Paul Winkler: Hey, welcome to “The Investor Coaching Show.” I am Paul Winkler, talking money and investing — a wide-ranging topic for sure.
Interest Rates and CDs
I thought I would do a little bit of education on a topic that comes up quite often. Kind of flying by the seat of my pants on this one just because it’s a topic that comes up so often that I figure I probably better address it.
So let’s say you are at the retirement stage. We get people that are getting with us and saying, “Hey, we have CDs that are renewing. We’ve had these investments in there, the interest rates have come down, things aren’t looking so good.” And I would contend that the interest rates weren’t that great when compared to inflation anyway.
We had this little burst of a period of time where interest rates were high compared to what they had been in previous years. And you can see 5% — even maybe a little bit higher than that — interest rates, but that was when inflation was very, very high. So you have a period where inflation is high, interest rates are very much correlated, or there’s a relationship between those two things.
So when interest rates are high, it’s typically because the underlying devaluation of the dollar or inflation is high.
That’s because if I am going to put my money off to the side in the sidelines instead of spending it, if I know that a year from now something’s going to cost 5% more than it did this year, I know that something is, let’s say $100,000 this year, I know next year it’s going to cost $105,000 and I know if I just stick my money into our mattress, I’m going to have to cough up another $5,000 in order to buy that item.
I’m going to go, “Well, wait a minute. I need to get something so that next year I’m not paying any more at least.” So I put it into an investment that pays 5%. I pull out the 105,000, let’s say, and let’s forget about taxes for a second, just to keep this simple.
And then I can buy that item that costs $105,000 and I’m no worse off. So hence, if we look at CDs, savings accounts, treasury bills, whatever have you, and we look at what the rate of return has been all the way back to the 1920s, you’ll see that it’s about 0.3% above inflation.
That’s the way it works. Now, if I look at that and go, “Well after taxes, what happens?” Well, I’m losing some money, but at least it’s better than poking the eye with a sharp stick. At least I got a little bit of interest on this thing, right?
Time Horizons
Now if we go, “Okay, well, I don’t necessarily need the money all back in one year,” now we start to stretch out to different time horizons.
What I mean by a time horizon is how long could I go without having any return and it’s not like the end of the world?
And that’s kind of what we’re looking at. “How long could I go? And I don’t feel like it’s been terrible?”
So if we look back to the Depression, you had the stock market going down 80%, right? And you go, “Oh man, if I needed my money inside of one year,” well, actually it took three years to get there, but if you take a three-year period and you go down 80% and you’re going to 1929, it goes down; 1930, it goes down; 1931, it goes down. And then 1932, it’s like, “Oh my goodness, when is this ever going to recover?”
Well, if I needed all my money back in that three-year period, I’m sunk. If I had $100,000 — you’re rich back then, really rich if you had $100,000 back then, but let’s just use it because we’re running with that number — and I have $20,000 in three years and I need to spend it all, well, I have really taken it on the chin. Right?
Now, technically during that period of time, you had deflation. So technically things cost less at the end of three years.
So it’s not as bad as it seems, right? It’s bad, let’s just face it.
But let’s say that I was going, “Well, I didn’t really need to spend this money for 10 years.” Now if we look from 1929 to 1937, 38 — a 10-year period right there — then I look at it and go, “Well, markets went way way down. But then they recovered.”
And you had in 1933 a pretty significant increase in value in the S&P 500 and in small company stocks. Then 1934 was a good increase, 1935 was a good increase, 1936.
You look at the recovery there, then you go, “Okay, well if I needed to spend all my money in 10 years, but I didn’t make anything, at least I didn’t end the period at a lower level.” And remember you still had deflation, so prices were lower 10 years later.
You look at it and go, “Okay, so it wasn’t the end of the world.” Maybe after inflation, I had eked out a little bit of a positive return. That’s what I mean by time horizon.
Now I’m using an extreme example like the Great Depression just because that is kind of what goes through people’s minds. “What if everything goes to heck in a handbasket?” Right?
The Best Mix for Taking an Income
Now, if I look at this thing and I say, “Well, you know what, I couldn’t go 10 years without a return. I need to go some period shorter, maybe six to nine years.” Then I could start to add a little bit of fixed income.
I could hold mainly stocks still. If I diversify really, really broadly and I own all the different areas of the market that I talk about on this show all the time. Now, if I really diversify broadly, I could look at a six to nine-year period of time.
And if you could have maybe six years, seven years where you have no return in that asset mix, again, not the end of the world.
This is what you’re always looking at: What’s the worst-case scenario based on history? That’s what we’re thinking about here.
Now, if you’re looking at retirement money, you’re probably screaming at the radio right now and saying, “Paul, Paul, Paul, Paul, I don’t need all my money. I’m not going to spend it all in 10 years. I’m not going to spend it all in six to nine years. I’m not going to spend it all.”
And there’s another time horizon of three to five years where you might have somewhere in the neighborhood of 50 to 60 percent stocks. “I’m not going to spend it all. I need to live off of it.”
Now that’s when you get into the second way of looking at this whole thing. You say, “Okay, what mix makes the most sense for taking an income?” So those mixes can vary.
You didn’t want a whole less than half of the money in stocks. Because again, if you’re getting overweighted in those fixed CDs and those types of things, like I said, you had one year where you had a really decent interest rate on those things, but after inflation, the rate of return was still zero. Because remember how bad inflation really was when you had 5% CDs?
The inflation rate was pretty nasty. Remember people looking for eggs and going, “What do you have to pay for a carton of eggs? Are you kidding me?” And you had inflation on so many different things that was so high that your rate of return after inflation was pretty nonexistent.
So what did happen during those periods of time? Well, you had stocks that did just fine. In 2002, it was rough for large U.S. stocks, but you had some areas of the market that didn’t do that badly.
They weren’t as hit as hard. But during 2003, you had wonderful run-ups, and 2024 so far, wonderful run-ups. In 2021, you had decent market conditions, and even 2020 wasn’t terrible, right?
Dividend-Paying Stocks
Now you look at that and you go, “Okay, so my return above inflation was significant in stocks,” and historically that has been the case. You go back 100 years and you see that with large U.S. stocks, about six to seven percent above inflation has been the return of large U.S. stocks, and about 9% for small companies.
Whereas go back to fixed CDs, right? Point two, 0.3, is not very good.
And what happens is people get into retirement and they go, “Well, I need to have income in retirement.” So what they do is they go, “I need to have income.” And then they look at products to provide that income, and this is where they get into real trouble. They go and buy dividend-paying stocks.
Well, what is a dividend-paying stock? It’s a company that has really high earnings compared to their price, which tells you that nobody’s worth it.
They don’t want to pay a whole lot. They don’t want to pay a whole lot for those earnings, and that must tell you something about the company.
If a company has high earnings but they have a low price, it must tell you that people don’t have a whole lot of confidence that those earnings are going to continue or those dividends will necessarily continue into the future. Now, that is where you get into value territory because typically your value stocks are those higher dividend-paying companies historically.
I saw an ad for a high dividend-paying small-cap fund, and I just had to laugh and I was like, “Oh my goodness, you got a small company that can’t think of anything better to do with their earnings than pay them back to the shareholders. They’ve run out of ideas.”
And I thought that sounds like a great concept for investing — not. Not such a good idea. This is funny, the investment ideas I see.
Using Annuities As Accumulation Vehicles
Then you see annuities and you go, “Well, annuity, they give the money to the insurance company and they take the risk of you living too long and you take the risk of you not living long enough and it’s an insurance contract really.” But people buy them and they use them as accumulation vehicles.
This is where I really have a problem with them. It’s because as distribution vehicles, there is a place for them, but people use them as accumulation vehicles.
They’ll use them and say, “Hey, this thing pays me a good return if the market goes up and it doesn’t go down as the market goes down.” Sounds really good. Matter of fact, sounds too good to be true.
So maybe you ought to think maybe it is too good to be true. That’s not a bad premise to go on.
And you go, “Well, wait a minute. How are they going to give me market returns if the market goes up and protect me against downside risk?”
Well, let’s go back and ask the question, what is the insurance company investing in? They’re investing in stocks, bonds, and real estate.
What are you protecting yourself against? Stocks, bonds, to a lesser extent, and real estate going down in value.
You’re going to protect yourself from something going down in value by investing indirectly into the things that could go down in value.
Does this make sense to anybody? And this is what people are being sold. It’s a product to give me income and as a deferred annuity. In other words, you invest in it and you hope it goes up in value so at some point in the future, you’re going to take an income from it.
That is why I am so against these products as accumulation vehicles. Now, there are some instances, albeit very, very limited, where it makes sense to use them as an accumulation vehicle, but it is not the ones you see being sold out there.
I am talking about using variable contracts. And I saw a piece of research the other day and it said only 15% of the contracts being sold — the annuity contracts being sold — are of that variety, number one, and a tiny fraction of that 15% are non-commission-based. Well, that knocks out just about everything out there being sold for me.
Now, I would use them if it’s non-commission-based, and I would use that type of contract because you basically have market exposure if you use the right type. But it’s almost never the one I see being sold. So let’s just perish that thought that investment advisors are using that. Okay? Now, taking an income is a process.
Now taking an income, I’m looking at it and going, “Okay, it’s not a product. It’s not dividend-paying stocks.” It’s not real estate investment trusts, REITs, or anything like that.
It’s not taking income off of fixed income like CDs or savings accounts. Because remember, my return after inflation is non-existent. I have to eat into my principle if I’m going to keep up with inflation.
That’s a problem because you don’t know how long you’re going to live. And the reality of it is we’re living longer and longer because medical science figures out some way to keep us fogging mirrors.
You don’t want to have that situation where all of a sudden now you’re out of money, but you’re not out of life. Okay? So the process is critical when you’re taking an income to make sure you get this thing right.
Your Investment Philosophy
Now, how do we go about this? Well, number one, we’ve got to make a decision as far as philosophy goes.
So you hear me talk about philosophy a lot of times and I ask, “What’s your investment philosophy?” And most people will say, “My philosophy is make money.”
No, that’s not an investment philosophy. There are two very distinct ways of approaching investing as I talk about: the idea that I can figure out which stocks are going to have higher returns than others or which markets are going to do better than others. Now, if I believe that I know which stocks are going to do better than others or which markets are going to do better than others, I must be more informed than the general consensus of all informed investors, which is a pretty lofty goal to be able to have that kind of information.
Because remember, every time I buy a stock, who am I buying it from? I am buying it from somebody that does nothing but trade that stock all day long.
It would be the height of arrogance to think that I can go in there and buy a stock in a company from somebody that does nothing but trade that stock all day long, and I can know better than they do what the future prospects of that company are. That would be pretty arrogant to think that.
Now we don’t think of it as arrogance. We just think, Hey, I’m so smarter than the average bear. And that’s all there is to it. But that’s how stocks work, how the stock market works.
You have market makers and those market makers hold an inventory in those stocks and whoever sells it for less, that’s who I want to buy it from and I want to sell it for as much as I possibly can. That’s what keeps markets on a level playing field.
Getting Pulled Into Predicting
Now what happens with markets in general is you have indexes and those types of things. And again, all of those underlying holdings are held by market makers.
So that’s why we don’t even try to play that game. Now, what I’m going to do is I’m going to take a quick break and after I come back from that break, I want to talk a little bit more about the process of taking income because I think it’s critical that you understand that there’s a tremendous amount of research.
Now, this philosophy thing I think is step one. If I take the philosophy that I don’t have to be better than the market maker and I don’t have to be able to predict where markets are going and I don’t have to predict which companies are better than others to be a successful investor, that ought to be a huge sigh of relief. I don’t have to do it.
Then why is it that we have so much research that shows that that is what we see? If that’s the case, why is it that so many people try to do it?
Why is it so hard for us to avoid doing it? And I think it really comes down to it’s just an ego thing.
I have studied these companies. I study the market, I read the news, and it’s my humanity that drives me to do this. I think I can do it. I think I can.
And Burton Malkiel from Princeton just put it this way, he says, “I truly believe that they’re not trying to rip off anybody.” This is a paraphrase. He says, “They really believe that they can do it. The evidence is, however, that they can’t.”
And even the academics that know this, I’ve seen some of the academics that I talk about here, you listen to them talk and you hear them go, “Hey, you know what? I think this is going to take off. I think this.”
And I’m like, “Wait a minute. You’re the person that wrote the book on how you can’t predict the future and you’re even being sucked in?”
It is super, super hard. It is super hard not to get pulled in.
Recognizing Your Biases
The thing is, I find myself, people ask me, “Hey Paul, what do you think the market’s going to do?” I’m like, you could probably twist my arm to get me to give you a prediction, but I know it’s nothing but just a shot in the dark.
I know that’s what’s going on. And I think it’s just that I’ve been doing this for so long and just recognize my humanity.
And then also having a psych background, and an education background, I recognize what’s actually going on and there are names for all of these propensities to try to figure out what’s going to happen next. And my biases, as we call them, my biases, my human biases, and it’s like I already have gone through it.
For example, you look at these little graphs and these pictures that they have on the internet, and yell, “This picture is not moving.” You’ve ever seen that on Facebook or something like that?
“This picture’s not moving.” And you swear your mind’s telling you this thing’s moving.
And we recognize that’s what our mind does, it plays tricks on us. And as long as I just recognize it and I go, “You know what? I’m not allowing this to happen,” then you can get over these biases. But it’s not easy.
I always say that “I” plus “E” is greater than “C.” Your instincts and your emotions tend to outweigh your cognitive part of your mind.
That’s what this show is about: helping you overcome that part of your mind that just says, “Hey, I think I got this,” and going, “Know what, if I understand more about investing, I won’t be tempted to try to do things that are just dysfunctional.” So after this, I’ll get more into the investing and as far as taking an income and those types of things and the research on that.
Diversification Within an Asset Category
Welcome to the Christmas season, and I hope you guys are just having a great time. Yeah. So getting back into the education mode, I think that the biggest question that we get from people really comes down to income in retirement.
I hear commercials for that kind of thing. I see financial firms doing this stuff all the time. They’re talking about, “We’re going to help you with your income plan.”
But then I look at actually how they’re doing it and I shake my head and go, “When I was a broker, yeah, I guess that’s the way we were taught to do it too.” It doesn’t make a whole lot of sense, but it’s a product approach because people just want a solution that’s product-based and nice and simple.
It’s really a process, I would say, process and end product. So if we look at annuities, that’s one thing I talk about an awful lot, dividend-paying stocks, real estate investment trusts, bonds, that’s another one I guess you could say that people are often taught to use.
So we look at how income is to be done. The research is pretty clear that diversification is really what we often talk about, and it’s almost an overused word. It almost is.
It is an overused word because there are two different types of diversification. There’s diversification within an area of the market, whether it be large U.S. companies.
Diversifying means owning maybe all five of the S&P 500 companies.
Russell 2000, you might be owning 2000 of those companies that are small companies. And then you’ve got Europe, Australia, Far East, you have 700-something companies in a typical international index. Now, of course, I always say index, but I don’t like using indexing in most asset categories because of the hidden costs of that.
But I’m just going to use that for the sake of this segment. If I’m looking at small international stocks, you might have 7,000 companies. So there are a lot of different companies involved, but that’s diversification within an asset category.
Individual Stocks
That would mean I don’t want to take risks that any single company or any group of companies could sink me because sometimes, I see people bring in their portfolios and they have individual stocks.
And if you were like a multi-billionaire, you might be able to get away with individual stocks because you could be your own mutual fund. But when you get down to it, you’re not a billionaire. Most of you out there are not.
And getting that level of diversification is impossible for a really small investor to be able to do because you might be, the example I might use is, let’s say you have the S&P 500 companies. And remember, I was naming different asset categories, and that had the least number of holdings, right?
Five hundred versus 2000 versus 700 versus 4,000. So if I look at that area and I go 500 companies and I trade in round lots, 100 share units, and I got $50 a share, let’s say, well, it’s 2.5 million just for that one asset category.
Now we’ve got small companies at 2000 and small international at 7,000 and something, and you start to get into the numbers where you’re at 20 to 30,000 stocks, you start to go, “Whoa, wait a minute, this is really tough.” And then when you’re trying to trade individual companies, off the market, block trades, securities, lending revenue, and those other things that I talk about that can offset expenses, you just forget about it.
So you look at what we can do as individuals, and it’s just simply impossible to be able to pull off what a big institutional investor will do.
That’s why you find that even huge pensions use commingled investment vehicles, and that’s the technical term, where you mingle your assets with other investors and other pensions in order to get the economies of scale and the efficiencies that you find in the institutional world.
Expected Return
So anyway. But I bring that up because I see that so often, especially net high net worth because investment firms are like, “Hey, we’re really sophisticated. We’ll set you up with your own mutual fund.” And I just shake my head and you go, Yeah, right.
And usually what they’re engaging in is some sort of stock picking process, which we know that it’s like, in any 15-year period, it’s something like 7% of investment managers beat what the market does on its own. Well, you might as well just be gambling and throwing darts because it’s not the same 7% the next period of time.
But it sounds sophisticated. It goes with what we think, we ought to have somebody really skilled.
This person’s really smart and they seem to know what they’re doing, and they just don’t know the statistics. They don’t know what an uphill climb that they have to try to beat what markets do on their own.
And it’s because it’s the belief that the returns come from finding stocks that are selling for less than what they’re really worth. Now, if we look at, let’s say, taking an income, now when I’m taking an income, I look at, well, what is my expected return of large U.S. companies? About seven above inflation.
What is it for small companies? About nine above inflation.
Now you notice I didn’t say the gross return, which is the return before inflation. I used the after inflation because remember, inflation can change from time to time. Interest rates on CDs were very high after inflation.
A 5% CD rate sounds really good, but when you look at it after inflation and see that it was still like one or less than one, then it doesn’t seem so great.
So I always try to do that because it tempers some of the expectations when you use after-inflation rates of return. Now, if I am looking across the board at all the different segments of the market that I might have, I have an asset category with a 7% above inflation expected return, nine above expected return. I got another asset category that might be in the neighborhood of 10 or so.
So I look at these various asset categories and I say, “Okay, I’ve got some bonds in there with the expected return of only 1% above inflation or 2% above inflation.” Now I can look around and I go, “Okay, I got all these different things that historically have got a return that’s above inflation, but some of them much higher than others.”
What did I have to do to get those higher expected returns? You notice I always say “was expected.” Because if we look back over the last 100 years and say, “What’s the long-term expected return of large U.S. stocks?” It’s 10% before inflation.
Now how many years was the return? Actually, 10. Almost never. So that’s why you hear me say “because the return is expected,” but it is all over the place.
Long-term returns have fallen within very, very small tolerances of that return. So that’s why we use the term “expected return.” Okay.
The Process of Taking Income
Now, if I’m taking income, I’m always looking around at what just did best in the most recent period of time. Did large U.S. companies?
Well, great, if they did, I’m going to take income from there. I’m not going to go put more money there.
That’s the mistake I see a lot of people making right now. They’re chasing that return. They’re going, “Hey, that area is doing really well.” And I go, “No, it did well,” past tense.
Don’t get fooled by that. So I don’t go and put more money there, but I take some income off of there.
And then next year, if it’s a small company, I’ll take an income from there. Oh, if it’s small international, I’ll take income from there. If it’s bonds because all the stock asset categories go down, I’ll take income from the bonds. I don’t care.
Whatever has done well, that’s where I’m going to take income from. And that’s why I call it a process of taking income.
And you look at, okay, does that fit in with the academic research? Yeah. It does really, really well because what we’re trying to do is we’re trying to make sure that a certain percentage of my portfolio is in a specific asset class.
Let’s say 7% is supposed to be in large U.S. If all of a sudden large U.S. does better than everything else and now it’s taking up 9%, well, it’s overrepresented. My risk is higher now. I don’t want my risk higher.
I’m going to need to sell some of that stuff. I’ll take it back down to seven. And then I go, next year what happens? And it might be a different area, but that’s the process aspect of it.
Capturing Market Returns
Now, what happens in the investing industry is, so often, the product aspect of it just adds a lot of expense and, a lot of times, a lot of risk too. If you think about it, if you’re owning nothing but a dividend-paying company, you’re owning all distressed companies to get dividends to live off of it.
Does that make a whole lot of sense that you have distressed companies in an older person’s portfolio? I don’t think so.
But people think, well, they’ve paid dividends in the past. Again, what are we looking at? Past performance.
What do we know? We know that past performance is no indication of future performance. Now, I don’t like the way sometimes it’s worded. “Past performance is no guarantee.”
It almost implies that it can be a good predictor, but we just know it just isn’t. So that’s what we’re looking at there.
We’re looking at, can we capture market returns? How do we best capture market returns at the lowest cost? Now, cost isn’t the only factor, obviously, because some asset categories are higher cost to capture than others.
And there are benefits and there are things that you can do to offset those expenses that may be more beneficial. In some asset categories, less liquid markets. Like for example, when you’re dealing with momentum expenses, momentum effects, and the ability to offset expenses that way, or securities lending revenue and ways to offset expenses or block trading.
There are a lot of different things that can be done to help offset expenses that can vary based on the asset category.
I talk about expenses and things like that, and it can be so twisted that people can be confused so fast. And that’s why I just tell people, “This is why we represent our clients, not the investment companies.”
Because I hear it like insurance agents. They represent an insurance company and what they’ll say is, “Oh, don’t worry about expenses. You don’t pay us, the insurance company does.”
And I just shake my head and go, “How did the insurance company get their money?” Are you kidding me? That’s what you’re telling people?
That’s shameful. The insurance company got their money because you put your money with them, they took money out of your money, and they paid it to the advisor.
Don’t tell me that the insurance company paid the commission out of their own good hearts and out of their own coffers. No, that’s not how it works. But you see, I see that stuff on people’s websites. It makes me nuts.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
