The Smart Take:
While your asset allocation recipe is the most important portfolio decision, we still want good ingredients. Listen to Kevin explain the broad differences in active and passive (indexed) ingredients, the evidence behind each, and some exceptions to where an indexing approach may not work as well.
Be sure to listen to the Paradox of Skill (8:20 minutes) as it applies to baseball batting averages and investment manager performance.
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Walter: It’s time for another edition of retire smarter. Walter Storholt here with you alongside Kevin Kroskey, President and Wealth Advisor at True Wealth Design. Kevin, you ready for another great episode today, part four of our series about your investment process. Yes, part four of our two part series. That’s right. Four of two. We were, we’re getting 200% more than we bargained for. A no, no, no. I was at a a hundred percent more than we were getting a hundred percent more than we bargained for.
Kevin: Yes. Yes I was. I’m, my mom always said I was an overachiever, so there we go.
Walter: There you go. Yeah, I have a feeling this won’t be the last time we plan to do a one or two part series that that extends to multi parts.
Kevin: Yeah. A quick aside, I just realized that I’ve been doing the podcast now for more than a year. I think about 12 or 13 months or so. I don’t know what episode we’re up to, but we’re also up to about a thousand listeners, a thousand downloads per month. So frankly, if you were to ask me if I would have expected a thousand downloads a month, people tuning in a year later, my answer would’ve definitely been no. So it’s nice to see that we’ve gotten some good compliments and good feedback and definitely have had some clients say that they, it’s been a nice way for them to learn and just learn more about things on their own terms, , when they want to. And we’ve had a lot of people reach out to us as well that aren’t clients and said that they found this pretty insightful and asked for our help. So it’s, it’s been good. It’s been a good year, Walter.
Walter: I definitely feel smarter after every show we record. So I think the name you picked for the program certainly is apt and a little, a little aside to that. You are at episode number 30. This is 30 today, so it’s a, a mini milestone if you will. I was saving the big party for episode 50, but we can throw a mini her Ray for episode 30 today. Sounds good. I actually meant to celebrate along the way. I actually meant to celebrate 25, but then we’d just, we got busy and forgot that we were recording 25, so I didn’t mention it when we got there. But that’s right. Well it’s going to be a good, a final part four of this conversation where we’ve been learning a lot about your investing process and evaluating different ways that these plans and investments and your philosophy into all of these things come together and how it differs from person to person. So what’s our aim here in the final part four of this conversation?
Selecting Good Investment Ingredients
Kevin: Sure. So again, let me, let me restate rule number one and cause it’s, don’t lose sight of this but your financial plan, your retirement plan is the objective of your investment plan. So if you don’t have that, don’t pass go. Don’t just start trying to throw a dart at the dartboard. , that is kind of rule number one. But then in the prior series episodes, we went ahead and we talked about really about the investing process. , what that looks like, what is a, not only an investment process light, but what should a constitute and we really talked about I would say the asset allocation. So asset allocation is not stock-picking. It’s really kind of combining whether it’s stocks, bonds, real estate, cash growth, stocks, value stocks, big stocks, small stocks, domestic, international and all kinds of different bonds as well.
Kevin: Into your beautiful looking pie chart that is tied back specifically to your own financial plan and the return that you need from your investments to make your plan work as well as considering the capacity for risk that you can afford to take now that you’ve turned off the paycheck spicket and are heading into retirement or close to it. But largely what we spoke about was that asset allocation. And for the reason being is you referenced in the last episode studies that have shown that asset allocation is going to explain more than 90% of the return that you’re going to get from your investments when you look at stock picking. And that is one of those variables, but it is actually a negative contributor to your net returns from your investment portfolio. And, and I said that , the ingredients that you pick, the underlying funds are important.
Kevin: Certainly you want to have good ingredients — organic, non GMO, all these kind of words that you hear when you walk into whole foods or whole paycheck or whatever it’s called. And I want to put some good ingredients in your body. You want the same thing going into your investment portfolio. But the recipe somewhat counter intuitive for a lot of people does in fact explain more and matters more than the ingredients. But both are certainly important. So while we focus most of our time on the recipe, on the asset allocation in this final episode, I figured we’d talk a little bit about the ingredients.
Walter: Okay. I always like talking about the ingredients. I mean it’s, it’s fun seeing the finished product, but sometimes the ingredients are just as much fun to sample and taste. I like your subtle dig there at a whole paycheck. That was good.
Kevin: Yeah. So what we’re going to talk about when we think about these ingredients, I’m not going to get in and start talking about specific mutual funds and these are the funds that are on our recommended lists or anything like that. I mean, we’re really going to talk about some principles and probably you’re going to walk away from this episode having more questions than answers, but that’s good because that’s going to be indicative that you’re learning and having some knowledge that you previously didn’t have. And so that’s kind of the path that we all take as we learn. We start often start learning that we, we become more humble and we ask more questions than what we have answers to. But that’s, that’s the ongoing path of learning. So, so we’re not going to be talking,
Walter: We’re not going to be talking about chicken noodle versus tomato versus a wedding soups. We’re just talking about soups and cereals, not special K versus, , what’s the other general mills, cereals, that kind of thing.
Kevin: It’s all lobster bisque baby. That’s all you got to know.
Walter: Just went up a few of them in my book with a with a lobster bisque dimension. Very nice. Okay. My grandparents live in Maine, so I’m a big everything lobster fan, , I’m, I’m all there for it. So. All right.
Kevin: So where we left off in the last episode, we talked a little bit about kind of active and passive and broadly defined. When you have passive investments, they’re more index like they’re not doing a lot of trading. They are not trying to make any sort of timing decisions as to when to get in or out of the market or when to favor this asset class or that asset class or buy or sell this or that stock. Those are more in the active camp. So again, passive is more index and then you have active and it’s all those other things that I mentioned.
Kevin: And again, there’s all these gradations in between. So some funds may literally be turning over their entire portfolio two times over the course of the year where some active managers or maybe , maybe they’re only turning over a third of their portfolio index funds on average, we’ll only turn over maybe like five or 10%, , once a year. The S&P 500 board will come in and say, Hey, these eight companies are, are now no longer part of the S&P 500. So there’s very little kind of turnover and active trading in that regard. But those are kind of two broad camps just to think about when you get into your investment manager selection or selecting your ingredients. And when historically before indexing really became more popular, there was this kind of belief out there and it’s still there.
Kevin: And, and a lot of people frankly still have it. But it was like, well, why don’t I just want to go ahead and do something that’s going to be average. I mean, heck, we’re Americans, right? Americans aren’t average. And so why would I want average investments? I want above average investments. Heck, I’m going to pick great investments. And I remember when I was going through grad school and learning about the research about active and passive investing. Testosterone levels were a lot higher back in early twenties, and probably a bigger ego and more confidence and certainly less humble. I’m like, well, I’m smarter than the average bear. I’ll be able to go ahead and pick some of these better investments and make smarter decisions. And I’m certainly above average. But one of the things we talked about last time is that sort of belief about ability works really well and other areas of our lives in sports.
Kevin: The Cleveland Browns pick up a free agent , from the New York giants. Odell Beckham jr he’s a great wide receiver in New York. He’s a great wide receiver in Cleveland so far. It also works in work. You are in charge of hiring and you are looking to fill position. Say it’s a sales professional and they have a demonstrated track record of success in the prior positions. You hire them, you believe their performance is going to persist in the new role in your company and investing. It just doesn’t work. It’s kind of this paradox of skill is what I would call it. And being that we’re in October and in the heart of the baseball playoffs, I thought I would work in a little bit of a baseball story here. Walter, have you ever done baseball announcing in your sports broadcasting career?
Walter: It’s one sport that I just could never really get into from a broadcasting standpoint. I probably would have been good at it cause , me, I talk a lot and so I, I can fill air time with the best of them. But now I did do some softball announcing, so that kind of, that kind of counts. I was the, PA announcer.
Kevin: Like on a weekend and there was a keg of beer on the side of the softball field. Is that what we are talking about?
Walter: The UNC North Carolina Tarheels women’s softball. I was the, I was the PA guy for a couple of seasons during my schooling years. And then for a season or two afterward, it was sort of a freelance part time gig. And I was, I was the PA guy. Not necessarily play by play, but let me tell you, I got into it. So they, they loved me. When I went in first auditioned they had like five or six students that are ready to audition. And so when I sat down at the mic, they were like, if you don’t mind this aside story, but I think you’ll find it humorous. And they said, all right, yeah, now your turn. So I sat down and got ready. That was just a scrimmage they were doing. So it was kind of, they were rotating in different PA people to try them out for the season.
Walter: And I looked over and I was like, I mean, do you want this straight laced or do you want it to like have a little fun with it? Like, how do you, how do you want to do it? And they were like, have fun with it I guess. And I was like, alright. So I turn on the Mike and the player walks up and I said, now batting number six, and the coach looks up at the PA booth, says something to somebody and points up at the booth and they come running up there. And I’m like looking around everybody. I’m like, Oh, I’m in trouble. They didn’t, they did not like that. And the girl pops her head and she says, coach wants to know if you can do the entire season you’re hired. And I was like, all right, great. So, it ended up being a lot of fun. So I leaned into it. I think the fans had a good time with it for a couple of seasons there. But that’s my, that’s the extent of my baseball or slash softball announcing.
Kevin: All right. All right. That’s a, I appreciate the insight into your past. That’s a good story there.
Walter: We’re going to have to redo Intro and we’ll do it in like a, a sports thing.
Kevin: All right. Well, speaking of guests, I have another one for you. I think this is more in the softball category, so, but it’s baseball, so I don’t know, it’s an easy pitch to hit. But who was the last professional baseball player to bat .400?
Walter: Oh gosh. I do not know my baseball history. Last baseball player to bat 400 Oh, I don’t know him. Well, can you give me a hint how far how long ago it was?
Kevin: No, no. Oh, okay.
Walter: Mike, Mike Trout, he’s the, he’s the big name now, right?
Kevin: Well, okay, so you’re off by several decades, but it was Ted Williams.
Walter: That was going to be my second guess. Actually. I’m sure if you had given me, and I don’t know if you’d given me the timeframe, Ted Williams would have been my other guests.
Kevin: So he did it back in 1941 just a little while ago. It’s nearly 80 years now. And so nobody’s done it sense how come is it? Is it because that a was the best and nobody else can do it?
Walter: Oh, I don’t think he was the best ever. Right? I mean, certainly very good. But somebody has got the capacity to do it again, I would think.
The Paradox of Skill
Kevin: All right, well here’s what I would say is the paradox of skill and then we’re, we’ll incorporate where luck comes in as well. Okay. So when you think about we’re athletes are today, I mean, you have people that are in the major league baseball league that are from around the world. I mean, you’ve got people that are coming in from Cuba, the Dominican Republic, Japan people that are kind of born and bred for this stuff by the time that they’re really walking around. So we have this global influx in terms of the talent that’s going into the leagues. The players are bigger, faster, stronger. They have better diets, improved training techniques. The overall skill level has just been raised for everybody. And so does it mean that people aren’t as good as Ted Williams? I would say just the opposite. I’d say that people today better, it’s a different era for sure.
Kevin: But for all those reasons, the average skill in the league has gone up. And the interesting thing is we can actually use statistics to prove this. So when you go back say, Oh yeah, it’s almost 120 years now. But around 1900 is when the modern era baseball was said to start. So yeah, 1900 and when you go back to those first couple of decades in the modern era, the average hitter batted between .250 and .260. So they were getting on base about one out of four times. And during those first couple of decades, there were .400 hitters about a handful of times. So people were getting up there and Ted Williams was the last one in 1941. And when you look since say 1950 all the way up through, just the recent past few years, the batting average has still been pretty stable.
Kevin: The average has been about one out of four times, but no one has hit .400. So statistically speaking, the average is the same. But when you look at the variation, the variation has got a lot closer to the average. And we call that standard deviation. Back in 1921 the standard deviation of batting averages was about 40 points. And by the time you got into Ted Williams in 1941 standard deviation had fallen to about 32 points and in 2003 it was just 26 points. So now that we know the standard deviation and the average, we can calculate, well, what’s the probability that somebody’s going to bet .400 and what we would find when we go through that math is that in any given year, the chance is below 0.1% or less than one in 1000 somebody’s going to do it. And that’s the paradox of skill. Whenever the average talent is improving the outcome, the activity combined skill and luck, and as skill improve, luck becomes more important in shaping results. So in baseball you have more people that are better, but you don’t have anybody that looks really as exceptional as Ted Williams did, at least compared to the average back in 1941
Walter: And it, and it’s even close, Kevin. I mean I’m just a, not to interrupt your flow, but I’m looking at, you got me looking at baseball stats now and the closest person to get there in the last 20 years, we’ll say from 2000 onward, there were a two guys who hit .372 in the year, 2000 Todd Helton and Nomar Garciaparra and I mean that’s, I mean it doesn’t seem like a lot, but in baseball terms, that’s still a pretty wide gap.
Skill Vs. Luck in Investment Performance
Kevin: Yes, it totally is. And the analogy here is the same thing has happened in investment markets. The average person, the average investment manager is better today than they were 2040 years ago. And when you look at, whenever you’re in the stock market or bond market for every buyer, there has to be a seller. And both of those people can’t be right. Somebody who’s going to win in somebody who’s going to lose. And so mathematically when you add this up, it’s called this kind of limiting constraint. And on average when you have all the active managers in aggregate, there’s no net winners, in fact, they lose by their costs, because the costs are higher for active management and passive management. So there may be some active managers that are winning. But those active managers are profiting at the expense of the other active managers that are losing in aggregate.
Kevin: So, and when you look at it, you can see the same sort of thing, like the dispersion, the returns, the variability in the returns is less today for many asset classes than it was before. The number of active managers that are outperforming their passive benchmarks are even less today than they were say like 40 years ago or so when indexing really started going. It’s kind of always been that way because costs of active management costs, having people having research boots on the ground, talking to, , company CEOs and CFOs and things like that, or having some sort of unique data source that other active managers don’t have. All that cost money. And I always like to joke and say, whenever I go to the investment conferences and I look around and see the people on how they’re dressed I can usually tell the active managers from the past of the managers because the active managers have the more expensive suits on and the better shoes.
Kevin: That’s what the paradox of skill says, as the skill gets better, if you do have somebody that is an outperformer generally is more attributable to luck than to their skill. And it’s just like, I used to do this when I would do some educational classes, I would pass around a coin. Everybody in the room would have a coin and I would say, okay, let’s just flip this coin. And if you get ahead on the flip, you stand up. If you get a tail, then you sit down. And inevitably if the low room is large enough, I would have somebody standing up after like four or five flips. And does that mean that they were a really good head flipper or does that mean they would just got a little lucky and same goes for investment managers.
Kevin: Inevitably the statistics will say that somebody is going to outperform. We talked about somebody that did this in the last episode, Martin Zweig and I’m going to give that smart person my money to manage. They have this ability, they have the foresight, they have a crystal ball. I’m going to give that person money because they did really well. And then you invest with them. And inevitably over the next five year period, you lag the benchmark. You underperform the person that you thought could go ahead and save you from the falling knife or the bear market. Just didn’t have that ability to replicate what they did in that prior period.
Kevin: And that’s exactly what we see that happens when we go back and think about selecting ingredients. All the evidence that shows that active managers in general do not keep up with their passive benchmarks. They’re more expensive. And some of the things that they do just tends to subtract value. And again, you always have to look at this, not a cost, but you should always start with a passive benchmark for whatever asset class as the benchmark, as a starting point. If you’re going to veer from that, you should have a good reason why. So we’re talking about kind of this more indexing based type approach. And one of the things I will mention is while that’s a good starting point, and that’s how I start as well, whenever we’re looking at investing in an asset class, it does have some shortcomings.
Where Indexing Doesn’t Work As Well
Kevin: So whenever you look at some asset classes, certain asset classes are good too. Be passive and go ahead and do an indexing type approach. When you think about bonds, bonds are an interesting one to go ahead and use. So that’s why I picked it. But almost everybody, if they look at it and say, a 401k statement that they had is going to have a, some sort of bond that’s like a U S aggregate bond. And oftentimes in 401k plans, there are going to be an index fund for some different liability reasons more often than not. But when you think about what happens within the index, within a bond index this, it’s Barclay’s US Aggregate Bond Index and it’s really changed over the last 10 years or so.
Kevin: Whether it’s the U S government or say a corporation that’s issuing debt, the more debt they issue, the more it’s going to be represented in this index. Now, let me ask you a question, Walter. If you’re a bank and if you’re lending money and you have a borrower, you have some company that keeps borrowing more and more and more and more. And are you going to be maybe raising an eyebrow compared to a company that’s not borrowing nearly as much? Which one really poses more risk?
Walter: If they’re being good about paying it all back then I’m okay with them getting more and more.
Kevin: All else being equal, they’re going to have more leverage and they’re going to have more risk. And these bond indices basically, it’s literally by total debt outstanding. So as you have a company that is issuing more debt, that company’s going to be more represented in that index over the last 10 years since the great financial crisis 2008, the U S government issued a ton of debt really ballooned their balance sheet. So what’s changed over the last 10 years is this U S aggregate bond index. The government bonds are much, much more represented than in the prior 10 year period. And not only that, but the duration of the bonds has gone a lot longer. So when you look at the index, the index composition, the underlying composition has really changed quite significantly over the last 10 years.
Kevin: And then when you actually saying, let’s go pick a one of these lowest cost index funds within the category. I just looked one up from Vanguard before I got jumped on the call today and you look over the last 10 years and literally it’s about the most inexpensive option in the category — and costs do matter that I’m always wanting to favor lower cost investment — but it’s been kind of middle of the road for the intermediate bond category. It’s been literally in the 50th percentile over the last 10 years. So, half of the funds in that category have done better than it and half of it done less even though it’s literally like the lowest cost option in the entire category. And that’s I would say is largely because it’s had to go ahead and follow the general market for bonds and it’s had owned more of these lower yielding longer duration bonds, namely government bonds. And so the underlying composition, it’s followed those changes and it’s hasn’t done nearly as well as the category in general.
Walter: Kevin, great points so far. I find the illustrations always helpful. Do you have any other examples of asset classes where the, this passive nature becomes a problem?
Kevin: Sure. I can think of a couple off of my head. And I don’t have the numbers like I did for the bond index, but Vanguard has another very inexpensive option for emerging markets. So these are Brazil, Russia, India, China, all these kind of burgeoning economies that maybe aren’t as well developed as see us or Canada or Japan or Europe or what have you. And that one too, again, don’t quote me here, but it’s, it’s probably right around that 50th percentile as well, even though it’s like literally the lowest cost option, an index option within the emerging market category.
Kevin: A couple more actually… So bank loans, bank loans are basically first position security — they’re going to get paid first before anybody else does if a company went out of business. But when you look within bank loans at some passive options within that asset class, again, I’m kind of going from memory here, but you’re probably going to find that the passive option is going to only have bested maybe 20 or 30% of the funds in the category. So 70 or 80% of the active managers have bested the index. So that’s another one.
Kevin: Also, you have a something called preferred stock. These are another type of security that banks or other financial institutions typically issue. If you look within that asset class, the passive options inevitably underperform the average active manager. So it kind of depends. If you were looking at large us stocks and indexing option is going to be pretty good. If you look at bonds, particularly aggregate bonds, maybe not so good, because the underlying composition of the index has changed significantly.
Kevin: These are all different investment asset classes we’re indexing may not necessarily work as well. So having a passive approach, having a low cost passive approach is the starting point, and I say is always a good starting point. And me personally, I always want to see evidence to the contrary. Why should veer from that starting point. But I’ve at least rattled off a few that gives you some good examples of where you can probably do a little bit better by having a smarter approach than just going for the pure low cost index option.
Walter: So great four part series, go in through all of these different little nuances of the investing process and it’s a lot to absorb. Kevin, if somebody listened to these episodes, what do you want to be? Sort of the, the main takeaway to walk away from kind of all this information about different types of investing and the science that goes in behind it. And some of the great examples that you’ve laid out for us. Yeah,
Kevin: Go back to rule number one and your financial plan. I know we haven’t really talked about financial planning through this series. But ultimately a big part of your retirement plan is the investment plan, which needs to be matched back to your retirement plan. And I can’t emphasize the importance of that enough. So that’s rule number one.
Kevin: As you get beyond that, it’s really about a process. It’s not some man behind the mask or , kind of a woman behind the curtain that’s just kind of haphazardly picking things because they heard a good idea at an investment conference or they read money magazine or something like that. Again, what we always default to, because we don’t have a crystal ball, we don’t believe anybody has a crystal ball is science. And that’s what we’ve talked about. We’ve talked about the process. We’ve talked about asset allocation or the recipe, which matters more than the ingredients or the underlying funds that you’re picking, which are, are also important. But that’s what we talked about. And so if you don’t have a process, if you’re not sure, if , you have a good process, if you’re not sure if you have a good allocation, a good recipe, if you’re not sure if you have good ingredients if you’re just kind of haphazardly picking things or you’re not sure if your advisor’s haphazardly picking things, we’d be happy to talk with you and give you a second opinion and take a look at that. But again, if you come into our office and you’re asking for that question number one is, well, what’s your financial plan going to look like? And literally if we don’t have a good plan, then there’s no way that we or anybody else like us can really go ahead and have a really effective investment plan for you.
Walter: Well, if you need help with, again, the full plan don’t come just looking for that one particular element. Kevin, appreciate some of the baseball knowledge on today’s show in addition to all the financial stuff. I I’ll be better at my next trivia night having absorbed some of this information. So that’s good.
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 references historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.