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The Smart Take:
Putting the odds of investing and retirement success in your favor should be a given as is being diversified. But what does diversification really mean? Ten stocks? One hundred stocks? Two asset classes or ten?
Building on the concept of standard deviation — or degree of variability — in investment returns, hear Kevin take the idea of diversification farther. Diversification is not just minimizing variability or owning the S&P 500. It’s also reducing the risk of underperformance by owning the stocks and assets classes that will deliver higher returns and reducing the variability in dollar outcomes from your portfolio.
Miss just a few of the best performing stocks each year or abandon an underperforming asset class whose future returns are now higher, and your portfolio will deliver more disparate results that are more likely to put you into the poorhouse. And that’s no way to run a retirement portfolio to last your lifetime.
The geek alert is sounded again for this episode but you don’t have to be an investment geek to get significant value from this one.
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Timestamps:
6:41 – Terminal Wealth Dispersion
11:23 – Reducing Risk
14:20 – Bill Bernstein’s Studies
18:32 – How This Impacts Retirement Planning
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The Host:
Kevin Kroskey – About – Contact
Intro: Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to Retire Smarter.
Walter Storholt: It’s the Retire Smarter podcast. Great to have you with us. Walter Storeholt, alongside Kevin Kroskey, president and wealth advisor at True Wealth Design, serving you in Northeast Ohio, the Greater Pittsburgh area, and Southwest Florida. You can find Kevin online at truewealthdesign.com, listen to past episodes of the podcast, read the blog, lots of other great information for you there as well. Kevin, great to be with you this week. I’m going to go ahead and get it out of the way right now; we’ve got the egghead alert.
Walter Storholt: We’ve been in a series of episodes of egghead topics recently, so we figured we’d start right off the bat with an egghead alert.
Kevin Kroskey: You set the stage very well, Walter, and I appreciate you and your people putting the egghead alert together for me. I can’t wait to share that with my seven-year-old, see what her reaction is to daddy getting the egghead alert sounded before he speaks.
Walter Storholt: I would be more than happy to send the MP3 to her and to your wife, and maybe they can queue it up on their phones and start using it around the house if you ever get into egghead moments.
Kevin Kroskey: You know, I don’t think I do with my daughter, being that she’s seven. I’m sure I will at some point in time. And candidly, anything that we talk about on here, I better do a pretty good job of just making it accessible with a story or a good explanation, and I certainly want to connect the dots on why it’s important. I think of Warren Buffett, the great. I mean, he’s humble, he’s generous, he’s one of the world’s best investors ever. And the way that he explains things is just fantastic. One of the ones I shared with you not too long ago is the one that he quipped where he said, “Money’s like soap. The more you handle it, the less you have.” He’s got so many of those.
I’m not Warren Buffett, but I strive to emulate him as best I can on the podcast and just explaining things in general. So some of the things we talk about, it’s really important to understand, at least for your advisor, and then it’s really important for your advisor to explain it in plain English why it matters and maybe what it is. Candidly I’ll have some clients that would say like, “Well, that’s what we pay you to worry about. We don’t necessarily need to worry about that.” And a lot of times, that’s true, and it’s just having maybe the expertise to know what’s important to explain something and just provide context and help set expectations so they can stay more disciplined and more prudent with their investing and planning process over time. So I never want to be on the island of eggheads without any context or anything. And maybe, Walter, maybe that’s why you’re here. Maybe you’re the Warren to my Buffett.
Walter Storholt: The Warren to your Buffet. I didn’t see that coming today. I liked that. I like that. I think it’s an important distinction to draw, though, that the podcast is different from what a first visit in a meeting and becoming a client would look like with you. You’re not triggering the egghead alert too much in client meetings. It’s a show-specific fun thing that we talk about. We cover broader topics and theory and those kinds of things. When people come to meet with you, all of this is in the background of then what happens in that meeting. But the meeting is much easier for people to then follow and understand because you’re able to put everything into the context of that person’s situation. And I imagine that helps people really understand what’s happening, what’s going on, and when you can use specifics like that, make it even easier for you to communicate a lot of these concepts and the why behind what you’re doing.
Kevin Kroskey: Yeah, it’s like a good doctor with good bedside manners. I mean, you want somebody that wasn’t just struggled through medical school, but they-
Walter Storholt: Stayed at a Holiday Inn Express last night.
Kevin Kroskey: What does that have to do with anything? What do you have against Holiday Inn Expresses?
Walter Storholt: No, that’s from the commercials. Don’t tell me, that doesn’t ring any bells?
Kevin Kroskey: Unfortunately, my TV is limited to seven-year-old TV these days.
Walter Storholt: But that’s like years old reference. I’ve never heard anybody not know the I stayed at a Holiday Inn Express last night commercial series. Everybody has seen that.
Kevin Kroskey: I’m sorry, Walter.
Walter Storholt: It was a whole campaign that they did for years, and it was all a series of some somebody helping on the side of the road in an accident. He says “Hand me a scalpel. I’ll do the surgery right here on the side of the road.” And they ask him, “Are you a doctor?” And he goes, “No, but I did stay at a Holiday Inn Express last night.” It was a whole series of commercials of all those kinds of scenarios.
Kevin Kroskey: It sounds funny now that you explained it, but from what I’ve been told, when you have to explain the jokes, they tend not to…
Walter Storholt: I can’t believe that. You are on an island here, my friend. You are definitely on an island. I’ve never met somebody who doesn’t get that.
Kevin Kroskey: My wife likes to say that I’m unique. I’m not exactly sure how she means that, but that’s what she says.
Walter Storholt: You don’t even have to have watched a lot of TV to get it. I’ll send you some YouTube links after the show, and it’ll help drive the point home. I’m sure there are a few of them out there. In any event, continue.
Kevin Kroskey: You want a good doctor, board-certified, can explain things in plain English. He or she is not going to tell you every little thing that goes into your diagnosis, what have you, but they’re going to help you understand what you need to know so you can feel confident in the path forward. That’s what we should strive to do. And that’s what I try to do. I mean, not always be Warren buffet, but nonetheless, you keep being the Warren to my Buffett, although I’m a little bit more skeptical about this after that Holiday Inn Express thing
Walter Storholt: I really hope you get some emails about this because there’s no way I’m on the island here.
Kevin Kroskey: All right. I believe you. I do.
Walter Storholt: I’m hurt that you don’t know the Holiday Inn Express joke. That saddens me.
Kevin Kroskey: All right, so what we are going to talk about today is not Holiday Inn Express, but we are going to, in fact, talk about terminal wealth dispersion. It’s basically diversification, but taking it a lot further than what I think people commonly understand diversification to be. And let me start with why does this matter again. And a basic principle, this is the Retire Smarter podcast, basic principle retirement planning is to make sure that your money lasts longer than you do. That’s a moving target. We don’t know how long we’re going to live, but we need to meet our lifestyle goals. We need to not just preserve our money but preserve our purchasing power over time. We will have inflation. We need our money to keep growing, and that’s the basic goal there.
And we’ve talked about it a few times over the last couple of episodes, but we really want to put the probabilities in our favor. That flows from having a good financial plan to having a good investment process, just to make smart decisions based on science and math. And you do that consistently over time; you’re not going to win every time, just like some of the blackjack examples that we used a couple of episodes ago. Just because you play the probabilities doesn’t mean you’re going to win the hand, but if you do that over and over and over enough, through your investing lifetime, the math of statistics will tend to play out in your favor, and the probabilities will play out or should be expected to play out more so in your favor.
What we talked about last time was standard deviation or the wiggle factor. And just really the key takeaway here that I was hoping that people got was just understanding what to expect, what’s normal in terms of the markets movements up and down, and that’s a good starting point. And a lot of times, what people will say is, “Well, we want to minimize that standard deviation, and that makes it really efficient. We’re well-diversified.” And that’s not the whole story. And that’s where this idea of terminal wealth dispersion comes in. I want to start real simple here. Suppose you own one stock, which you should not do because 100% of your risk is in that one stock.
Years ago, before mutual funds came out, there were some different studies in the Journal of Finance and some others about how many stocks do you really need to own to go ahead and reduce the standard deviation? And again, that’s just one way to measure risk to a certain degree. I would say it’s a more apt a measure of how consistent things are or are not, or volatility’s another name. But in the last episode, we talked about the S&P 500 and how the standard deviation is… A round number’s over time about 20% per year. And if you own one stock, an individual stock is probably about two to three times as volatile or two to three times the standard deviation of the S&P 500, if we’re talking about the stocks that comprise it. So that just gives you an idea of how much riskier or how much more volatile one stock is compared to the whole market as defined by the S&P 500.
But then some of the old studies showed if we just own about 15 or so individual stocks, then guess what? Our standard deviation comes down pretty gosh darn close to 20%, just like the market in aggregate. But that’s only 15 stocks out of 500 for the S&P 500 example. Again, I’m using the S&P 500 here only as an example. There are small company stocks, growth stocks, value stocks, different industries, different sectors, markets outside of the US. There are all kinds of other asset classes to invest in and to diversify with, but I’m just using the S&P 500 only as an example.
So the key, when you think about standard deviation versus terminal wealth dispersion is just because you’re lowering your volatility or that wiggle factor, so 15 stocks approximate the same as owning the whole 500, really what that means is you’re lowering that volatility risk, but it’s not the same thing as maximizing returns. Some episodes ago, we talked about the difference in returns, and let me bring you back into the foray here, Warren, and just give you a little bit of an example. Let me pause, Walter, AKA Warren, are you with me?
Walter Storholt: For a second, I was like, “Did he call me Warren?” And then I remembered I was the Warren to your Buffett, so I circled back around.
Kevin Kroskey: I’ll give you a choice here. You could have one of two return sequences in year one. So for option A, year one, you can have a 15% return, and then year two, you have 5% return, or option B, you can have a 10% return in each year. Which one would you prefer?
Walter Storholt: I’ll take the 10% each year.
Kevin Kroskey: Okay. How come?
Walter Storholt: I just like the steadiness of it. The predictability.
Kevin Kroskey: Okay, that’s great. And if you do the math there, 15 plus 5 is 20. 10 plus 10 is 20. Divide them both by two, and you see the average return for both A and B is 10%. However, I like to say we don’t eat average returns. We eat compounded returns. And the compounded return for the one that goes 15 and 5 is in fact, less than the one that goes 10 and 10. So around of applause for Walter, AKA Warren.
Walter Storholt: I knew it was going to be a small trick question. Like Warren, I’m just keeping it simple.
Kevin Kroskey: You got it. So you’re doing really well. But anytime you have volatility, the compound return is going to be less than the average return, and again, we only eat compounded returns. We only live on compounded returns. And that matters. So if you have the standard deviation, you don’t have any standard deviation if you get 10, 10, 10, 10 every year, but we all know that’s not going to happen in practice. So you’re going to have some volatility. The theory goes, if you can minimize that, well, that’s great, because then you can have higher returns, but that, again, doesn’t tell the whole story.
What you actually find when you look at market returns over time is like for the S&P 500, really there’s going to be probably a handful or two of stocks that are going to provide really, really high returns. And there’s going to be, on average, more are going to lose money than are going to make money. And when you put that together, if you’re only picking 15 stocks, because you say, “Hey, my standard deviation or my volatility is minimized, it’s the same as owning all 500. I need don’t need to add any more.” That’s true, but it doesn’t tell the whole story because you’re introducing something that we would call security selection risk. Are you picking the right stocks? If you just miss one of the really high performers, you’re probably going to underperform the broad market of the 500 stocks.
And studies will show that if you maybe own 25 stocks, you can reduce that risk by about 80%. If you own 100 stocks, you can reduce that risk by about 90%. It’s something technically we call alpha risk or that security selection risk. But if you own all 500, as an example, obviously you don’t have any of that risk. So there comes to be a certain point where not only do you care about minimizing that standard deviation, but also focusing on this diversification aspect and owning more stuff. And the example that I’ll give, there’s a guy by the name of Bill Bernstein. There’s a lot of, I think, famous Bill Bernstein’s that are out there. But this guy actually was one of the first ones that I read that helped me really find my passion for this line of work.
He has an interesting story. He was a medical doctor, a neurologist. He tells his own story in a preface to one of his books, but he talks about how he just always felt like he was getting taken advantage of at some of the Wall Street firms where he invested his money with. He’s just a remarkable person, but I guess in his spare time, when he wasn’t a neurologist, he just did a lot of studying on investing and what the science of investing showed. And he ended up writing many, many books about investing and about the signs of investing and just chronicled his journey over time.
I highly recommend it if anybody is…sound the egghead alert, but if anybody’s interested in becoming a little bit of an egghead, there’s a book he wrote called The Four Pillars of Investing. It’s a little bit more the engineering version. It is a little more eggheady. And then he came out with another one later called The Investor’s Manifesto, which is shorter, much more accessible, but it touches on a lot of the same key points. So both of those were really good if anybody wants to pick up a book on the history and science of investing and just learn through Bill and his story.
But he’s also written many articles over the years. He actually wrote an article on this topic, terminal wealth dispersion. There’s not a ton of it that’s out there. Candidly, I don’t think I learned about terminal wealth dispersion when I was studying for the CFP or went through anything like this. This was something that Bill Bernstein, in fact, taught me, I don’t know, probably 15, 20 years ago, just by reading his work. So what he has here is he basically looked at the S&P 500 at the end of 1999. And he formed 98 randomly generated 15 stock portfolios, and he looked back over the prior 10 years. And again, it was all random. He mathematically used a random generator here. And he was just comparing the returns for those 98 portfolios, 15 stock portfolios, to the return of the market over the prior 10 years.
And again, this is a mathematically valid process. It’s not like he was picking the worst ones. Everything was randomly generated, and he did enough portfolios to make the comparisons meaningful. And over the prior 10 year period, and again, this was the 1990s, so returns were really high during this time, but the S&P 500 returned about 19% over the prior 10 years. Walter, you want to guess what percentage of those 15 stock portfolios failed to beat the market?
Walter Storholt: Ooh, I’ll say a very high percentage. 80.
Kevin Kroskey: What does that mean exactly, Walter? Come on, Warren. You’re not being the Warren to me Buffett with that one.
Walter Storholt: Not very good. Not very good.
Kevin Kroskey: So three quarters or 75% failed to beat the market. So I would agree with your very broad characterization of a very high percentage. And when you looked at the returns, basically some of the scatter, and this is that dispersion in the terminal wealth dispersion, when you looked at the returns over time, there were several portfolios that underperformed the market of the S&P 500 by 5 to 10% per year. That’s per year. You do that compounded over a 10 year period. You’re talking about huge, huge dollar differences. And he did a nice dissection, but basically, each, and every year, a disproportionate fraction of the big return from the market came from a very few super stocks.
One of the examples that he used over that time period was Dell Computer, which increased in value over 550 times. And if you’re picking just a small number of stocks, whether it’s 15 or 20, you’re introducing that security selection risk or alpha risk as they call it, and if you just don’t get one of those super stocks, your returns are more than that likely going to go ahead and lag the market. So when you think about retirement planning, again, if we’re talking about just putting the odds in our favor, if you’re just picking some individual stocks, you could get lucky. Maybe there’s going to be five super stocks that year, you’re picking 15, and you just get incredibly lucky, pick all five, and your returns are going to be super high. You’re going to be way higher than the market.
However, just like 75% of them failed to go ahead and beat the market in his randomized example, you’re actually introducing much more risk, and you should expect on average that your results are going to be poorer than the market. So most people, if they were faced with this clear bet, “Hey, do we want to have a concentrated portfolio and try to become fabulously wealthy, or do we want to reduce our risk and diversify a lot and just try to have a more consistent return stream and try to maximize our returns to boot”. Which one would you pick? And most rational people, and I hope all of our clients that we serve would go ahead and pick the latter. If you’re going into retirement and you’ve accumulated all your money that is going to last the rest of your lifetime, and you need to act as if it’s going to last the rest of your lifetime, you don’t want to go ahead and start betting on trying to win that lottery ticket.
If you were doing that early on in your career, at least you have the rest of the career to go ahead and make up for it if the probabilities don’t play out in your favor if you do have a concentrated portfolio. A couple of episodes ago in January, we talked about when to sell an underperforming investment, and I said usually that question isn’t so much an investment problem but an asset class problem. Sometimes things are going to not do as well as other things. That’s, again, the basic idea and premise of diversification to a certain degree. But it should be expected, and that’s why we talked about that concept of standard deviation and really what’s normal.
We also talked before about price. Just because something goes up in price, it gets more expensive in investing, and in investing, it’s this conundrum where people think that’s a good thing, but we all know that if you pay more for something, than more likely than not, you’re not getting as good of a value. So it’s this investing conundrum, but all these things really culminate in putting the probabilities more into your favor, making sure that your money’s going to last your lifetime, and you really need to have those proper expectations on what to expect in terms of returns in order to stay disciplined throughout the whole process.
You’re probably not going to worry about terminal wealth dispersion. You’re probably not going to go out and read Bill Bernstein’s books, but these things are really important to understand. Somebody who’s mending the store needs to understand that. For our clients, that’s me and the other advisors at True Wealth. If you’re going at this alone, or if you have another advisor, they should absolutely make sure that they understand this, because if you’re not doing these things, you are introducing more risk. You are not putting the probabilities in your favor. And that’s just not a good thing to do when you’re going into retirement planning phase and having to have your money last the rest of your lifetime.
Walter Storholt: It sounds like the leaf blowers are encouraging you to wrap up.
Kevin Kroskey: Yes, they are. Sorry About that. But yes, you’re absolutely right.
Walter Storholt: No worries. I really enjoyed these last two episodes, actually, and seeing how standard deviation, or as you, very Warren Buffett like, like to refer to it as the wiggle factor, which I commend you on that, how you use it in different ways. So you look at the S&P as a whole, and there’s a standard deviation, you apply it in a very broad sense, but also not afraid to apply it in a very narrow sense and an individual basis, whether it’s an individual’s portfolio, we’re looking at stocks, using standard deviation or the wiggle factor as a tool through which you can analyze a lot of different things as an advisor. That’s pretty neat to see that in action in some of the examples that you use.
Kevin Kroskey: And as we started a couple of episodes ago, we talked about small stocks and value stocks and how they had been out of favor. And I didn’t mention this in the episode, but over the last several quarters, these stocks have really been on a tear. So if you were looking at your statement, say, mid-2020, and saying, “Man, why do I own these kinds of socks? They’ve been really out of favor for quite some time. Let me just go ahead and sell those, and I’ll buy these other ones that have been doing really well.” Well, fast forward a few months, and that would have been the exact wrong thing to do.
Now, who knows, again, the future is uncertain, but it’s all about putting the probabilities in your favor. And generally speaking, when something goes much, much higher in price, what we can expect from it is less going forward if something has been out of favor, but it still meets the criteria of being a good investment overall. Well, then candidly, you should probably be buying a little bit more of it because now the future returns should be expected to be higher. A lot of investing is counter-intuitive to a certain degree, but hopefully, some of these things that we talk about here make it less so, and I can make it more Warren Buffet-like.
Walter Storholt: If you have any questions about what we’ve talked about on the last couple of episodes, feel free to reach out to Kevin Kroskey and the team at True Wealth Design. You can do that by calling 855-TWD-PLAN. That’s 855-893-7526. Or even better, go to truewealthdesign.com and click on the are we right for you button to schedule a 15-minute call with an experienced financial advisor on the True Wealth team. That’s truewealthdesign.com, and that contact information is in the description section of today’s show, so it’s easy for you to find.
Kevin, before we wrap up, I did download the audio from one of those Holiday Inn Express commercials. I figured we could play that real quick, and at least maybe you would get the gist. Now I did this on the fly and didn’t actually listen to it, but I’m assuming it’s a normal 30-second commercial example that they had as part of their campaign, so bear with me. Let’s see if this works.
Speaker 1: Sponge. How’s everything look?
Speaker 2: Looks good. It’s real good.
Speaker 1: What’s his BP?
Speaker 2: 120 over 80.
Speaker 1: Okay folks, close him up.
Speaker 2: You’re not Dr. Stewart.
Speaker 1: No. But I did stay at a Holiday Inn Express last night.
Walter Storholt: So they had a whole series of things like that that were in their commercials. You didn’t get the visuals to go along with it, but you get the idea.
Kevin Kroskey: I don’t remember it. No recollection. Zero.
Walter Storholt: Oh man. I’ve been quoting it for years. I think it was probably the late 2000’s. Like 2008, 2009, 2010 timeframe probably when they were coming out. Somewhere in that timeframe.
Kevin Kroskey: I was probably just reading too many Bill Bernstein books back then about terminal wealth dispersion.
Walter Storholt: I was going to say you were just reading too many egghead books. It lined up exactly that way, and that’s why you never got into that commercial campaign. But in any event. I’m hoping some other folks remember that campaign and got the joke there, but that was fun. Kevin, thank you so much. Really good last two episodes. Enjoyed these. Glad you’re feeling better and can’t wait to see what you have prepared for us next time.
Kevin Kroskey: We’ll have to intentionally go on the opposite side of being an egghead and just-
Walter Storholt: The un-egghead route?
Kevin Kroskey: Un-egghead, yeah. I’ll work on it, but let’s… I don’t want to say dumb it down. That’s not a good descriptor, but…
Walter Storholt: But more terms like wiggle factor.
Kevin Kroskey: And maybe we’ll try to work on maybe a couple of stories. Maybe I’ll pull some out from some client meetings over the next few weeks and see if it’s something worthwhile to share.
Walter Storholt: That sounds like a plan. Thank you so much. That’s Kevin Kroskey. I’m Walter Storeholt. Thanks for joining us. Don’t ever hesitate to reach out if you’ve got a question. Hey, in fact, if you’ve got a topic suggestion, please let us know. Go to True Wealth Design and use the contact form.
Kevin Kroskey: Are you saying that because of these last two? Help Kevin. Don’t let him talk about this stuff anymore. That’s okay.
Walter Storholt: I’m just saying, in general, if somebody’s got a topic they want to hear about.
Kevin Kroskey: I’m more than happy to have that feedback, so absolutely.
Walter Storholt: Maybe they heard another term that sounds like standard deviation or terminal wealth dispersion, and they want a good explanation on that eggheady term. You never know. I’m just throwing it out there. Go to truewealthdesign.com. Feel free to get in touch. We’d love to hear from you, and we can maybe bring that up as a future topic on the show if you’ve got something good for us. It’s always fun. For Kevin, I’m Walter. We’ll talk to you next time right back here on Retire Smarter.
Disclaimer: Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.
