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00:00:01
🔥 Factor Investing: Can You Really Beat the Market? | Dan Huffman 📈
888 Plays10 days ago
Watch and Subscribe on YouTube
🏅Dan Huffman explores the ins and outs of factor investing, a strategy that focuses on specific drivers like value, size, and momentum to potentially boost long-term returns.
He offers expert insights into how factor investing compares to traditional strategies like VTSAX and chill.🏖️
📈 The conversation covers everything from small-cap value investing to the role of momentum in portfolios and whether factor-based strategies can truly beat the market. Dan emphasizes the importance of understanding your risk tolerance and knowing when to rebalance a portfolio.
In this episode, we discuss:
1️⃣ What is Factor Investing: How it compares to passive index investing and why it might be worth considering.
2️⃣ Value vs. Growth Investing: Breaking down the key differences and potential advantages.
3️⃣ Small-Cap Value Investing: Why this specific factor gets so much attention and how it may affect portfolio performance.
4️⃣ Momentum Factor Investing: A look at how recent winners continue to perform.
5️⃣ Rebalancing Factor Portfolios: How often should you be reviewing and adjusting?
🔗 Dan Huffman’s Links:
💡 Cornerstone Financial Planning: https://cornerstonefiplanning.com/
🍀 Size Matters if You Can Control Your Junk: https://www.sciencedirect.com/science/article/pii/S0304405X18301326?via%3Dihub
📚 Kenneth French Data Library: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
📊 Portfolio Visualizer Backtesting Tool: https://www.portfoliovisualizer.com/
🔗 David's Links:
🍏 Forget About Money on Apple Podcast
🎧 Forget About Money on Spotify
📜 Dan Huffman Quotes:
💡 "Factor investing isn’t for everyone, but for those who want to go beyond traditional index funds, it offers a way to optimize long-term returns." — Dan Huffman
🔗 "The academic research is clear—factors like value and size have outperformed the broad market over time." — Dan Huffman
#financialindependence #valueinvesting #indexfunds #investingstrategies #FactorInvesting
🎧 Listen & Subscribe: Don’t forget to subscribe for more information on investment strategies, financial independence, and more! Hit the bell icon 🔔 to stay updated.
Disclaimer: This episode is for entertainment and educational purposes only and does not constitute legal, tax, or financial advice. Consult a professional for your specific financial situation.
Transcript
00:00:00
Speaker
What is factor investing? And will a factor investing strategy beat your portfolio's current investment strategy? Here we go.
00:00:12
Speaker
Welcome to the Forget About Money podcast, where we encourage you to take action today so that you can focus on what matters most to you. Joining us today is Dan Huffman, a financial planner and founder of Cornerstone Financial Planning. Dan discovered the financial independence community in 2015 while serving as an army physical therapist in Afghanistan.
00:00:32
Speaker
Motivated by his passion for financial literacy and desire to spend more time with his family, Dan transitioned from active duty to the reserves in 2021 to pursue a career as a financial planner, helping others achieve financial freedom and live intentionally today. Welcome, Dan. Hey, David, thank you for having me. I've been a big fan of your content for a long time.
00:00:53
Speaker
I appreciate that, thanks. Dan, today we are exploring factor investing, an investment strategy that focuses on specific drivers like value, size, and momentum to potentially enhance portfolio returns. We'll discuss how it compares to traditional passive broad market index investing and whether it's worth considering for your portfolio.
00:01:15
Speaker
We'll also touch on the risk and rewards of factor investing and how to apply it in today's market. But before we get into all of that, Dan, because of your line of work, you have to provide a disclaimer. So let us hear it. Yeah. So the information shared is for educational and informational purposes only and should not be considered financial investment tax or legal advice, nor is it a solicitation or endorsement of any specific company, security or offering.
00:01:43
Speaker
So consult with a qualified financial professional for advice tailored your individual situation. Past performance is not indicative of future returns and I do not guarantee the accuracy of the information provided. The opinions expressed are my own and do not necessarily reflect those of any affiliated entities. Thanks, David.
00:02:01
Speaker
Well, anything that prevents you from getting sued is great with me. So let's get right into factor investing. yeah What is factor investing and how does it differ from traditional market investing? So I'll start with traditional market investing. Typically, and this is how I learned how to invest. People just invest in mutual funds or especially in the financial independence community.
00:02:24
Speaker
we do think about broad market index funds. And ever since Warren Buffett endorsed the S and&P 500 as a standalone portfolio, basically with 10% bonds, he said, people have really jumped onto the simplicity of that. And then with JL Collins publishing the simple path to wealth and endorsing Vanguard's total stock market index fund, a lot of people I think were just immediately drawn to how simple it could be to invest and to get a great long-term return from investing in the market.
00:02:53
Speaker
So that research and the reason why those two recommendations from those two, I'll call them celebrities, you know, why they work is because of what we call the efficient market hypothesis. And so we know that it is very difficult to beat the market. And so for decades, you know, people have accepted the market as the standard of return And then they've looked at portfolios that either beat the market or underperform the market. And they would compare those to the market to try to explain why one portfolio did better or why one portfolio did worse. So traditionally what it looked at is how stocks and bonds kind of interact together.
00:03:31
Speaker
So when we think about very basic asset allocation, we typically think of the ratio of stocks and bonds in the portfolio, and then people determine that, and then that's what they invest in. And that's kind of, you know, explaining most of the return that they'll get over a long period of time. Factor investing, I would say, goes one level deeper. So it's not as simple as just holding the market and chilling for the rest of your life.
00:03:54
Speaker
But it's really more so will say on the stock side how can we diversify our stock holdings and perhaps improve our long term returns or also looking at the bond side because there are some factors on the bond side that also have landed towards higher returns over time.
00:04:10
Speaker
So it's really getting a little more granular on each side of the investment pie, we'll say, and then trying to do better there. Okay. So we talked about, you know, the index fund was, I guess, invented in the seven late seventies by Jack Bogle. At least that's what I believe. I think that's true. yeah and and that's taken up And rightfully so, for for many reasons, there's a lot of value in that, of course. But you're saying there's something else that maybe we should be considering to get some more dynamic returns out of a portfolio for long-term retirement investing. How do factors start? like Where did this research begin and who was the first people to come out and say, hey, but what about these things like momentum and size and and and then figure out the dynamics between of them between them and then how that affects your portfolio return over time?
00:04:58
Speaker
Yeah. So those are great questions. And honestly, I think my personal evolution as an investor kind of mirrors that of history, um, even though it's completely incidental how I stumbled on to factor investing. But you mentioned I was deployed back in 2015 and I was actually teaching a financial literacy class and investing class for the young soldiers in our FOB. And I was really diving into my own investments at that time. And like Let's pause there five means for operating base that is correct and i was not a father i left the base often um so no no jokes to any of the people who did not. but um What i started to notice is i was diving into the investment research was that over very long periods of time small cap stocks tended to be large cap stocks.
00:05:46
Speaker
And so I thought when I saw that, wow, I'm a genius. I'm going to you know start investing in all these small cap stocks and I'm going to beat the market, we'll say, over a long period of time and get a higher return. Well, as my investing education, I guess we'll say, continued to progress, um I actually started a blog back in 2017 and it kind of forced me to dig deeper into this research.
00:06:11
Speaker
And it turns out there's actually some pretty fascinating history to it. And small cap stocks were one of the first what we'll call anomalies in the stock market um that was ever discovered. So historically, again, if we go back to like the 1950s, 1960s, there was some pretty basic but yet groundbreaking research because this was the first time people were actually researching investing.
00:06:34
Speaker
And what they were showing is that it's really difficult to beat the market. And so this is going back that long that we've known it's tough to beat the market. And so there was this asset pricing model called the capital asset pricing model. And what it was able to do that was so groundbreaking was it was able to describe the difference in returns between two different diversified portfolios. The problem was is that it could only explain about two thirds of the difference in a portfolio.
00:07:00
Speaker
So let's say David, that you had a portfolio and I had a portfolio and your portfolio beat mine. We could put them both in the capital asset pricing model. Yeah, I know you get the higher return there. And, uh, we could explain about 67% or roughly two thirds of why you beat mine.
00:07:18
Speaker
The problem is we couldn't explain the other third. so For a long time, people thought, well, it's because David's a better stock picker than Dan is. and so That seemed to maybe hold true. and That was one of the reasons why actively managed mutual funds at that time were able to kind of grow in support because you know they had the expert picking funds that could beat the market, we'll say.
00:07:39
Speaker
That was our goal, right? But what happened was kind of in the sixties and then into the seventies, uh, Eugene Fama and Kenneth French, which are professors at very well-known universities, Dartmouth and university of Chicago, they began doing a little more specific research and they basically came up with the efficient market hypothesis. And so they were the ones saying that the market represents all the known information at any given time. And therefore it's very, very difficult to again, beat the market.
00:08:08
Speaker
But what they started to do is they started to incorporate more, but we'll call them factor models into their research to try to explain away that missing third of our ability to explain the difference in portfolios. And so during that time, um another researcher, he found that small cap stocks tended to be large cap stocks. And so that was kind of one of the first anomalies, we'll say.
00:08:32
Speaker
And so the question in investing becomes like we're looking we're taking risk to get a return right so the question becomes do small cap stocks have unique risk that would make us believe that they should be large cap stocks. And if so is that consistent and so that was in the early nineteen eighties.
00:08:51
Speaker
And it turns out that at that time they did determine that was true. Small cap stocks have inherent risks that are different than large cap stocks. That mean that investors in small cap stocks over long periods of time should expect to be large cap stocks.
00:09:05
Speaker
And so that became what I consider the first official factor. So we call that the size premium, simply meaning that over long periods of time, small stocks beat large stocks. Now, without getting into too much nuance on the size factor, it is actually the weakest of all the factors today. But what's unique about the size factor is that all the other factors have larger effects in small cap stocks than they do in large cap stocks.
00:09:33
Speaker
So again, while I tend to not get caught up on small cap as much as I used to, I do understand and appreciate that say value or some of the other factors that we'll talk about, they tend to have more robust returns in the smaller stocks.
00:09:47
Speaker
Okay, so size matters is what you're saying. and Actually, it's actually it it's funny you say that, David, because there's a very popular article I like that is called size matters if you control your junk. All right. Maybe we'll link to that in the show notes. I'm not sure exactly what that's about, but if it's legal, we'll put it in the show notes. It's a fascinating study, trust me.
00:10:08
Speaker
Small cap value in particular seems to be one of those next level um topics that people who are smart about money want to talk about and they they will make solid claims. And I know Paul Merriman, who at the time of this recording, we just recorded an episode a couple of days ago and it will go out probably If somebody's listening to this a couple of weeks ago, he is a huge advocate of small cap value. But at the same time, you've got people like Big Urn who are not. ah Big Urn is a huge sequence of return. I would say expert. I don't know anybody who's done more work. Maybe Michael Kit says, maybe not. I don't know. here
00:10:48
Speaker
I think we are wins the title. Yeah, I think so too. But he's against it. And his his ah argument is that over the last 15 years, small cap has not outperformed.
00:11:00
Speaker
And i'm I'm not sure exactly what has an outperformed, but I think just the broader market in general, maybe is is the argument. So why make a why do the extra work, maybe extra work, and air quotes, some people like this stuff is not considered work. Why do those extra ah keystrokes for something that has not been valid for a number of years? So that's, I understand both arguments.
00:11:20
Speaker
But that's, we're talking about small cap value. What are, but small cap value is not the only factor. What are, what, can you just define a factor in like layman's term and then tell us what like maybe the most popular factors people look at in this context?
00:11:35
Speaker
Yeah, definitely. So factors, if we want to think about, again, with investing, we're coming to a risk versus a return, right? So I think in the most simple of terms, people invest in the stock market rather than the bond market because they expect a higher rate of return from the stock market. And that's a risk-based return. We'll say generally, bonds tend to be Less volatile they're a little bit safer will say and i'll say you know safer in quotation marks right cuz we all saw what happened in twenty twenty two but in general we expect a higher return from stocks because of the unique risks of stocks verse bonds. Well factors are the exact same type of risk but within the stock side or within the bond side.
00:12:18
Speaker
So when we look at some of these other unique factors and risk factors that determine a potential higher return in the future on the stock side, you know, again, we see the market that's kind of the first factor and it was that stocks beat bonds. The second factor was size. Small cap stocks tend to outperform large cap stocks. The third one was value.
00:12:40
Speaker
So companies that are trading at low valuations tend to outperform companies that trade at higher valuations over long periods of time so where famine french really improved on the capital asset pricing model. Was it they developed a three factor model.
00:12:56
Speaker
And that three-factor model drastically improved the explanatory power between those two portfolios. So if we go back to the example of your portfolio, David versus mine, after using the Fama and French model, what we could say is David's portfolio beat Dan's portfolio because he had more small cap stocks and more value stocks, but it still wasn't perfect. So later on in the nineties, Fama and French actually came out with a five-factor model.
00:13:21
Speaker
And so, along with value and size, they ended up adding what's called profitability, which are companies, this is going to sound like a no-brainer, but companies with strong profitability, stable earnings, low debt, they tend to beat those companies with high debt and other you know less financially sound, um I guess, characteristics over the long term.
00:13:42
Speaker
and then investment. So investment's a factor that companies that invest less into their company tend to over time outperform those that might be rapidly just raising money, throw it and throwing it into their company into like research and design. And then those companies that rapidly do that tend to fail at a higher rate. So low investment companies tend to outperform the higher investment companies.
00:14:05
Speaker
And so what Fama and French found is after controlling for all five of those factors, the market, size, value, profitability, and investment, they were able to explain about 90% of the difference between our two portfolios. So what this did is it greatly diminished the benefit of stock picking because now what they're saying is if we can, you know, in advance identify those companies that display these characteristics and then build index funds around them,
00:14:33
Speaker
we should be able to help the everyday investor get better exposure to these types of stocks that we believe over the long period of time will outperform their opposite. So that's really where those different factors came into play. Now you did mention this, but momentum is another factor. So there's kind of two factors that aren't included in the Fama French data.
00:14:54
Speaker
That's momentum, where stocks that have been doing well recently continue to do well recently. This is actually the most robust of all the factors. The challenge is capturing it. So, Larry Sweetrow actually has a really good book, and I always butcher the name of it, but it's... ah Here it is, Your Complete Guide to Factor-Based Investing. And he lays out all these criteria for what it takes to be, we'll say, a valid factor.
00:15:19
Speaker
And one of them is investability, but basically the ability of a fund to capture the return and do it in a tax efficient way and like a cost efficient way with trading costs. So momentum is one of those that definitely is very robust in the research. But when you account for trading costs, because it's a high volume trading strategy,
00:15:39
Speaker
It does diminish the return of it but it's definitely still there. And then another common factor that people see is low volatility and that stocks with less price fluctuation doing better. So on a recent podcast, he had Frank Vasquez on and I think he was talking about this a bit with the different approaches that he uses.
00:15:59
Speaker
And low volatility would be one of those that would probably make sense in that type of portfolio because it diversifies and what doesn't go down as much doesn't need to go up as much to recover either. So those are the main stock factors. Those are what are believed to be unique risk inherent to some stocks in the market but not all stocks. So the belief is that by overexposing your portfolio to those types of stocks over a long period of time would generate higher portfolio returns okay make sense make sense academically to me now you mentioned that perhaps if a mutual fund could be built around these principles it has the chance to beat the just s and&p 500 buying hold strategy.
00:16:41
Speaker
If all of the studies have been done on factor investing and it seems like they're fairly thorough and we do have the ability to research and back date test, all of these things, I'm assuming fund companies have come up with mutual funds that represent this style of investing. Is that true? Yeah, it definitely is.
00:16:59
Speaker
So, you know, again, this is not an endorsement of any one company, but dimensional fund advisors was begin in the 1980s on this entire premise. And so I have a ton of respect for them and they've published a ton of the research in this area since they came out. So there are many, there's a handful of good companies that really do try to produce this type of research and then also provide the funds that people can actually invest in to capture the risk premiums of these factors.
00:17:27
Speaker
You know, one thing I wanted to mention too is, you know, you mentioned Paul Merriman and Paul Merriman was very influential in my journey as well, because around the same time I was learning about this on my own, you know, I found him in the financial independence space. And so he really connected some of those dots for me. And what I appreciated about Paul Merriman is that I think he was growing as an investor when all of this research was brand new. So I think he was really ahead of his time and how he invested.
00:17:57
Speaker
And at the time when he was being an investment manager, you know it was all actively managed mutual funds and maybe just a couple index funds. you know Like you mentioned, um the S and&P 500 index fund goes back to around 1974, I believe, but it didn't really become popular until much later. And so you know Paul Merriman, I think, has a tremendous amount of knowledge and expertise on this.
00:18:21
Speaker
And then I also wanted to comment on, you know, bigger earn because I have a ton of respect for bigger earn as well. And I've always been kind of puzzled as to why he wasn't, you know, a big fan of factor strategies because he is so smart. And so I can't speak for him, but based on what I've read, what I'm seeing is that, you know, we always give the disclaimer past performance doesn't guarantee future results.
00:18:46
Speaker
From what I've seen him write on his blog, it seems that he thinks this is more of a product of back testing the data and saying, well, of course, if we look in our rearview mirror, we know which horse won the race every single time. Right. But the challenge is, can we identify that horse or the top three horses moving forward? Right.
00:19:06
Speaker
So I think that his take is that this is more letting our future investment decisions be based on history. But I'd say that the difference that I see in the Fama and French research is that they include a long period of time in their research. So they're going back to 1926 through the present and they make all their data publicly available on Ken French's website. So researchers around the world can literally do this, this analysis on, you know, up to date data basically every month.
00:19:36
Speaker
And what they found is that there are multiple periods of time in which factor strategies fall out of favor and that's when we would say maybe the past fifteen years you you know value did terrible growth beat value. So there's all the headlines like is value dead well historically values been dead like five times.
00:19:53
Speaker
you know, or multiple times. And that's exactly one of the reasons why it's believed that the value premium will survive because it falls out of favor. And when it falls out of favor, it's poised for the biggest comeback. And we actually kind of saw that since COVID with value stocks going on to come back and be growth. So the way I look at it is I do think we have to be cautious like big earnings about just betting that, you know, the factors will be the growth or that they'll be the S and&P 500.
00:20:23
Speaker
I think we need to be cautious about how we anticipate that happening in the future. But what I think makes sense is knowing that it does come and go. There will be periods of time where value beats growth. There will be other periods of times where growth beats value. So of all the factors too, value is probably the most popular because Warren Buffett, we all know Peter Lynch, there's famous value investors, right? But profitability is a growth strategy.
00:20:48
Speaker
So going back to 1926, there's been no five-year periods with a negative return between a value and profitability blended strategy. That's huge. So being able to look at that and you know think about, well, how could I construct a portfolio where at least a portion of my portfolio has historically had a very strong five-year return? you know To me, that's a huge value add.
00:21:13
Speaker
But again, can we guarantee that there's no five year period that's negative in the future? No. But I always think of Mark Twain's quote, you know, history doesn't repeat itself, but it often rhymes like I don't know what the future holds. I can't guarantee what the future holds. But I do think the factor strategy and combining some of these factors in a portfolio, I do think that will make things better.
00:21:37
Speaker
but I can't guarantee it and I can't guarantee by how much, but I do think over a long period of time, it improves the odds. Okay. ah Now, if somebody has made it this far and and into this particular podcast, they very likely enjoy this stuff and is inclined to, I don't want to say tinker because that gives a negative connotation, but to make moves in their portfolio for justifiable reasons rather than just fire and forget into a broad market, low cost index fund.
00:22:06
Speaker
Is that how let's say somebody who doesn't know anything that we're talking about made it this far into this conversation. Is that how we need to divide like the groups of people up the people who care about the stuff or like or I don't see care because everybody cares about their money. But yeah, it's people who are inclined and want to learn more to To do these extra keystrokes for this potential return and those who just want to live their life ah knowing that just a simple fire and forget strategy like the x and chill. Can get them ninety percent of the way there or a hundred percent away there where ever whatever they decide is enough like how i can understand but because i could be listening to me like that's just too much work i don't understand it.
00:22:48
Speaker
moving on like are they lost? Are they just gonna be missing out? I don't think so. I think everybody's different, right? But I'm saying all this because I do really think it's just like, if you had these if-then statements in money conversations, one of the very first question is, do you enjoy managing money? Yes or no? If the it's no, then we're gonna go through this way. And like, okay, maybe here's some strategies that might fit into your lifestyle, into your temperament, and into your personality better.
00:23:14
Speaker
And if it's this, then no, let's educate you on this other, you know, simple path that will play jail Collins. But there may be another way for you in particular. Is that how you see it when you're having conversations with people?
00:23:26
Speaker
Yeah. So I don't think that everyone should probably invest with the factor strategy. I do think it requires some extra level of a little bit of learning and understanding and openness. But what I will say, you know, back in the day when I was blogging, this always cracked me up because I would take so much flack for having such a complex portfolio, right? And I was advocating for like three funds or four funds at that time. And, um, what cracked me up though, is that the people who are against it,
00:23:55
Speaker
are all in on a broad market index fund, and that's factor investing 101. The market is the original factor. so If you believe in that, you should automatically believe in the exact same premise for every other factor that's there. The same research that says you should hold a broad market-based market index fund is the same research that says perhaps a value don't make sense, perhaps a size don't make sense, you know, and on and on. And again, this isn't portfolio or investment advice to enjoy listening, but this is where I think people need to start questioning like, does that make sense? Or how come I don't view it like that? But even if it does make sense, then the next step has to be to put it in practice. And that's where some people just don't want to.
00:24:36
Speaker
Yeah, definitely. But you know, like, I feel like people move money to high yield savings account to get an extra few percent versus leaving it in their bank, right? Like that takes more effort than me investing how I invest. but Okay. know So it's really, if we're talking about a 20 to like 50 year time horizon for people, this could make a massive difference. You know, it historically has made a massive difference. But again, we, I don't believe the past will exactly replicate itself.
00:25:05
Speaker
All right, Dan, so we have the simple path to wealth where a person would just invest regularly dollar cost to average into an SCP 500 or another low ah cost broad market index fund over time. But that's the same keystrokes as if you were investing into a mutual fund that represented and used factor investing. How do the two perform because that's still simple. It's just that you're just investing in something else that should be tilted or should have additional risk ah profile in order to gain a few percent, maybe even a year over time. Yeah. So this is where it goes to the back testing. So we can look back and see how things performed. Now, again, the limitation of back testing is that this doesn't guarantee that the future replicates the past exactly.
00:25:50
Speaker
But again, i like the mark twin quote i don't think it'll replicate itself but i think it'll rhyme now the risk is that it doesn't and that's the biggest risk of factor investing is that i take these risks today i i make this. Assumption that factor investing is true i invest like this and then in fifty years towards the end of my life i'm like dang it i should have just done something else right so that's the risk.
00:26:13
Speaker
but I believe that we're going against a lot of the academic research that does get at the persistence of the strategy and so that's where we look at it so again simply back to testing the broad us market from nineteen seventy two through the present.
00:26:28
Speaker
which is, you know, we're in September of 2024 now. And I use portfolio visualizer for this, if anyone wants to play around with this at home. But if we were to compare two portfolios, one, which would be, I'd say a basic factor strategy, kind of using the Fama French three factor model, but I'm not going to get too specific on that ah versus the broad total market index, the annualized return. So the compound annual growth rate per year.
00:26:55
Speaker
is 12.50% for the factor strategy and 10.72% for the broad-based market. So over those 53-ish years that we're hitting now, the the factor strategy has beaten the market by about 1.7% per year. And that's huge. That's a massive difference over 50 years. Now over those 50 years, what's important to remember is that that includes the last 15 years or so, where ever since like 2000,
00:27:24
Speaker
you know, maybe the mid 2000s before the global financial crisis, you know, value started falling out of favor and um growth beating value. But it should also be noted that from like 2000 to 2009, value did great. In fact, one of the reasons I became a factor investor was analyzing how a factor portfolio performed during the dot com bust from 2000 to 2002. And it drastically outperformed the market. It was hugely protective.
00:27:54
Speaker
And so that's one of the risks of holding just a pure market fund is your entire investment. You could have a lost decade in retirement and that would be catastrophic. That's why I believe in you know diversification beyond just that. Yeah. So coming back to just the returns, you know the returns can be significantly different, but again, I'm not going to ever guarantee that the next 52 years, the strategy would beat the market by that much again.
00:28:20
Speaker
Okay. And so this follow-on question might be not a fair one because you said this was what you just explained was 53 years of research and back testing. And we only have the fact, the five factor model since the mid nineties and then the establishment of mutual funds that trade in this style. Are there, meat like are the, since mutual funds have been established, have those mutual funds beat the S and P 500 index?
00:28:44
Speaker
Um, yes. So the question is though, is what are we trying to beat? So if we're using the S and P 500 as a benchmark to beat, you know, a lot of people, I think just pick that because it's the best known index, but in reality, picking a benchmark to compare your portfolio to gets a lot more complex than that. But I do think at the highest level, if people want to think about the S and P 500.
00:29:08
Speaker
or you know a total market index fund is being the benchmark, um they can do that. But that's where over time, there will be years where this strategy beats that and then there'll be years where that beats the strategy. Again, this strategy, like every every portfolio I do put together, I will share this, you know the S and&P 500 is a component of that portfolio because that represents the market in the factor strategy.
00:29:33
Speaker
So it's always the market plus some other factors, you know, the index, the fund costs range, you know, there are some funds that are as cheap as like 0.07%. And I think the most expensive one that I recommend that I use is 0.25%. So it does go up quite a bit.
00:29:54
Speaker
The returns have also justified that. And so the after expense return would have still beaten their opposite. But just remember too, when we're talking about say small cap value versus the SMP 500, that is not the comparison that's being made in the research. It's really more like small cap growth versus small cap value or small cap versus large cap. It's not, you know, some arbitrary 100% benchmark.
00:30:22
Speaker
So a lot of the academic research, they go long, we'll say, in something like small cap value. And they would compare that to a portfolio that's long in the opposite of small cap value. So again, like high expense gross stocks. And so that that's a difference that I do see between, we'll say DIY investors versus how I would say a benchmark for a portfolio should be made. But I also look at it from an opportunity cost.
00:30:48
Speaker
And if you adopt a factor strategy, the opportunity cost is that you're not in like a broad market index fund that costs 0.03%. You know, so there is a difference in that. I think for me, I look at the long-term academic research, which is again, starts back in 1926 and goes through the present. And I see multiple periods of times in which the factor strategy has been awesome. And then when it's been pretty terrible.
00:31:13
Speaker
But all in all throughout all that time with all those periods of underperformance it still tended to beat the market it still has been in the market over that long period of time or it's been their opposites over that long period of time and so for me i decided that that's a risk i'm willing to take. But it could be that the next thirty years my strategy fails and i would have been better off.
00:31:33
Speaker
having you know invested differently, but that's a risk I'm willing to take and we all have to take those risks. Okay. Can we can we prioritize? Can you just list the five? We don't have to go back in and redefine them, but can you list the, say the five factors that were in the five factor model, if this is also what you think is still currently relevant today?
00:31:52
Speaker
And then again, I don't want you to necessarily say what you personally have tilted in your portfolio or not, but could you talk about which of those five factors actually matter more and are easier to track and maybe implement if somebody is interested in factor investing.
00:32:07
Speaker
Yeah, so again, the five-factor model included the market, so think broad-based index fund like S and&P 500 or total market index fund, and then size, so we're talking small cap stocks, value, again, the low price to earnings, low price to book type metrics, and then investment, which was companies that have lower rates of investment tend to do better than those with high.
00:32:31
Speaker
And then profitability with companies that are higher profitability tend to beat those that are lower profitability. And then the two that I mentioned that weren't in the five factor model are momentum, which is those stocks that are doing well recently continue to do well for at least a time. And then the low volatility stocks tend to be high volatility stocks.
00:32:51
Speaker
So I think if people are interested in those, you know, there's there's really good research on those. So if they Google those, check those out. If there's something that makes sense, then I think that it could be a reasonable thing to investigate further and try to find out how that might fit in their portfolio. But what I would not do is just blindly say, I'm going to go grab all seven of those and slap together a portfolio.
00:33:15
Speaker
because inevitably the market will beat it and i'll be like a shoe now i'm gonna sell and then i'll sell right before that portfolio goes on to beat the market. You know and to me that's just like the people who try to trade actively manage mutual funds always underperforming the mutual fund by about fifty percent so this is not a chasing returns type of strategy i think this only works as a good buy and hold long term strategy that you're comfortable with.
00:33:42
Speaker
Okay, so let's say I'm a diehard five fan, and I've got a couple hundred thousand dollars in VTSEX or SP500 or broad market, and I hear this, I'm like, okay, well, I know I'm pretty well set, so but i'm but I'm interested in this factor investing. Would a conservative or smart way or however you want to you know characterize that decision would be to just add and you know continue to what you're doing, but then add one ah add a mutual fund or ETF that prides itself on one of these factors. And if so, what's the factor that actually is a small cap value? I mean, is that the one that you would probably gain most of as far as the Delta, if you were just to add that to your overall portfolio? So yeah, I will generally and cautiously say small cap value seems to be where the most attention is. You know, I'm not going to endorse that as the one
00:34:36
Speaker
Paul Merriman certainly does. And I'm a fan of Paul Merriman. So I'll leave that as that. okay But I do think just taking it one step at a time makes sense. Again, kind of my own educational evolution, as I was sharing earlier, I went from the market to small cap to some value. And like each time I learned something new, it made sense. And then when I put it together, the whole puzzle started to become more clear.
00:35:00
Speaker
And so I do think for anyone who's listening to this that thinks it may make sense to them, I would just say start researching it. And I think the research will lead you to where you want to be.
00:35:11
Speaker
Now, one thing I will mention, though, is you know what is the difference between holding a broad-based market and index, total market and index fund, where you own all the stocks, as everyone says, versus these types of funds where you only own some of the stocks? So all of the stocks that I own are held in a total market index fund, right? The difference is that what we're doing is we're tilting by over weighting our portfolio towards these types of stocks.
00:35:38
Speaker
So rather than getting the market capitalization exposure of what that actual stock you know fits into the entire stock market of the US, we're over weighting these stocks in our portfolio. So that's the only way to actually like harvest or realize this excess return in proportion to how we overweight it. Or if you underweight them, that's the also the way to you know not get this return and get more of the market's return.
00:36:06
Speaker
So I think it's, yeah, I like for people to realize that they already own all these stocks. If they hold a broad based market index fund, you know, maybe like Vanguard's total stock market index fund, you know, the S and P 500 doesn't include most of these, but if they do hold a total market index fund, they already own these stocks. What I'm talking about is over weighting some of those stocks beyond their market capitalization weight. Yeah. Based on the factor.
00:36:31
Speaker
Yes. yeah Based on the factor premiums that lead us to believe that historically over long periods of time, these types of risk go in favor and out of favor. And usually after they've been out of favor is when they come back, they tend to have the biggest return. And that's why this is a long-term approach and really tough to time. In your own journey and in your future practice as a certified financial planner or financial planner, like I don't know that much about your history or even your um philosophy on investing other than this conversation today. What are some of your personal slash professional philosophies about money management or investing that you want to make sure people grasp? It doesn't necessarily have to be related to factor investing.
00:37:13
Speaker
Yeah, that's a good question. I do think when it comes to investing that for me, it has become important to not just take the first step. I think, you know, that is kind of why when I had my blog back in the day, I was kind of on a crusade almost against holding just a single total market index fund.
00:37:32
Speaker
Now I do think I've come maybe full circle to where I'm like, that's totally fine. If that's what people know and understand, I think understanding and believing in your investment philosophy is by far the most important thing because that's how I know you won't bail when things look rough. But what I am a big believer in is that if you just learn a little bit more, I do think you can probably, and again, no guarantees, but probably improve your odds of a higher return ah over a long period of time.
00:38:00
Speaker
by just not going to the simplest level possible. You know, when I used to talk about this, people used to bring up Occam's razor, you know, where the simplest solution is the best, right? So that sounds great when you have two competing equal opportunities or problems to face. The problem is, is that that's been disproven in math, philosophy, computer science. Pretty much every field of study has disproven that.
00:38:25
Speaker
to where it's actually a more complex answer is actually the best answer. What I would say is if complexity adds value to your situation and it makes sense, then kind of go with it. you know But if it doesn't make sense, then absolutely do not. Do you think you're going to be able to stick with this strategy throughout your own lifetime? Yeah, I definitely do. I mean, I'm 100% bought in, but again, that's me and that's based on my understanding And I think one of the areas, you know, we joked about that paper earlier with the awesome name that size matters if you control your junk. Like I read those types of academic papers. And so the academic papers. yeah Yeah. Yeah. It is. Trust me. You can share it.
00:39:07
Speaker
But um you know I like that stuff and as a physical therapist in the army I was very big into evidence-based medicine and just doing my best for my patients and you know I think I could critically read a paper and know its flaws and know its strengths and how I could apply it to the patient in front of me.
00:39:27
Speaker
And that's kind of how I view this as well. And so, you know, I do believe I'll stick with this for the long term. It would take a lot to convince me otherwise, but I also need to be open-minded that could happen. That is a risk. Yeah. One, so I think I'm not sure what number podcast this is for me, maybe 39 or 40, but One of the themes that has, one of the early epiphanies I've gotten from interviewing people on this podcast, Rick Ferry, Dr. William Bernstein, Paul Merriman, they all agree on one overarching philosophy. And and this is really like taking a bigger ah bigger weight in the way I look at things too. the The best investment strategy is the one that you are going to stick to, yeah period. It's not this 1% here, it's not the 2% there. Because if you're not going to stick to it,
00:40:15
Speaker
all the back studies don't matter. It just doesn't. So I think that's that's that's really made a ah significant impact on how um how I shape even these conversations too. Yeah, absolutely. you know One mistake I made when I was first learning about factor investing I thought it was so awesome. So I found this great fund that I thought would be good and had a great history and a great long-term return, right? So I invested in it. It didn't do well. It got beat by another fund I had. So I sold it. And then that very next year, the fund did 28% while my other fund that I had bought did like 18% or something. you know So the market was up big no matter what, but that other fund killed it.
00:40:57
Speaker
And I was just like, you know what? I was trying to be too smart. I bought in and then I questioned myself. I jumped off the roller coaster as Warren Buffett says, and that too gets hurt. And so yeah, now I'm more just set it, forget it, but make sure it makes sense to you. And for those in the accumulation phase, you know, continually investing is huge. So your savings rate, probably the most important thing.
00:41:23
Speaker
I think this is more of kind of a secondary, let's optimize what we're saving into for a long period of time. yeah But that's how I view this. Yeah. And actually I was going to say that it's one thing for us to focus on like graphs and data points and this fun versus that's fun and back testing and portfolio visualizer, but I don't know anything unless you just routinely pick individual stocks that go to zero. I don't know anything that's going to affect your overall portfolio success than your savings rate. Absolutely. Yeah, absolutely.
00:41:53
Speaker
Well, Dan, thank you very much for being an incredible guest and sharing your valuable insights on factory investing. It's good to finally meet you. I know you and I went back and forth maybe a couple of years ago yeah and we were talking about TSP and and then you reached back out when you discovered I had the podcast. I'm glad we're having this conversation. and We got to reconnect and I appreciate your time and expertise. And thank you for joining. Yeah. Thanks for having me, David. and It's been great talking. And thank you all for watching and listening.