In my last post, I discuss what happens when the valuations of large companies are driven to unsustainable levels and end up retreating to market-level valuations, otherwise known as “reversion to the mean.” Ignoring this investment concept can often lead a beginner or even the most experienced investor, astray.

I dedicate an entire website page to this concept because I want investors to understand the relatively basic idea of what goes up is likely to come down, and that what goes down is likely to bounce back, in other words, it “reverts back to the average.”

Here’s a visual to explain the idea:

It is at this point, when C is outperforming the average and A is underperforming the average, that many investors sell A in favor of C.

Reversion to the mean causes lots of problems for lots of investors because almost everyone begins by choosing A, that is, they choose a mutual fund or a sector with a good track record.

Then, when A reverts to the mean, or goes underwater, these same investors must decide whether to hang on to the underperforming A or switch to C.

Most people invest in sectors or mutual funds that have had a good track record (after all, that’s the most logical way to choose mutual funds). Unfortunately, because of the powerful force of reversion to the mean, investors inevitably become disappointed with their selection and are on to the next hot fund or sector.

If you want to be a successful investor of common stocks, forget about conventional wisdom and focus instead on reversion to the mean.

In 1976, The Vanguard Group, led by its founder John Bogle, created the first retail index fund. Although slow to capture the attention of investors, this fund, initially labeled the S&P 500 Index Investment Trust, has grown to become the largest mutual fund in the industry today.

With a focus on simplicity, in 1992 Vanguard created the Total Stock Market Index Fund to include mid-cap and small cap stocks – one fund that essentially represents ownership in all the publicly traded U.S. companies.

With a common stock portfolio consisting of one “Total Stock Market Index fund,” some might consider ownership of “all” the publicly traded companies as the ultimate in diversification, and for many investors, it is.

While we can’t argue with the premise of one low-cost, tax-efficient portfolio as the ultimate in simplicity, looking at the stock market from a different perspective offers significant benefits of diversifying beyond a Total Stock Market Index fund. Let’s take a closer look at the data.

Traditionally, most index funds have been constructed on a “capitalization weighted” basis. This means that the market capitalization (number of shares outstanding times price per share) determines its weight within the fund. As a result, even though Vanguard’s Total Stock Market Index fund reflects the collective price movement of “all” the publicly traded companies, in essence, its performance is impacted by the largest of the large cap stocks, with its top 10 holdings representing 18% of the portfolio. In other words, the Total Stock Market fund is basically an S&P 500 Index fund, and its performance confirms the same.

From a diversification standpoint, the goal isn’t to simply own thousands of companies in one mutual fund. It is to identify different components of the market that move dissimilar to each other, at least in the short run, and build a portfolio on this premise. Academic research reveals that the most effective way to accomplish this is to identify value stocks and small stocks to complement ownership in the large cap stocks of the S&P 500 Index.

The benefit of this approach to diversification can be found as recently as the 2000-2007 timeframe. Reflecting on the beginning of that era, large cap stocks of the boom had driven the price to earnings (P/E) valuation of the S&P 500 index to over 30, far outside its traditional range of 15-20.

Over the next eight years, various dimensions of the market produced the following annualized returns (represented by the corresponding Vanguard funds):

bs graph

The above data serves as a reminder that for investors who embrace only domestic large cap stocks, they face the almost impossible task of “staying the course” for an extended time when these stocks underperform by a wide margin, as they inevitably do through normal market cycles.

There is another compelling benefit for investors to consider in diversifying beyond large cap stocks. Because large companies tend to be the “darling” of both institutional and retail investors (in 2000 a few names that come to mind are Intel, Microsoft, and Cisco – today, it is the likes of Apple, Amazon, Google, and Facebook) the valuations of these companies are driven to unsustainable levels. As a result, future returns tend to be muted on these companies as P/E ratios retreat to market levels.

This “retreating” to market-level valuations, also known as “reversion to the mean,” is one of the most powerful forces at work in capital markets. This mean reversion theory persists across all global markets and all time periods. Thus, one can conclude that a basket of stocks with cheap valuations relative to the market will consistently outperform stocks with expensive valuations over time, and the research shows this to be true.

Overlapping periods: July 1926 – December 2016

bs GRAPH 2

With current market valuations expensive by any measure, we feel that the persistence of a “value” premium in both large cap and small cap stocks will play an increasingly important role in the total return of clients’ portfolios. In addition, these dimensions of the market provide the necessary diversification and much-needed motivation to “stay the course” in all types of market environments.


Taxes - CH blog“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin, 1789

And in this world, where we try to minimize taxes, we need to stay updated on the newest tax laws and the recent changes in many of our paychecks. Recently, the IRS released a revised withholding calculator to help verify allowances and ensure you aren’t getting too much or too little of a pay bump. You may want to review the new numbers and avoid a few surprises when you file your taxes in 2019.

Bill blog 2-15In my column this month, I remind readers to get their fair share of the market and then move on. When your energy is focused on one specific hot stock, you miss the whole point of passive investing as discussed in my book, The Coffeehouse Investor. You miss out on the things you should be focused on – getting on with your life.

Published 20 years ago, the Coffeehouse principles still ring true.

“When you accept that your common stock portfolio will do no better or worse than the broad indices tracked, you are putting the pursuit of performance in its place.”


When we meet with clients who are approaching retirement, we always discuss the next chapter. Ensuring a client is financially prepared for retirement is one thing, but what’s often ignored is the mental preparation required for retirement. It can be an alarming adjustment when the working life abruptly stops.

Have you penciled out how you intend to spend your time and energy during retirement? Take this quiz to give you some insight on where your attention should be directed.

As you carefully build long-term financial plans, you need to consider your own personal retirement plans. Hopefully, these plans encourage you to continue growing and pursuing dreams, even after the day job ends.

A few important takeaways from the new tax bill signed into law include:

  • With the increase in the standard deduction ($12,000 for individuals and $24,000 for married filing joint), the limitation on the deduction for real estate and state income taxes ($10,000 per year), and the elimination of certain miscellaneous itemized deductions, fewer people will itemize, and instead choose to take the standard deduction.
  • Individuals with little or no mortgage interest will most likely take the standard deduction unless they have substantial charitable contributions or medical expenses.
  • Going forward, if individuals don’t generally itemize and they wish to maximize the deduction for charitable contributions, it may make sense to bundle dome1several years of contributions into one year or fund a donor-advised fund.
  • If you are over age 70 ½, it becomes even more beneficial to make charitable contributions directly to your charity from your IRA. These contributions, which are limited to $100,000 per year, are not reflected in your income and also satisfy the required minimum distribution (RMD) requirement.
  • You can now distribute up to $10,000 per year from a 529 education plan for K-12 expenses. This should be considered in your long-term education plan, if applicable. In addition, this could be another way for grandparents to help save and pay for their grandchildren’s education.
  • (Applicable to Washington) Though the Federal Estate Tax exemption has been doubled, it is still important to remember that Washington State’s estate tax has an exemption of $2,193,000 (2018) per person. Even if you are under the federal exemption, estate planning is still important if you are in the range of the Washington State estate tax.

Working with a tax professional or financial advisor can help you work through many of these new details. If you want to invest in a more tax-efficient manner or build your long-term financial plan, let’s connect.

With the year-end approaching, it is always wise to consider a few tax planning opportunities. Some of these strategies may be affected by upcoming potential tax changes with the current administration. However, the basic tenants of tax planning still apply no matter what happens. These include:


Regardless of what tax bracket you are in, it generally is beneficial to reduce your income or defer to another year. This may be especially true if tax rates go down next year. Some strategies to consider include:

  1. Delaying or deferring income to another year if it is possible and prudent. You will want to talk with your CPA to make sure this is a viable option in your situation.
  2. If you are 70 ½ or older, you can contribute up to $100,000 directly from your IRA to a qualified charity. This avoids taxation of the income on the distribution and is the most tax efficient way to fund charitable assets from IRA funds.


  1. Maximize charitable contributions. Also, consider gifting long-term appreciated stock or mutual funds to a charity. You avoid the capital gains on the stock and receive a deduction against your ordinary income.
  2. Sell stocks or mutual funds that are in a loss position. You can offset the loss against other capital gains or capital gain dividends. Any losses in excess of capital gains are deductible against your ordinary income up to $3,000.
  3. Maximize your retirement contributions. The maximum 401(k) deferral is $18,000, or $24,000 if you are 50 years old or older. If you own a business, consider all retirement plan options since some can provide greater contributions than others.
  4. Maximize your Health Savings Account (HSA) contributions. The individual contribution rate is $3,400 and the family contribution rate is $6,750 for 2017.
  5. Keep track of your additional sales tax on home additions and car purchases. If you have made large ticket purchases during the year, you may be able to get an additional deduction on your tax return.


These strategies don’t necessarily result in a deduction, but they do provide tax-free or tax-deferred savings options.

  1. Maximize IRA contributions. Even if the contributions aren’t deductible, the growth would be tax-deferred.
  2. Consider a backdoor Roth IRA. If your income is too high to directly fund a Roth IRA, you still may be able to contribute through a backdoor Roth IRA.
  3. Fund your child’s Roth IRA. If they have earned income, you can fund a Roth IRA up to their earned income or $5,500, whichever is less. This is a great way to save money on a tax-free basis and start your children on a long-term investment plan.

With any investment plan, having a long-term financial plan that encompasses a tax-efficient approach is the best method. Sticking to that financial plan is then your next best move.


Securing adequate Medicare coverage can be a challenge. Here are three tips to consider in securing a cost-effective plan for you.

As health expenses rise, paying attention to your health as you age is more important than ever. Review “Keep your body tuned up and your mind tuned in.”  Simple stuff, to be sure, but aging well means addressing the basics of eating, sleeping, socializing, exercising, as Tara Parker Pope points out in this thought-filled article.

We are huge fans of compounding here at the Coffeehouse – it’s the gift that keeps on giving. During Thanksgiving, we discuss the best part of the “investment pie” and the advantages of holding your investments over the long haul.

Individuals who spend time selling stocks and mutual funds that go up in price are missing out on the largest piece of the money pie because they don’t give their investments a chance to sit there and do what they supposed to do – compound. There are two great examples in the Coffeehouse book on the power of reinvesting dividends over time. In the first example, 60% of the profit increase is due to compounding! Why would you ignore a piece of the pie like that?

Speaking of pie, we also enjoy eating a great pie. We want to share Bill’s pumpkin pie recipe from the book, enjoy! From our family to yours, Happy Thanksgiving.

Pie recipe2

BS blog 10-11

In his latest column, Bill Schultheis challenges investors to focus not on sectors and stocks but rather, on personal inflation rates, asset allocations, and saving and spending. He reminds readers that focusing on financial planning decisions that can be controlled, will actually determine whether financial goals are reached in the end.