I have always admired folks who can take a rational look at, and clearly articulate, an opposite viewpoint, while still embracing their own beliefs. 

 

Charles Kirk is the creator of “The Kirk Report” one of the nation’s most popular financial web-sites aimed at providing stock market analysis and individual stock recommendations to individual investors.

 

He has been successful by diligently following the stock market and makes a living through the frequent buying and selling of individual stocks. 

 

Investors who embrace The Coffeehouse Investor approach to building wealth know that our philosophy is very much the opposite – the best way to maximize long-term returns in common stocks is to buy and hold a globally diversified portfolio of low-cost index funds.

 

However, I am well-aware that many investors who embrace the Coffeehouse philosophy with the majority of their portfolios at the same time enjoy the challenge of trying to beat the stock market by purchasing individual common stocks.  In fact in my book I wrote one chapter addressing this issue, titled, “Let’s Have Some Fun.” I encourage those investors who do want to trade stocks to allocate a maximum of 5 to 10 percent of their portfolios to active stock selection. 

 

In the book, I write, “And who knows?  Somewhere among the millions and millions of stock pickers you might be the next Warren Buffett. But I am not sure it is worth risking your entire portfolio to find out you aren’t.”

 

Charles Kirk recognizes that following the stock market and actively buying and selling stocks is not for most investors.  As such, he is also a big proponent of the same investment philosophy embraced by Coffeehouse Investors.  Recently he interviewed me and my thoughts on investing, and graciously allowed me to re-print the interview on my web-site. 

 

A big thank-you Charles, for allowing me to highlight the Coffeehouse message to all your faithful followers . . .
 

 

A couple of years ago I dedicated quite a bit of time and effort to encourage others to adopt some form of a passive, “lazy portfolio” approach. My belief that this remains the best way for most people to achieve long-term investment success remains as true today as it did back then. Recent volatility in the markets have only proven again how timeless this approach really can be.

Through the years I’ve made little secret of the fact that money my wife and I have set aside for our retirement uses a passive investment approach. This is also why I feel it is so very important to talk about this subject from time to time. In my view, no matter how well you may do in the markets as a trader or investor, if you don’t also learn how to live below your means and put money aside for your retirement that at least consistently matches the market’s performance over the long-term, everything you learn and do will be entirely in vain. Unfortunately, too many people focus far too much on their short-term goals and do things that prevent their long-term success in the market.

That’s why I’m so excited and honored to have a Q&A with Bill Schultheis – a well-known expert in passive investing. Mr. Schultheis has dedicated his career to helping others understand and appreciate the value of a passive investing method.

The author of very popular book titled “The New Coffeehouse Investor: How To Build Wealth, Ignore Wall Street, and Get On With Your Life,” Bill Schultheis is also known for his lazy portfolio allocation that is tracked and compared with other passive model portfolios over at MarketWatch. Bill is a principal at Soundmark Wealth Management and a former broker for Smith Barney. Over the years Bill discovered that when you simplify your investment decisions you end up getting better returns. As clear evidence of that view, he recently received the prestigious 5-star wealth manager award for being best in client satisfaction. In a time and age when very few are happy with their brokers and financial advisers, this is quite an amazing accomplishment!

As you’ll soon discover in this Q&A, Bill’s critical view of Wall Street, clear understanding of how investors’ chase for performance sabotages their returns, and the many other topics we will cover are as refreshing as well as helpful. We sincerely hope you enjoy the Q&A and find something here that will enable you to achieve your long-term financial goals.

Q&A With Bill Schultheis

Kirk:  Welcome to the Q&A! I’m excited to have you here as I’ve been a fan of yours for some time.

Bill Schultheis:  Thank you, Charles. I appreciate the opportunity to discuss the world of investing from the perspective of The Coffeehouse Investor. This Q&A is a unique opportunity to address the many challenges facing investors today, and how the timeless principles I introduced to readers 10 years ago are more important than ever before.

Kirk:  You are currently employed as a fee-only financial advisor and author of The New Coffeehouse Investor.” But let’s start from the very beginning. How and why did your interest in the market begin?

Bill Schultheis:  I grew up on a wheat farm in southeastern Washington state, in a corner of the world that the National Geographic labeled a “Paradise called the Palouse.” This part of the country continues to produce some of the best wheat yields in the nation, and our farm, on the banks of the Snake River Canyon, is, in my biased opinion, the most beautiful farm setting in the world.

I grew up on that farm with seven brothers and sisters. Every one of them graduated from college and has gone on to live incredibly successful lives with wonderful families. They went on to become lawyers, engineers, systems specialists, physical therapists, commercial airline pilots – I have one brother who is an incredibly successful artist, with work being shown around the world, and finally, one brother who still farms that farm, and single handedly runs a very successful million dollar farming operation of over 3500 acres that I was a part of way back when. These are people who are consumed with their families, their careers, their communities.

The reason why my seven brothers and sisters are so successful is because each one of them possesses two qualities that are integral to success They know how to work hard and they get along with people.

I share a little about my brothers and sisters because these are the types of investors I had in mind when I wrote my book. And I must say that for every person who tunes in to Jim Cramer’s Mad Money on CNBC, there are thousands of people like my brothers and sisters who look at the guy for what he is, a crass entertainer. They know he isn’t the answer to building a successful portfolio, but they are not quite sure who to turn to for a more intelligent approach to portfolio design.

I got involved in the stock market very early, probably around 9 or 10 years of age, when my dad bought me one share of stock in Pittson, a coal mining company.

For a number of reasons, farming wasn’t the career for me. Because of my agricultural background, my first job was working for Merrill Lynch in the agriculture commodity pits on the floor of the Chicago Board of Trade, and after that, I settled in as a stockbroker for Smith Barney in Seattle, Washington.

Kirk:  It’s clear from your book that you have a strong dislike for Wall Street and the financial services industry, yet you initially got your start as a stock broker. Tell us about your transformation and how you eventually came to realize that Wall Street always works against the best interests of its clients.

Bill Schultheis:  Well, first of all, as everyone knows the traditional compensation structure of Wall Street brokerage firms is commissioned-based, meaning that the more trades you make, the higher your income will be. Therein lies a huge problem, or conflict of interest. On one side of its mouth, Wall Street says that investors should focus on the long term. On the other hand, it compensates its employees through active trading. To put it bluntly, its compensation structure is in direct conflict with what is in the clients’ best interest. It is no different than having the local manager of Jiffy Lube pay its employees for each tablespoon of sand they put into an engine’s crankcase. It just doesn’t make sense to me.

Kirk:   In your book you said that at an early age you “wanted to get rich” and then shared a story about trading wheat futures after college. Within one week you confessed that you lost your entire life savings. Clearly this had a tremendous impact on your view and professional career that has followed. In fact you write that at that point you decided never to try to outsmart the market. Have you ever been tempted to try your luck again after all of these years?

Bill Schultheis:  I can’t remember ever buying an individual share of stock in my lifetime, and yet I suspect my returns in the stock market over the last quarter century have outpaced 95% of investors – in large part because I never trade and keep my costs low. I am the ultimate buy and hold investor.

Kirk:   It is clear that you view the markets as being relatively efficient. This is not a view commonly held among many people. Why do you think this is still true?

Bill Schultheis:  There is a growing debate over the definition of an “efficient” or “rational” market, and whether markets are indeed efficient or rational. This debate has been fueled in part by people like Yale’s Dr. Robert Shiller, and TIME magazine columnist Justin Fox (author of the recently published “The Myth of Rational Markets”). They go as far to say that this notion of “efficient” markets played an important role in the global financial crisis of the past two years.

First of all, it has become pretty obvious within this debate that there are lots of different definitions of “efficient markets and rational markets.” It is like that story of 10 blindfolded people who are touching different parts of an elephant, and describing a different animal.

I don’t think any intelligent person has ever argued that markets are rational. A quick reflection on the history and price action of commodities and securities, whether it be tulip bulbs or dot com stocks, makes it pretty clear that the emotions of investors cause markets to swing far above and far below their longer term “fair market value range.”

Are markets efficient? On the surface, that is a more interesting debate. But for Coffeehouse Investors, that question is largely irrelevant as well. A more pertinent question investors should ask themselves is, “What is the price I pay to try to uncover market inefficiencies – and fail?” Research carried out by the likes of Terrance O Dean or the Dalbar Group show that most investors fail miserably at beating the market. I am not saying the market can’t be beat. I am saying that the millions of investors who are responsible for saving and investing for their own retirement are likely to end up on the wrong side of the Dalbar study and underperform the stock market by 50% over the next decade because they are trying to beat the market.

Kirk:  As one who earns a living by trading stocks, I have to tell you that I was taken aback by one of the statistics you shared in your book – less than 10% of millionaires of this country consider themselves active traders and 42% of the millionaires make less than 1 transaction per year in their investment portfolios. So, is it your view that active trading is a sucker’s game and to be avoided at all costs by everyone?

Bill Schultheis:  For anyone who wants to commit a portion of their dollars to the stock market as part of a long term investment holding for retirement, active trading is a sucker’s game.

If someone is able to beat the stock market through active trading over the next 25 years, my hat is off to them. What a person does with their individual account is irrelevant to me.

But there is a big difference between managing your portfolio so that you can live a decent retirement, and taking 10% of your money and trading stocks. One is investing for the sake of investing, the other is investing for the sake of entertainment. If someone wants to trade 10% of their portfolio because it is fun, I don’t have a problem with that.

But if someone has a three-year lucky streak and then starts promoting their trading scheme to investors like my brothers and sisters as a way to invest for retirement, that is where I draw the line and want to get involved in the discussion. The first question I will ask is, “If anyone is so confident of their trading method, why not offer a money-back guarantee to investors for the amount of any future underperformance? That seems to silence the trading wizards pretty quick.

My point is, there are thousands of stock pickers out there all screaming “I am number one!” Who are we to believe? Who should we choose? Why not choose the person that screams the loudest with the best track record? That decision will last for three years, and then the guru underperforms miserably, and so you are on to the next hot stock picker.

If an individual investor is contemplating an active strategy, I want them to realize that trying to find the top-performing stocks or mutual funds and knowing when to buy and sell them is a losing strategy. It might work for a week, a month, or a year, but over a lifetime of investing you are virtually doomed to fail. That is why we embrace the simple and sophisticated concept of investing in low-cost, tax-efficient index funds.

If an investor understands that the odds are extremely small that they will beat the market over the long term, and that person still wants to proceed with active management, I have no problem with that. As I have said, I really don’t care what a person does with their money – AFTER they have heard both sides of the argument.

I have a simple example, or exercise in my book called “Outfox the Box” that highlights the long odds of beating the market. In the hundreds of seminars and speeches I’ve presented over the past decade, everyone chooses the $8,000 box. Why then, would anyone want to choose active management? I am simply pointing out that the odds are against you.

Kirk:  One may argue that your unsuccessful experience trading wheat futures early on has significantly impaired your ability to recognize that some are able to do quite well in the market even over the long term using active strategies. How do you respond to such an argument?

Bill Schultheis:  The simple lesson I learned a quarter century ago has served me well. Again, I am not saying that investors can’t beat the market. Certainly, folks like Peter Lynch and Warren Buffett have bested a broad market index. I simply want to point out to investors that the odds are extremely likely that they will fail, and the harder they try, the more miserably they will fail. One of the problems I address with active management, and the pursuit of market-beating returns, is what do you do when your active strategy begins to underperform? What should the thousands of investors in Bill Miller’s Legg Mason Value Trust do when it begins to “dramatically” underperform the market? Do you stick with it, or do you switch, and pursue the next five star fund?

On top of that, engaging in active management is prohibitively expensive, as highlighted in this report. The additional fees and commissions in active management present a huge bogey to overcome when trying to beat the market over the long haul.

Kirk:   So, bottom line you think that luck plays a more significant role in market outperformance than people care to admit?

Bill Schultheis:  I haven’t given much thought to the role “luck” plays in market outperformance. My mission with The Coffeehouse Investor is clearly to point out to the average “intelligent” person, who takes this thing called investing very seriously, that trying to beat the market is a losing strategy for building wealth.

I am very aware that some investors like to “play” the stock market, and are intrigued by it – like my father, for example. He will never buy an index fund, because he is mesmerized by the buying and selling of common stocks. I would never try to convince him that his strategy is a bad strategy, because, first, it would be a futile attempt – he loves trading stocks, and second, it doesn’t really matter to him how he does. He could lose his shirt and he still has income from the farm to live off of. He is happy trading stocks and so I am happy that he is happy. But when he starts telling my brothers and sisters that he made a bundle on XYZ and they should buy it for their IRA retirement account, that is when I want to enter in to the discussion, because my brothers and sisters can’t afford to lose their shirts and hope to have a successful portfolio throughout their retirement. The irony of this scenario is that he has absolutely no idea how his returns have matched up to a benchmark over the years, much like the Beardstown ladies, and much like most individual stock pickers; they don’t keep track.

In reality, we are dealing with two different sets of people here. My father buys and sells stocks for the entertainment feature, and maybe the mental challenge. My brothers and sisters own common stocks as part of their retirement portfolio. There is a big difference between the two. Unfortunately, that stark difference becomes blurred when you get Wall Street’s marketing machine involved.

Kirk:   Clearly the stats you share in the book confirm your point of view on the importance of indexing. In fact, you go to say that Wall Street’s best-kept secret is that only 14% of all managed mutual funds beat the stock market average in each of the last 3, 10, and 15 year periods. Moreover, this doesn’t even include the expenses paid on load mutual funds, the capital gains tax liability of mutual funds held in taxable account, and merged or discontinued funds. You then go on to say that you “know of no other industry in which so many self-proclaimed experts try so hard to convince us that they are wildly successfully at which they so miserably fail.” So, if active investing is so unsuccessful, how does Wall Street get away with such outrageous fraud?

Bill Schultheis:  First, many companies that run actively managed funds ARE falling on hard times, as witnessed through the outflow of funds, and the actions of some (i.e., Putnam) to reduce fees and become more competitive. Traditional active mutual fund houses are a dying animal. The explosion of ETFs is another sign that investors are starting to turn away from traditional actively managed funds. With that said, the financial industry continues its relentless marketing campaign to try to persuade investors into thinking that there is value in owning top performing funds and ETFs. One reason why so many investors continue to invest in actively managed funds is because they are unaware that there is a smarter alternative.

Kirk:  As you have already mentioned, in the book you offer a great game called “Outfox The Box” and you offer the opportunity for visitors of your website to play it on their own. Can you briefly explain what this game is and why it is so important for all people to play?

Bill Schultheis:  In that game I want to get across the point to investors the overwhelmingly small odds that they have of beating the stock market over time. I want them to ask themselves, “Do I really want to take time away from my family, my career, and my lifetime pursuits, in an attempt to own the top performing stocks or funds, when the reality is that I am likely to fail, and end up costing myself a lot of money in the process?

Kirk:  A strong belief in the “reversion to the mean” appears readily apparent in your writings. In fact, you say that, seemingly, the most logical way – i.e. pick stocks and funds with the best track record – is incredibly harmful to performance. Why is this?

Bill Schultheis:  A good place to start that discussion is to assume that any way you slice the stock market pie, (by industry, sector, market cap, book to market, etc., and figuring you have more than 20-30 stocks in the slice), each slice will generate similar returns over a 10 to 20 year period.

These different slices may have vastly different returns in the short run, but in the long run, their returns are likely to be similar. This means that if you are intent on purchasing slices with impressive recent track records, to average out in the long run, they are likely to underperform in the future.

Take for example a large, east coast mutual fund company that has over 500 different types of mutual funds. Do you think they are going to advertise their worst performing, one-star funds? Of course not. They are going to tout the 5-star funds. So Mr. Investor buys that fund, and three years later, sells it, because it underperforms, and buys the new 5-star fund the mutual fund company is advertising. As I explain in my book, “Contrary to Wall Street’s self-promoting interests, diversification does not mean owning the top ten industries, the top five countries, and the two trendiest ETFs. It means investing in different components of the market that potentially have low correlation in the short run, even though similar returns are expected in the long run.”

Kirk:   Dividend reinvestment and compounding over a long time is very important to you. Why is this something most short-term investors/traders miss out on?

Bill Schultheis:  If you take out the dividend reinvestment returns over a 15-year period in the stock market, the returns drop significantly. That makes for an awfully big bogey for actively traders to make up if they are hunting for all that return in capital appreciation.

Kirk:   So, bottom line, it is your view that the way to financial success with your investments is to match the market’s performance over the long term. I have to say, that sounds great on paper. However, even you admit in the book that “past performance is no indication of future performance.” I mention this so that you can help me and others address an important paradox.

As you know, the events over the past year have given more than a few of us sincere doubts that the market will provide the same sorts of returns that we’ve seen in the past. It doesn’t take a genius to understand there will be significant consequences from the amount of money printed over the past year to rescue the financial markets combined with a consistent fiscally irresponsible government and leaders who simply refuse to balance the budget and eliminate the debt. As such, for many of us (including me) it requires a leap of faith to believe that the market (under these unique conditions never seen before) will produce similar positive results over the long term. In fact, although many of us wish to believe that “everything will work out in time” (which is human nature and an admirable element of the great human spirit) we must also admit that such reasoning is based on faith and optimism rather than on pure facts, especially since past performance offers no guarantee.

So, here’s my question, how do you think on one hand that past performance is no indication of future performance but at the same time hold the opinion that matching the market’s overall performance is still the only way to go to achieve long-term success?

Bill Schultheis:  That is a great, great question. We are inundated with economists and market pundits who pretend to have an accurate reading on the future. The reality is that no one knows for certain what the future holds. I agree with you that we are digging ourselves a deep hole especially with the exploding federal deficit, and for that reason I think it is important to be diversified, not only in U.S. equities, but domestic equities, fixed income, and inflation protected securities as well.

It is quite possible that global stock markets might generate returns substantially less than its historical long term average of 9 to 11 percent. But that doesn’t mean we should necessarily avoid it. What are the alternatives? Stick it all in 3% CDs? Heck, value index funds are paying dividends almost that much right now.

At current valuations of 16-18 times forward earnings, I think there is a good chance that equities will at least match, and more likely outperform fixed income investments by a wide margin over the next decade, if only because rates on fixed income securities are so low right now. With that in mind, an allocation to equities is a risk worth taking for me, especially at these valuations.

Kirk:   People are amazed when I remind them that the S&P 500 is virtually unchanged over the past six years. For most of us, six years is a very long time indeed!

You must admit that it is very well within the realm of possibility that we could potentially see even worse performance over the coming five, ten, twenty, fifty year period. Given that, how does one truly commit themselves to a long-term investment strategy in the face of these overwhelming and legitimate concerns about the future of our country and economy when past performance offers no guarantee?

Bill Schultheis:  You are right, Charles, the stock market may have a prolonged period of underperformance. That is the risk we take for the potential of reaping higher returns over the long haul. One can invest for the long term, and it still may prove to be the wrong decision. That is the nature of investing and living in a world where there are few certainties. At least Coffeehouse Investors recognize that they are doing all they can to maximize their chances for returns in the stock market by buying and holding a globally diversified portfolio of low cost index funds. My feeling is that if the stock market is at today’s levels 20 years from now, there isn’t going to be much of anything worth holding on to, except a small plot of land to plant your potatoes.

Kirk:  You’ve made good arguments to back up your views, Bill. We appreciate it!

Let’s move on and talk more about specifics in your approach so that others can actually implement a strategy that will match the market’s performance and produce long-term success.

You write in the book that the first step is to tune out the Wall Street crowd and tune in to yourself. In fact you say that the greatest obstacle to building successful portfolios isn’t finding five-star mutual funds and number-one rated stocks – we are our biggest obstacle, along with our own reluctance to change and embrace the obvious. Then you reveal 3 key principles behind your approach. What are these three key principles?

Bill Schultheis:  The three principles are:

 

  1. Don’t put all of your eggs into one basket – the key is to diversify your assets in such a way that you maximize your chances of reaching your goals with the minimum amount of risk
  2. There is no such thing as a free lunch – markets are efficient and any attempt to beat them is likely to prove disastrous – it is essential that you capture the entire return of each asset class and leave it at that
  3. Save for a rainy day – develop a long term savings plan with a keen eye on your saving and spending levels – essential to reach your long-term goals

Kirk:   Let’s talk about the first principle – diversification. At the beginning of your book you share a story about “Bob” who refused to diversify his portfolio and suffered big losses as a result. Why do you think it is so difficult for investors to create and maintain diversified portfolios?

Bill Schultheis:  There are several reasons – to name a few, in no particular order:

  1. Many investors don’t possess the investing wisdom to determine a proper allocation for their portfolio, in part, because they don’t know how to put together a simple financial plan, that is the basis for one’s asset allocation. This is where an astute investment advisor/ financial planner can help out; by creating an allocation that broadly represents one’s need and ability to take risk.
  2. In Bob’s case, the greed factor got the best of him. He was more concerned about making money than he was about maintaining his current lifestyle for the rest of his life.
  3. The emotion of fear can have an equally negative effect. When portfolios are dropping month after month, as they have been for much of the past two years, many investors are tempted to pull all of their money out of the stock market, only to re-enter the market at significantly higher levels.

Kirk:  In the book you shared the following asset allocation model that basically provides guidance on how your portfolio should be allocated based on your age and investment temperament:

 

file bill_assetallocation.gif

First off, how does one decide between the conservative and aggressive approaches?

Bill Schultheis:  That is a personal question that can be answered only after one has created a financial plan and recognizes the tradeoff between an aggressive or conservative approach. It has been my experience that very few “intelligent” investors are able to successfully analyze the many factors that weigh on an allocation that is right for them.

Kirk:  Ok. Let’s assume they do that and work with a financial advisor to help them determine which one is most appropriate. Once that is decided, the next step is actually implementing a long-term strategy that targets and maintains the desired asset allocation.

Obviously, as an independent investment advisor, you have the opportunity to sit down and help your clients out based on the client’s own time horizon, objectives, risk tolerance, etc. And, while those things are very important, those trying to figure out how to do this on their own may have some difficulty with your book as only overly broad brush strokes are provided. In fact, you do not offer a present allocation with specific index fund or ETF recommendations.

Bill Schultheis:  I have received several comments over the past ten years that suggest the book doesn’t provide enough information for investors who want to build portfolios. My intention was never to write that particular book – for several reasons. First, I wanted to write a book that was easily read by intelligent investors of all ages. I wanted them to walk away from the book with a clear understanding that they aren’t missing out on anything by not owning the top stocks and funds with their investments. I wanted them to recognize that it was critically important to simply “match” the stock market’s performance to be a successful investor and reaching their financial goals was to be found in the three principles, not in 5 star mutual funds. econd, there are several excellent books available (by Bernstein, Ferri, etc) that explain the finer points of building a Coffeehouse-type portfolio. I couldn’t add anything beyond what those authors share in their work.

Kirk:  In an effort for further clarification, let’s talk about some specifics as a starting point so that people can best understand your approach and to clear up my own confusion on this matter. At your website I found the following chart that is curiously not shared anywhere in your book:

 

Allocation

 

This allocation is identical to the model portfolio tracked by Marketwatch. Are you suggesting that this model approach offers a starting point, but that the recommended asset allocation should supersede the final composition of an investor’s portfolio or am I missing something here? Please clarify.

Bill Schultheis:  One month after the book was originally published in January 1999, I started writing a weekly investment column for a few daily newspapers across the country. To provide a framework within which to discuss The Coffeehouse Investor philosophy, I created the generic 60/40 portfolio so that investors could follow a benchmark when reading my weekly column, and give them a conceptual idea of what a Coffeehouse portfolio could look like.

That specific portfolio quickly took on a life of its own, and continues to garner quite a bit of attention in the national financial media. During the eight years that I wrote the column I continually stressed to the reader that this allocation was only ONE EXAMPLE, and that it should be tailored to one’s specific risk parameters.

Kirk:  Ok, that makes sense. It is simply a teaching example. However, at your website you provide yearly performance of this portfolio showing an annualized 17 year return of +8.61%. How does this compare with the S&P and are transaction costs & management fees used in the computation of this data?

Bill Schultheis:  During the same period, the S&P 500 Index generated a return of +7.9%. The numbers shown on the website include either live index funds with expense ratios included, or hypothetical index funds, when only indexes were used, with an expense ratio of 20 basis points included.

I would also like to add that I am very up front with the reader, telling him or her that this type of performance is unlikely to persist in the future. In fact I am 100% positive that it won’t.

Kirk:  Although I realize it was only a sample portfolio, I must also ask why the model you’ve outlined does not have any exposure to markets beyond the U.S.? After all, one of the reasons why Ted Aronson’s model portfolio is outperforming yours and the rest is because of its exposure to emerging markets.

Bill Schultheis:  The 60/40 Coffeehouse portfolio does include a 10% allocation to international, and 10 percent to REITS. If I were creating a portfolio today, I would increase the international allocation and include emerging markets, probably 5 to 7 percent, but would stress to the investor that the way a portfolio is split up between domestic, international and emerging markets is far down the list on factors that are important in reaching one’s financial goals. Whether I have 0, 5 or 10 percent in emerging markets isn’t nearly as important as how much I save and spend. That is the message I want to get across to investors.

Kirk:  Along those same lines, why doesn’t the portfolio have any exposure to commodities? In fact, it is common that many passive strategies ignore this asset class completely even though studies have clearly shown that it tends to offer tremendous diversification value. Why is that?

Bill Schultheis:  There is a raging debate among folks in the passive arena as to the pros and cons of commodities in portfolios. One side says this asset class has great diversification value, an argument that fell flat on its face over the past two years. The other side says that commodities generally appreciate at the rate of inflation, so not worth it in a portfolio – one is better off buying treasury-inflation protected securities (TIPS) as an inflation hedge. If someone wants to put commodities into their portfolio, I have no problem with that and recommended allocation is probably 5 to 10 percent. However, at this percentage, it isn’t that big a deal whether one owns commodities or not. How much I save and spend is, and that is the factor I focus on as an investor.

I have to tell you a funny story. Everyone knows that gold has been red hot of late. A couple of months ago a noteworthy financial publication was advocating gold for portfolios – it was a big cover story article. At the end of the article, the author suggested placing 1 to 2 percent of a portfolio in gold. Give me a break! If an investor is worried about how to allocate 1 or 2 percent of a questionable asset class in their portfolio, they need to get a life. One percent is meaningless.

Kirk:  Yet another classic example of Wall Street doublespeak!

Since no specifics are provided in the book, what are the names of low-cost index funds and/or ETFs you frequently recommend to your own clients in order to build and maintain a portfolio like the one you have recommended and/or how does one go about researching a low-cost index fund or ETF?

Bill Schultheis:  The majority of our index/passively managed funds are either iShare funds, Vanguard Funds, Dimensional Fund Advisors funds, and Schwab funds.

There are several books on the market today that do a good job of detailing which ETFs are worth placing in one’s portfolio. Although there are many ETF providers out there, a person could build a successful portfolio using iShares ETFs exclusively. I would start with Rick Ferri’s book, “The ETF Book” as the bible on exchange traded funds.

As long as you own a broadly diversified, low-cost portfolio of index funds, the ones you choose aren’t nearly as important as sticking with the funds you choose, especially when other index funds outperform the ones you own.

Kirk:   At Marketwatch you can see how the Coffeehouse portfolio has performed in comparison to the S&P 500 and other passive portfolios. I’m curious to know what you think are the strengths and weaknesses of other portfolios tracked by MarketWatch in comparison to your own.

Bill Schultheis:  For the past ten years, in all my writings, I have continually stressed that there is no perfect way to build a “passive” or index portfolio. The Coffeehouse Investor is all about recognizing the importance of not trying to beat a benchmark, but simply building a globally diversified portfolio of low cost index funds, and then sticking with it in up and down markets – rebalancing periodically and making sure your asset allocation between stocks and fixed income broadly reflects where you are at in your life.

With that said, I think that all the lazy portfolios are a good example of what a Coffeehouse-type portfolio could look like. To comment on them individually, I am a believer in keeping things simple, and so probably wouldn’t advocate owning 11 funds (i.e., Aronson, Fundadvice).

I am also an advocate in the persistence of a value / small premium inherent in the stock market. It just makes sense to me that a basket of low priced stocks is likely to outperform a basket of high priced stocks over time. For that reason, I would suggest that an investor accentuate their equity holdings in those dimensions of the market, which aren’t included in some of the portfolios (Margaritaville, Second Grader).

Finally, on the fixed income side, while I think it would make sense to include a TIPS fund for a portion of one’s bond allocation, I wouldn’t put the entire allocation into a TIPS fund (Margaritaville). I would also include a Short and Intermediate bond index fund, or Total Bond index fund.

Kirk:  Many people who desire to implement an approach of this nature have a difficult time getting started. How do you recommend they go about it – lump sum, dollar cost averaging, etc.? Does your recommendation have anything to do with the amount of money on hand or is that entirely irrelevant? Any rules of thumb you can share would be appreciated.

Bill Schultheis:  If I had one thousand or one million dollars to invest today, I would invest the entire amount immediately, and not try to time the market, which I have found is a losing proposition for my clients and myself. And because the stock market generally trends higher over time, the odds are in one’s favor to invest sooner rather than later. The decision on whether to invest today or six months from now is largely irrelevant to whether one reaches their financial goals ten or twenty years down the road.

With that said, I realize that emotions are involved when investing a chunk of money all at once, and so if I sense one is struggling with this decision, and to hedge one’s emotions, oftentimes I will suggest allocating half the position today and waiting three months to allocate the balance.

Kirk:   I believe you have suggested yearly rebalancing to the target allocations even though you admit it is emotionally difficult to reallocate assets away from the class that is doing well and invest them in a class that has underperformed. But as you say “those who neglect this important aspect of portfolio diversification often find that when the tide eventually turns (as it always does) they are stuck with an excessively large, underperforming asset class.” Dominant trends tend to last longer, why is one year an appropriate time frame for rebalancing instead of, say, every month, quarter, six months, two years, five years, etc.?

Bill Schultheis:  There is no right or wrong answer on the perfect time or best method of rebalancing. For the vast majority of investors who are indecisive about when to rebalance, they are focusing on the wrong thing. They should spend more time on their financial plan, and by that I mean their saving and spending, which will have a far greater impact on their financial well-being than their rebalancing date.

When it comes to rebalancing, what is important is that this decision is reviewed periodically, ESPECIALLY as one approaches their retirement years. A good example of this over the past decade was the period 2002-2007. During this time the stock market generated some huge returns, and anyone’s equity allocation of 2002 had certainly grown to be a much larger number by 2007. For investors who were nearing retirement, they certainly should have been taking a close look at whether they needed 60 to 70 percent in the stock market at that point in their lives.

Kirk:  For rebalancing, do you think the best time is year-end or do you think it can be at any time through the year?

Bill Schultheis:  I think toward the end of the year it makes sense to review rebalancing, especially as it relates to any tax-planning issues that might need to be considered. However, as financial decisions come up throughout the year, these times also present a good opportunity to review one’s allocation.

Kirk:  Your second principle suggests there is no such thing as a free lunch and that markets are efficient. While we’ve already talked about your view regarding this, it brings up an important point. It is clear that by extension this also seems to suggest that any element of market-timing or risk management in a passive indexed portfolio is to be avoided at all costs. I don’t have to tell you that others disagree with your view on this (including me). For example, in previous Q&A sessions (such as the one with Mebane Faber), there are simple but effective strategies that have proven to be tremendously helpful in limiting downside exposure and help to preserve capital during the inevitable bear markets. Is it your view that these market-timing strategies are inherently flawed and unsound?

Bill Schultheis:  There are many strategies that have been effective in the past, but how confident is one that this strategy will be effective over the next 20 years? I have been in the financial services business for over a quarter of a century, and over this time have always been on the lookout for new and improved strategies. The story is always the same. It is a good strategy until it isn’t. A perfect example of that is Dogs of the Dow. It was THE ultimate strategy. Brokerage firms flooded the market with securities that mirrored the concept, and it fell flat on its face, at least long enough that everyone got burned and sold out and was on to the next hot strategy.

Through all these years, I have come across and reviewed countless systems that profess to “beat the market”. Some systems might work some of the time, but I have yet to come across a system that has proven, not only from a logical standpoint, but in real life, to stand the test of time. The question we need to ask ourselves is, “What happens if you align yourself with someone’s system, and it fails, and fails miserably?” What are you going to do then? As I comment in my book, life gives you a second chance to learn from your lessons and do the right thing, but it doesn’t give you back the time you lost while learning the lesson. When it comes to investing, time is the most precious asset class of all.

I don’t blindly advocate the Coffeehouse philosophy. I am constantly reviewing financial writings for a better way upon which to maximize one’s returns in the stock market. If someone can convince me that they have found one, I will share it with Coffeehouse Investors with a zeal in which I share the current message.

I think one example in which I embrace an idea, or investing concept that stands a good chance of beating a cap weighted, total stock market index over time is through a tilt to the value or small value dimension of equities. For instance one of the reasons I tilt my own portfolio to value / small value is that over time I feel the value premium will persist. Some say it is a risk issue, I personally think it is more of a behavior issue. It is only human nature to want to own stocks of well run, fast growing companies. And for that reason, those companies’ stocks are bid up to a level that you are paying more for a dollar earned than for slower growing companies. For that reason alone, I think the value premium will persist – human nature doesn’t change much in this department.

Another reason I tilt my portfolio is to hedge my emotions. It is always nice to own a part of the market that is doing well, relative to other dimensions. The important thing here is that I recognize my decision for what it is, and if I am wrong over the next twenty years, so be it. I am sticking with it, and if it does underperform, it probably won’t be by much, and certainly won’t be the driving factor on whether or not I reach my financial goals. How much I save and how much I spend will be a driving factor. Whether or not my portfolio is tax efficient will be a driving factor. Whether or not my portfolio is low cost will be a driving factor.

There is a perception among many investors, especially those who work in the financial industry, that settling for “average” through index funds just isn’t good enough. They want more than that. I come across this sentiment once in a while when I sit down with a prospective client, especially younger clients who want to invest more aggressively. My response is that if you DO want to invest more aggressively, do it in a manner that gives you a fighting chance of beating the market over time. The LAST thing you want to do is load up your portfolio with 5 star mutual funds, fast growing companies, or somebody’s trading strategy that has worked for the past 5 years. That is flat out stupid. If you want to invest more aggressively, tilt your portfolio away from bonds or TSM and toward the value / small part of the market.

Kirk:  That’s great advice, Bill. Bottom line, do you think any element of risk protection and market timing is appropriate (at least in some cases)?

Bill Schultheis:  I do not believe in market timing. However, if you want to reduce your risk, increase your fixed income allocation.

Kirk:  How do you keep abreast of all that is going on in the financial arena?

Bill Schultheis:  I have always been an early riser (maybe it was my farming youth, and later on, living in the west-coast time zone). I usually hit the ground running by 5 a.m., and have browsed through several daily and weekly periodicals by six a.m. I love to see this thing called life unfold day by day. Every day is a new day to make history and every day, collectively, we are making history, sometimes in a profound way. Hopefully my work at the Coffeehouse is a small part of this history and change in the making. But sometimes change comes about oh-so-slowly.

For instance, the cover story of the October 31, 1994 issue of FORTUNE magazine was titled, “The Coming Investor Revolt – Why mutual fund managers, investment advisers, and brokers aren’t earning their keep.” I copied off this cover story, and sent it, along with my Coffeehouse Investor book proposal, to countless publishing companies across the country. For three years I got the publishing door slammed in my face. Finally, the same publisher and editor who put together “The Millionaire Next Door” decided they wanted to take a chance on The Coffeehouse Investor.

Five years after sending out my first book proposal I got it published, and on December 19, 1999 in my weekly newspaper column, at literally the zenith of the 401(k) plan, when everyone was madly in love with these accounts and planning on retiring at 55 because these accounts were going up 25 percent a year, I wrote “401k accounts will prove to be a financial debacle, the likes of which this country has never seen.”

Now, here it is, almost ten years after that prediction, and I come in to work this week, and the cover story of TIME magazine shows the title “Why it is time to retire the 401k,” with a 401k sinking into the sea. I am not going to say, “I told you so”, but I do have some ideas on a much more sensible retirement account plan. That is a different topic for a different day.

Kirk:   If we had uncensored access to your personal portfolio, would we see a similar configuration as your sample portfolio or something entirely different?

Bill Schultheis:  My portfolio has the following allocation:

  • U.S. 33 percent (with value and small tilt)
  • International 23 percent (with value and small tilt)
  • Emerging markets 14 percent (with small and value tilt)
  • Fixed Income 30 percent

My target allocation is about 35 – 40 percent in fixed income, and I try to keep my equity allocation between domestic and international/emerging markets at about 50/50, so I will probably be rebalancing in the next few months.

Kirk:  I must say, that’s quite a bit of exposure to international & emerging markets versus the sample portfolio you’ve outlined. Can you offer your reasoning for a larger bias toward markets outside of the U.S.? In addition, isn’t your personal portfolio allocation a form of shadow market-timing away from U.S. equities due to your heavy exposure outside of the U.S.?

Bill Schultheis:  The 60/40 “Coffeehouse” portfolio, that consists of a 40 percent bond allocation, and 10 percent each in U.S. Large Cap, Large Value, Small, Small Value, Int’l and REITS was created in 1999 as one example of a passive “index” portfolio for people to consider. Over the past decade, in my personal account, and in clients’ accounts as well, we have increased our international exposure to more broadly reflect a “Global Market Cap” weighting. I don’t feel comfortable continuing on with such a large exposure in emerging markets, and will be rebalancing those dollars in the near future.

In regards to the overall allocation between domestic and international, I continue to emphasize in my writings and in my dealing with clients, that whether one has that last 10-15 percent in domestic or international isn’t nearly as important as the financial plan one creates and adheres to. I can’t stress that enough. As investors, we need to focus on and spend our energies on the issues that matter most of all!

Kirk:  Now, let’s move on to the third principle which requires you to “save for a rainy day.” In my view, this is one of the key strengths of your book because you don’t fall into the trap where most personal financial books go awry and insist that people undertake a significant lifestyle change regarding how they spend and save money. In fact, in the book you recommend that everyone close their eyes and contemplate what their life would be like today on 20% of their current income. For many, this would be a complete nightmare!

For you, it seems to start with a clear awareness of your financial situation. In fact, you share a statistic in your book that 57% of investors have not spent any time calculating how much money they should be saving to reach a retirement goal. That’s unbelievable! In fact you say they need to be “fully aware of the gap between how much you are currently saving and how much you should be saving to reach your goal so that when financial decisions come up in the future, such as buying a new this or new that, the issue of being responsible for your financial future is at least present at your financial making table.” How does one become aware of what they need to save for retirement?

Bill Schultheis:  The first two steps in creating this awareness are to start keeping track of how you save and spend your money, and then utilize some financial planning software that will allow you to determine whether you are on target to reach, or maintain your financial goals. For instance, if you are 40 years old, and your goal is to retire when you are 65 and maintain a lifestyle through retirement similar to the one you are living today, are you on track to accomplish this? There are a bazillion financial planning software programs out there – but the one that I think is great and use for my clients and myself can be reviewed and purchased at Torrid Technologies.

Once you have carried out this exercise, and determine, for example, that you need to be saving more, you can then begin to make some thoughtful decisions, based on your awareness of where your money is being spent, on how best to either cut back, or earn more income. I am such a big believer in creating this awareness, because then you at least are conscious of the decisions you need to make, and how they will affect your financial well-being 10, 20 years down the road. For instance if you are serious about needing to save an extra $300 dollars a month to reach your goal, you are much less likely to purchase a new car if you don’t really need one.

Kirk:  Thank you. Many have asked me for a good resource for financial planning software and I’m impressed with your software suggestion. Thank you!

Once you become fully aware of your financial situation, in the book you also offered a handy retirement worksheet for readers to use:

 

Retirement Worksheet One 

Retirement Worksheet Two

You seem to suggest that knowing your burn rate along with the knowledge of how much you need with your retirement goals after using this worksheet is critical. I agree completely! However, it is sad but true that many people in America do not have the time needed to invest and/or make enough money to hit the goals they desire. So, what do you suggest these unfortunate folks?

Bill Schultheis:  It all boils down to personal responsibility; either making conscious decisions to alter one’s lifestyle today for a better future tomorrow, or accepting the fact that you won’t be able to achieve the future financial goals at your current pace.

It is pretty obvious that a significant part of our population is living at or beyond their means, not taking personal responsibility for their financial decisions today and planning for a decent future tomorrow. However, in my work and connection with thousands of investors over the past 10 years, I have found there is a huge part of our population, especially women, who DO want to take responsibility for their financial future – it is just that it seems so overwhelming that they don’t know where to get started or how to go about it.

And unfortunately, as consumers, they are blasted by the financial media into thinking that the secret to their financial success is in buying 5 star mutual funds. The reality is that pursuing 5 star mutual funds is not only irrelevant, but counterproductive to reaching one’s financial goals.

Kirk:   In your book you said that “any company that doesn’t provide employees an opportunity to invest in index funds should be held accountable to its employees to the extent that the company’s plan’s managed mutual fund underperform their respective stock market indexes.” Have you ever thought about contacting members of Congress to support a bill that would require this? (I’d be happy to aid in the effort if you like!)

Bill Schultheis:  I would love to get more involved in an effort to create sound legislation for consumers of financial products, especially in the retirement arena. Unfortunately, right now my time doesn’t permit it. Ironically, about 5-6 years ago, I participated on a panel with my U.S. Senator regarding these very issues. I was surprised at this person’s complete lack of understanding of the very basics of investing and the decisions that go in to accentuating one’s chances of being a successful investor.

Kirk:   One question I receive by many after advocating indexed focused strategies is that many 401(k) plans do not offer the ability to easily create and maintain a portfolio like the one you’ve recommended. What words of advice do you have for those in retirement plans which only allow for active investment management and/or high fees?

Bill Schultheis:  That is a tough position, because if you address this with the HR/decision maker, you could potentially be putting your career on the line. My suggestion would be to gently introduce the Coffeehouse philosophy to the decision makers, and suggest that because they have a fiduciary responsibility to do the right thing for their employees, they might want to make some changes. In the past couple of years, there have been several cases of legal action taken against companies who provided abysmal choices for employees.

Kirk:   As you know, many products have become available in recent years that are being marketed to passive investors, including the use of target date mutual funds. What’s your opinion on these products? Are there any good ones worth considering?

Bill Schultheis:  If a target date mutual fund is constructed in a manner that it reflects a Coffeehouse-type of portfolio, meaning low fees and adequate diversification, I think they can be wonderful tools as investments. Simple and low cost. I think Vanguard has some of the best in the industry. But in considering these, careful attention should be placed on the fund’s allocation between stocks and bonds, so that it fairly reflects an allocation that is right for you.

Kirk:   I have been asked many times whether passive investors should use ETFs instead of index funds. It is no secret that the use of ETFs has grown immensely in recent years. In the book you say that “the benefits of owning ETFS need to be weighed against any downsides, including the temptation to trade them more than traditional index mutual funds, and any commission charges associated with buying and selling your brokerage account.” That’s true, so what (if any) in your opinion would be the benefits of using ETFs instead of index funds?

Bill Schultheis:  In my opinion, the big benefits of ETFs are their low cost and tax efficiency in taxable accounts.

Kirk:  In the book you explain the two major types of risks that investors face – the risk of inflation (i.e. living expenses increase faster than your income from your investments) and stock market volatility (the risk of losing money in the stock market). The latter has been a big problem for all investors over the past year, even though as you make clear in your book, having a longer time horizon helps alleviate that problem. However, risk of inflation is something that many investors worry about these days. How does your model portfolio tackle this problem effectively and what (if any) strategies are you recommending to your clients about how to hedge this risk?

Bill Schultheis:  It is interesting that you should bring that up, because just this morning I printed off a report that says “Social Security makes it official: No COLA in 2010.” The first time ever, or at least since 1975, when automatic adjustments were adopted. So while inflation is certainly a dark, ominous cloud on the horizon, it isn’t something we are dealing with today.

Historically, equities have performed at a rate that has beaten inflation, and I suspect that will continue in the coming decades. Certainly TIPS provide for protection of one’s purchasing power, and we are integrating these into portfolios to hedge against the real possibility of inflation.

Kirk:  If experts are correct and we enter a period of hyper inflation, are there any adjustments you would make in your own investment accounts, those of your clients, or your target model portfolio?

Bill Schultheis:  Certainly shortening one’s maturity risk on the fixed income side is one solution, as well as loading up on TIPS.

Kirk:  One area we haven’t talked about so far is your basic philosophy in managing risk. Can you share a few thoughts regarding this subject?

Bill Schultheis:  As boring as it sounds, my philosophy is to remain diversified in both the equity and fixed income allocations of your portfolio. No one knows what the future holds, and the goal is to be able to adjust one’s portfolio based on current market conditions in relation to where one is at in their lives. This is especially true for folks who are nearing, or at retirement. Structure your portfolio so that it is more conservative than you can possibly stand, and hope you are wrong. Taking the opposite approach, of being too aggressive and hoping you are right is wrought with financial AND emotional disaster.

Kirk:  In my jaded experience (especially since I maintain a website focused on helping people perform better in the market), I discovered that the vast majority love to 1) time the market and 2) beat the market. Since you are not going to change human nature and these desires, how do convince others that yours is the right road to be on so they actually stick with the plan over the long-term?

Bill Schultheis:  Certainly, with your track record of beating the market, you have captured the attention of a large following of investors who want to time the market and beat the market. But I have to disagree with you on your overall assumption. Most investors are so busy with their lives and so consumed with their families and careers that they don’t have time to follow the market. All they want to do is have a peace of mind that they are doing the right thing with their investments. The percentage of investors who actually make a conscious decision to time the market or beat the market is very small. I mean really, how many people come home at night, every night and tune in to Jim Cramer’s Mad Money? How many people who own a 401k actually subscribe to Morningstar? Not many. Most investors can barely tell the difference between a bond fund and stock fund. Most investors don’t have clue what an index fund is, or a vague one at best, in relation to an actively managed fund.

Give me 15 minutes and a roomful of intelligent investors, and when the time is up, 80 percent of them will never invest in an active fund or with a stockbroker again.

Kirk:  You admit in the book that “somewhere deep inside our psyche is part of us that wants to whoop it up -you know get a little more involved in the stock market thing than simply indexing our stock investments and getting on with our lives.” You then recommend to readers that “if you want to have some fun in the market after you index the majority of your assets, it is ok to take a small portion of your stock market money and invest it in your own common stock ideas. But, at the end of the year, compare the return of your own stocks with the stock market average.”

So, if someone accepts your advice and finds that they have what it takes and they produce sizeable returns in comparison to the market minus all expenses, fees, and taxes, isn’t it foolish to think that those same people should continue dedicating the vast majority of their money to passive investing strategies? Clearly, there can be exceptions to the rule that there are some who can effectively manage their money well and can graduate past indexed strategies even though I realize they are more the exception that the rule.

Bill Schultheis:  The reality is that the vast majority of investors are more concerned about owning a successful portfolio than beating the market. However, if someone wants to take on the challenge of beating the market, I am not going to try to stop them, just as I am not going to stop someone from trying to figure out a system for beating the house at blackjack. And if they succeed, I am not going to ridicule them, I will be the first to congratulate them on their successes. But I still won’t recommend them to my seven brothers and sisters. Maybe they will succeed for a year or five. But the chances of them succeeding over the next couple of decades, in all different types of markets, is very small.

Kirk:   One of the most damaging things I’ve personally witnessed over the past year is how many have thrown away indexed strategies in favor of being more active. This growing group of people have become convinced that buy and hold strategies of the past are dead and worthless. In your view, why are these people wrong?

Bill Schultheis:  Well, as things unfold and the stock market continues its impressive rally, I suspect that some of those folks who tried to engage in market-timing this past year are regretting it.

If there is one thing that this past year has brought to light is that many investors need to grow up and deal with reality. They have no problem when the market goes up 30, 40, or 50 percent in a 12 to 18 month period, as it did from 1995-1999 and 2003 – 2007. They think that everything in the world is working great, free markets are terrific, and modern portfolio theory is some sort of holy grail. But heaven forbid the market should ever revert to its long term average of 10 percent by falling 30, 40, 50 percent. Then they have a cow and start running around saying the sky is falling and the world is going to end and markets are broken.

The stock market is a volatile creature! It always has been and always will be. Deal with it or don’t invest in it.

Now, I must admit that a good portion of the market hysteria over the past year, and especially amid its steep decline, was media driven. When you have half the financial reporters chattering all day on CNBC that capital markets are broken and the world is coming to an end, eventually you start wondering yourself whether or not that is in fact true. The reality is that one of two things is going to happen – our global financial system is going to collapse and everything is going to be worthless (yes, even gold), and in that case I’m heading back to the farm to live off the land, or it isn’t going to collapse, and the global economy is going to muddle along for the next century as it has the last century, with growing economies that reflect a growing population of people who for the most part want to continue to go to work every day and bust their butts to improve their quality of life – this will ultimately be reflected in growing stock markets. Sure we have got big, ugly problems. Welcome to the human race. We’ve always had big ugly problems. It is called life. I am an optimist and a realist at heart, and if I am wrong, I will be on the sinking ship along with everyone else.

Kirk:  Along those same lines, there has been a lot written about the fallacy of “stocks for the long run”, in that bonds have outperformed stocks over the past 30 years. How should one allocate assets now based on this observance?

Bill Schultheis:  I roll my eyes (and laugh a little) when I read these articles – some written by some fairly prominent people in the industry, though I won’t name names. My response is, give me a break. In 1980 the 10-year treasury was at 12 percent and today it is at 3.35 percent. Of course there was a rip-roaring bull market in bonds. To project that out in the future, implying that bonds might continue to perform in the same manner, and then hinting that someone should tilt one’s portfolio to bonds because of that is beyond ludicrous.

In the same discussion, much has been written in the recent past about tilting your portfolio one way or another based on equity valuations. The easiest thing in the world is to sit here today and say that one should have been completely out of the market ten years ago when the P/E on the S&P 500 was over 30, or that the market was a screaming buy in the first week of March, 2009 at Dow 6500. It isn’t so easy to make those market timing calls, those tactical allocation calls, during the moment. To anyone who suggests that they can do it successfully, I invite them to put their money where their mouth is, give me a money back guarantee that you can do it over the span of 20 years, to come out ahead over a more traditional Coffeehouse-type approach, and I will gladly invest my entire portfolio with you.

If I was building a portfolio today, I would ignore stock and bond valuations and create an allocation that broadly reflects where one is at in life, based on their need and time frame for risk. Keep in mind that if the stock market is going up year after year after year, and you are taking care of business on the home front, you are already taking money off the table by reallocating to bonds, and vice versa in down markets.

Kirk:   I understand from your book that you are quite a golfer and mountain climber. How do these pursuits, in your view, help you become a better investor?

Bill Schultheis:  I love to golf and climb mountains, in part because these two endeavors offer me solitude to think and daydream. I am a little bit of a loner at heart, and work in a career that requires me to be anything but. After struggling at golf for many years, I am finally getting to the point where I am really enjoying the game because I have figured out that the most important clubs in my bag are my putter and wedges. In golf, as in investing as in life, if you control the things you can control, and don’t worry about the things you can’t, you usually come out on top.

One of the reasons I like golf so much is that there is a direct correlation between how hard one works at their short game, and their score.

For instance, hitting a driver and long-middle irons can be a challenge, and difficult to master. But anyone can go out and practice their short game, and with hard work, develop an impressive short game. Take someone who has never played the game of golf before. They would have difficulty drilling a two foot putt consistently. But have that same person practice a two foot putt five thousand times, and I can assure you they would improve dramatically. Same goes for chipping, and to a lesser extent, shots from 125 yards and in. Why do you think Tiger Woods is one of the top putters inside 15 feet? Because he has practiced more putts than anyone else inside 15 feet. But what do you see at driving ranges across America? Everyone smacking their drivers. My goal is to be the best short game player at my club, shooting par golf from 125 yards and in, and when I do that, I know I will beat almost everyone on a net basis. There is no reason why I shouldn’t be shooting par golf from 125 yards and in. Right now, when I lose a match, it isn’t because anyone beats me, it is because I beat myself from 125 yards and in. And maybe, just maybe, someday I will shoot a 72, like you Mr. Kirk!

My favorite golf book is Dr. Bob Rotella’s, “Golf is not a game of perfect.” The same can be said about life. Success doesn’t mean hitting perfect shots or living the perfect life, it is how we manage and accept and deal with our less than perfect shots, and how we deal with our failures and imperfections in life, that will determine our happiness and well being.

Mountain climbing – where do I start? I love the solitude, the starkness of climbing a mountain, of putting one foot in front of the other, hour after hour, day after day. The first hour that you begin to climb, with that heavy pack on your back, all the thoughts you have stored up in your brain from your week at work, your arguments with your mate, your confusions and frustrations, are bouncing around like bumblebees in your consciousness.

Six hours later, step after methodically slow step, you are at peace with your world. You have tuned out the world and have tuned in to your heart pounding in your chest and your blood flowing in your veins. It is a great sensation. You have cleansed your conscious of the arguments, frustrations and confusions, and have now created an emptiness – a space in which creativity and life’s good energy begins to enter into your being. You start to daydream about the small and not so small changes you are going to make in your life to live the life you want to live.

For instance, during my first expedition on that big, nasty, beautiful mountain called Denali, I spent the first four or five days stewing over the question “I am 32 years old, what the hell am I doing with my life?” After that, I began to ask myself, “What AM I going to do with my life?”

Now, here it is, 16 years later, and this thing called Coffeehouse has unfolded in a way that I never could have imagined back in 1993. But despite everything that John Bogle has done, and everything the Bogleheads have done, and everything you and I have done to promote the philosophy, we have barely scratched the surface in regards to the impact of we can have in helping investors to build wealth, ignore Wall Street and get on with their lives.

So maybe it is time for me to get back on the mountain and create a space so that I am even more creative and more bold in the way we present this message to others. What an incredible opportunity we have, working together, to impact this world in a positive manner.

Kirk:  Indeed – an incredible opportunity!

They say that there are 2 types of people in Wall Street – those who don’t know, and those who don’t know that they don’t know. How can the investor have confidence seeking advice from an industry where nobody knows?

Bill Schultheis:  I wrote an OP-ED piece last summer to the editors of major newspapers across the country titled “Madoff and (Not) Me.” It hasn’t been published yet, but it asked the question, “Who DOES one trust when dealing with Wall Street? Here is a novel idea: Why not trust yourself? That is what the three Coffeehouse Investor principles are all about. When clients come to us, they don’t trust us to try to predict interest rates or pick the top sectors or stocks, they come to us because they want us to help them facilitate the three Coffeehouse Principles into their portfolios and into their lives. They already embrace these principles and want to take responsibility for their own financial well-being. They accept these principles as true, not based on anything I’ve said, but based on their own common sense and intelligence.

Kirk:   Many of the online brokers have reported a surge of new accounts as people feel they can do better on their own than by paying others to manage (i.e. lose) their hard-earned money. Has your firm experienced any significant client turnover during this period and what thoughts do you have regarding this surge of interest into DIY investing?

Bill Schultheis:  Although we have lost a couple of clients this past year, we have seen a huge surge, especially in the last 5 months, of investors from across the nation who were introduced to Coffeehouse at some point in the past 10 years, and now, something has spurred them to make a positive change in their life, and in doing so, they choose the Coffeehouse philosophy as the way they want to manage portfolios and integrate it into their lives.

I am not surprised that there is a surge in DIY investing. Investors are realizing that they aren’t getting any value added by working with an advisor/stockbroker who thinks that their role for the client is in finding 5 star mutual funds and top performing stocks.

The majority of investors don’t care about 5 star funds. They want some assurance, a roadmap if you will, that they are going to be able to live a quality life for the rest of their lives, similar to the one they are living today. Our wealth management firm brings clarity and common sense to that roadmap in a way that is authentic to the client and in a way that they can grasp what is and isn’t important.

Kirk:  If anything, portfolio design is becoming tougher in a world flooded with choices. Most have too many mutual funds, ETFs, stocks, options, alternative assets, and strategies to consider. How do you suggest investors confront and overcome this obstacle?

Bill Schultheis:  And it is only going to get worse. Take for example the ETF world. The financial industry is exploding with every type of ETF imaginable, with all new types of ways to construct indexed beyond the rational cap weighting, and now, even the active fund managers are getting in on the ETF action.

This is where a competent advisor can play a decisive role in helping investors to see what are and aren’t good building blocks for portfolios. My advice when building portfolios is to remember that less is more. By simplifying and reducing the number of funds/investments you own, you will bring added value to your portfolio and your returns.

Kirk:  You advise people to put their investments on auto-pilot so they can concentrate on other endeavors. For many who’ve put their assets on auto-pilot, the past year has made them feel that their auto-pilot setting has sent them straight into the mountain and they have lost a significant amount of money (for some near the time they need the money to retire). Isn’t it against human nature to put investments and our financial futures on auto-pilot?

Bill Schultheis:  Following one’s account value on a day to day basis, and making investment decisions based on what the Fed did or didn’t do at its last meeting, is a recipe for financial disaster. I have long advocated a consistent and timely review of one’s asset allocation decision based on where they are at in ones life. If this is too complicated, use John Bogle’s simple rule of thumb of placing your bond allocation equal to your age.

For someone who had their portfolio on autopilot AND was taking care of business on the home front, and getting ready to retire this past year at age 65, this would have meant that they would have had 35 percent in equities and experienced a portfolio decline of about 12-14 percent at its worst, and now, with the recent market rally, are probably close to breakeven if not above. This is hardly a disaster that the financial media makes it out to be.

For investors who were 65 and lost 40% of their portfolio, it can only mean that they had 75 percent or more of their portfolio in the stock market. That isn’t the stock market’s fault, or the 401k’s fault, it is the investor’s fault because they didn’t follow some simple investing principles. Speaking of stock market declines and losing money, we need to look, not only at older investors, but younger investors as well. It is a completely different story.

For a large percentage of the population, those under age 35 or so, with peak earning and saving years ahead, they should welcome, in fact be celebrating a stock market decline. If I was 35 years old and had a modest nest egg, with 30 more years of saving and investing in front of me, I sure as heck would rather be investing money with the DJIA at a starting point of 6500 rather than 14,000. It all boils down to education, and helping investors look at the big picture beyond what the DJIA did last week and their account values.

I heard Yale’s Dr. Robert Shiller speak last summer, who, by the way, is a huge advocate of investor education. He said that the average investor doesn’t have a clue as to what this thing called asset allocation is. Clearly, this past year confirmed that statement.

Kirk:   “Know thyself” is a widely perceived key to investment success. Is the setting of unrealistic goals by your clients a frequent problem you encounter?

Bill Schultheis:  For clients who are within 5 to 10 years of retirement, or who are retired, we rarely run projections for them north of 5 percent, and in some cases, even that might be a little aggressive. If they can’t make their plan work at 5 percent, it isn’t the market’s problem, it is their problem, and they need to make some changes in their life. If someone wants to take on more risk than what we feel is prudent for them, we have a heart to heart talk of the consequences should they be proven wrong. One of my favorite sayings, especially to older clients, is to make your portfolio more conservative than you can possibly stand it, and hope that you are wrong.

Kirk:  You stress the importance of keeping expenses low and have said that fees are directly correlated to performance. In fact you share a terrific chart showing the cost of underperformance of someone who invests $500 a month over a 30-year period:

 

Underperforming

So other than buy and hold low cost index funds over the long-term, are there any other suggestions you have for keeping expenses low and reducing this risk of market underperformance?

Bill Schultheis:  Keep costs low and especially minimize taxes to capture as much of the return of each asset class as possible.

Kirk:   What is your opinion on the Roth versus regular IRAs? In your view, is there any risk that Uncle Sam may change the rules on these investment plans (i.e. create new taxes and transaction fees) that we should contemplate now in our long-term strategies?

Bill Schultheis:  As you know, there will be an opportunity from high income earners to contribute to Roth IRAs in 2010. The decision on whether to take advantage of this is fairly complex – beyond the scope of this interview – but I do not think that Uncle Sam will someday start taxing these investments.

Kirk:   With the continued popularity of index funds, do you see more financial advisors starting to embrace the same business model of your wealth management firm, of being 100% passive on the equity side?

Bill Schultheis:  I don’t have any statistics, and while I suspect more and more advisors are starting to utilize ETFs with their clients, many in the form of a “core and explore” type of portfolio, the reality is that the vast majority of financial advisors still feel that their role in working with clients is to predict the future and choose the top performing stocks and funds for clients.

There are so many drawbacks to an active approach, and so many benefits to our approach, that I AM surprised that more advisors don’t see the difference as well. When you engage in a relationship with a client, and hold yourself out as someone who can pick the top stocks, funds and sectors, you immediately create a relationship where both you and the client begin to focus on performance, especially relative to the benchmark.

When we sit down with a client, the client never second guesses what we are doing, or the decisions that we are making, within a portfolio. You get what the market gives you. Clients understand that. It allows us to discuss and deal with issues that are actually relevant to a client’s well being – not whether the oil sector is going to outperform the healthcare sector over the next 18 months.

Kirk:  What are some of your favorite financial planning tools and resources for the do-it-yourself investor?

Bill Schultheis:  There is a wealth of wisdom shared by folks on the Boglehead diehard forum. Just incredible. Although I don’t post there very often, I keep a close eye on the comments that are posted. They are a great, great group of people. Incredibly intelligent, thoughtful, and courteous. I have to tip my hat to Mel Lindauer and Taylor Larimore as the founding fathers of this great web site.

As you know, I am a big believer in creating a financial plan, and then revisiting it on a regular basis, so I would have to say that Torrid Technologies’ software is a cut above most others, as previously mentioned in this interview.

Kirk:   You believe financial advisers can be helpful to keep you on track and aligned with your goals. Do you recommend fee-only advisors? How would one find a good advisor to sit down and take a cold hard look at their financial situation?

Bill Schultheis:  I do recommend fee-only advisors, and although many investors profess to be do-it-yourself investors, the reality is that there are very few investors, especially as one approaches retirement, who can successfully navigate the intricacies of portfolio management and financial planning.

The first step in working with a financial advisor is to decide that you are going to work only with an advisor who embraces the passive, or indexing philosophy 100 percent. This is important, because now, with the explosion of sector ETFs, one has to probe even deeper when finding an advisor.

Many advisors are holding their shingle out to prospective clients as experts in picking the top performing sectors, trends and industries, and then managing this through sector ETF index funds. This is nothing more than active management disguised as passive investing. Don’t fall for it.

When you find an advisor who truly embraces the passive, “indexing” philosophy in a fee only compensation arrangement, you greatly increase your chances of aligning with an advisor who recognizes his or true value in working with clients. It allows you to begin focusing on what is and isn’t important in the process of wealth management.

Kirk:  When all is said and done, what is one thing you really want the reader of your book to get out of it?

Bill Schultheis:  I want the reader to finish the book and say, “Hey! I don’t have to pursue top performing stocks and funds to become a successful investor and reach my financial goals. I don’t have to rely on anyone in the Wall Street industry to predict the future. I am in charge of my financial destiny.

At the same time, I want investors to understand, especially those who are nearing retirement or are retired, that there is a big difference between building a static portfolio today, and managing a portfolio amid all the life changes and all the market changes that are going to occur over one’s lifetime. The first exercise can be simple and straightforward. The second exercise is likely to be extremely complex and time-consuming.

I want the reader to recognize that time is a precious commodity, and consider making the right choices with your investment decisions today, so you don’t have to do it ten years from now. Don’t let the next decade be your own “lost decade of investing.”

Kirk:  It would seem that an important part of your job is to educate your clients. To help, do you ever recommend investment books? If so, which ones?

Bill Schultheis:  First, I encourage them to read Coffeehouse, because that book, more than any other (in my humble opinion), drives home the wisdom of indexing one’s portfolio in a way that people “get it.”

If someone wants to take it a couple of steps further, I suggest they read Dr. Bill Bernstein’s Four Pillars of Investing, or Bogle’s first book, Bogle on Mutual Funds. Rick Ferri has written the bible on Exchange Traded Funds “The ETF Book” – a good read. For fixed income and alternative investments, Larry Swedroe and Jared Kizer have collaborated on a masterpiece “The Only Guide To Alternative Investments You will ever need.” I love the first Boglehead book, “The Boglehead Guide to Investing.” They have just come out with a second book “The Boglehead Guide To retirement planning.” I haven’t read it yet, but it is getting rave reviews.

There are several other books that stand out, including Charles Ellis “Winning the Loser’s Game,” and of course, the all time classic, “A Random Walk Down Wall Street” by Burton Malkiel. I loved the late Peter Bernstein’s, “Capital Ideas” and am just finishing Justin Fox’ “The Myth of Rational Markets.” I began reading it with a very cautionary bent, but am thoroughly enjoying it as a history book on the evolution of the efficient market theory. It is a great book.

Kirk:  Who are the people in this business of investment advice that you admire the most?

Bill Schultheis:  At the top of the list would have to be John Bogle for his courage and foresight in bringing index funds to the masses. I admired Jonathan Clements, and his “Getting Going” column he wrote for some 15 years in The Wall Street Journal, frequently advocating the Coffeehouse philosophy. I like reading Jason Zweig’s work, especially his research on neuroscience. I have enormous amount of respect for Taylor Larimore and Mel Lindauer, and ALL the Bogleheads who so freely give of their time and wisdom to help investors who want to do the right thing. I am drawn to the discussions on that site every day. Witty, smart folks.

I greatly admire Charles Schwab for what he did in 1974 of circumventing the thieves of Wall Street and bringing investment opportunities directly to individual investors. He turned the investment advice world upside down, and is still going strong 35 years later. I’d love to play a round of golf with him some day. His boldness challenges me to be bold in my own work.

I also admire the financial advisors and writers who have given so selflessly of their time and wisdom to help investors get it right. At the top of my list are people like Rick Ferri, Paul Merriman, Larry Swedroe, Bill Bernstein, Frank Armstrong. I am sure I am leaving a few others out, and for that I apologize.

Kirk:  What do you think may be the key ingredient to their success?

Bill Schultheis:  They recognize that they have an enormous opportunity to have a profoundly positive impact in their world, with the vision they possess, and the wisdom they share, and the things they create to make it happen. They are bold in their mission, and they inspire me to do the same.

Kirk:  A common element I find in all successful investors is that they are always working on expanding their knowledge and improving their strategies. What have you been working on lately in this regard?

Bill Schultheis:  I am always looking for new and creative ways to articulate the Coffeehouse message to investors so that they “get it.” I am working closely with my two business partners, Todd Flynn and John Buller, on more creative ways to present financial plans. I am working on time management and work flow of my own day. There is so much that I want to do – I want to get 48 hours worth of work done in 6 hours so that I have more time to golf and climb mountains and play tennis and spend time with my lovely wife, Zhiqin. (She is of Chinese heritage, uprooted her very comfortable life in China 13 years ago, so that her son could have a better life in the USA. In that time period, she has established and then sold two successful businesses. Talk about an inspiration. Every day she wakes up and says, “America, land of opportunity.” She has me saying the same thing, and I appreciate my country a little more because of her. Coincidently, the third edition of Coffeehouse is being published in the Chinese mandarin language, and we are excited to be working together to bring the message to that culture.)

Right now it probably takes me 8 hours to do what I could do in half that time. To do that, I am going to have to be super efficient, super focused, attend to what I need to do, delegate things that can be better accomplished by other crew members – and we have a great crew of eight that I work with. I want to work smarter and play harder.

Kirk:  A goal I share with you as well!

Many of my members are short term traders, most part-time, some full-time. But at some point in their lives, they will stop earning income from their trading and instead rely on their investment portfolio for support. What advice can a long-term oriented investment counselor like yourself give short-term oriented readers that may be helpful in achieving their retirement security?

Bill Schultheis:  I would give the same advice to them that I offer to clients, which basically means embracing the three Coffeehouse principles. In regards to transitioning them from short term traders to long term investors, I will offer to them what I perceive to be the upside and downside of each strategy, but in the end, I never spend much time convincing anyone that my approach is better than their approach. I simply present my case, and leave it at that. If someone doesn’t want to embrace it, that is fine by me. There are way too many other investors out there who are screaming for help and who recognize they need to do the right thing. These folks tune in to common sense pretty quick – those are the ones I want to help most of all.

Kirk:  In the book you talk about discovering on one of your mountain climbs that clutter of every day life might be keeping you from pursuing your dreams and living a life you would choose to live if given a chance to do it all over again.

How did you learn how to declutter your life and do you have any recommendation for those of us who seek to live simpler, but better lives?

Bill Schultheis:  First, uncluttering my life, both physically and mentally, is a never-ending challenge. It certainly isn’t something I have mastered, but I am aware of it, and actually enjoy the ongoing challenge and reward it presents to me. Too many of us are a collector of “stuff.” Look at your desk, look in your garage, and look in your drawers. Get rid of some of your stuff. Give it away, sell it on Craig’s List, or throw it away.

Turn off the television, turn off your computer, and go for a walk. Go for a long walk, three times a week, without your i-pod. Walk in silence. Deal with that bouncing bumblebee in your head. Create an emptiness, a space for your true self to shine through. It sounds warm and fuzzy in this interview. It isn’t. It is tough to create that space, it is tough to go for that walk in silence, day after day, because it means being alone with your thoughts, and that is sometimes a scary place to be. Don’t believe me? Sit down, sit cross legged, and meditate for ten minutes. I bet you can’t do it for 2 days in a row, much less two decades.

Kirk:   Finally, if you had one piece of advice to share with all traders and individual investors what would it be?

Bill Schultheis:  If you do embrace the Coffeehouse Investor message, take the time to introduce it to someone in your life who could benefit from it. Introduce it, not as my message or John Bogle’s message, but as your message to them. You believe in it as if it was your own, because it is. My goal from the very beginning was to introduce The Coffeehouse Investor, and its three principles, to every investor who is responsible for saving and investing for his or her own retirement. Working together we can reach that goal and change people’s lives for the better.

Kirk:  Thank you so much, Bill!

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The Coffeehouse Book

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The Coffeehouse Investor

How to Build Wealth, Ignore Wall Street & Get On With Your life by Bill Schultheis

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