The Indexing Advantage
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|The Lange Money Hour: Where Smart Money Talks
|Click to hear MP3 of this show|
- Guest Introduction: P.J.DiNuzzo
- Are Stocks and Bonds Still a Good Investment?
- A Safer Portfolio
- The DiNuzzo Money Bucket Stack Analysis
- The Difference between Active Investing and Index Investing
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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
Dan Weinberg: Welcome to The Lange Money Hour. I’m Dan Weinberg, along with CPA and attorney Jim Lange, and tonight, we welcome back to the program P.J. DiNuzzo. P.J. is a nationally-recognized expert in investment management. He was approved as one of the first one hundred Dimensional Fund Advisors and rated a five star advisor by Paladin Registry Investor Watchdog. His Pittsburgh-area firm, DiNuzzo Index Advisors, Inc., consistently ranks among the country’s top five hundred investment companies. Tonight, P.J. and Jim will be talking about maximizing your retirement assets by using a strategy that is both consistent and flexible, and where better to start than low-cost index investing. Plus, you’ll learn about the DiNuzzo Bucket Stack Analysis and how it can help you manage your risk in a way that provides comfort and flexibility for investors. You can call us with your questions. (412) 333-9385. That’s the number in the studio. Now, let’s say good evening to Jim Lange and P.J. DiNuzzo.
Jim Lange: Welcome P.J.
P.J. DiNuzzo: Good evening.
Jim Lange: Well, before we get into the meat of tonight’s program, I do feel honor bound to give full disclosure about a relationship that I have with P.J., in that usually, when I have a radio guest, whether it’s Ed Slott or Jack Bogle or Jane Bryant Quinn or Jonathan Clemens or whoever it might be, I usually plug their book if I think that it’s a good book. But frankly, I don’t make one nickel on the sale of the book. I don’t have any financial interest in whether you buy the book or whether you do business with any of these people, and by the way, I never pay them. I’ve never paid a nickel for anybody to appear as a guest on a show. But there has been no financial interest either way. That isn’t the case with P.J. DiNuzzo. P.J. and I have an arrangement, a financial arrangement that has worked exceedingly well for our company, his company, and, more importantly, for our mutual clients. So, my company, which is Lange Financial Group, we do some of the strategic work like how much money people can afford to spend, should you take a one-life or a two-life pension, what are the best strategies for your Social Security, when and how much should you do for a Roth IRA conversion, should you be putting away money for your grandchildren’s education, what’s the estate planning look like, what’s the best way (given your situation) that you should take care of the charities of your choice. We do that type of planning, and that’s what we love to do. P.J., though he certainly has knowledge of all those areas, his firm and, I believe, his strength, is actually managing money, and he uses what I believe is the best set of index funds on the planet, which is Dimensional Fund Advisor funds, and let’s say that you had never heard of me, and you went to P.J. and you said, “P.J., I’d like you to manage my money,” and he would, you know…we’ll talk much more about what he does, but ultimately, he would charge you a fee, and it’s a very fair fee. But if you, instead of going to P.J. first, you were to come to our office, you would get charged the identical fee to the nickel, but you would also get the benefit of our office. So, we would run the numbers. We would do calculations, and it’s a big deal the first year, and then, in subsequent years, we’d do annual reviews, and then he does a big deal the first year. But instead of paying us a fee and him a fee, you pay one fee to both of us. On the other hand, if you like what you hear and you end up possibly doing business with the combination of us, then I am obviously no longer objective in this radio show, and I do feel honor bound to mention that. I will say it has been the best association, or joint venture, of my professional career. I believe we have roughly $170,000,000 under management, and we’re growing at a huge rate. I think we’re at $40,000,000 just this year. But much more importantly for the investor is we have a 99% retainage rate, meaning that we take a lot of time before we accept somebody, but if we do, we have maintained 99% of those. So, anyway, with that long introduction, I did feel honor bound to disclose the nature of our relationship that I am not independent with P.J.So, P.J., the big thing that everybody’s talking about right now is diversification, and why not just keep it simple? Put money in the S&P 500, you know, a good index fund that is proven and reliable, that has done well over time. Why do we really even need to diversify?
P.J. DiNuzzo: Yeah, Jim, and it’s always interesting. If we take a look at the average individual’s holding period for individual securities, the average individual holds their average mutual fund position for approximately three years. We don’t even want to look at Shanghai’s in China. I think it’s five or six or seven trading days, so a very impatient market over there in China. So, the average individual’s having a challenge with really making a commitment, having a strategy and making a commitment to it, and you’ll go through periods of time where what our core beliefs, or any firm’s core beliefs, as far as diversification, value stocks outperforming, small cap stocks outperforming, etc. would be slightly out of favor for a period of time. And that’s really a key of how master investors, so to speak, such as Warren Buffett, have done so well over the decades upon decades and decades, you know, they have a philosophy. They have a strategy that they draw from that philosophy. They implement it, and they have the discipline to stay with it. So, we’re certainly in the camp, and we have never wavered regarding full and proper diversification. I mean, the S&P’s been strong. You could maybe look at this in retrospect in a few years as a flight to quality, so to speak, the last few years of this bull market. But, you know, we’re firm believers in diversification. If we take a look at the largest portfolios on earth, endowments, foundations, institutional portfolios, and, more importantly, what I consider to be the brightest people on earth, I mean, full and proper diversification, you’ll see something along the lines of whatever they have in the stock market, around two-thirds in the U.S., two-thirds in international. Of what you do have in the U.S., two-thirds will be in large stocks, and certainly, the S&P 500, which we would call U.S. large core, and U.S. large core is basically half growth and half value in the S&P, around half and half. That is a large component of that, but you’re still missing a lot in diversification. missing out on small real estate international. So, when you go back and take a look at periods such as 2000, 2001 and 2002, individuals would be shocked, even though it wasn’t that long ago, to take a look at how the S&P performed versus the diversified portfolio, or being all in the S&P when we came out of 2000, ’01 and ’02, how much stronger the outperformance was in international. So, one thing, unfortunately, for individual investors, and that’s why they tend to underperform as much as they do, they have a very limited frame of reference. They don’t maintain their positions long enough. They’re not diversified as well enough. Yeah, so, I mean, that would be my ‘as succinct as I can’ case for full and proper diversification.
Jim Lange: Well, let’s look at it from maybe two different angles. If I’m an investor, I’m probably interested in two things more importantly than anything: one, I’m interested in the highest return I can get with the greatest amount of safety. So, you had mentioned, let’s say, two areas: small cap and international, which are typically not in the S&P 500. If you had a portfolio that not only included large U.S. companies, but also included, let’s say, small U.S. companies and international companies, historically, would you have a better return than if you just own the S&P? And then we’ll get to the safety issue next.
P.J. DiNuzzo: Yes. Historically, by adding these other premiums (small, international, etc.), the data has shown that that has provided a greater total return than just the S&P.
Jim Lange: In fact, the difference between, say, small cap stocks versus large caps is actually quite substantial, isn’t it? Not only in the last, say, you know, eighty years or ninety years, but even just in the last ten years.
P.J. DiNuzzo: Yeah, small stocks, historically, we’ve got an eighty-seven year database now going back in small stocks, have outperformed large stocks, again, talking the small stock index versus the S&P, for example, by a couple of percent per year, and if you take the miracle of compounding of two percent more per year, that’s quite a dramatic outperformance over time.
Jim Lange: All right. Well, I see we have a question. Why don’t we answer the question, and then I want to go back to the issue. So, I think that what you have already said is that, let’s say, small has significantly outperformed large, international has significantly outperformed U.S., and we’ll get to the safety issue, but I know that there’s a listener on the line. So, why don’t we take the question if that’s okay with you?
Dan Weinberg: They’re actually not on the line, but they did ask a question off air. This is Ken, and Ken wants to know what to do now with the current threat of rising interest rates in the stock market at its peak. He says that it seems like there is an extremely good chance that both stocks and bonds will lose value in the next couple of years. What would you guys say to that?
P.J. DiNuzzo: Yeah, Jim, you want me to go ahead and take that?
Jim Lange: Yeah.
P.J. DiNuzzo: Okay, yeah. Yeah, one thing that’s unique, I’ve been in the business for a decent period of time. I’m getting ready to go into my twenty-seventh year, and pretty much every meeting, maybe not every, but at least every week if not at least multiple times every month for twenty-six years, the individual sitting across the table from me has told me, “I don’t know what to do, I’m trying to make a decision, things are unlike they’ve ever been before, these are challenges we’ve never seen before. I don’t know what I’m going to do. The market’s run out of steam, I read some article, I heard something, I heard a report on TV.” And I’m not making light of it, but that’s just human nature. As they say, the stock market always climbs the wall of worry, and one thing I try to mention to people to get over that is I always look at it that I’m not investing in the stock market, I’m investing in the economy, in the global economy, and the companies are a subset of that. They make up that global economy. But if you get economies growing at, let’s say, approximately three percent, you’ve got inflation on top of that, there’s dividends that are being paid by productive companies, that’s where the premium comes from of stocks over and above bonds. Now, you’ve got to be able to hold on to those through rising periods. I was just talking to a prospective client earlier this morning, and go back and take a look at a period such as January 1st, 2000 through December 31st, 2009. Some market historians would argue that it was the worst decade in history, even worse than the Great Depression. The S&P 500 averaged losing over one percent per year over that entire ten-year period of time, and it’s surprising how well 50/50 all index portfolios performed during that period of time, 60/40 all index portfolios. If you knew going into January 1st, 2000, and you had a crystal ball and you knew we were going to have two of the four fifty percent plus meltdowns in our lifetimes in 2001 and ’02 and ‘08 and ’09, and you said, “I’m just going to invest in CDs and I’m not going to lose a penny. Every month, my portfolio’s going to be making money.” It’s astounding how poor your performance would have been with a CD versus, let’s say, for example, a 50/50 balanced portfolio. So, even if you had a crystal ball going into the worst ten-year period in time, if you said, “I’m going to sit this out and only earn interest, only have a CD,” you dramatically underperformed even a balanced portfolio.
Jim Lange: Well, I think that that makes sense because ultimately, when you are investing in…well, of course, you don’t do it in individual stocks. You do it, let’s say, in a whole bucket of stocks. But you’re actually investing in companies, and historically, when you own equities and you’re investing and you actually buy companies, you are historically going to get a much bigger return than if you lend money to companies, and, as you said, historically, so many times, people have, let’s say, said, “Well, I’m going to stay out of the market.” But if you had stayed out of the market even just since the problems that we had in 2008, you would have missed some of the best years that we ever had.
P.J. DiNuzzo: Yeah, you’ll never make it up, yeah.
Jim Lange: And I remember very clearly, people saying, “Oh no.” And even when the market came back in 2009, “Now’s the time to get out. It’s red hot. It’s about to go down,” and I think really it’s a much sounder strategy to have a well-diversified portfolio and you’re not radically changing your percentages of stocks and bonds every year because of, you know, let’s say your political beliefs or, you know, because of what’s going on in China or Europe or Greece or anything else. Is that fair?
P.J. DiNuzzo: Yeah, that’s fair, and the thing is, Jim, you know, we always think back to the giants of modern finance, and even going back before that to Benjamin Graham, who was basically the Warren Buffett of his day. That’s who taught Warren Buffett years ago back at Columbia University, and you think back to, you know, one of his famous statements, over a short period of time, Benjamin Graham said that the stock market is a voting machine, and over a long period of time, it’s a weighing machine. So, the voting’s the emotions, and emotions can carry the day for six months or a year or two or three years, but the weighing machine, I mean, if you take a look at…I’m not going to give away exactly how long ago it was, but when I was in high school, there’s well over a hundred million more people in the United States alone, just from when I graduated high school. That’s extra Cheerios, cars, gas going in the cars, houses being built, etc. So, you’ve got a natural upward bias in the global economy continuing to grow because of people. You’ve got inflation on top of that. You’ve got successful companies paying dividends, and if it’s not nine percent (as it’s been historically), you know, there could be some cause that over the next decade, that you may have a return of six or seven percent in large stocks instead of the historic nine. But the point is, you can’t procrastinate or you can’t be paralyzed. You have to appreciate that all you can do is all you can do. So, if the market does six the next ten years and you get your six, you’ve got to be as happy as you can be. That’s as good as you could have done.
Jim Lange: Well, let’s go back to the issue of diversification. All right, so, we know statistically, in the long run, small company stocks…when I say ‘small,’ I don’t mean a mom and pop grocery store, but let’s say a billion dollar instead of a hundred billion dollar or two hundred billion dollar. But small stocks have significantly outperformed large stocks, international stocks have significantly outperformed U.S. stocks, and emerging market has significantly outperformed U.S. stock, although we don’t have quite the time period to compare. On the other hand, each one of those areas by itself is more volatile or risky. Do you end up with a safer portfolio by having several different types of investments, even if the individual investments themselves might be more volatile?
P.J. DiNuzzo: Yes, Jim. That’s what happens, and it’s really because of how these investments interact with each other, and just for me to qualify as a chief investment officer, I would say U.S. small stocks have materially outperformed U.S. large by eleven percent, let’s say, versus nine. But international, it’s not so much that they outperform the U.S. I mean, they’re pretty much matched up with their counterpart. If we go back and take a look at international large caps the last, let’s say, forty years, that return is very similar to the international blue chips to the S&P 500. It’s just that low correlation in that whenever U.S. large is not doing well, the material percentage of the time, international large, is doing well. So, with that low correlation, that’s really what provides, that’s where the magic happens in building a portfolio, putting these unique pieces into the rest of your formula, if you will. But the emerging markets, again, since they’re growing the fastest, they have basically, as a group, outperformed, and, as you said, we’ve got a little bit over a quarter century, a little bit over twenty-five years of data. But we expect that to continue to persist in the fastest growing economies on earth.
Jim Lange: All right, well, you’re talking about international, and you know, most of our listeners are…
P.J. DiNuzzo: Yeah!
Jim Lange: They don’t read the news. They’re at least listening to the news because this is a news station, and they hear about Greece, and they hear about China, and they go, “Oh my goodness! What a mess! I’d better get out of the international. I’d better get out of China.” Or they think that China might bring, in effect, the whole U.S. economy down. How would you react to this type of news, and do you think it is useful for people to make the financial decisions based on news and things that they hear?
P.J. DiNuzzo: Yeah, I would not base it certainly on news, you know, on the noise that’s out there. But you know, just to quantify, in a portfolio such as ours, and there’s other qualified advisors out there that are building world class portfolios. If we have sixty percent in stocks and forty percent in bonds, let’s say in our entire portfolio, on average, we have approximately one percent of the entire portfolio, there’s only one penny on a dollar invested in China. It’s a very, very, very small amount…although the country’s large, people read about the GDP. There’s just not that many stocks on their stock exchange that meet the rigorous criteria that we would want to invest in them. So, really, it’s just a bunch of noise that’s in the newspapers, etc. I mean, at the end of the day, the super majority of our portfolio is U.S. and international large, dividend-paying blue chip stocks.Jim Lange: So, P.J., we’ve been talking about diversification, and frankly, I’ve had you articulate the benefits of diversification, which, perhaps, you and I just kind of take it for granted, because that is the wisdom of the ages, if you will. But I know that you do something a little bit special that you call the ‘DiNuzzo Money Bucket Stack Analysis.’ Could you tell our listeners what that is and how that works?
P.J. DiNuzzo: Yeah, Jim. What we do…and again, my focus tonight would be on how we work together jointly and provide great solutions for our joint clients. After you’ve had an average couple of consultations with a prospective client, we then have an initial discovery consultation, getting to know the individual (it could be a household, a couple, partners, individuals), to get to know them as well as possible, and one thing that we’ve noticed over the years is basically not a lack of customization to individual investors. They tend to be with a very small company that doesn’t really have the resources potentially to do them justice, or they may be with a company that has enormous resources, but just doesn’t pay that much specific customized attention to the individual client. So, we’re in a real nice sweet spot in the market being a medium-sized firm with the resources that we have, and being able to customize these portfolios into the buckets that we discussed, and what we’ve come up with over the last twenty-six years, a long time ago, and continued to refine, is…you know, what we say at the end of the day is that basically half of our business is the numbers and the other half is the emotions, and this really helps on the emotional side as well.
What folks who do like us, and I always qualify that, folks who do like us, what they like is that we pay attention to them, we have gotten to know them uniquely and individually, we’ve developed a customized plan for them, we have a customized plan for every dollar that they have regarding an investment strategy, a tax planning strategy, a withdrawal strategy, a cash flow strategy, and in building the strategy, we think of oftentimes taking an individual’s portfolios, taking that money and stacking it up mentally from the floor to the ceiling, and then taking a look at the base (or foot or foundation) of that stack and that’s the most important, that would be what we call our ‘cash reserve’ bucket. The cash reserve bucket is what we target. What we specialize in is retirement planning, retirement income planning, as you mentioned earlier, index investment management. So, on the retirement and income planning side, as we’re helping individuals prepare for retirement, we start to set some objectives and some goals and some targets that we want them to have at least twelve months in that cash reserve bucket. Now, that’s important from a financial perspective, but it’s just as easily important from a behavioral perspective that we know that we’re going to go through the typical market cycle and the stock market goes through generally a little bit in advance. It’s often predicting the future by three to six or nine months. But we’re going to go through spring, summer, winter and fall in the portfolio, and when we’re down in winter and people are thinking bad thoughts and they haven’t been outside, they’ve been locked up in a cabin for months, they haven’t seen the sun, they start to sometimes think bad things, “I’m never going to see the sun again,” and they don’t have an anchor and bad things can happen on their decisions. So, this cash reserve bucket is helpful. So, they’ve got the peace of mind that, “Hey, I’ve got twelve months of my monthly living expenses in the local bank, FDIC insurance, no stock exposure whatsoever.” Now, the cash reserve bucket also helps us on the upper end, so we’re always looking at what’s the ceiling, what’s the floor? So, the ceiling on this that’s helpful is we never like to have over three years in that cash reserve bucket. So, we have individuals, probably at least one a month, that we run into that have over three months in their cash reserve bucket and were able to identify to them, explain it with them, and they were able to understand that hey, this money is years and years away from me even possibly needing it, and maybe it’s still in some type of fixed income or bond-type investment, but earning one or two or three percent more than what they’re currently earning. The way that they have it invested adds real value to the relationship.
So, after we have the cash reserve bucket, the next one we come up with is what we refer to as the ‘needs’ bucket, and I wish I could come up with an easier way, so to speak, of arriving at this, but you know, as you’ve seen, Jim, we go through information methodically, copiously, painstakingly, we go through building a personal balance sheet for an individual the same as if they were U.S. Steel or PPG Corp. What are all your assets? What are all your liabilities? Then we go through what is all of your income and what is all of your expenses? And then we bifurcate those expenses into fixed expenses and variable. But we go down through line by line, and we’ve got our software customized over the years that we want to capture every expense, but especially we want to capture and follow through with all the food, clothing, shelter, healthcare and transportation. So, this gets into portfolio construction, certainly in doing it the best way, we’d argue, with indexes, but also on the behavioral side, anytime we go back and take a look at bad market periods, starting in October ’07 through the whole year of ’08 into March and April ’09, 2000, ’01 and ’02, 1973-74, any of these bad periods, when the forensic economists, so to speak, go back and dig through the financial rubble of these periods, what they’ll notice is, you know, obviously, they’ll notice the order imbalances that ten people want to sell and only one person wants to buy or twenty want to sell and only one wants to buy, and then they’ll go through and they’ll go back in and take a look at just who actually were these individuals. You know, Jim Smith from Peoria, Illinois, Jane Doe from Sacramento, California, and they’ll take a look at these individuals and what was it that caused them to sell, and what caused them to sell in these instances was, basically, their portfolio was too aggressive for them, too aggressive for their risk tolerance, too aggressive for their time horizon, and what the, so to speak, forensic economists have come up with, the behavioral scientists have come up with, is if your food, clothing, shelter, healthcare and transportation on average across the country, if that portfolio goes down by much more than ten percent over the course of a year, that causes an alarm to go off for the average individual.
Jim Lange: By the way, a couple things that I should add. You do do a more copious, detailed job than any financial advisor I’ve known, and I’ve been exposed to thousands, literally all across the country. When you say you construct a balance sheet, I see that and it’s a huge amount of work, and I always love your saying: “Everybody’s a snowflake.” Because we do that on the number crunching side. You know, we actually crunch everybody’s individual numbers, and there is no, you know, you fit in this slot…
P.J. DiNuzzo: Yeah.
Jim Lange: …you fit in that slot. It really is individual, and I know that you base your whole portfolio on that, which I just think is tremendous. It’s a tremendous value to your client. And like you said, part of it is, yes, it is a better way to invest, and the other part is now people are going to feel safer because if the market does go down and their cash and their immediate needs are taken care of, then they’re going to be less likely to panic and bail when the market is low.
P.J. DiNuzzo: Yes, exactly. It’s a behavioral side. Yes, exactly.
Jim Lange: Right, and then, I guess we can keep talking a little bit because there’s some interaction in our office because, for example, we might want to have different tax-type investments invested differently. So, if, for example, we do the Roth IRA conversion analysis and we determine…or somebody actually comes in with Roth IRAs, because I’ve been talking about Roth IRAs even before they were allowed in ’97, and then they were passed in ’98. But the Roth money would certainly be invested differently…which, presumably, you’re going to spend much later. Maybe you’re never going to spend. Maybe that’s your legacy money. You’re going to invest that money differently…
P.J. DiNuzzo: Yes.
Jim Lange: …and much differently than you would, say, a cash needs or a clothes/shelter-type need. Is that right?
P.J. DiNuzzo: Yeah, Jim. That would actually be in our top bucket. That would be in what we would refer to as our ‘dreams and wishes’ bucket. That would be at the very top of the stack, and the ideal investment for that bucket…we skipped the ‘wants.’ I’ll go back to that. But that top bucket, if we look at that and say that there’s a 99% chance that that household is not going to touch that money while they’re alive, and then they’re looking for the beneficiaries, for their heirs, etc. to receive that money, what better, I mean, in our mind, the perfect investment, tax-free growth, tax-free withdrawals, than the Roth IRA? It’s just a perfect fit.
Jim Lange: All right, and then you have a couple in between. Is that right?
P.J. DiNuzzo: Yeah. So the foot or foundation again is that cash reserves bucket, the money in the bank for the sleep at night. Then we’ve got our needs bucket, and we identify that…and as you said, Jim, I’ve used that snowflake metaphor, what have you, for a long time because it is true. You can’t say oh, this is a green or this is a yellow. This is a number seven-type account. I mean, it’s literally different every single time, different numbers, different solutions, different customization. So, we’ve got the cash reserve bucket. Then we have the needs bucket for food, clothing, shelter, healthcare and transportation. Then, on top of that, we get into the discretionary, which would be our wants bucket. Our wants bucket is for all of our non-essential spending. It’s for dining out, vacations, entertainment, travel, and there are a number of categories in there. Sometimes, clients will say different things and that’s where the customization comes in. They’ll say, “P.J., I understand you got the food, clothing, shelter, etc. in the needs, but I really feel very special. You know, myself and my spouse, or myself and my partner, have talked for years and we really want to spend at least ‘X’ number of dollars in retirement on vacation.” So, we’ll lock that in and we’ll move that down to the needs bucket so that they know they’ve got food, clothing, shelter, etc. plus that their vacation, and whatever expenses, maybe putting aside so much money per year in 529 plans for their grandchildren, or whatever that may be, covered. But then, once we get to the wants bucket, so then we’ve identified, at reasonable rates of withdrawal, how much funding we have to have. And we literally don’t know when we go into that initial discovery consultation, is an individual going to have extra money, so to speak, in the dreams and wishes bucket? If so, how much? Then that’s where we’re talking, you know, myself and our wealth advisor, talking to you and your law firm on the estate planning side, and to your CPA firm on the tax planning side. For the Roth IRA conversions, ideas are going back and forth. We’re kicking around how to best help our clients pay the least in taxes, structure them as well as possible, protect their assets going forward.
So, that’s what leads us into maybe the last segment after the next break. I think we had talked about the four corners. But really, you know, with this money bucket stack analysis, what we have at the end of the day is a very specific, customized asset allocation, which means stocks and bonds. So, what we end up with is, on average, three different strategies for the average household. We’re running one strategy for them for their needs, another strategy with a little bit more in stocks for their wants, and then another strategy with more growth or full growth or aggressive growth in the dreams and wishes bucket. So, by having three customized strategies, that allows us to produce an optimal optimized outcome.
Jim Lange: Well, I know it’s a lot of work for your office, and then if you add in what we’re doing, because we’re often optimizing Social Security with apply and suspend, and that might change the timing…
P.J. DiNuzzo: Yes.
Jim Lange: …of when people are going to get money from Social Security, and potentially what we often do is hold up on Social Security using the apply and suspend technique, and then do a series of Roth IRA conversions, which I know has an impact on your cash flow planning because it’s not just investment planning, but it’s cash flow planning too.
P.J. DiNuzzo: Yes.
Jim Lange: And I will just quickly mention that I am not independent with P.J. P.J. and I have a combined service where our office runs the numbers, does some big picture planning, estate planning, retirement planning, Roth IRA planning, Social Security planning. His office actually manages money, using what we both believe is the best set of low-cost index funds on the planet, all for a cost of between fifty basis points, meaning one-half of one percent on the low end and one percent on the high end, and it has been a win-win-win, meaning it has been good for us, it has been good for P.J., and most importantly, it has been great for clients who pay one fee, and that’s one of the reasons we enjoy a 99% retainage rate, and I usually have a guest where I, you know, if I like the book, I tell the listeners that it’s a good book. I recommend that you buy it. Well, here, I’m going to plug my own book. Retire Secure! is my flagship book. It sells for $24.95. For KQV listeners, it is free, and the other thing that it has at the end of the book, it has a long explanation of how P.J. and I work together. So, if somebody is interested in having, in effect, both the tax strategies, the Social Security, the Roth, with money management using this stack analysis that we’re talking about for between fifty basis points and one percent, there’s a very good explanation on that, and the book, which comes hard copy, by the way, we don’t send you an e-mail, we use good old fashioned direct mail, we send you the book and it is free, by going to JamesLange.com.
All right. So, P.J., the thing that we really probably…I guess I just kind of mentioned it a little bit, but I always love your terminology. You know, you sometimes have an interesting way of putting things, like for a less sophisticated investor, you might say, “Well, they don’t know a stock from a rock,” or something like that. But the other thing that you say is, you talk about the four corners. Can you tell me about what you mean by the four corners in personal finance?
P.J. DiNuzzo: Yeah, Jim, and that’s really…and I’m not patronizing yourself or your firm or anything, but really, that’s the best part, to me, about the joint, so to speak, strategic partnership, I’ll put it that way, that we have, in that every individual who’s listening to the show tonight or who does this for themselves, or is working with anyone, for that matter, basically has a personal financial house, the way that I look at it, whether they know it or not, and the personal financial house is going to dictate their success for the rest of their life because that’s where all the money’s going to come from, the cash flow, anything to do with finances. And if you took a look, if you pulled the roof off, if you lifted the roof off your personal financial house, you’d notice that there are four large rooms in your personal financial house, and let’s say there’s a bright line even down the middle of the house. So, if you looked at one corner, let’s say the first corner, the upper left, would be the estate planning corner. You could say estate planning/legal, customized beneficiary designations, etc. And attorney Jim Lange is a long-time estate planning attorney. He has a phenomenal group of very competent, very qualified estate planning attorneys in his office who specialize in that corner. So, for us, being able to have a joint strategic partnership where we work as closely as we do, and the value that’s added by your firm, analyze the initial analysis, getting people in the proper structure, taking care of things in the ongoing basis, everything with estate planning, the huge, huge benefit in that room.
Then the next room, I would say, is next to the estate planning room, and that would be the tax planning room. Jim, of course, has even been a CPA longer than he’s been an attorney, and he has a handful of extraordinarily competent CPAs in the office that myself and our wealth advisors are talking to. I’d say, literally, one of our wealth advisors is speaking with one of Jim’s estate planning attorneys or CPAs on a daily basis, working together, as Jim had said, for the ultimate goal of helping our clients. And it’s in this tax planning corner that…actually, I first met Jim, first referred my first customer, my first client over to him, rather, over twenty years ago, and one thing that’s always amazed me…again, I’m not patronizing Jim, just speaking to the audience, is that of, I’d say, ninety to ninety-five percent or even more of the Roth IRA conversions, and it could be Roth IRA conversions, it could be capital gain harvesting, any way to get money away from the taxman as much as possible, let’s say, before seventy-and-a-half when you have to start your required minimum distributions, it’s been Jim who’s taken a look at that individual’s finances and has recommended for them to harvest a certain amount of Roth conversions per year, and is showing them in black and white how much they’re going to save in tax savings over their lifetime, and also, equally or of greater importance, over their children and beneficiary’s lifetime, and it’s always amazed me whenever Jim’s done this analysis that, again, over nine times out of ten, the clients that Jim’s making this recommendation for have a CPA, they have a tax advisor, and this was something that was just missed on their end that Jim’s been able to bring a phenomenal amount of value to the table. So, on that half of the room, either Jim or one of his estate planning attorneys or one of his CPAs does an annual review, depending on how Jim allocates it, but you have a professional from one of Jim’s companies doing an annual review, looking in those two rooms, at your overall picture.
And then, on the bright line, through the house, in the other two rooms on our side of the house, so to speak, would be the retirement income planning room. You know, we have sixteen team members, six wealth advisors, and again, if there’s two things that we’ve specialized in for twenty-six years, it’s retirement income planning and index management. So, as Jim said, between all the detail that we have with building the personal financial statements from the ground up, we’ve got all the ‘gee whiz bang’ software that any other firm would have, but it’s the age-old saying: garbage in and garbage out, and we see other firms come up with numbers that are completely off target, because they don’t have the high quality initial data that we have from the couple of meetings that Jim has spent with clients initially and the couple of meetings we spent. So, we’re spending four, sometimes five, high quality initial consultations to get all this initial foot and foundation information correct. So, the retirement planning is an ongoing process. With our typical client, we like to meet twice a year for a semi-annual progress meeting on the investment side, where I serve as chief investment officer. As Jim had mentioned a number of times, we’ve been an efficient market theory firm basically since our inception. It was pretty rough at the beginning in the late 80’s and early 90’s because we had Vanguard, but there wasn’t anywhere near the selection of indexes available at that time. But when we couple all of these four corners of the room together, the estate planning, the tax planning, the retirement planning and the investment management, individually stand alone, they are tremendous solutions and add significant value, but it’s really in that harmony and when they work in concert where we’ve got the best outcomes. It takes at least three companies to do this, which is amazing as well, as Jim has two companies, again, the estate planning firm, the CPA firm, and on our side, the register and investment advisory practice. But to have three firms who can work together with one goal in my mind, only one goal, and that it to help every client, or every prospective client that we meet, to help them as much and materially as possible for them to succeed, because, as we know, we’ve both been in business for a long time, and if our clients succeed, we’re going to succeed. So, you know, we both have a fiduciary standard. We place our clients first and foremost at the top, and as long as we take care of that, everything works out well going forward.
Jim Lange: And the one thing we didn’t talk about today, and Dan, tell me if we have time or not. Does P.J. have a minute or two to talk about index investing and the difference between index investing and active investing, and why we are advocates of index investing, and particularly, Dimensional Fund Advisors? Do we have time for that?
Dan Weinberg: Oh yeah. He can take six minutes, if he wants.
P.J. DiNuzzo: Oh okay, yeah, all right.
Jim Lange: Oh good.
P.J. DiNuzzo: Sounds good. The majority of the money that individual investors hold in their portfolio still today, over fifty percent is still in active mutual funds. So, as you said, Jim, you know, what’s the bright line or the litmus test from one versus the other? As the audience may have heard, there’s a lot more information out there regarding indexes: the S&P 500 for U.S. large stocks, the Russell 2000 for U.S. small stocks. But what we see, over time, is over the average ten year period of time, all of the active managers, and those would be all the names which I won’t mention on the air, that individuals may be very familiar with, are in their portfolio. There’s basically one of two ways. You take the market rate of return, or you try to beat the market and try to outperform the market, and what we see over the average ten year period of time is, on average, three out of four active managers underperforming the index that they’re trying to beat. So, you know, when I saw that data years ago, it didn’t take me long to convince myself to say I’m going to just index as much as humanly possible in the portfolio. So, you know, if we can win, on average, three out of four times over a ten year period of time, and it is because of all these very, very intelligent active managers with all the market participants who are analyzing each and every individual equity stock security, each and every individual fixed income bond security, and pricing these as well as humanly possible (we call that ‘price discovery’) on basically a nanosecond by nanosecond basis, that the market is very efficient. So, if we think of all these millions and millions of highly intelligent investors pricing these securities on a second by second basis, it becomes very, very difficult for someone to sit, so to speak, on the outside looking in, and come up with a thesis that ‘I know something that all of these millions of investors don’t know, and they’ve really mispriced the security and I’m going to take advantage of that.’ I think, Jim, when I was looking at the data the other day, that I think there’s only…from fifteen years ago, if you took a snapshot of all domestic stock managers in the U.S. fifteen years ago, that at the end of last year, on 12/31/14, I think there were only thirty-nine out of a hundred that were still in business. So, on average, sixty-one percent of all active equity stock mutual fund managers had closed the fund, and you don’t close it if it’s successful. You close it because it’s underperforming your benchmark. That’s a short period of time when it comes to investing, that getting close to two out of three, not only did it underperform but it actually closed, relative to their performance to the index.
So, you know, you’ll hear fancier words like efficient market theory. That’s just a thought, again, that you have millions and millions of buyers versus millions and millions of sellers, looking at a security, pricing out, again, Google, Johnson & Johnson, Facebook, whatever the individual stock is, and arriving at the best price at every moment of the day, and you can get back to what I referred to earlier in the show, the analogy of Benjamin Graham. You’ve got that voting machine. So, that’s just the emotions of individual investors, and if individual investors do one thing for sure, they either overshoot or undershoot. They have a hard time staying in the middle. That pendulum gets stuck in the wall in one side, and then when they pull it out, it doesn’t stay in the middle of the room for long. It goes and gets stuck in the wall on the other side. So, individuals have a real hard time on the behavioral side. So, you know, what I would recommend to the audience, to the listeners, is if they’re not that familiar with it, you know, the world wide web, go and Google it. Go online, read up, you can go to Investipedia and look up some definitions, but taking a look at efficient market theory, taking a look at indexing, and then, as Jim had referred to earlier, the diversification, not putting all your eggs in one basket, having indexes, as far as U.S. indexes versus international, and, of course, the typical investor would want to have bonds in a bond index as well in their portfolio.
Jim Lange: Yeah. Charles Ellis calls looking for the best mutual fund or the best stock, he calls that the ‘loser’s game.’
P.J. DiNuzzo: Yeah.
Jim Lange: Because the vast majority of players do lose, and I think your approach where, let’s spend the time, instead of playing the loser’s game, of really planning out people’s finances, the cash flow, the tax loss harvesting…
P.J. DiNuzzo: The Social Security, like you said.
Jim Lange: The Social Security, the Roth, etc. I think is just a much better approach.
P.J. DiNuzzo: Yeah, exactly. Spend it on the planning side. And we tell clients all the time, I mean, we’re standing on the shoulders of giants, and I tell clients in pretty much every meeting about investing. I say the wheel’s already been invented. In our mind, it’s the nicest, smoothest, roundest wheel on earth. We don’t want to waste our time trying to reinvent that wheel. Let’s apply that. Let’s use it, and as you said, let’s use our valuable time and all of our expertise and knowledge to help clients on all the various planning topics that you had just mentioned.
Dan Weinberg: All right. Any closing thoughts? Any more closing thoughts?
Jim Lange: Well, again, I want to thank you, P.J., and I’ll just mention that the book is out. It’s free, and it has a good description of how P.J. and I work together, and that’s at JamesLange.com.END
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James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.
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