Apple podcast app, email your screenshot to podcast at you stay wealthy.com. And I'll send you this PDF.

Really quick, last but not least, I just want to remind everyone that this show is for informational and educational purposes only. Nothing discussed should be taken as a recommendation or advice. Please, please, please consult with your trusted advisors, your financial advisor, your tax advisor, your attorney before taking any action. Okay, with all that out of the way, let's talk about implementing a low cost index fund portfolio that's based on evidence and

and provides exposure to the different dimensions of returns. I'm gonna share three things that I think are important to understand, and then I have a special guest who's gonna drop in to share some more technical tips with us.

The first thing I want to share and remind you of is that in this series, we are just talking about stocks. And as you well know, most people don't just own stocks. They own bonds, physical real estate, maybe even private investments like a business. And I mentioned this because it's important to look at your entire portfolio and understand how all the pieces work together. For example, if you own high-yield bonds...

You might decide to take less risk with your stocks and take a less aggressive approach when targeting some of these dimensions and factors that we've discussed. That's because high yield bonds can start to behave like stocks during catastrophic time periods. In fact, high yield bonds are actually more correlated with stocks than they are with safe U.S. government bonds, as shown in a study done by Alliance Bernstein, which I will link to in the show notes.

On the flip side, you might have a large allocation to CDs or US treasuries, which might influence you to take more risk with your stocks and the factors that you're targeting, knowing that if the stock market crashes, we go through a tough time period. You have safe investments that historically have held their ground during these catastrophic times.

Next month, I'll be diving into the world of fixed income, aka bonds, and we can explore more about the dimensions of returns in the bond market and how to think about that slice of your portfolio based on all the research that's out there. But for now, this is just a gentle reminder to look at your entire portfolio and

and really understand how everything is working together before throwing your entire stock allocation into a risky small value ETF, just because you like some of the things that you heard.

The second thing I want to mention, which our guest is going to dig into a little deeper here shortly, is to consider the amount of time and effort involved when implementing a more advanced portfolio. The more you begin to add these different dimensions and target factors like company size and relative value, the more work you have to do to keep your portfolio in balance.

As shared in last week's episode, US value stocks have been underperforming for a really long time now. Let's just keep it simple. I'm going to use a very simple example. Imagine that you owned two stock funds over the last 10 years. You had 50% invested in a plain vanilla S&P 500 index fund and 50% invested in a small value fund.

Now, if you didn't touch your portfolio for the last 10 years, you might open up your account and find that it's now, and this is just hypothetical, you might open up your account and find that it's now 75% weighted to the S&P 500 fund and 25% weighted to that small value fund.

That's because the S&P 500 did very, very well and small value did very poorly. And so you might open up the account and be like, wow, it's completely out of whack. I started at 50-50 and now it's 75-25. Now you might say, well, that worked out pretty well in my favor. The S&P 500 has done well and small value has done poorly. So hey, that worked out pretty well. But we all know that hindsight is 20-20. We don't know what the next 10 years is going to look like.

Similar to the funds we've discussed and we will be discussing today, it's important that we take a systematic approach when managing our investments. If through your research and due diligence, you determine or you and your financial advisor determine that 50% of your portfolio should be allocated to small value investments,

you should have a regular systematic process for keeping that allocation intact. This process, as you might know, is referred to as rebalancing. And I bring this up because oftentimes rebalancing is only talked about in the context of stocks and bonds. In other words, rebalancing your portfolio to keep your stock allocation and your bond allocation in line with your risk target.

But I'm highlighting here today that rebalancing is also important once you start to target different sources of stock market returns because those start to move in different directions as well.

Outside of having a systematic process to ensure that you keep your portfolio in line with your intentions, the great thing about rebalancing is that you're taking advantage of that old adage, buy low, sell high. So going back to my earlier example with 50% in an S&P 500 fund and 50% in a small value fund,

In a year where the S&P 500 did really well and small value did really poorly, you would have sold some of the S&P 500 fund, i.e. sold high, and you would have bought some of the small value fund, i.e. bought low. And you would have been doing this in a systematic prudent manner, not trying to guess the future, but making the best possible decision with your investments, given all the information that you have in front of you.

So in summary, just know that the more slices you start to add to your stock portfolio in an attempt to target these different dimensions of returns, again, also known as factors, the

the more work is required to keep things intact. Now, you might enjoy the extra work and prefer to spend your time that way, or you might decide this is interesting, I like it, it's just too much, and I'm just gonna keep it simple. Or this might lead you to consider outsourcing it to someone else so that you can spend time doing the things that you love. And all three of these conclusions are okay. I always like to say there's the textbook answer and then there's your answer. So just something to keep in mind there.

The third thing I want to leave you with before our guest drops in is the consideration of what percentage to allocate to these different factors. First off, one common question that I get out of the gates here when talking about portfolio construction is how much to split between U.S. stocks and international stocks.

While some asset managers and financial advisors prefer to have what we call some home country bias, which means they put more in US stocks than international stocks, they have that bias towards our home country here. I personally prefer just to cut it down the middle. There are years and decades where US stocks have done better than international stocks. And there are years and decades where the roles are reversed. And

I don't have a crystal ball. Also, I'm comfortable investing globally, which not everybody is, but I'm very comfortable investing globally. So I lean towards this 50-50 split.

Also, as the Wall Street Journal recently pointed out, and I'll link to the article, US stocks have been dominating international stocks for a decade now. With US stock valuations just going higher and higher and higher, one could argue that now might be a good time to remove that home country bias. I'm not saying go and put all your money in international stocks, but if you do have that home country bias...

You know, one could argue that maybe now is the time not to have that home country bias because U.S. stock valuations are much higher than those overseas.

Of course, this trend could continue for another decade. You have to be okay with that, right? We don't know the future. But again, I'm just trying to make the best possible decision with the information that I do have in front of me. So once you come to your own conclusion there, and you can do some more research and Google around or listen to other podcasts, but once you come to your own conclusion, you can start to think about how much of your US stock and international stock allocation you want to tilt towards next.

small value, profitability, et cetera, all these dimensions of returns we've talked about. In the PDF guide that I put together, which again, if you email me, leave a review, I'll share it with you. I share a sample allocation in there. So you can see again, kind of how all these things come together. But I would just say that there are two main things to consider here. Number one,

targeting factors like small cap stocks can add risk to your portfolio. So the first consideration when doing that, again, like if you're just starting with a plain vanilla S&P 500 stock portfolio, like, okay, how can I make some improvements? The first consideration is, well, how much additional risk do you want to take outside of the market risk you already have in that plain vanilla S&P 500 index fund that you hold?

So the first thing to consider is how much risk do I want to add? Because adding some of these factors or some of these premiums, trying to capture them can add more risk. That's the first thing I want you to think about. The second is,

I'm in this camp that if you're going to target these different dimensions of returns that I think I'll just say me, like I want to make a meaningful allocation so that I can reap the long-term rewards. If I just add two or 3% to one of these factors or premiums, it might be unnoticeable and might be just more of a headache for me to manage than anything else.

Personally, and again, not a recommendation, but I like to have at least 10% in each asset class or factor that I'm targeting so that I have that meaningful stake. Also, if you're just wanting to dip your toe in the water, it might signal that you just aren't confident in this approach. And I think confidence is really, really critical when it comes to elevating your portfolio and making some of these more advanced changes, right?

especially when things don't behave like you expect them to in the short run. And I think value stocks here in the US is a great example, right? 12 years of underperformance. If you don't believe the data and you're not confident in the approach, it can get you in a lot of trouble. We need to stay committed to our investment plan and our approach over long periods of time through thick and thin in order to benefit. So again, the two things to consider as you kind of pool all these resources together and work towards taking action is,

Think about how much additional risk you want to take in your stock portfolio. And then think about that meaningful allocation. Like if you're going to do it, consider making that meaningful allocation instead of just dipping your toe in the water with, you know, two or 3%.

Okay. As promised, we have a special guest dropping by today. Jack Vogel is CIO of the asset management firm Alpha Architect. His academic background includes experience as an instructor at Drexel University in finance and mathematics, as well as a finance instructor at Villanova.

He also has a PhD in finance and an MS in mathematics from Drexel and graduated summa cum laude with a BS in mathematics and education from the University of Scranton. Let's just say he's really, really, really, really smart. And he's done a ton of work in the world of portfolio construction. So get your notepad out and buckle up.

Hi, this is Jack Vogel. In this week's episode, Taylor kindly asked me and the Ioffe Architect team to highlight how one can implement a factor investing approach and what tools an investor can use to examine and filter certain stocks and funds. First, I wanted to recap. Taylor previously explained that the largest driver of returns was the market return.

This is simply taking a passive approach and investing in a market cap weighted fund or portfolio, whereby the larger firms have larger weights and smaller firms have smaller rates. It turns out that beating the market is very difficult. Hence the success of Vanguard, which offers cheap exposure to market cap weighted portfolios. However, Taylor also mentioned other factors or drivers of returns.

Factor investing, such as size, value, and momentum, is a way to systematically tilt your portfolio towards factors that academics have shown to have a premium over long periods of time. I'd like to emphasize the term systematic as a factor investor really is an active investor when compared to the market.

However, this is an active approach done in a simple and systematic fashion, as opposed to just waking up and actively trading the newest hot stock. A simple example of factor investing is a value investor. A value investor prefers to buy stocks that are cheaper relative to other stocks. Now, what does it mean for a stock to be cheap? One approach, which is how academics study factors,

is to use a point in time value of some fundamental variable and compare this to the market price of a stock. The simplest example is the P/E ratio. This is the price of the firm divided by the earnings per share of the firm. So let's say that we have two stocks that are both trading at $100 a share. Firm A's earnings are $5 per share and Firm B's is $10 per share.

In this very simple example, when we divide the price of the stock by the earnings per share, we see that A has a P-E ratio of 20 and B has a P-E ratio of 10. Now, in this simple example, a value investor who can only invest in these two stocks would prefer stock B because it is trading at a lower multiple of earnings compared to A. In other words, B is cheaper.

relative to A. So how does an investor put this into practice? Of course, the first thing you're going to do is you're going to start with more than two stocks. But besides that, what do you do? Luckily, there's many websites that allow investors to screen stocks based on a value such as the P/E ratio. One example is on our website, we have a stock screen that allows investors to sort larger US stocks based on values such as P/E.

Of course, investors may prefer other value metrics such as the DFA favorite of book to market or our favorite EBIT over total enterprise value. Luckily, we have all of these factor metrics on our site.

Now, of course, an individual picking stocks can be dangerous to their wealth. So I always want to caveat that investors should form portfolios of stocks, having at least 35 or 40 or more stocks in a portfolio. In addition, do-it-yourself factor investors need to remember an important item about factor investing. You need to systematically rebalance the portfolio. You can't simply invest in this and hold it forever.

Value investing happens to be a nice factor given that one can wait almost a year or over past a year to rebalance the portfolio. So if an investor invested in 50 stocks today, you would wait one year and rebalance the portfolio in a year from now. Of course, if you had gains, you would wait a year and a day to get long-term gains. If you had losses, you would maybe rebalance before a year.

Other factors, such as momentum, do require more frequent turnover. So what about investors that don't have the time or willingness to sort stocks, as well as have to worry about rebalancing the portfolio? Being a factor investor while following a systematic process definitely will require some work. Well, luckily for these investors, there are many factor investing options in the marketplace. While not a comprehensive list,

Here are three items that I think investors should keep in mind when you're examining different funds in the marketplace. First is the wrapper. In my opinion, the wrapper matters a lot. In general, ETFs are more tax efficient than mutual funds. This is especially true for factor investing, which, as I did mention before, requires turnover in the portfolio.

For example, momentum funds are turned over at least every six months, and many funds turn over the portfolio every quarter or even every month. So for a taxable investor, this amount of turnover is going to create short-term gains and additional taxes paid. So if the investment is in a taxable account, all else being equal, I'd start by looking at ETFs given their ability to defer taxes.

If it is in a retirement account, of course, mutual funds and ETFs have the same tax status. A second topic that a factor investor should examine is how many stocks does the fund own? For example, let's say you wanted to invest in a value ETF or a value mutual fund. Well, why do some stocks have 50? Why do some funds have 50 stocks? Some have 500 stocks and others have 1,000 stocks.

Is the 50 stock value fund better or worse than the 500 stock value fund? Unfortunately, there really is no perfect answer here. All I can say and what we can say is that there's trade-offs that investors must take. It is generally true when we're looking at trade-offs that a 50 stock portfolio is going to have more tracking error relative to the market compared to a 500 stock portfolio.

So let's do two examples. In the first example, if an investor is using the value allocation to be the core holding of their portfolio, and they're also concerned about relative performance compared to the market, well, then the 500 stock portfolio may be the better solution from a behavioral perspective. Alternatively,

If another investor is using the fund to get access to the value factor while also having a 70% to 80% of their money in a cheap market cap weighted index fund, then the 50 stock portfolio may make more sense. Of course, some may decide to put all of their money into the 50 stock fund. However, this would come with the downside of having larger relative performance tracking error compared to the market.

A third and related topic when comparing funds is the following. How do the funds weight the stocks within the portfolio? One approach is to market cap weight the positions. And we talked about this before where larger stocks get larger weights in the portfolio. Another approach is to equal weight the positions whereby each stock gets the same weight within the portfolio.

A simple example of the effect that this can have is over the past three years, this was as of August 25th, 2020, the total return to the S&P was around 46%, while the total return to the S&P 500 equal weighted fund was around 23%. So in this example, the exact same 500 stocks, just given different weightings, market cap versus equal weight had a large performance difference.

Now, this highlights that over the past couple of years, smaller cap stocks, which equal weighting does, have underperformed larger cap stocks. So now that we have three items to look at, first being the wrapper, being a mutual fund or an ETF, second, how many holdings are in a fund, and third, the weighting methodology, how can an investor look for funds? Luckily, there are a lot of great websites out there.

A couple that come to mind are Morningstar and ETF.com. Obviously, ETF.com focuses mainly on ETFs. Some other websites that are great are Kuifin, YCharts, and Portfolio Visualizer.

And our own site actually allows investors to find information about different funds. For example, on our site under the fund screener, you can screen all ETFs out there and find those that rank the highest on a specific factor that you may prefer, such as value, size, momentum. From there, an investor obviously can do a lot more diligence on these funds and dig into some of the other topics that we discuss.

Hopefully this short overview will help investors interested in factor investing have better outcomes.

All right. A big thanks to Jack and the entire team over at Alpha Architect. They publish tons of research for free on their website that's accessible to the public. And they also manage a handful of academically sound ETFs that align with everything that Jack just discussed. So head over to alphaarchitect.com, learn more about what they're up to, read their research, read their material and check them out.

Once again, if you want to snag the PDF that I put together for our listeners, it includes dozens of publicly traded funds that meet a lot of the criteria we've talked about in this series, as well as a sample portfolio to see how it all kind of comes together. Leave a written review of this podcast in the Apple Podcasts app and send a screenshot to podcast.com.

at youstaywealthy.com. I really, really appreciate all of you. I appreciate your engagement, your good questions and helping me grow this show so we can get it in the hands of more retirement savers. I hope you enjoyed this series and I'll see you back here next week as we begin our deep dive into the world of bonds.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services. ♪