The Investing Mistakes Even Smart Investors Make (EP.269)

0:02We all need to make smart decisions with our money. The Long-Term Investor podcast shows you how by distilling complex financial matters into easily digestible lessons. And now, here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff. Welcome back to The Long-Term Investor. In this episode, I'm joined by Liz Muirhead, a senior portfolio strategist at Vanguard, who was visiting our office in St. Louis to do the mid-year outlook with our advisors. And it turned out we had just set up our brand new podcast studio in the office. So I asked Liz, unprepped, to hop into the studio and talk about all sorts of different topics.

0:45We talked about why individual bond ladders often provide more psychological comfort than economic advantage, where active fixed income can add value, how mega IPOs enter indexes, and why broad diversification means that you already own tomorrow's market leader. And honestly, as I tried to summarize the conversation, I realized that doesn't even capture half of what we talked about. So this is a longer episode. We dive into all sorts of different things. And there was one resource I mentioned during the episode that is linked at the top of the episode description. Basically, it's a calculator that Plancorp built to estimate your annual fee and the value that you could earn by working with a professional advisor.

1:29As always, you can find detailed show notes at thelongterminvestor.com. But enough of me, let's dive into the conversation with Liz Muirhead. Hi, I'm Peter Lazaroff, Plancorp's Chief Investment Officer. And today I'm here with Vanguard's Liz Muirhead. Liz, thank you so much for joining me today. Thank you for having me. Maybe you could give a brief background on who you are and what you do at Vanguard. Absolutely. Happy to do that. So I actually just celebrated my 29th anniversary with Vanguard. Wow, congrats. The gray hair comes with the tenure. I started in the back office, spent 17 years in our manager due diligence department.

2:14And then for the past five years, I have been a senior portfolio strategist working with advisors on broad topics like understanding markets, portfolio construction, and actually sometimes even digging deep and going through advisors models and helping them figure out how they can do a bit better. Very cool. And Vanguard, I feel like when a lot of people think about Vanguard, they think about Jack Bogle, they think about index funds, they think about the power of simplicity. One thing that I find when I talk to people who are interested in investing, but either aren't advisors themselves, maybe some of them work with an advisor, maybe some of them don't, they often feel like investment management has become commoditized.

2:58Sure. And I think that Vanguard has done a lot of, Vanguard amongst a lot of people have done great work to make some version of investment management commoditized. You know, like it has never been easier to build a diversified portfolio of cheap market exposure. Yes. However, there are a lot of things involved in the investment management process that aren't necessarily a commodity. You sort of made a face when I said that phrase. So tell me your reaction to that. Like, what do you think about that? So Jack Bogle solved a major problem for end investors, which is access to institutional quality management.

3:36So direct stock exposure, the ability to invest in the S &P 500, for example, and then later the total market, that was something that was reserved only for professional investors, institutions. And so being able to give access to that broad diversification, especially at very low cost, was a novel idea. the challenges that Jack believed that if people had access, that would be enough. And over time, we've learned that just having access to the right products doesn't necessarily mean that you're going to use them appropriately. I mean, like I can buy an entire gym system for my basement, but I might benefit from actually having somebody show me how to use it all, I'll make sure my form is good so I don't get injured.

4:29Index funds are great, but I've often seen people misuse them. It turns out that hundreds of thousands of years of human hardwiring and evolution has not just been scrubbed away. Like you're never going to take the human out of human nature. I think a lot of what I'd like to talk with you about today are some of these areas that perhaps show how investment management is not just a commodity. how there are different offerings and different ways in which both an advisor can add value, but I'd also like to address some misconceptions that not just individual investors have, but that maybe even financial advisors have.

5:05So why don't I start with the one that I feel like I've spent more time in the past 12 months talking diligently about, individual bonds versus bond funds. Now, let me set the table. Individual bond funds, if you wanted fixed income exposure, That used to be the only way you could get fixed income. You had to buy individual bonds. As a result, people would put together bond ladders. I think that a lot of the professional community has gone past the point and has seen the research and has seen the product development to say, yeah, you can certainly improve upon bond ladders. But with individual investors, I still see them obsessed about the certainty of getting their principal value back at maturity of the individual bond.

5:50Yes. Give me some background on how you think about individual bonds versus bond funds and maybe some of the misconceptions you see among both individuals as well as advisors themselves. Sure. This is a topic that comes up quite a lot, Peter. One of the things that we've seen is that holding individual bonds can be helpful as a behavioral tool for clients because that certainty, not having to see that bond mark to market, that bond is changing value every day. But that value change isn't visible to clients. And so it helps them behaviorally stick with the plan. The challenge is that if you're using individual bonds, you are leaving a lot of money on the table.

6:37So a couple of examples. In most cases where we see individual bond portfolios, it's where the client has an indeterminate time horizon. So the client has their retirement portfolio. They know they're going to retire maybe at a particular age, but they don't know how many years they're going to live into retirement. how much money they want to leave for their heirs, charitable bequests, etc. And so they have a very long term and uncertain time horizon. If they hold individual bonds, those bonds are going to mature. And then what are they going to do with that money? They're going to buy another individual bond.

7:18Miraculously, this is what the bond mutual funds and ETFs are already doing. So they are laddered bond portfolios, but they hold a lot more bonds. they're professionally managed. And because they're professionally managed, you're also getting better trading costs and liquidity. So these are all really positive things. Now, there's a time and place for individual bonds. Let's say that, you know, my son was going off to college and I wanted a bond to mature each year in order to use those proceeds to pay his tuition. That would be a great reason to have a laddered bond portfolio because when that bond matures, I know for sure how much money that's going to be.

8:01I'm going to pay the tuition bill. I'm going to go on with my life. But in the situation where I'm taking that money and now buying a new bond, I'm subject to reinvestment risk. What are interest rates today versus where they were years ago? And in that bond portfolio, because it's just for me and I'm the only investor in it, I'm probably not going to have as much money to build as much of a diversified portfolio. So when we look, especially on the muni side, what we tend to see is people concentrate those individual bond portfolios in very short term bonds. They leave a lot of return on the table because the muni yield curve is very steep.

8:43So you get a lot more yield by having 15 or 20 year bonds than you do by having five or 10 year bonds. The second thing is that they're focused in the highest quality of investment grade. Whereas if you have a diversified bond portfolio, you can use AAA and AA like people do in individual bond portfolios, but you can also hold single A and BBB. Those are still investment grade ratings, but there's a lot more value. And there's an opportunity, too, to differentiate with active management in that single A and BBB credit rating bucket. So we see a lot of that nuance in how people are leaving significant amounts of return on the table in an individual bond portfolio.

9:31And they don't realize it because the individual bond portfolio isn't marked market. And they don't really have a good sense for how it's performing relative to an enduring stable duration, stable term mutual fund or ETF. First of all, I couldn't agree more with everything you're saying. There's so many tangents I want to go down, except the very last thing you said is going to make me pivot again and say they don't know how they're performing. I don't think any individual investor really knows how they're performing. I have seen dozens of spreadsheets from investors over the years trying to show me what their performance is.

10:06And people just we don't have to get into the complexities of how to calculate time weighted return. But unless you are doing that, you don't know what your performance is. And most custodial websites, I want to say all, but I don't know if it's true. but most custodial websites don't provide that information. So the ability to not understand your performance, you know, we talk about is investment management a commodity? Performance reporting is a big deal, particularly transparent performance reporting. And with bonds, you don't know what the costs are because they're embedded into your yields.

10:37You really don't know what your opportunity cost is without seeing a benchmark and a time-weighted return of those individual bonds. You know, I just feel like it's a place where we could spend an hour going over misconceptions, but I will then, I'll pick my battles here and just hone in on one other thing you said, where there's a lot of opportunity for active fixed income management to add value. Now, people who think Vanguardian, they typically think indexes, aren't indexes great? But the bond world is different than the stock world. Like, let me paint a picture. You and I walk into a bank together and I have debt out the wazoo and just like a little bit of income, Whereas you come in with a pristine balance sheet, you have a high income, lots of assets.

11:19If the bank were an index fund, they would lend me more money just because I'm more indebted. That doesn't make a lot of sense. There's also just, I think more than half of the buyers of fixed income don't have economic interests. So people buy bonds because they have certain liquidity requirements. There are just all sorts of opportunities to add value in active fixed income. I happen to think that Vanguard has a very thoughtful way of thinking about active fixed income. Like where are some of the other things that you see there being a big benefit of utilizing an active fixed income portfolio?

11:52Sure. Well, I want to be clear. We have index and active. We love all our children. But in the active fixed income arena, what we see is there's a real opportunity for differentiation from a credit perspective. Think about the U.S. stock market. we're talking about thousands of issuers, you know, four digits. In the bond market, we're talking about tens of thousands of issuers, five digits. And in many cases, those issuers have multiple bonds. So take a company like GM, there's not, you know, there's one GM stock. There are hundreds of GM bonds. And so a good active manager can look at that range of bonds and can determine this bond has a relative value that makes it more attractive than that bond.

12:43So it would be like you and I walking into the bank with very similar balance sheets, but you have a better yield than I do. And so the bank's like, hmm, that's attractive. I want to make that investment. That's the power of active management in fixed income. The challenge is that there are a lot of active managers out there that charge very high fees. And in fixed income, you can only add so much value through active management. So if you're charging a very high fee, the way that you generally compensate for that is by taking more risk. And that's where we see in some cases, indexing has been a way for people to get that same risk exposure.

13:28but use index products to do it and use factor tilts within that. So the active management is the overlay. It's how you use the index products instead of the bottoms up selection. We think there's an opportunity to add value in both. Yeah, I really think that if you are an individual investor or an advisor who is using individual bonds, you know, other than the use case that you had suggested, I agree where you're matching an asset with a liability, whether it's I have a tuition payment in X years. And so I want to lock that in. You're using it for the investment, long-term investment portion of your portfolio.

14:03There is a lot of new research. There's a lot of new product that you really need to start to familiarize yourself with. You know, investing isn't always about just earning the highest return, no matter what. You know, you do have to have a portfolio you can live with and meet your objectives and is aligned. But I tend to find that when people come to us at PlanCorp, the number one place I'm like, oh, well, there's easy value to add is in the fixed income portfolio. But I want to go through some more like misconceptions. Otherwise, I'll talk to you about fixed income for an hour. I think it's fascinating.

14:35We might lose the audience. That's right. Well, here's something the audience definitely is into because it's all over the headlines is SpaceX was the first of a series of mega IPOs. When I think of, again, Vanguard managing one of the largest, if not the largest, like total market index product. A lot of people were concerned with how that one specific mega IPO, as well as some of them coming down the pike might influence the market, might influence exposure. And what are some misconceptions that you've seen both advisors and individuals have about the mega IPOs in 2026 and beyond? I think one of the biggest misconceptions that I kept teary, even just from my personal friends, was, oh my gosh, SpaceX is going to come to market and it's all of a sudden going to be the biggest stock in the index because they kept hearing in the press it's been valued with a$2.6 trillion market cap.

15:30The reality is that inclusion in indexes is based on what we call free float, which is what percentage of shares are available for sale. And so looking at the free float of a company like SpaceX, we're talking about a market value that is actually closer to the size of a FedEx or a 3M than the value that was being quoted in the market, in the press. And if we actually look at some of the indexes that have already included it, the largest inclusion that we see is in the completion index from S &P, which is 1.3 percent, I think the last I looked. In more of the standard large cap indexes, we're talking about less than half a percent.

16:17So it ended up being much smaller in people's portfolios than the headlines in the press made them believe. And I think we'll see something similar with some of these other mega IPOs. The reason that some of them are coming to market is honestly to allow some of the owners of shares to generate some liquidity and some diversification for themselves. It's not so that the private owners can completely unload all of their holdings. They are definitely not interested in doing that. And in fact, when it comes to Elon with SpaceX, I think he has a 366 day lockup before he can even sell a single share.

16:56I'm sure he can borrow against him, but that's a topic from another day. You know, it's interesting to me about IPOs in general. There hasn't been IPO, an IPO appetite in my memory since like the Facebook IPO. And prior to that, you know, you have to kind of go back to the tech boom, the tech bubble. And I'm not even remotely considering there's a bubble here. I'm just sort of saying like, this is sort of a renewed place of interest among investors of all types. It also sort of highlights that there's a lot of appetite still for individual stocks, where I feel like the financial advice profession has become much more well-versed in the idea that individual stocks are much riskier than they seem and the likelihood of trailing the overall market is substantially higher than most people are aware of.

17:41What are some misconceptions and mistakes that you see among investors who are owners and traders of individual stocks? So often what I see is people are making decisions based on recent backward looking performance. And certainly we're wired as humans. We use social proofing. We get opinions from others. You know, I'm here in St. Louis. If I were looking for a great restaurant to go to, I would go online and look at ratings and say, okay, this is a good restaurant. Let me go give it a try. If I'm traveling to another city, I might look at the weather report to figure out what I should pack. Those same types of tools that we use to make decisions in our everyday lives are actually very unreliable tools when it comes to deciding which stocks to buy.

18:27If we can go back in time, actually a little bit, one of the things that I often like to ask people is, would you have known what the best stock is today in order to buy it back in that historical period? So one of my favorite questions to ask individual investors is, if you could, would you have wanted to buy NVIDIA back in 2003? If I ask that of a room of 150 people, every single person raises their hand. And then I ask them, how many of you own a total market or S &P 500 index fund? And most of them will raise their hands and I'll say, congratulations, you bought NVIDIA in 2003. It entered the index when Enron left.

19:09So that's a really important point for people. We don't know what the NVIDIA of 10 years from now is going to be. But if you're in a well-diversified portfolio, you probably already own it. if you're buying whatever stock has been hyped up on whatever news show you watch or you saw on twitter you may miss it and that could be very unfortunate now i'm of the opinion that the starting point of a portfolio like you're starting from scratch like how do you build a portfolio the average investor should own the whole market as best they can which you know if i'm probably a little bit oversimplifying it means just owning like total market index funds right i think what's interesting over time is how there's been a lot of research for many, many years that while index funds are a great way to own the whole market as cheaply as possible, you know, Jack Bogle coined the cost matters hypothesis.

20:05Absolutely. I do think people get confused that index funds are a case for the efficient market hypothesis. They're not really. They're really just about if you keep costs low, you get to keep more of your return. And that's great. I equate it to of fastballs used to be measured with just velocity. Well, actually, even before then, people just sat behind the dugout and squinted and they're like, oh, the pop of the glove was really loud or, oh, the swing of the batter was just, you know, so much effort and they weren't even close. And then velocity came in. And if you could throw a ball fast, you were a prospect.

20:36And if you couldn't, you were not. And if it didn't work out like, hey, here's this guy who throws 95 miles an hour. And if he didn't pan out, it wasn't ever the scout's fault. It was just, you know, like he didn't live up to his potential. But then we had stuff. They have these tools, StatCast and PitchFX, where they see spin rate, they see the angle of the wrist, they see the finger grip, all of these little characteristics that explain why fastball is great. What I think a lot of the investment community is unaware of is that the same thing happened with indexing. Indexing was first developed not to be a performance vehicle, but to measure performance.

21:12We had all these stock pickers out there in the world. We didn't know how anybody was doing. So let's measure it. And we realized that there were characteristics, this market exposure that explained it. But there were other characteristics as well. Things that here at Plaincorp we call factor. Liz, you joined me on my podcast a few years ago to talk about indexing versus factor investing. And there are things like the relative price of a company versus its fundamentals, the relative size of a company, It's profitability. It's momentum. There are characteristics that drive what an expected return for a stock might be.

21:49And so while I don't want to put words in your mouth, but I believe you agree with me that buying individual stocks is not necessarily the optimal way to invest. You want to be diversified broadly. Index investing versus something called factor investing, there may not be a right answer, but there is a lot of opportunity. Do you mind talking a little bit about the differences between... That was a long introduction for a question that I really just wanted to talk about baseball. But ultimately, you know, talk to me a little bit about index versus factor investing and how people should think through the choice of choosing one strategy versus another.

22:25Sure. So in an index strategy, you're you're really just accepting what the market will bring you. We know that there are equity factors that have outperformed during certain periods of time. We've seen the value factor, you know, the small cap factor. We've seen volatility, quality. They outperform during some periods of time and they underperform during some periods of time. So if you are somebody who has the risk tolerance to persist through a period of underperformance, factor investing might be a good option for you to emphasize some of the things that you value from an investment perspective.

23:04If that moment where quality, I really like quality personally, if that moment where quality has underperformed for multiple years is going to make you say, forget this quality stuff. I just want to invest in what's working. You are better off just sticking with indexing. So it's really about your risk tolerance and your appetite for that. Are you willing to try to extract some additional return from the market by emphasizing factors that we know have provided some enduring value over different periods of time? Or do you just want to keep it simple and accept what the market gives you and know that you won't have any of that regret?

23:43Yeah, I think regret minimization is a big area where an advisor is working with a client, recognizing that we don't live in a spreadsheet and that the mathematically optimal choice isn't always the right choice for an individual. Jack Vogel used to say the enemy of a good plan is a perfect plan. I love that. You have to find the plan that works for clients, not just the plan that the academics would tell you is most sound. Well, and I think that if you're an individual, the more of these things that deviate from an all index portfolio, the more likely you are also to get stung or get hurt or injure yourself.

24:19I'm going to keep the analogy getting more worse, worse and worse and more grotesque. But when you go into factor investing, you mentioned quality. I mentioned profitability, similar, but not the same. And also we both, I said cheapness, you said value. We were referring the same thing, but people define them differently and then products implement them differently. And so, you know, I'd let off the conversation with, I don't believe investment management is a commodity. Despite the fact that there are a lot of online influencers, there are a lot of do-it-yourself evangelists who aren't necessarily advisors, aren't necessarily coaches, but they're widely followed and maybe they don't even consider themselves influencers, but they say asset management's free.

25:01It just isn't. There is a lot of complexity. You also have this degree of customization and personalization, whether it's through a separately managed account, whether it's through trying to diversify away concentrated stocks through an exchange fund or a 351 exchange or option strategies. There are all these areas where you can add value with an advisor, but you can't necessarily get on your own. I mentioned SMAs. I do want to talk about tax loss harvesting real quickly. I think our most educated clients, the most educated individual investors that I interact with, think that tax loss harvesting adds value.

25:39Our research agrees. Yes. But how you tax loss harvest matters quite a bit. Tell me a little bit about what your research says on the topic of tax loss harvesting. So it's very interesting. We think that tax loss harvesting is an area where advisor relationships have been able to add meaningful value. And I have to tell you, I'm a CFA charterholder. I do this every day. I am not paying attention to my portfolio enough to optimize a daily opportunity to tax loss harvest. But one of the trends that we've seen in the industry, and this is a tool that is available through advisors today, not through to individual investors, are these separately managed accounts that can take a group of holdings that look like the S &P 500, but exploit opportunities for tax loss harvesting, sometimes even on a daily basis.

26:32So the client can then build up losses that help them tackle one of the biggest problems of index investing, which is eventually you need to liquidate this portfolio. And if you've done your job well, you have significant gains. So getting to that next stage where a client is in retirement and trying to draw down their portfolio can result in them having significant tax bills. And that's the point at which the complexity can start to get so great that they raise their hand and say, you know what, I need somebody to help me with this. The tax loss harvesting research that Vanguard has provided, along with a lot of other thought leaders and academics has been really influential the way that we design our processes.

27:18And most tax-loss harvesting for a long, long time required a down market. So let's say I own an S &P 500 index fund, and let's say I bought it, you know, in 2021. 2022 comes along, there's a bear market in stocks, bonds are down a lot, and I get the opportunity to sell that ETF that's tracking the S &P 500, capture a loss, use it against a future gain. But oftentimes, you know, there are individual companies within the S &P 500 who are trading at a loss. So I'm going to overgeneralize and say, like, let's say Pepsi is down and you can sell Pepsi and buy some Coca-Cola and still have, I realize Pepsi owns other things beyond cola products, but, you know, help me out people where one pharmaceutical for another or one oil company for another.