Larry Swedroe, Director of Research at Buckingham Strategic Wealth and columnist at ETF.com, talks about how his views on active vs. passive, the value premium, market predictors and expected returns held up since he wrote his first book 20 years ago – and how he feels today about global diversification and alternative investments. Plus, Joe and Big Al talk dynasty trusts, for those with an estate like Secretary of the Treasury Steve Mnuchin, who is worth about $300 million.
- (01:52) Have Over $24 Million? Get a Dynasty Trust
- (08:39) Larry Swedroe 20 Years Later – Active vs Passive, the Value Premium and Market Predictors
- (19:45) Larry Swedroe – Expected Returns, Diversification and Alternative Investments
- (33:52) Sinking at Retirement – Price-to-Earnings Ratios and the Shiller CAPE 10
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“We would predict that stock returns would be about 3%, in real terms, going forward. Some optimist thinks the economy’s going to grow faster, they are going to say a 5 or 6% real return. Somebody else would say valuations are too high. Therefore the P/Es are going to shrink and you’re going to get no real return for the next 10 years, or even negative which is what Jeremy Grantham and John Hussman have been predicting for the last five years. Markets have ignored their predictions. So – difference between opinion and science.” – Larry Swedroe, ETF.com
That’s Larry Swedroe, Director of Research at Buckingham Strategic Wealth and columnist at ETF.com. Today on Your Money, Your Wealth®, he talks about the opinions and the science of investing. How have his views on active vs passive, the value premium, market predictors and expected returns held up since he wrote his first book 20 years ago – and how does he feel today about global diversification and alternative investments? Plus, Joe and Big Al talk dynasty trusts – good info if you happen to have an estate like Secretary of the Treasury Steve Mnuchin, who is worth about $300 million. Now, here are everybody’s favorite fat cats, Joe Anderson, CFP®, and Big Al Clopine, CPA.
01:52 – Have Over $24 Million? Get a Dynasty Trust
JA: We got Larry Swedroe coming up next. I would stick around for that. Love Larry. But what you want to talk about is dynasty trusts?
AC: I do. It’s something I don’t think we’ve ever talked about in 10 years.
JA: Well, we’re not estate planning attorneys, and so I don’t know if we’re qualified to talk about them.
AC: I’ve got an article. (laughs) So assuming the author is correct, although I did some research. So I actually want to talk about a strategy that, it’s not going to apply to everybody, but those that it applies to, it’s a gigantic strategy, Joe.
JA: Huge. Yuge.
AC: Yeah. “Yuge” is right. (laughs) So “yuge” that Steven Mnuchin set up one about six months before he came into office.
JA: Oh really?
AC: Yeah. So anyway, here’s a little background. So right now, when you pass away, $11.2 million goes to your heirs, estate tax-free.
JA: Well how about if you’re married, don’t you double that up?
AC: Correct. If you’re married, it doubles up. So we’ll call it $24 million – we’ll just go with round numbers. $11 million, and 24 million if you’re single. So for most people, it’s like their assets will never get to those levels, and this doesn’t really apply. But if you have assets above these levels, or think you may have assets above these levels, then a dynasty trust is something you may want to consider.
JA: So you’re thinking of this for yourself. (laughs)
AC: I think you should! (laughs) Maybe if you and I put our money together…
JA: And add seven zeroes… (laughs)
AC: (laughs) Could we get $100,000? Oh yeah. $24 million. So here’s how it works. So basically you set up a trust. This can be any kind of trust. I won’t even talk about dynasty for a second, but then I’ll come back to dynasty. So you set up a trust for your kids or grandkids, or anybody that you want to. Those are the future beneficiaries. You put assets into that trust. And as long as it’s below the $11 million if you’re single, or $24 million if you’re married, there’s no gift tax, because gift tax and estate taxes are related. So you get this asset. Let’s say you’ve got $24 million, you put $24 million into this trust. Now it’s outside of your estate.
JA: So it’s an estate freeze.
AC: That’s another term, it’s an estate freeze, exactly. Which means then, that $24 million, maybe you live for another 30 years, it grows to $50 million or whatever the number is. So that entire $50 million is not part of your estate, therefore not subject to estate taxes, which are currently 40% when you’re over these $11 million, $24 million limits. So it’s called an estate freeze because you get the asset out of your estate, and so all future growth of that asset is outside of your taxable estate.
JA: Do you have access to those dollars, if I wanted to spend any of them?
AC: I don’t think so.
JA: So it’s an irrevocable transfer…
JA: …that is going to your direct beneficiaries. And what you’re doing is avoiding the looming estate tax.
AC: That’s right. So clearly, you only do this when you have extra. When you have excess.
JA: Yeah, you know, 24 million bucks is extra. It’s like crumbs. (laughs)
AC: if you don’t need that you’re doing pretty well. (laughs) And most states have limits, in terms of how long you can set up these trusts. Like for example in California, the longest is 90 years, or 21 years after the death of the creator, the grantor. So at any rate, here’s the dynasty part: certain states don’t really have limits, or have very long limits. For example, South Dakota has a thousand year limit. So in other words, you could set up…
JA: Huh. That’s one reason to live there. (laughs)
AC: Well you don’t have to live there. You actually can do it in California. You can set up a dynasty trust in South Dakota, with your California assets. That works. So in other words, if a generation, simple math, a generation lives 100 years, then you’re going to be able to provide for the next ten generations by setting up this trust right now, depending upon how the distributions are.
JA: So you set it up where the grantor sets up this trust, you put in your crumbs – $24 million. (laughs) And then that 24 million can continue to grow, you invest it as you choose. You as the grantor don’t necessarily have access to it, because it’s outside of your taxable estate.
AC: Yeah you actually need another trustee.
JA: So there’s a second, third-party trustee.
AC: Yeah, third party or child or some other trustee.
JA: You cannot be the trustee.
AC: I don’t believe so, because it’s outside of your estate.
JA: Got it.
AC: Yeah. And we’re not estate planning attorneys. (laughs)
JA: (laughs) Yeah, there’s a couple of estate planning attorneys listening going, “what are these yahoos talking about?!”
AC: Here’s why I wanted to bring up though because, for those that have a lot of money that want to take care of generation after generation, it’s a great time to do it, because the estate limits are so large. Because if you think about it, when the estate tax limits were a million dollars, or $600,000, which is when I started my career if you’re married, you could only put $1.2 million in. Now you could do $24 million, which is a gigantic number. And in 2025, these limits come back to closer to $5 million, and who knows what it’s really going to be. It’s a very high number right now, so a lot of estate planning attorneys are doing a lot of these trusts right now. And you don’t have to necessarily have $24 million. Because what happens, for example, if it comes back to a $5 million dollar exemption And you think your married estate is $15,000,000, let’s say. So in that particular case, if it comes back to $5 million exemption each, you’re going to have $5 million still exposed at 40%. So some people are doing it just in anticipation of perhaps lower estate tax limits.
JA: Right, that’s a good point. Well, so if you get $24 trillion lying around, Big Al can help you out. (laughs)
AC: Give us a call. We can help you. (laughs)
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08:39 – Larry Swedroe 20 Years Later – Active vs Passive, the Value Premium and Market Predictors
Welcome back to the show, the show is called Your Money, Your Wealth®. Joe Anderson here, Certified Financial Planner, Big Al Clopine, he’s a CPA. Thanks a lot for tuning in. We have a good friend Larry Swedroe on the line. We haven’t talked to Larry in a little bit. He’s been on the show for many years. One of the brightest minds in finance. He’s written several books on investing, financial planning, alternative investments, you name it, he’s written about it. And we want to welcome Larry to the show. Welcome Larry, how you doing?
LS: I’m doing just great Joe, thank you for having me.
JA: You know, it’s 20 years since your first book came out. I’ve got a question for you. What do you think, if you were to write that book again today, would it be any different than your first go around 20 years ago?
LS: Yeah I think there are a few things. All of the core principles would remain identical, so I feel great about that. So the two core principles, if I had to summarize them, in the book, were – the first was examining the debate between active and passive. Should you be a stock picker, market timer, or hire people to do that for you? Or should you accept market returns in the asset classes you want? Meaning passive, using low-cost funds, whether they were index funds or similarly structured portfolios. That debate if it was a prize fight it would be a technical knock out long ago. Every year, we see from S&P with their passive versus active scorecards, the vast, vast majority of active funds in every single asset class – domestic, US, international, emerging markets, stocks, bonds, high yield, everywhere we look, active gets slaughtered even before taking into account the effect of taxes, which is the largest expense of active management for active funds. So that debate is over, we won, if you will, and feel great about that. However, there’s a second, lesser-known debate that’s really part of the book, and that’s the idea of, “Do you follow the John Bogle school,” I could call it. Bogle was the creator of the first retail index funds, and he argued and presented, he felt the evidence that the best way to invest, that gives you the best chance of getting the highest returns for the risk you took was to own market-like portfolios. So for the US, that would be a total market fund – you could use a Vanguard fund to do that, and internationally, you would own an EAFE fund, and emerging markets you could own the Vanguard Emerging Market Index Fund. In the book, I present the evidence that showed that there was a high likelihood, and logical reasons to expect it, that small and value stocks would outperform. And even though it was a bit more expensive to invest in them, you’d outperform, and in every case we looked at, whether it’s US, international, or emerging markets, the DFA funds we used in small and value categories outperformed the Vanguard Total Market Fund. And on top of that, if you narrow it down to individual asset classes, like small value or large value, the DFA fund outperformed the similar Vanguard fund. So I feel great and vindicated if you will, the fight is never over. We don’t know what the future holds. But investors who relied on the advice there certainly have been well rewarded, not only with higher returns but higher risk-adjusted returns. So that’s what’s all similar Joe. We’ve got some differences too.
JA: Well, you also wrote a piece on the value premium. And if you take a look over the last several years, I guess from 1927 to now, the value premium is close to 5% – and what that means is that value is up from growth, roughly, about 5% give or take. I don’t have the data in front of me. But over the last ten years, growth has outperformed value. So some people think that hey, maybe that doesn’t necessarily work anymore. Maybe people know that value companies, there’s more information and education than ever before. So what’s your what’s your take on some of these factors continuing to play out? Because 20 years ago, you had a very convincing story. Today, with these factors, do you still feel as confident that they will continue to outperform?
LS: It’s a great question, and one I addressed in my penultimate book, “Your Complete Guide to Factor-Based Investing,” which was published in 2016, I believe. And that book looked at the research and showed that there were 600 factors in the research, Joe. We only felt there was enough evidence to give us confidence in investing our money, and our clients money in them, in 8 of them. So I think that’s saying we’re highly skeptical in looking at the research. But we did have confidence in eight that met all of the tests that we established. The premiums had to be robust, meaning they would hold up, for example, to different definitions. So is there a value premium only in price to book? And by the way, the premium was 4.8% since 1927, so very close to your 5. But there should also be a premium for price-to-cash-flow or price-to-earnings. We know there’s less risk of what’s called data mining or data snooping – a lucky outcome. It has to be persistent over very long periods, like 90 years, if we have the data. And it has to be pervasive all around the globe, as well. So not just the U.S. outcome. And there have to be intuitive reasons for us to believe it will exist, meaning small and value stocks are riskier. Discovery of that fact doesn’t make them any less risky, any more than discovery of the fact that stocks have higher expected returns than bonds changes the fact that they’re riskier, and therefore the premium shouldn’t go away. So when we look at these things, value passes every one of these tests, and the last 10 years, value has underperformed. But that’s happened in about one out of every seven 10 year periods. Not that much different than for market data, where it fails one out of every ten 10 year periods. So these things happen. They’re called regime changes, they’re unpredictable. We just don’t know when they happen. I can’t see any reason to think value won’t exist in the future. In my article, I also presented some evidence we could discuss on why that should be the case and looking at valuations.
JA: Well, you talk about predictors in that article, and we talk about active investing, passive investing. Active investing is, in a way, trying to predict the future. But then in some of the evidence that you’re presenting, that I agree with, is also a little bit predictive. Can you help?
LS: Well there’s a difference. One is an opinion. The other is based on facts. So what we would use – and looking at predicting, for example, when we predict stock returns, we don’t pull that number out of the air based on our analysis of economic conditions, or whatever we might want to think about. We use the current market valuation. Earnings yield, if you will, and then assume that we can’t predict that it will change in either positive or negative. In other words, the market’s estimate of the right price is the best one we know. And today that gives us, to use what’s called the Shiller CAPE 10, or cyclically adjusted price-to-earnings ratio to smooth out earnings. The Shiller CAPE 10 is about 33. That gives you an earnings yield of about 3%. So we would predict that stock returns would be about 3%, in real terms, going forward. Some optimists who think the economy’s going to grow faster, or whatever it might be, might predict faster growth and therefore they are going to say a 5 or 6% real return. Somebody else would say valuations are too high. Therefore the P/Es are going to shrink and you’re going to get no real return for the next 10 years, or even negative which is what Jeremy Grantham and John Hussman have been predicting for the last five years. Markets have ignored their predictions. So – difference between opinion and science.
Last point here. If the value premium went away, as a lot of people think, because it’s become so well known, then we should have seen massive cash flows into these stocks, driving their valuations up, relative to growth stocks. So I took a close look at the PE ratios of value stocks today, relative to growth stocks, and then looked back to what they were in 1994, after the famous paper, “The Cross-Section of Expected Returns” by Ken French and Gene Fama, that established the value premium in literature, and I found interestingly enough, whether we looked at the P/E ratio or the price to book ratio, the valuation ratios are virtually identical. And since valuations are the best predictors we have of returns, then to me, there’s little reason to believe the value premium is gone.
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19:45 – Larry Swedroe – Expected Returns, Diversification and Alternative Investments
JA: Welcome back to the show, the show is called Your Money, Your Wealth®. Joe Anderson here, Certified Financial Planner, Big Al Clopine, he’s a CPA. Thanks a lot for tuning in. We’re talking to our good friend, Larry Swedroe. He’s a Principal and Director of Research at Buckingham Strategic Wealth. There’s a bunch of questions I guess I have with your last several statements. When you look at expected returns based on the CAPE Shiller 10, what is the mathematics that you’re looking at to come up with those numbers?
LS: It’s pretty simple concept. First of all, why use 10 years? That’s what happened to be what Nobel Prize winner Shiller used in his study. And he found that the ten years, by smoothing earnings, some years, earnings are way down. You’re in a recession. But stock markets are forward-looking and the market would expect recovery. So you’re getting too low an estimate of earnings from that. And some years you’re in a big boom and no one can expect that to last forever. So you want to take an average of the last 10 years. And other people hav since done research that shouldn’t be anything magical about 10 years. Maybe that’s data snooping if you will. So you run an infinite number of periods and you find out 10 years happen to work, so you claim victory. It turns out, whether you use the CAPE 9, CAPE 8, 7, 6 or 5 or even the one-year earnings, you get fairly similar outcomes. And so it doesn’t mean you’ll get an exact outcome but it’s a pretty good predictor of the mean. And so what that means is when CAPE 10 is say, average 16, if you want to incorporate all the possible outcomes that happened over the next 10 years, when the CAPE 10 was 16, the average return was 10, you could get returns as high as 18, and you could get them as low as two. In other words, the volatility around 10, or dispersion, was as much as plus 8 and minus 8 on either side, which means it’s not a great predictor. And by the way, if there was a perfect predictor that never would be any risk in stocks. So there’s no such thing. But it means that we can’t predict great with great confidence, an exact number, but it tells us that whenever the PEs are higher – so higher CAPE 10s always predict lower future mean returns, the best outcomes are worse, and the worse outcomes are even worse. And when the CAPE 10 is lower, the median is always higher. And the best outcomes are better, and the worse outcomes are not as bad. And so the math works very simple. The easiest way to think about it is this: think of a stock like a bond. The only difference is that it gives you some expected growth because the economy over time grows. So it’s like a bond has a yield, a stock has a yield. Think of it as the earnings yield. So you invert the PE ratio. So instead of a price-earnings ratio, you have an earnings-to-price. So if the P/E ratio is for argument’s sake 33, you invert that and you get an earnings yield of 3 percent. Now the economy and earnings grow in real terms, historically, let’s call it 2% a year, and therefore we should take that earnings yield of 3%, add 2%, that’s 5. And then we make an assumption that the current valuation will hold into the future. Because we can’t predict or know whether that current 33 is too high or too low. If you want to guess that it’s going to drop to 20, then you would obviously forecast much lower returns, because you are going to lose, because people are willing to pay much less for earnings in the future. Do you think they’re willing to pay more? Then the returns will be better than your forecast. Turns out, nobody can forecast better than simply using the simple math that we just went through.
JA: And so using this information, of stating that, “if I look at the P/E ratio of the US markets is 33. So my expected rate of return is 3%, plus whatever…”
LS: Real. Real return.
JA: Real return, yeah. So that might cause investors to do something maybe that you or I wouldn’t necessarily advise. By maybe getting out of US entirely, and loading up on, maybe emerging markets, because emerging markets’ P/E ratios are completely different than the U.S. and they have a little bit higher expected return today. How would you help someone work through some of all of this technical data that we throw out there, but then be realistic about it to use it in an everyday practical manner?
LS: Yeah, great question Joe. So the first thing, just to walk through the numbers, is the US, we think, has an expected return somewhere in the neighborhood of 6%. And we think, based upon the fact that the developed markets outside of the U.S. have much lower valuations, the expected return including inflation – so a nominal return, is more like 8%, and then emerging markets with even lower valuations would be more like 9. Now that doesn’t mean that international and emerging market stocks are better investments, any more than it means that Treasury bills yielding 2% or a Treasury bond at 10 years yielding 3, is better than a junk bond yielding 6. Obviously, the market thinks the US is a safer place to invest and therefore has a lower expectation of returns because it’s bid up values to get that safety. So the way I think about it is very simple. I don’t believe I’m any smarter than the market in allocating capital, and the U.S. is 50%, roughly, of the global market capitalization. So I want to be 50% US. Of the remaining 50, about three-eighths of it is developed. So I want to own developed international stocks, and about one-eighth of the total is emerging markets, so about one eighth emerging markets. And if I’m willing to take a little bit more risk, than a set of 12 and a half percent or emerging markets, I might be willing to up that to 15 or maybe 20%. And if I’m concerned about emerging markets, I don’t want so much risk, I might lower it from 12 and a half to ten. But I should not drift too far from that, because otherwise, you’re guilty of hubris, thinking you’re just smarter than the collective wisdom of the market. And that person likely doesn’t exist. So you want to be globally diversified, and then simply rebalance. If the US does relatively poorly over the next 10 years, it means you’re going to be just buying more US, and vice versa.
JA: One last question in regards to global diversification. I noticed that you’re talking a little bit more about alternative investments. Has your opinion changed going into some alternatives than maybe when you’d written your book 20 years ago?
LS: Yeah, that’s the thing. We come back to your original question. We went over what’s the same, and 90% of it, I would say is the same. We went over that. The differences are there’s been new academic research since my first book was published. I covered that in my “Your Complete Guide to Factor-Based Investing,” which I mentioned earlier. So now we have identified a few more factors: profitability quality and momentum being the leaders in equity. So now we have five equity factors we at least look at, instead of just three. So that’s a little bit different. And 20 years ago, alternatives, I basically ignored because they were the province and you could only invest in them through opaque hedge funds which charged 2% and 20%. So any value that they were added, they were capturing, not you. Well, the world has changed and there are now hedge-fund-like strategies that are not opaque, that are totally transparent, and you can see that the funds like a fund family called AQR is implementing using the same type of research that Dimensional Fund Advisors used in equities, and they’re using that in not only equities but in bonds and currencies and commodities, and with much lower fees than 2 and 20. And then there’s a fund family called Stoneridge, which is providing access to alternatives that people like Warren Buffett have been investing in for decades, or Yale Endowment, investing in things like insurance, and what’s called selling volatility. And there’s a third product, Small Business and Consumer Lending. And now you can do that because the SEC has created vehicles which do not require daily liquidity. So Warren Buffett owns a reinsurance company. He can go buy one-year contracts to do reinsurance or issue them. Yale can go buy a one year contract, but you can’t put that in a mutual fund because you need daily liquidity. Four years ago, the SEC approved an interval fund which only required limited quarterly liquidity of 5% a quarter. And so you could now make a five-year small business loan to companies and diversify that. And so Stoneridge has an alternative lending fund. They also have this reinsurance fund, and they sell puts and calls on stocks, bonds and commodities and currencies, what’s called the variance of volatility premium. All unique sources of risk that diversify us away from the risks of stocks and bonds. So you get a more diversified portfolio that isn’t concentrated so much in unique risk. So we’re moving as much as 25% of our client assets into these alternatives today, and they didn’t even exist four years ago.
JA: Right. How do you look at that, if they haven’t existed? If it’s not been around for 90 years it’s of hard to judge. What are some of the due diligence that you do, or maybe if someone is looking to get into something like this, what would you recommend they do?
LS: Well it’s almost impossible, Joe, for individuals to do the due diligence on their own because they can’t do the due diligence on the company like we can. We’ll go travel to their site, meet their team, they’ll bring an entire team of their top eight or 10 people to present to us, and we grilled Stoneridge for three years with various meetings visiting their trading room to make sure they could execute. Where are they putting their own money in their own investments? Is there transparency? What’s the culture of the firm? Are they there doing the right thing or are they there just to earn commissions and stuff like that. So we will take a lot of time. But the fact that the products were not available to the public does not mean that the data isn’t there for decades, and sometimes even longer. Reinsurance has been around for 150 years and the reinsurance business goes back in the US decades and the Yales and Harvards of the world have been investing in it. It’s not publicly available in the form of a mutual fund. But the research is there, the evidence is there, and the logic that they should provide premiums is there. So they have to pass the same kinds of tests here as well. So you have to have the skills and the knowledge to do the due diligence. But that’s one of the ways a good advisor can add value is to do that in the same way that you are doing that in recommending, whether it’s DFA funds over Vanguard, or whatever.
JA: Got it. Talking to Larry Swedroe, you can check him out at ETF.com. Great stuff, Larry, thank you so much for your time and your busy guy. It’s always a pleasure talking to you.
LS: My pleasure. Talk to you again soon Joe.
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33:52 – Sinking at Retirement – Price-to-Earnings Ratios and the Shiller CAPE 10
AC: So Joe, Investment News is a publication we get weekly. And there was an article this last week that caught my attention. And I want to get your thoughts on this because you are a sage. Plus, I’m going to see how accurate you are relative to Larry Swedroe. (laughs) So it’s called Sinking at Retirement. Already a tough start. “Sinking at Retirement: market performance in the first few years of retirement determines financial security throughout one’s golden years. Here’s why people retiring today could find themselves underwater.”
JA: You know, that is called sequence of returns risk. And it is a very significant issue that people don’t really understand. And I think where this article is getting at – and don’t get me wrong, you just read the title. (laughs)
AC: (laughs) You’re already predicting. It’s like 2,000 words you already know what it’s about.
JA: Probably they’re saying, “OK, if I take a look at markets right now, people have enjoyed a very robust stock market over the last 10 years.” And they’re saying, is the stock market overvalued, undervalued? And then you kind of prefaced a little bit of it of the CAPE 10. The Shiller P/E ratio.
AC: I did.
JA: And so Swedroe was talking about that just earlier in the show. And if he’s saying, “OK, well if expected rates of return, given a CAPE 10 Shiller ratio at 30, your expected rate of return is going to be roughly, anywhere from three to five. And three to five on your stock allocation is significantly lower than maybe seven to 10% that we’ve been accustomed to – or even an 8 to 12% that we’ve been accustomed to on the equity component of your portfolio. And so when you have that type of lower expected returns, what does that mean? That means that there’s going to be a correction at some point. I think we all know this. So when people are lining up to retire, and, “I’m going to retire next year,” and then all of a sudden we run into a year or two year bear market, where now they’re down 20%, and they’re taking dollars from their portfolio, it’s very, very difficult to get caught back up.
AC: Yeah and Joe, to kind of set this up, so the CAPE ratio or the CAPE 10 ratio was 33 at the beginning of the year, and get this – that was higher than it was before the bear markets of 2008 and 1929. And of course, there was no such thing as the CAPE 10 back then. They just kind of went back and looked at it the best that they could. And it’s approaching what the value was in 2000, before the dot-com bust. So that’s the concern.
JA: So what they’re saying is that market valuations are high.
AC: They’re high right now.
JA: Given P/E ratios – price to earnings ratios. So what a price to earnings ratio is, is that you’re taking a look at what price are you willing to pay a company for the earnings that they’re generating. That’s why we buy stocks in the first place. So we want a piece of that profitability of the company. We want some of that equity, or the earnings that are coming out, or the growth of the company. And so, the price we’re willing to pay for those same earnings are a lot higher today than where they were, let’s say, 10 years ago. What does that mean? That the stock valuations are higher today than they were for that same company. And so it’s like OK well, at those valuations, we’re back at 2000 levels. The CAPE ratio is a lot higher today than it was in 2000 What happened in 2003, 2002? Worst bear market we saw since the Great Depression.
AC: That’s right. And Michael Kitces, who, along with Larry Swedroe are a couple of the smartest guys in the industry. Here’s what he says: “We view this as an elevated risk time in retiring. This is as close as you can get it to all-time market highs, and dangerously high valuations make it a risky time to retire.” And he goes on. He says, “the worst time to retire is when stocks have run for a while without an intervening bear market,” which has been true since 2009. We haven’t had a bear market, which is a 20% correction. Then he goes on to say, “this is when expected returns are low or negative. Conversely,” he said, “the best time to retire is during a bear market when the client portfolios will benefit from good returns on the upswing.”
JA: But it is so difficult to time. It’s not like, look at the CAPE 10 and that is going to determine your retirement date. (laughs)
AC: “I’m going to I’m going to postpone my retirement.”
JA: No I think the point of the discussion is that you have to start taking a look at a defense strategy if you’re looking at retiring. Period. You have to have a different portfolio to create income than that you’ve used to accumulate income. You just have to have a strategy that is going to put it into play, yes, if a bear market hits me, am I still going to be able to accomplish all my goals?
AC: Yeah, and that’s exactly right. And to me, that’s the crux of this article – it’s telling you how to handle this. It’s not saying don’t retire. It’s pointing out there are some issues here with the market the way it is, and here’s how you go about it. So I’m going to first talk about what Wade Pfau says. We had him on our show a couple three weeks ago. He started by saying, you know the 4% rule, that’s that’s been widely regarded as the safe distribution rate – that came out in the 1990s.
JA: No, 70s. Bill Bengen. Right here in San Diego.
AC: Was it 70s? That far back? Yeah, El Cajon. OK. At any rate, and at that time, fixed income was a lot higher. And all these simulations showed that there was a high probability of retiring at age 65, that at a 4% distribution rate you would not run out of money.
JA: Right, because you use 10% for your stocks, 5%on your bonds.
AC: Sure, yeah. So it looked pretty good. And that was based, I think, on a 60/40 stock to bonds.
JA: So you’re looking at, I don’t know 70%.
AC: Yeah. Exactly. You’re taking out 4, you’re earning 7, keep some in for inflation, you’re probably okay. But what Wade Pfau is saying is, one thing you can do is lower your distribution rate. And there are all kinds of studies, and he’s come up with all kinds of different numbers – there are a million variables, but he said just rule of thumb, maybe instead of four, maybe it’s more like three right now. In some cases, it could be lower. And in some cases could be higher. Depends – if you retire young, it’s got to be low, because the money has to last longer. If you retire in your mid to late 70s, you can probably withdraw 5% and be OK, but that’s not a guarantee. The lower the distribution that you take, the more likely that you are going to succeed in retirement. In other words, have the money still be there through your lifetime.
JA: You know it’s funny too, when you when you look at portfolios and some of those studies that these academics do, is that you would think, “OK as I get closer to retirement, I’m going to continue to add more bonds or safe or fixed income into my overall portfolio.” And some of the studies that I’ve read is the opposite in some directions. So the longer that you’re in retirement, the more stock you allocation that you need because of longevity.
AC: Yeah I’ve heard that too. But again, it’s tough with the higher CAPE ratios right now. Joe, here’s another thought. So Cornerstone Wealth Advisors has developed a sustainable withdrawal strategy that is flexible. So in other words, if your portfolio goes down – and people have talked about that, instead of a constant 3 or 4%, maybe you start with a 3 or 4%, but just be willing to adjust it in certain market conditions. Pull back the reins a little bit at certain times.
JA: Right, that’s why this whole thing is an ongoing process. It’s not necessarily stagnant in time. When you look at everything right now, I think it’s a perfect time for people to readdress what they’re trying to accomplish in regards to retirement. Because valuations are high, P/E ratios are very high, and if we do have a correction – and a lot of you have recency bias in most of the portfolios. And Al and I review hundreds if not thousands of portfolios on an annual basis. And I would say, a very consistent message that we see is that most of the holdings that people have is all large company growth stock. S&P type mutual funds – which is fine, but you’re heavily weighted in that area, and then you’re taking a look at valuations and they’re almost at all-time highs. So diversification now might be playing a more important role than you’ll ever imagine.
All right. That’s it for us today, for Big Al Clopine, I’m Joe Anderson. Thanks a lot for listening. We’ll catch you next time on Your Money, Your Wealth®.
If you missed the interview with Dr. Wade Pfau that Al just mentioned, you can check it out at YourMoneyYourWealth.com. We’ll have more from that interview with Wade Pfau talking about the 4% rule for retirement withdrawals on the podcast next week, so make sure you’re subscribed at YourMoneyYourWealth.com, Apple Podcasts, or your favorite podcatcher. In the meantime, special thanks to today’s guest, Larry Swedroe. You can read Larry’s latest in the Index Investors’ Corner at ETF.com.
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