Allan Roth: 'I Embrace Dumb Beta'

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Our guest on the podcast today is Allan Roth, one of the pre-eminent hourly financial advisors in the United States. After a career in corporate finance and as a consultant for McKinsey and Company, Roth started the holistic financial advisory firm Wealth Logic in 2003. Wealth Logic focuses on financial planning and ultra-low-cost simplified investing; his firm's motto is "Dare to be Dull." In addition to working directly with clients, Roth is a prolific writer: He's the author of How a Second Grader Beats Wall Street, which was published in 2009 with the second edition in 2011, and he's also a regular contributor to Financial Planning magazine, Advisor Perspectives, ETF.com, and AARP.

Background Information • Allan Roth bio • How a Second Grader Beats Wall Street • Allan Roth's archive for Financial Planning • Allan Roth's archive for Advisor Perspectives • Allan Roth's archive for ETF.com • Allan Roth's blog on AARP.org Advice Business/Choosing an Advisor • "Save $52,000 on Financial Advice," by William Baldwin (Forbes, May 10, 2016) • Vanguard Personal Advisor Services • "The CFP Board 'Inexcusably' Protects Certificants," by Allan Roth (Financial Planning, Aug. 2, 2019) • "Does the CFP Board Choose Advertising Over Enforcement?" by Allan Roth (Financial Planning, Sept. 24, 2018) • "Looking for a Financial Planner? The Go-To Website Often Omits Red Flags," by Jason Zweig and Andrea Fuller (The Wall Street Journal, July 30, 2019) • "CFP Board to Create Tax Force to 'Strengthen and Modernize' Enforcement," by Brian Anderson (401(k) Specialist, July 31, 2019) • "CFP Board Responds to The Wall Street Journal" (cfp.net, July 29, 2019) • "How to Choose a Financial Planner," by Allan Roth (AARP Magazine) • Finra BrokerCheck

Asset Allocation • "William Bernstein: If You've Won the Game, Stop Playing" (The Long View podcast, May 7, 2019) •"How to Set Your Asset Allocation," by Allan Roth (The Wall Street Journal, Dec. 2, 2016) • "The Risk of Taking a Risk-Profile Questionnaire," by Allan Roth (CBS News.com, Aug. 21, 2009) • "Financial Advisor Exposes His Own Portfolio," by Allan Roth (AARP.org, June 15, 2015) • "Mind the Gap 2019" by Russ Kinnel (Morningstar.com, Aug. 15, 2019)

Investment Selection and Portfolio Management • "Why CDs Can Still Be Better Than Bonds by Allan Roth," by Allan Roth (CBS News.com, Aug. 20, 2013) • "Municipal Bonds and the Industry's Dirty Little Secret," by Allan Roth (CBSNews.com, June 20, 2010) • "4 Reasons Not to Load Up on Muni Bonds," by Allan Roth (aarp.org, July 14, 2015) • "At Last, a Tool Muni Investors Sorely Needed," by Allan Roth (CBSNews.com, July 8, 2014) • Municipal Bond Price Discovery Tool • "A Seer on Banks Raises a Furor on Bonds," by Nelson D. Schwartz (New York Times, Feb. 10, 2011) • "Low-Risk Inflation Protection from Uncle Sam," by Allan Roth (aarp.org, Feb. 24, 2017) •"When Will Smart Beta Be Smart?" by Allan Roth (ETF.com, July 9, 2019) • "Boosting Returns with Rebalancing" by Allan Roth (ETF.com, March 19, 2018) • "Give Due Care to Your Cost Basis Elections," by Christine Benz (Morningstar.com, Feb. 27, 2013) • "Advanced Strategies for Investment Taxation" by Allan Roth (Advisor Perspectives, May 6, 2019) • Smart Beta (Research Affiliates) • "How Can Smart Beta Go Horribly Wrong" by Rob Arnott, Noah Bech, Vitali Kalesnik, John West (Research Affiliates, Feb. 2016) • "The Arithmetic of Active Management," by William Sharpe (Financial Analysts Journal, January-February 1991) • "Fidelity Zero vs. Vanguard: Which Index Fund Is Better?" by Allan Roth (Financial Planning, Aug. 14, 2018) • "At Vanguard, Customer Complaints Rise Along with Assets," by John Waggoner, (InvestmentNews, Feb. 16, 2017)

Retirement Planning • "Is the 4% Rule Still Safe for Retirement Planning?" by Allan Roth (Financial Planning, May 8, 2019) • "Estimating the True Cost of Retirement" by David Blanchett (Retirement Insight and Trends, June 30, 2015) • "Why So Critical of Annuities?" by Allan Roth (CBSNews.com, Sept. 17, 2009) • "My 3 Most-Often Recommended Annuities," by Allan Roth, aarp.org, Dec. 20, 2016 • "Reducing Retirement Risk with a Rising Equity Glide Path," by Michael E. Kitces and Wade D. Pfau (Journal of Financial Planning) Influences • Prospect Theory • Predictably Irrational by Dan Ariely • "What I, and Millions of Others, Owe Jack Bogle" by Allan Roth (Financial Planning, Jan. 16, 2019) • A Random Walk Down Wall Street by Burton Malkiel • Bogle on Mutual Funds by John C. Bogle

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.

Jeffrey Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Our guest on the podcast today is Allan Roth, one of the pre-eminent hourly financial advisors in the U.S. After a career in corporate finance and as a consultant for McKinsey & Company, Allan started the holistic financial advisory firm Wealth Logic in 2003. Wealth Logic focuses on financial planning and ultra-low-cost simplified investing. His firm's motto is "Dare to be Dull." In addition to working directly with clients, Allan is a prolific writer. He's the author of How a Second Grader Beats Wall Street, which was published in 2009 with the second edition in 2011. He's also a regular contributor to Financial Planning magazine, Advisor Perspectives, ETF.com, and the AARP Magazine.

Allan, welcome to The Long View.

Allan Roth: It's an absolute pleasure to be here. Thank you, guys, very much.

Benz: Allan, you have built a thriving financial-planning practice with a business model that some advisors argue can't work. So, you charge clients on an hourly basis. Did you start out charging clients by the hour, or did you start out with some other business model?

Roth: I started out hourly. When I hit my midlife crisis and left the corporate world and wanted to do something different in financial planning and investment advisory, I looked at every profession I know--doctors, lawyers, accountants are fee for service hourly, and that's the model that I started with, and still with, and I'm committed to.

Benz: So, some advisors assert that the hourly model is fine for less sophisticated or maybe less wealthy clients, but that higher-net-worth clients should pay a fee based on their assets under management. Your average client, you told me, has $10 million in assets. So, clearly, you don't agree. Let's talk about that, about the right advisor model for clients who have high net worths.

Roth: Yeah, well, that argument just doesn't hold any water. I mean, if I'm charging an hourly rate, and my rate is not cheap at $450 an hour, I can't help somebody with $10,000 in assets. But you know, somebody with $50 million, for instance, who just sold their business, that's an incredibly simple plan. There aren't tax ramifications to get out of where they are, et cetera. So, I argue it's just the opposite, that the larger the portfolio, the more sophisticated the investor, the better an hourly model works.

Ptak: You screen clients to ensure that they're a good fit for you. So, what are qualities that would disqualify me if I were a perspective client as a potential client in your practice?

Roth: Well, if you thought you were smarter than the market, you wanted some great alternative mutual funds that have performed well in the last couple of years; you wanted to know what the hot stocks were; you don't know what an index fund is, let's say, or the impact of costs and performance. Those would be certain things that would say I'm probably not a fit for you. Another thing, because I have zero assets under management, you know, I'm only right for somebody that wants to take over their portfolio and understand it and rebalance and do certain things. So, that's the more sophisticated investor. If somebody simply wants to go ahead and manage my portfolio, I'll typically recommend a low-cost advisor such as the Vanguard Personal Advisor Services.

Benz: I want to talk about some pieces that you've been working on around the idea of CFP accountability. You were ahead of the curve in terms of shining a light on the fact that the CFP Board, the Certified Financial Planner Board, wasn't adequately disciplining CFP certificants who had already faced disciplinary action from some other body. You wrote two pieces. Jason Zweig wrote a piece. Let's talk about that and what the CFP Board has said to you in response, because you've been pretty vocal in your criticism.

Roth: Yeah, I'm not happy about this. I got my CFP license because I wanted to be held to a higher standard, et cetera. But many, many years ago in my practice, I saw a CFP with fiduciary responsibility selling a couple of annuities to a client and he couldn't make up his mind whether to charge commission or a percentage of assets. So, he did both. The fees were 5.29% a year. The facts were so horrible that the broker-dealer, an insurance company, offered a very generous settlement, which the client took but wanted to file a complaint against that advisor. And the CFP Board first lost the complaint and then found no conflict with fiduciary responsibility. So, that's where it all started.

And I wrote an article for AARP on it many, many years ago. And over the years, the CFP Board has been advertising a higher standard. And I'd asked every year Kevin Keller, the CEO of the CFP Board, that I did not want my money to go to advertising, I want it to go to enforcement. And I've been tracking all along the way that when the CFP Board takes action, it comes after Finra or courts or other regulators have taken action. So, it's a lower standard. So, I wasn't shocked at all and had been working with Jason Zweig on this when they found 6,000 some odd people with clean records by the CFP Board having had actions taken against them by Finra and other regulators. So, I'm very disappointed. Advertising a higher standard but not enforcing it is bad for the public and is not a 501(c) charitable mission.

Have I stated my views strongly enough?

Benz: I think you have.

Ptak: Isn't part of it prevention, though, maybe at the front end? Making sure that they are qualifying those into the profession who truly deserve to have the designation versus--I know, enforcement is obviously a very important piece of it, and you want to make sure that it's as robust as possible in sending a message to CFPs that they need to uphold the standard. But do you think that there's work that ought to be done at the front end just to make sure that there's a weeding out process that goes down that mitigates the risk that someone, once they attain a designation, they do something that's not in the best interest of their client?

Roth: Yeah, I mean, sure. I mean, go to BrokerCheck before admitting the person as a CFP, or at least disclosing on the website that "Allan Roth paid a $10,000 fine for taking a client's money" or something like that. It certainly needs to be disclosed. Unfortunately, the CFP Board and management seems to be more enamored with growth. And I argue that Jack Bogle, the founder of Vanguard, always said growth was never the goal, trying to put the client first and do something good for the client resulted in growth. And I think the CFP Board has it backwards. They're trying to grow, bring more money in, and that's going to backfire. Whether or not I'll renew my CFP license next year remains to be seen.

Benz: Do you think advisors have enough accountability in general? In my experience, consumers seem really confused about, A, how to select an advisor, but also on an ongoing basis, once they have, what they should be looking for in terms of assessing whether that person is doing a good job for them. Are there things that we could do to help light things up a little bit for consumers?

Roth: Well, you know, it's hard. I mean, when you select a doctor, you don't know what the outcomes …

Benz: True.

Roth: … et cetera. You can see what people have said about the doctor. But that's kind of bedside manner versus technical skills. So, I would start with the very low bar, go to BrokerCheck, whatever and make sure there haven't been any disciplinary actions or complaints. But you're asking an advisor how to select an advisor. So, I've got a little conflict of interest here. But I would say, you know, number one, are they talking about harnessing the entire market with lower costs and rebalancing? Or are they talking about, "Hey, Christine, it's not the costs that matter. It's the return. We're going to pick some investments that are going to beat the market. And these are very complex strategies that I'm going to put you in. You won't understand it. Trust me, I understand it." That's a warning sign. Simplicity is almost always better. And no one cares more about your money than you do. So, make sure that you understand the philosophy. Make sure you can explain that philosophy to any 8-year-old.

Ptak: And so, that investing message--you know, "I can go out and earn you a certain return" and that being a warning sign--seems like it'd be an effective screening-out process. What about when it comes to sort of the planning and advice dimension, maybe sort of stepping away from how one would build a portfolio and what sort of outcomes you would achieve. If you've got somebody that's trying to take your measure, let's say, to make sure that you can help them to plan effectively for the future. What have you found has worked best between you and your clients in aligning expectations and ensuring that they know that they're going to get what they're signing up for?

Roth: Well, I mean, you want to make sure that the advisor knows what your goals are, whether it's to fund college or be financially free, which is the ultimate goal, is to have enough money to do what you want with the rest of your life. Are they talking about that? Are they designing things that are tax-efficient in terms of asset location, et cetera? Are they giving you reasonable returns that are going to get you there? Are they talking about things like in retirement where you withdraw your assets from, paying taxes sooner at lower rates than later at higher rates, things like that? I've always said investing is simple, but I never said taxes were and withdrawals have tax ramifications.

Benz: Switching over to investing, you've hinted, and I think if people are familiar with you, they know that you're a big proponent of very simple low-cost index-focused portfolios. But before we get into the specifics of investments, let's talk about asset allocation. I know that you're a big believer in sort of the Bill Bernstein approach to risk management; basically, don't take any risks that you don't need to, or if you've won the game, quit playing. Is it sometimes a challenge to bring clients around to that way of thinking to get them to derisk their portfolios after they've done well with stocks throughout their investment careers?

Roth: Yeah, it is. I tell clients that the asset allocation, how much risk they take, what percentage in stocks versus cash and bonds is the second most important decision that they're going to make. And we spend a whole lot of time on that. So, the first part is understanding the clients' willingness to take risk. And that's typically done with a risk profile questionnaire, which I think are actually worse than worthless because when stocks are near an all-time high, we think we can take a lot of risk, then stocks plunge and suddenly we become very risk averse. So, you've got to try to understand that, and I try to help the client imagine the pain they would feel with another 50% decline like we've had twice since 1999, or even a Japan-like scenario.

Second is the need to take risk, and that's what you mentioned--Bill Bernstein, when you've won the game, quit playing. That doesn't mean get out of stocks. But remember that money is stored energy, it's freedom. It's the ability to do what they want with the rest of their lives. Why take risks that they don't need to? And then, sometimes I have to negotiate with my clients. For instance, if I strongly believe they shouldn't be more than 60% stocks and they want to be 70%, then what I'll do is, say, let's start with 60%, and then when stocks are down 20% or more from today, you can go up to 70%. And some people said, I'm trying to time the market, and I said not at all. What I'm really trying to do is test the clients resolve. And guess what, when stocks are down 10%, usually that appetite has gone away to increase risk.

So, the most important decision is committing to stick with an asset allocation. I can't predict the markets, but people are predictably irrational, and Russ Kinnel's work on "Mind the Gap" shows some of this, that people tend to want to load up on stocks when they are at an all-time high and then sell when they've gone down. And by the way, I've seen a lot of data that showed in 2008 and 2009 that advisors did it probably worse than individual investors.

Ptak: You used the word negotiation before, and so I would imagine there is always a push-pull with a client. Some of them may be more risk tolerant, forgive the word, than others. Do you find that there are trends across your client base where maybe the clients want to risk up a little bit more than you would recommend, so the negotiation is to bring them lower, or conversely, do you find it's the opposite, and does it vary at all depending on maybe sort of stage of life or their financial circumstances?

Roth: Well, yeah, it all varies. I mean, somebody young needing to save a lot of money has a higher need to take risk, and as long as they have that willingness to take risk, we can get to a fairly aggressive portfolio. But when stocks are on a tear, and typically on average, helping a client reduce risk in 2008 and 2009, I was helping a client take some risk because stocks were a Ponzi game, et cetera, and I was saying, "Well, what kind of phone do you have? Where do you get gasoline? What kind of chocolate that you eat? Capitalism is going to survive."

So, yeah, and when times are good, I'm typically trying to get the client to take less risk. When times are bad, I'm trying to get them to take more risk. But it varies across the board. Sometimes I have clients that I'm comfortable being more than 100% in stocks, sometimes I have clients, I don't want to be more than 10% in stocks.

Ptak: With bond yields being as paltry as they are, do you view fixed income as the same risk mitigant that maybe it would have been 10, certainly 20, 30 years ago, when yields were more inviting? Or do you find that in some of these cases you're directing clients to maybe use cash in lieu of fixed income, just because that way they don't take on the interest-rate risk?

Roth: Well, those are two different questions. First of all, bonds are nowhere near an all-time low. You mentioned 30 years ago, I could get a CD paying 12%, which meant after taxes, I earned 8%, or a high-quality bond fund. Unfortunately, inflation was about 15%. So that means, after taxes and inflation, I had lost a lot of money. So, bond rates are much better today than they were back then. And I'm a strong believer that take risk with stocks, and the purpose of the bond, the fixed income, is to be the shock absorber of the portfolio.

Now, your second question is, because the yield curve is now inverted, meaning that you can earn as much with short-term money as going out five, six years, or maybe a little bit more, do you shorten your investments? And there are pros and cons on that shortening the duration of the bonds or the CDs. The strategy that I like happens to not be a fund. We don't know what interest rates are going to do. The top economists have called the direction of interest rates correctly, meaning the 10-year Treasury, 30% of the time less than the coin flip.

So, a strategy that I use, that I've spoken to Christine about, are going--you can't do this through a brokerage firm--but going directly to a bank, such as Ally Bank, and buying a five-year CD, which as of yesterday was paying 2.65% and had a five-month penalty. So, that if rates do increase, and when rates increase, bond and bond funds decrease, you pay a very small penalty, in this case, it's 1.1%, to get out of the CD and reinvest it at the higher rate. So, you can kind of have your cake and eat it too. And this is only available to small investors because you want to stay FDIC insured. So, you know, for hedge funds with billions of dollars, $250,000 is rounding error.

Benz: So, for higher-net-worth clients like yours, a standard prescription for the bond piece of their portfolios would be a portfolio of individual municipal bonds. You've been writing about this recently about the shortcomings of muni bonds compared to even taxable-bond products. So, let's talk about that. Let's talk about some of the limitations with munis in client portfolios.

Roth: Yeah. I have my clients invest no more than 20% in muni-bond funds. And that happens to be roughly twice the market cap of investment-grade bonds. And my argument for the longest time was, they have risk because companies almost always got rid of their pension plans, their defined-benefit plans and went to defined-contribution 401(k) plans, but states and municipalities still have those pensions out there, and healthcare obligations. And even with a 10.5-year bull market, the underfunding is still very large. So, I'm not predicting, I'm not being a Meredith Whitney who went on CBS saying there was going to be a massive default in the next six months. But if stocks don't have a great next 10 years, there could be some correlation between stocks and muni bonds that has never been there before. Because if stocks don't do really well, those unfunded pension liabilities are going to increase as all the baby boomers have retired and those payments are going out and there could be some systemic stress.

Now, there's a second reason and that is, I just looked at people who have flocked to munis so much that they've driven the yields down. And at any tax rate, people can make more money with a government bond or a Barclays Agg high-credit-quality bond fund after taxes than by owning strictly munis, so they can have more diversification and a Barclays Agg is roughly 64% backed by the U.S. government. Do you want me to get into the muni-bond delusion, which is even worse?

Benz: Sure. Touch on that.

Roth: OK. A lot of brokers will tell clients, "Why buy a muni-bond fund, like Vanguard's (I think we looked at yesterday it was, if my memory is right, yielding somewhere around 1.55%) when we can get you munis yielding 4% or 5%." And it goes like this, we buy the muni at a 10% premium, so $110 for every $100, and let's say, it's yielding 4%, a 4% coupon. Now, if you think about it, it's going to mature, or be called, four years later at $100. So, that difference of $10 over four years for getting time value of money, roughly 2.5 of that $4 is just return of your own principal. Furthermore, the broker is probably charging 0.5% to manage that portfolio, so that lowers it to more like 1%. And why that's legal, I don't know. I've actually met with Lynnette Kelly, the executive director of the Municipal Securities Rulemaking Board. As you can probably tell, I am not enamored with regulators or the CFP Board, but the MSRB, Municipal Securities Rulemaking Board, is a self-regulatory organization. And guess what, when you regulate yourself, you generally tend to come up with rules that are good for yourself.

Benz: You're a big believer in rebalancing. But you've talked about how tax management is a big part of your value proposition as an advisor. So, let's talk about how those things come together that presumably if you have clients who have most of their assets outside of tax-sheltered accounts, how do you help them, say, at this juncture, where maybe they're looking at portfolios that are overly equity-heavy given where they want to be? How do you derisk that portfolio in a tax-efficient way?

Roth: Well, I mean, taxes are very, very important, and all things being equal, you want to be tax-efficient, but you don't want taxes to drive the overall portfolio. So, in that scenario, where the only way to rebalance--number one, is that they are in the savings mode, they can put more money into whatever asset classes done the worst. But if you have to pay some taxes to get back to your risk allocation, I would say, do it, take the assets that have the smallest tax ramifications rather than use an average cost basis. It's a pain in the tail. But you want to pick the specific lots that have the smallest tax consequences. But oftentimes, more often than not, people have a Roth account, they have a traditional account, they have taxable accounts, that we can rebalance, or have them put new money in without having to pay much in the way of taxes. But a lot of people in 2007 didn't want to rebalance because of tax ramifications. So, guess what, the market rebalanced for them. That's when they got out of stocks, which was the wrong time.

Ptak: What do you give clients in terms of asset allocation that they couldn't get with a very basic target-date fund? For instance, when it comes to adjusting risk exposures upwards or downwards, what are some of the things that would really distinguish your approach versus maybe something they could grab from off the shelf?

Roth: Well, I'm a big believer in target-date retirement funds, because most people don't have any money--significant money--saved up outside of their 401(k) account. So, a low-cost, Vanguard-type of target-date retirement fund is just brilliant for them because it's going to harness the power of inertia and rebalance for them and the like. The reason I don't use target-date retirement funds is asset location. For instance, my own portfolio, I am 45% in stocks, but if you looked just at my IRAs and 401(k)s, you'd see I am 100% in fixed income, and you'd say Allan is weenie. He doesn't believe in stocks. If you looked at my taxable accounts, you'd say, "Wow, Roth is a big risk-taker." So, what I'm doing is locating the assets to be most tax-efficient, which a target-date retirement fund can't do that for someone who has assets in different wrappers such as Roth tax-deferred and taxable. And then, finally, while I'm a big believer in these target-date funds, it doesn't necessarily mean that your situation--I may retire in 10 years, but I don't think I should be in a target date 2030 fund. It doesn't happen to fit my overall risk profile.

Benz: You like the very basic index funds, the total market index trackers, whether for U.S. equity, international equity, or fixed income. Are there any other assets that are in your tool kit in addition to those big three?

Roth: Yeah, I think I mentioned CDs. I have more money in CDs than I do in bond funds. I think that a REIT index fund very different than a private REIT with a 10% commission because most real estate is not owned by public markets and correlations with stocks are lower, not negative, but lower that there's an argument to have some REITs but it also depends on--if you live in California and you have a $4 million starter home, which I have some clients that have, probably don't need more real estate, et cetera. Precious metals and mining, again, very, very low correlations, but they've had horrible performance, and I think no more than 1% of the population should have precious-metals and mining fund.

Benz: And in what allocation? What would be sort of the range that you would use for …?

Roth: No more than 1% of the portfolio. It's tiny. Very, very tiny.

Benz: OK.

Roth: Now, a lot of alternative investments--market neutral, long-short funds, managed futures--not a penny has ever been made in the aggregate in the futures market. It's a zero-sum game before costs. So, I love the fact that they have low correlation to stocks, but they also have low to negative expected returns. If I took half my money, went to Las Vegas and gambled it, there's no correlation with the U.S. market. But it doesn't mean it would be a very good investment strategy. And Christine, you've met my wife, she would kill me if I did that.

Benz: How about TIPS? Do you see a role for them in client portfolios, especially …?

Roth: Oh, yeah. Absolutely.

Benz: OK.

Roth: TIPS, but the strategy that I use to protect for higher inflation and higher interest rates is the CD strategy with the early withdrawal penalty. But if a client doesn't want to do that, because it does take some time, then a TIPS would be a good strategy. And I argue that a Treasury Inflation-Protected Security TIP is the least risky asset on the planet because it's backed by the U.S. Treasury and what really matters is our real earnings versus inflation. But if that were true, then TIPS should have less volatility than the traditional Treasury, and it's not true, there's more volatility. And I argue that people are happier earning 10% when there's 12% inflation than earning 3% when there's 2% inflation. So, we aren't logical about that. So, TIPS are only good for someone who's going to stick with it, because they are a whole lot less volatile than a total stock index fund but more volatile than, let's say, a total bond fund.

Ptak: Has your approach to helping clients manage inflation risk evolved over time, given just how benign inflation has been over the past really couple of decades here? It's been fairly tepid. So, do you find that perhaps whereas you might have emphasized that heavily in the past with clients that perhaps it's a lesser emphasis now or do you think that it's the sort of thing that we shouldn't sleep on that it will rear up as time goes on again?

Roth: Not really. I mean, I don't mean to brag on your podcast, but I am really good at predicting the past. It's the future, that's a whole lot harder. And none of us really knows what future inflation is going to be. I for the longest time thought I was uniquely qualified to forecast inflation wrong, but it turns out that I'm up there with the top economists. So, we don't really know what inflation is going to be. But 30 years ago, I would have said your best chance to beat inflation would be stocks and real estate, and bonds should be the more stable portion of it, and I think that is the same today. Now, the tax ramifications are less, because remember, if interest rates do rise, that's actually bad for savings, et cetera, because that means after inflation and taxes the return is likely to have gone down.

Ptak: Do you think there could be some performance-chasing going on in the realm of total market index funds? In other words, could investors maybe have unrealistic expectations that relative performance will always be as strong as the total U.S. stock market has been? I mean, those types of index funds have really killed it over the past 10 years or so. So, do you think that there's some chasing that could be going on?

Roth: Absolutely. Recency bias is alive and well. I mean, stocks plunge, and we think it's going to plunge further. Stocks surge, we think it's going to continue to go up and with the longest bull market in history, those painful memories of 2008 and early 2009 are long and forgotten. So, that means, yeah, probably people have higher expectations of stocks than is likely to happen going forward. I don't think that indexing itself is the problem. For instance, five years ago, I couldn't be at a conference and go more than 60 seconds without hearing smart beta, factor investing--and money pours into part of the market, and that means, all things being equal, it's likely to underperform going forward, it's not a for-sure thing, and small-cap value has underperformed large-cap growth I think the last time I looked at Morningstar over the last five years by almost 10 percentage points a year. So, I'm always concerned when money pours into part of the market. I'm less concerned when money pours into a nice, boring, dumb-beta, cap-weighted total stock fund or total international stock fund.

Benz: You indicated that you're a cynic of so-called factor or strategic-beta products. Are they any more attractive to you, given that costs have come way down? Or are you opposed to any and all active bets?

Roth: You know, I think one of the tenets I live by is I am not smarter than the market. So, factor investing is a viable active strategy for whenever you pick parts of the market, whether it's small cap, value, momentum. There's over 500 different factors out there now that almost all come from performance-chasing, and Rob Arnott himself, who I kind of consider the father of smart beta said, wrote a paper, where smart beta can go terribly wrong. So, do I think that smart beta is going to underperform as much as it has over the last five years? Probably not. But again, those factors, the original small-cap and value factors, were never billed as a free lunch. Dimensional Fund Advisors, which is a great fund family, and I give them all the credit in the world for saying it's not a free lunch, it's compensation for taking on more risk.

So, I embrace dumb beta, just owning the entire market, and there's something really cool about a total stock or total international stock index fund, because if I own that with a 0.04% expense ratio, then I'm guaranteed to beat the average dollar invested in U.S. stocks, because I own the entire market and I owned it at lower costs than most other people do, whereas was when you go with smart beta, when you go with factor investing, you may do better, you may do worse. But I found it's very appealing with clients when I can tell them I can guarantee them mathematically, William Sharpe's "Arithmetic of Active Management," a really brilliant three-page, very easily readable paper, proves that that has to be.

Benz: You've long recommended Vanguard's products to your clients. Are you swayed by any of the competitors that have actively been bringing lower-cost index products to market?

Roth: Well, first of all, I give Jack Bogle not only credit for saving people billions and billions of dollars in fees for Vanguard, but in also forcing competitors to lower fees. So, I think it's wonderful whenever an investment advisory firm or a brokerage firm, mutual funds, et cetera, ETF lowers fees, it's a wonderful thing. Now, what are they doing? They're creating loss leaders so they can sell more-expensive products--annuities, managed portfolios, et cetera. Whereas Vanguard, everything is cheap so that they don't have the expensive product to cross-subsidize. So, I trust Vanguard a bit more. Within the tax-deferred or tax-free account, I'm more likely to recommend a non-Vanguard sort of fund, because if they later raise fees, then they're not caught with tax consequences. But I do trust Vanguard more. But I've got to say service at Vanguard has--there's been a lot in the media and I kind of agree with that. And oftentimes, by the way, I can have a client custody at a Schwab, a Fidelity, wherever and then buy the Vanguard ETFs, which now have lower expense ratios than many of the Vanguard mutual funds, which has just changed over the last several months.

Benz: Well, I wanted to ask about that, traditional index fund or ETF, how you decide for your clients. Can you walk us through that real briefly?

Roth: Generally speaking, at the custody of Vanguard, I recommend the mutual fund, which is just a different share class of the same fund that Vanguard also has the ETF. So, they're just as tax-efficient. And until recently, they always had the same expense ratio. But the thing that I liked about the mutual funds that were better is number one, dividends get reinvested more quickly, you can buy a fixed dollar amount, you can do automated dollar cost averaging. Later, you can always convert to the ETFs. So, I've always--these are really immaterial reasons, but the mutual index funds, in my opinion, were superior, not so much that if the client wanted to custody at a Fidelity or a Schwab and TD Ameritrade – and oftentimes, by the way, they will pay an acquisition fee to the client of $5,000--as much as $10,000--for clients to move money in, and then we use the ETFs. But again, the decision between ETF or mutual fund when it comes to Vanguard index funds is fairly immaterial.

Benz: I wanted to talk a little bit about retirement planning, Allan. You've argued that a 4% starting withdrawal rate is too aggressive. Is that forever or just right now, given starting bond yields being so low and modest expected equity returns?

Roth: When I run a Monte Carlo simulation with more muted returns of, let's say, 5% real for stocks, and many people think that that's too high, and 1% real for bonds, I get about a 90% probability of it lasting 25 years of a balanced portfolio at about 3.5%. So, I do think it's a bit aggressive. And then as I tell my clients, the cost of--I'd rather have a client come back to me in 10 years and say, "I've got too much money, what do I do?" versus "I'm running out of money, what do I do?" The first one is the easier problem to save.

And David Blanchett at Morningstar has just done some incredible work where he takes it a step further, and we look at what percent--and that 3.5%, by the way, means that for every $100,000 you're spending $3,500, 3.5%, and you're increasing it every year with inflation. And in reality, people can adapt. If markets plunge, maybe you delay the vacation or eat out a little bit less, et cetera.

So, David Blanchett's work kind of looks at two things, how much of the income is guaranteed, let's say, from a source like Social Security, and how much of the expenditures are discretionary. So, if 95% of what I spend is on my rent, utilities, and food, I can't cut a whole lot, versus if I do a lot of vacations and such, things that can be cut. So, his work shows that the greater the percentage of the income that's guaranteed and the greater percentage of the expenditures that are discretionary, the higher you can spend per year.

Benz: Well, speaking of guaranteed income, I think like every sane financial planner, you encourage a lot of your clients to delay Social Security filing if they possibly can. How about annuities? Do they fit into your tool kit at all from the standpoint of trying to enhance that income before you even get into tapping the portfolio?

Roth: Well, yeah, in the vast majority of the cases, especially for a married couple, it makes sense for one to wait on Social Security, and I call that delaying Social Security the best annuity on the planet. A piece that I'm writing for AARP Bulletin right now, Mike Piper helped me with the calculations, but it essentially is like buying that government annuity at a 40% discount. Right now, the only inflation-protected private annuity that you can buy is from a company called Principal, and the returns are just too low.

Most annuities are just a straight, single-premium immediate annuity. That's where, let's say, I invest $100,000 and I'm guaranteed they call with a 6% income stream, or $6,000 a year. And the argument goes, why wouldn't you do that versus buy that Ally CD owing 2.65%? Well, number one, you have to do the math. At $6,000 a year, you've got to live, I think, 17 years just to get your principal back. So, it really isn't income. And what you're doing is essentially buying an indirect bond fund, because the insurance company will have it backed by bonds. So, you're doing it indirectly paying commissions and covering their fees, and you're buying essentially a bond fund with the duration of the rest of your life at a time when interest rates are at an all-time low. So, I'm not a fan of them, but certainly better than many other types of annuities like a fixed-indexed annuity, the old equity-indexed annuity. So, it's certainly better than other products. But I'm generally not a fan of buying an annuity through an insurance company.

Ptak: What strategies would you recommend for retirees who encounter a rough equity market, say, early in their retirements?

Roth: Yeah. It's tough, and you're most at risk in the first few years of retirement. I'm not a believer, for a couple of different reasons, in the increasing asset allocation that …

Benz: The glide path.

Roth: … Wade Pfau and Mike Kitces have come up with. There's a couple of issues with that, namely, behavioral. Most people don't get more heavily into stocks after they get older, et cetera. So, the sequence of risk is very, very hard to manage. And the best way to manage, in my opinion, is to pick a relatively conservative portfolio. I'm not a believer in setting buckets of money, having just two years' worth of cash, because we're assuming that the market will recover in two years, and guess what, the Japan scenario, decades later it hasn't recovered. So, there is no easy answer to manage sequence of risk.

Benz: But it sounds like maybe starting a bit conservative and also really managing that withdrawal rate initially would be a couple of things that you'd be thinking about.

Roth: Yeah. In fact, in general, Daniel Kahneman's groundbreaking work on prospect theory, which essentially says, we get twice as much pain from losing $1 as pleasure from gaining $1 helps me get the client. Let's say, if you're thinking you're going to be between 50% and 60% equities, let's start towards the lower amount because you're going to have the tendency to get greedy and buy more when stocks go up, but you're going to have the tendency to panic and sell when stocks go down. And that second tendency is twice as powerful as the first. So, we might start closer to that lower portion of that allocation.

Ptak: You mentioned Kahneman. What's some other research that's been particularly influential to the way you work with and plan for clients? And maybe in that vein, are there any mistakes that you've made over the course of your career--we all make them—that maybe you've learned from and that now inform the way that you work with your clients?

Roth: Yeah, I tell my clients if they want a financial planner that's never made a mistake, I'm not the right guy. The best behavioral-finance investing book I ever read really wasn't about investing, and it was Dan Ariely's book Predictably Irrational, and that is how irrational we are; all of these biases--recency bias, overconfidence, et cetera--lead us to do bad things. But you know, I used to know everything.

When I graduated college in 1980, I took the money my parents gave me and I bought gold, because gold was sure to go up, because countries--the U.S. had huge deficits printing money, fiat money, currency was going to become pretty close to worthless. Gold was a sure thing. Well, fast forward almost 40 years and my money has doubled, meaning that it hasn't come close to keeping up with inflation, not even close. Had I heard of Jack Bogle and his S&P 500 index fund, instead of making about $6,000, I would have made about $350,000. So, whenever you think something is a sure thing, you better think twice. It's one of the lessons that I learned.

And then, don't ask me how, but I must have been sleeping under a rock or something, and I hadn't heard of this company called Vanguard. So, 1989 was my first index fund, and I started with Fidelity and Dreyfus. And Dreyfus later raised fees dramatically, trapping my money in between paying those higher fees or paying the capital gains tax, whereas Fidelity did the right thing. As you know, their index funds are now lower-cost than Vanguard's and they have the new Fidelity Zero funds.

So, I've made lots of mistakes. One was going to Aspen and putting most of my money in a house in Aspen that we lived in, and I didn't sleep well at night. Two years later, we sold it for twice what we bought it for, and it worked out well. But that was pure luck. Don't confuse luck with skill. So, I've made lots of mistakes. I had no idea when I graduated Northwestern Kellogg, out your way, in 1982, trained in traditional economics, believing that I was a logical rational being who was strictly out there to maximize wealth, et cetera, had no idea how I could be that stupid. But the whole subject of behavioral economics, which I teach, is just fascinating to me.

Benz: You mentioned Jack Bogle, Allan. So, let's talk about the impact that he had on your career. Obviously, he had an impact on how you positioned investments for yourself and for your clients. But let's talk about his influence in shaping your career and also in shaping your advisory offering in the way that you have.

Roth: Well, I had worked for a couple of decades in corporate finance and consulting with McKinsey & Company. So, my midlife crisis was to do something very different. And [Burton] Malkiel was the first person who influenced me when I got my MBA, A Random Walk Down Wall Street, don't try to beat the market. Then Bogle on mutual funds was just brilliant, made so much sense to me. And I sent him a blind letter saying, "Wow, I appreciate what you've done. I'd love to meet you sometime." But sure, I was going to get nothing in response. And a week later, I get a handwritten note, "Hey, I'm coming to Colorado next month, let's get together." And it was like meeting my favorite rockstar, a politician, president. I couldn't believe it. I mean, I just looked at that note. And Jack spent about an hour-and-a-half with me on that first meeting like 16, 17 years ago, and when he walked into the room, he looked kind of angry, and I'm like, "Mr. Bogle, what's wrong? What's wrong?" He had lost $1 in the soda machine at the hotel. And he was going to get that dollar back. I thought that was odd, but of course that's the relentless keeping costs low that mattered so much.

We talked about my Dreyfus mistake. We talked about many things. And every year that I've seen Jack since, he would bring up that conversation, and he would remember it so much better than I did. Cognitive decline did not get to him. Even last October, which was the last time I saw Jack before he passed, he brought that up. So, meeting Jack Bogle was like meeting my hero. And the fact that we saw each other once or twice a year, and I could talk to him fairly regularly was just wonderful.

Benz: Well, Allan, it's always great to get your perspective on so many issues. Thank you so much for taking the time out of your schedule to be with us today.

Roth: It's totally my pleasure. And remember, Christine, you promised me, in my next life I'm going to get a job at Morningstar, because you guys are outstanding.

Benz: Thank you so much, Allan. Thanks for being here.

Ptak: Thanks, Allan.

Roth: Bye.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify or wherever you get your podcast.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And @syouth1, which is S-Y-O-U-T-H and the number one. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@morningstar.com. Until next time, thanks for joining us.

About the Podcast: The Long View is a podcast from Morningstar. Each week, hosts Christine Benz and Jeff Ptak conduct an in-depth discussion with a thought leader from the world of investing or personal finance. The podcast is produced by George Castady and Scott Halver.

About the Hosts: Christine Benz and Jeff Ptak have been analysts and commentators on investments and the investment industry for many years. Christine is Morningstar's director of personal finance and senior columnist for Morningstar.com. Jeff is head of global manager research for Morningstar Research Services, overseeing Morningstar's team of 120 manager research analysts in the U.S. and overseas.

To Share Feedback or a Guest Idea: Write us at TheLongView@morningstar.com

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decisions.)