Paul Merriman: The 4-Fund Strategy That Beats the S&P 500

0:00What should your portfolio look like? We're going to discuss that today with investment expert Paul Merriman, a former wealth manager who now runs a foundation dedicated to financial education. Welcome to the Afford Anything podcast, the show that understands you can afford anything but not everything. Every choice carries a tradeoff, and that applies not just to your money, but to your time, your focus, your energy, to any limited resource you need to manage. So, what matters most? This show is dedicated to exploring that question, and we cover five pillars. Financial psychology, increasing your income, investing, real estate, and entrepreneurship.

0:42It's double-I fire. I'm your host, Paula Pant. I trained in economic reporting at Columbia, and I help you prioritize. And I'm here at the Bogleheads Conference in Minnesota with Paul Merriman. Welcome, Paul. It's great to be here, Paula. Thank you. Thank you so much for joining us. Now, the last time you were on the show, we talked about a two-fund portfolio. This is something good for beginners who want something just a smidge more advanced than target date funds. With a two-fund portfolio, and we won't go into the details because people can listen to episode 300 in order to dive into that discussion.

1:19But with a two-fund portfolio, you talked about how adding just a little bit of additional complexity, that small cap value fund? Correct. That slight bit of additional complexity can boost your returns while not making your standard deviation go crazy. What I want to talk to you about today are further iterations of that. How do we get just a little bit more sophisticated and a little more sophisticated and a little more sophisticated? Well, I'll address whether the two-fund strategy is for beginners because theoretically, that is a portfolio you could use for the rest of your life. The target date fund takes care of moving money from equities to a fixed income.

2:07And that slice of small cap value would give you that extra kick, at least based on history. Probably a half a percent. If you put a little more in, it would be a full percent. But that's a lot over a lifetime. But if you want to get a little more aggressive, you certainly could even do more. What people are really surprised to find out is that a portfolio, I'm talking about the equity part of the portfolio, that is half in small cap value and half in the S &P 500 actually does not have any more risk than the portfolio that would be 10 or 20%. It is interesting. And the reason that is is because they don't go up and down together.

3:00And what it allows you then to do is to get more exposure to small cap value along with the target date fund. And, of course, we have a free book for people entitled Two Funds for Life if they really want to dig into that. But to take it the next step, what I think we want to do is to look at what that target date fund has in it. Does it represent the equities that you want to own for a lifetime? And it's not that they're bad equities. They're just fine equities. But we do know that group of equities that they have there now is kind of like the S &P 500. But if you replaced that S &P 500 with a portfolio that's 25 % in the S &P, 25 % in large cap value, another equity asset class, 25 % in small cap value, and 25 % in small cap blend.

4:13And believe it or not, going back all the way to 1928, the volatility is lower with the four funds than the one. And the return is almost 2 % higher. And will the future look like the past? We all struggle. With whatever we believe about investing, we do know there is no risk in the past. We always know what we should have done. What we don't know is the future. But that four fund strategy gives the investor a ton of diversification. And when you put the four together, you're guaranteed never to be number one at the end of the year. You're guaranteed never to be the last in that year. And that kind of right down the middle has produced a remarkable long-term return.

5:07So I noticed right away that you recommend offsetting that S &P 500 exposure with small cap value and small cap blend. But I know I'm going to get a bunch of emails from people saying, but look at large cap performance. I mean, this is recency bias at work, but look at large cap performance. Look at NVIDIA. Look at the Magnificent 7. Look at how well large caps are doing and how much they've driven the overall economy. Yep. And particularly even large cap growth, right? What would you say to anybody who raises that objection? You know, what I would challenge them to do is to look at a quilt chart that shows all the way back to 1928 the returns of all four of these major equity asset classes.

5:58Now, here's what we know about the S &P 500. It is the highest quality of those four classes, asset classes, which means that they should have the lowest return over time, not the highest. But having said that, when we look at the last 96 years, yes, in 41 % of those years, you have the worst performance, not bad performance, but the lowest because of less risk. But there are, I think it's 28 % where it's the number one. And oftentimes, they're number one many years in a row. And this is what I think investors struggle with. They don't know what to expect. They do not have realistic expectations because they are stuck with recency bias.

6:50And so whatever's happened recently is more important, more likely to continue to do the same thing in the future. And that has cost people tons of money because chasing performance is what gets them in trouble. In fact, small cap value, after it has a five or 10 year run, when it has way outperformed the S &P 500, people then start thinking, well, I got to have some of my money there. No, that is not the time to go in. The time to go in when it was not number one. And hopefully your dollar cost averaging in, picking up these cheaper shares. By the way, the same is true with the S &P 500. From, as you know, 2000 to 2009, it lost 1 % a year.

7:39And if you failed to continue to put the money in there, you would have missed the huge run that went on after that ugly 10-year period. So I think the idea is to be able to know enough about the past so that you have real good expectations. It's a bunch of random stuff that happens. You cannot know when small is going to be the best, when value is going to be the best. These are things that when you look at the quilt chart and the stunning color, so you can see the colors of the different asset classes. If you get that right, you're going to have the patience to do what John Bogle wanted you to do, stay the course.

8:22We just want you to stay the course in things that are likely, we don't know, but likely to produce good returns. You know you have low expenses. We want you to be an index like mutual funds. Those are not difficult decisions. But we all live with the unknown. Nobody knows. And I'm going to share something that I just read in John Bogle's great book, The Little Book of Common Sense Investing. Coming back to the conference, I decided I should read it to see what he said that would remind me of something I should be talking about. 1980s and 1990s, we had no idea what was going to happen. Companies did fine, but investors bid the prices of stocks way, way up, worth a lot.

9:15That is what Bogle calls the speculative return on those. The speculative return does not last. Eventually, the economics, The profits are going to drive the return on most of these companies. And so how can we know when people are going to get crazy and bid up stuff like with the mighty seven, the magnificent seven? How are we going to know when that's going to happen? And how are we going to know when they decide enough is enough and they feel a little silly that they paid two or three times what they should have. And now they're getting out because one, the market's going down. And two, they're afraid that it's going to keep going down a whole lot further, which ends up very often giving you a period of time that the market is undervalued.

10:08If you want to be a market timer, God bless you. I mean, I'll give you, I wish you the best. But I think people mostly when they try to do market timing, they hurt themselves rather than getting the best that they could. So my goal is to get people to be balanced in equity asset classes that have a long history of success. And then keep your hands off it. Don't touch. All right. So I'll tell you the argument that I heard. And just to be clear, I myself don't believe this, but these are the voices that I hear. There are people who would argue that it's not 1929 anymore. And what we are facing today is an inflection point that's ushering us into a new era due to AI and that the productivity benefits of AI are going to accrue to the largest companies, to Meta, to Google, to Amazon.

11:05they're going to accrue to those companies in such an overwhelming manner that no other company will be able to keep up. So behemoths will become bigger and bigger and bigger. And so they argue, therefore, that we are ushered into a new era of the largest of large caps. It's an argument that's easy to agree with. Right. And it also is an argument that was made many times over the last hundred years that there were changes in the economy that were going to create permanent advantages to certain people over others. And the bottom line is, at least from my viewpoint, returns in the future are going to be like returns from the past.

11:56If I look at what the S &P 500 did last year, I think up 26%. I went back and looked. Lots of years, it was up 25 to 30. Now, the reason it was up 26 is going to be different than the previous reasons that it was up 25 to 30. And I looked at every one of the asset classes, and they all showed me the same thing. There was nothing new. As a matter of fact, you just mentioned 1929. A lot of folks may not realize that from 1929 to 1938 and 2000 through 2009. The period 2000 through 2009 was worse. It lost more money than the period 1929 to 1938. And people criticize my work sometimes. They say, why do you go all the way back to 1929 or 28?

12:48That stuff doesn't matter. It isn't what was going on that matters. It's just the market. The market goes through these swings up and down, and it appears to be pretty random, except afterwards, we can always explain why it happened. We're experts afterwards. So do I believe that the S &P 500, particularly because of AI and the handful of companies, is going to remain at the top of the list? When you look at that quilt chart, you will see lots of times that it was at the top of the list. And then it ended up at the bottom of the list. From 1976 to 1999, the S &P 500 compounded at more than 17%.

13:36People were thinking that that was the future. What's happened since 1999? The S &P 500 has compounded at about 7.5%. Now, have things changed? Why would the magnificent whatever we might have in our economy, why is it the market has produced a lower return today than it had during a period of time that we didn't have AI to make the case for why things are so good? It is the nature of humans. We love telling stories. We feel obliged to make up stories. Some people do it as a profession. They're called politicians. But for most of us, we too make up stories. And in most cases, our stories turn out not to be right.

14:27Not that we weren't well-intentioned, not that we weren't intelligent, but it's because the market does what it wants to do. And we all think we've got it figured out. I'm trying, I'm preaching, if I'm going to call it that, for people to give up the attempt to outguess the market and just be the market and be the market in a way that historically it paid a premium because that's all we're looking for is to get a normal rate of return. What we don't know is that we don't know how good the economy is going to be. And then we don't know how much people are going to pay for whatever earnings that they might make.

15:07So there's a whole lot of unknowns that are daunting enough to have to market time and figure the next right move to make probably just makes it more difficult and less likely to help you. I like the phrase, be the market. It feels like something you'd hear at a yoga class, like be the market. You are at one with the market. Yes. And I love that too, the idea of it being a peaceful, it's something that you can control. So this is the beauty of of an index fund versus actively managed fund. When I just reread Bogle, he said the index fund is the only fund that is honest. Now, I hadn't thought about that when I read it years ago when the book came out.

15:56Why is the index fund honest? Because they tell you, we are going to do everything we can to be the market. We're not trying to beat the market. We want to keep the expenses low because we don't have to spend time or money second-guessing and trading and trying to be better than the market. The active manager says, we think we can beat the market. We got great people, smart people who are here to take care of your money and we are going to help you beat the market. Now, what they don't say, if they were really honest, we just want you to know, by the way, that as much as we want to beat the market, the studies show that maybe one out of 10 actively managed funds beat the market over an extended period of time, say 20 years.

16:50And the problem is, I would like you to believe that would be us, but the fact is nobody has ever figured out how to pick that fund at a time. And so I just want you to know that if you hire us, More than likely, we're going to underperform our hopes and your expectations. But when you are the market, you are actually picking up the growth of this engine that we have. And it goes way beyond seven companies. It is the whole economy, basically, that you're picking up when you own that S &P 500. And what you hope is that you'll be given the normal return, which, by the way, John Bogle says is 9.5 % a year.

17:36And then if you look at the return of the market over the last 90-some years, it's been 10. So what he says is you got 9.5 % for the engine itself and one half of 1 % speculating on the future. So that's the way I look at it. And of course, when you have a belief, the challenge is what's behind that belief? Show me the, remember, show me the meat advertisement. Now, what is the meat behind the things we believe? Nobody argues about low expenses. Nobody seems to argue that lower expenses are better than higher expenses. Nobody argues that lower taxes is better than higher taxes. Nobody argues about more diversification is better than less diversification.

18:29What they get into an argument about is something about which they have no control. And that is what the market's going to do next. And I'm 81 almost. And so I've got a relatively few years to be in the market. and at 81, my wife and I are half in equities and half in bonds and half in small, half in large and half in value, a little more than half in value and a little less than half in growth. And we just, we stay the course. We take out our annual distribution to live on the first week of the year. And I don't even care what the value of the portfolio is because I can't do anything about it.

19:19And it is a waste. If I think about that, be the market. Well, in that piece of being the market, hopefully someday people will be able to say, I am satisfied being the market and I am not going to worry about it in the meantime, because it drives a lot of people nuts. They should be able to do something. Take control. And Bobo says, don't do anything. Just stand there, which is the opposite of what we're trained. Don't just sit there. Get to work. You know, solve the problem. Right. In fact, the problem is solved if you don't do anything rather than getting in there and monkeying around with your portfolio.

20:02But it's human nature to want to do that. I'm curious. Yes, you said that you take an annual distribution. Two questions. Number one is why do you draw down annually rather than quarterly or monthly? The second question is do you have a cash or cash equivalent allocation as a runway to protect you against any dips in the market that would force you to sell off depressed assets? Well, first of all, we are half in bonds. And basically they're all governments or munis. The second thing is we do keep an extra year or more depending on what our plans might be in terms of housing or special travels or some things of that nature.

20:48It's not what I'd recommend to people who want to be efficient. You're right. If you want to be efficient and the market generally goes up, take the money out monthly. Don't take it out before you need it. Right. So the market can be working. I'm at the other end of the spectrum. I know who I am. I get nervous when I'm doing things with our investments to underwrite our life at the same time as the market's going up and down. If I take it out the first of the year, I know that's what we have during the year. And that is to cover, by the way, the money we give away as well as the money we use for travel and our basic needs.

21:28I don't have to worry about whether the market is up or down in any particular month. And I say to my wife, do you mind if we wait a few weeks before we take the money out? Because I will be like a lot of people given the choice. I will want to second guess. My emotions become part of the process. I don't want that. And the other part is that my wife likes to spend money. I don't like to spend money. This is very common with couples. And I have found that if we have an agreement, we take 5 % out of each year. That is our money for the year to use and to give. And that then creates kind of a budget.

22:14And so she knows, hey, I got all this money to spend. This is great. And if the market goes up, which it normally does, she gets a raise in what she has to spend. And when the market goes down, we take a cut in pay, which makes me happy because that has an amazing impact on the value of your money over a lifetime. If you can cut back a little bit during the bad times and be willing to spend during the good times, it works out so much better that way. If you look at the numbers. So emotionally, there's the money. That's for the year. Let's have some fun. Let's not worry about having money. Let's not care if the market's going up or down.

22:59And it feels good. I solve a marital problem. I solve a financial problem. And the market normally goes up. So she knows every year she has a good shot at having more money to spend the next year. You say you spend less than years that the market goes down. Does that mean you reduce what you take out? You mentioned 5%. do you reduce that down to 4 % or 3 %? No. We take five of a lower number. Oh, okay. And we have tables. For this Boglehead conference, and you might want to include it in your notes as well, we have over 200 tables that are built and charts and things that are built to help people understand this process.

23:44So I made a page that had links to all of those major groups of tables so people can go and investigate the numbers on their own. As you know, we are purely teachers. We are not managing money. We're not selling anything. We just are trying to teach them the things that we've learned. And I've got a trustworthy group of volunteers who are willing to work for nothing along with me. And that's what we spend our time doing. And those tables are the meat. Those numbers are the meat because it's supposed to be, from my viewpoint, we're trying to show the evidence. I want to see the evidence that something is better than something else.

24:27And this is our attempt to create that evidence. All right. I'll get that list of links from you, and we will put that in the show notes. If you're watching on YouTube, that's going to be in the episode description below. And if you are listening on a podcast playing app, we will make sure that it's in the show notes that are on the website.

24:49The kids are back in school now, and I finally have some extra time to plan a weekend getaway for just us. We've been wanting to visit Lancaster County, Pennsylvania for a while now because I've heard so many people rave about it. We love exploring new places, finding the cutest shops, and eating at restaurants that the locals love. DiscoverLancaster.com is the best place to learn about the unique things to do and upcoming events. Plan your trip alongside us at DiscoverLancaster.com slash amplified. I want to shout out to all the small business owners out there. You wear a million hats. You're doing a lot of things.

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27:28about.

27:36Taking our attention off of distribution and back onto asset allocation, because most of the people who are listening to this are in the accumulation phase. Most of the people who are listening are currently working and saving and investing. We've talked a little bit earlier about how a lot of the growth recently has accrued to just a few companies. And it has raised the question, what about equally weighted indexes? What if you feel as though the nature of index funds causes you to be so overweighted in just a few that you should diversify into equally weighted? What are your thoughts there? Well, first of all, the idea of equal weighting of asset classes is what I was talking about just a little while ago, the 25 % each in the four different equity asset classes.

28:29But then there is the equal weighting of the individual companies. So instead of having cap-weighted portfolios, as the S &P 500 is, you have every company has the same impact percentage-wise, which is a totally different portfolio. Now, people need to understand that now a portfolio is being managed that is going to be way more expensive to manage and will have tax consequences, heavy-duty tax consequences, in this attempt to keep these companies in that relationship across 500 companies. It's a very different way of managing. There have been funds around for a long period of time, back into, I think, into the 80s.

29:19And Invesco has one that's been around, I think, for that whole time. And if you look at its performance compared to the Vanguard S &P 500, most of the time, they've done better. They being the Invesco equal weighted fund. Recently, partly because of the Magnificent Seven, there is a bit of an advantage, but it's a very small advantage. The disadvantage for the equal weighted approach is that you are going to have to pay more in taxes in a taxable account. So I would only use that, if you're going to use that, in a tax-deferred or tax-free account, particularly with the people in the FIRE movement.

30:11A lot of them like the total market index. Yeah. Okay? VTSAX. We live and breathe it. Yeah. Well, I want to talk about that because it's important to understand the difference between the S &P 500 and the total market index, there is virtually historically no difference in return. So you could, based on return, be just as excited about the S &P 500 as the total market index. Now recently, the total market index has underperformed, again, because of the Magnificent So we have that impact there too. What the academics tell us, whether you have 500 big companies that are growth oriented, or you have 3 ,500, kind of what the total market index is, that is mostly growth oriented, you really haven't made a difference.