Afford Anything Podcast Summary: "Small Cap Showdown! Paul Merriman vs. Dr. Karsten Jeske Battle … with Millions Hanging in the Balance"

Podcast Information:

• Title: Afford Anything
• Host: Paula Pant
• Guests: Paul Merriman and Dr. Karsten Jeske
• Release Date: March 14, 2025

1. Introduction

In this special episode of the Afford Anything podcast, host Paula Pant moderates a high-stakes debate between two financial experts: Paul Merriman, a staunch advocate for the efficient frontier and diversification through small cap value investing, and Dr. Karsten Jeske, known as Big Earn, who argues for a simpler investment approach using broad market indices like VTSAX.

Paula Pant [00:00]:
"Today we have a celebrity death match... Paul Merriman... and Dr. Karsten Jeske... debating whether or not you should have small cap value in your portfolio."

2. Opening Statements

Paul Merriman [02:24]:
"I believe... there's a premium for the risk of being in stocks. Two, there's a premium for the risk of being in more risky stocks than more conservative stocks... I would like them to have a piece of their portfolio in the small cap value... because all of the academic research that I have seen..."

Merriman emphasizes the historical benefits of including small cap value stocks as part of a diversified portfolio, citing academic research supporting their long-term outperformance.

Dr. Karsten Jeske [04:13]:
"We are actually not very far apart in our views. I think we both prefer equity investments, especially for young people... People in the small cap value community... have overselling their product... over the last 18, 19 years a small cap value has underperformed..."

Jeske counters by questioning the continued premium of small cap value stocks, pointing out their underperformance in recent decades and suggesting that investors might achieve similar results with simpler index funds.

3. Historical Performance of Small Cap Value

Paul Merriman [09:01]:
"From 1970 to 1979, large cap growth companies did not do well. Small cap value did do well from 2000 to 2009... the small cap value compounded at 10 and the S&P 500 compounded at a minus one."

Merriman presents historical data showing periods where small cap value stocks outperformed the broader market, arguing that their inclusion can significantly enhance portfolio returns.

Dr. Karsten Jeske [15:44]:
"I found that... to find significant outperformance of the buy and hold investor between even 1970 and today, yeah, there's some outperformance, but it's not even statistically significant between small cap value and the S&P 500."

Jeske challenges Merriman’s claims by asserting that when considering different starting points and recent performance, the outperformance of small cap value is not statistically significant.

4. Risk and Diversification

Paul Merriman [13:30]:
"If you took the S&P 500 versus a portfolio that's half in S&P 500 and half in small cap value, you would have at the end of this 50 plus year period twice as much money in the combination of the two."

Merriman argues that adding small cap value to a portfolio not only boosts returns but also reduces the frequency of losing years, enhancing overall portfolio stability through diversification.

Dr. Karsten Jeske [22:08]:
"Adding more small cap value is unequivocally going to increase your standard deviation."

Jeske highlights that incorporating small cap value increases portfolio volatility, questioning whether the marginal return benefits justify the additional risk.

5. Actively Managed Funds vs. Index Investing

Dr. Karsten Jeske [36:47]:
"The DFA fund is called DFSVX... it has an outperformance of 61 basis points since 1993... but considering... tracking error is 12.6% annuallyized."

Jeske critiques actively managed small cap value funds like DFA and Avantis, pointing out their higher costs, tracking errors, and diminished outperformance in recent years compared to theoretical models.

Paul Merriman [53:40]:
"DFA and Avantis don't wait for an annual reconstitution. They do it when they want based on the mechanical, systematic strategies they use."

Merriman defends these funds by explaining their systematic approach to managing small cap value investments, asserting that they have still managed to outperform despite challenges.

6. Market Timing vs. Buy and Hold

Dr. Karsten Jeske [72:21]:
"I think just simplify your life. Just hold one fund and make it the total market fund and take the emotions out."

Jeske advocates for a straightforward investment strategy, emphasizing the difficulties and emotional challenges of managing multiple asset classes and engaging in market timing.

Paul Merriman [75:08]:
"I'm advocating particularly for individual investors... to find the combination of equity asset classes and when they get older, fixed income to address their need for return and their risk tolerance."

Conversely, Merriman supports a more nuanced approach, suggesting that a diversified portfolio with both broad market indices and small cap value can better serve investors’ long-term financial goals.

7. Principles of Investing and Decision-Making

Dr. Karsten Jeske [96:05]:
"I have faith in my toolkit and my experience and past data being informative for future data."

While Jeske emphasizes reliance on empirical data and analytical tools, he cautions against overcomplicating investment strategies, promoting simplicity and passive investing principles.

Paul Merriman [103:38]:
"I believe that the future will look like the past... our quilt charts show one year at a time going back to 1928."

Merriman stresses the importance of historical performance as an indicator of future potential, advocating for strategies that have demonstrated consistency over time.

8. Conclusions and Key Takeaways

Paula Pant [110:01]:
"Key takeaway number three, Investment decisions ultimately come down to probability and personal trust... investing requires making decisions with incomplete information and living with uncertainty."

The debate culminates in three primary takeaways:

1. Historical Performance vs. Future Uncertainty: While small cap value has a history of outperforming the broader market, its recent underperformance raises questions about its future premium.

2. Simplicity vs. Complexity: Investors face a trade-off between simple investment strategies, which reduce stress and complexity, and more intricate approaches that may offer higher returns but come with increased risk and management burdens.

3. Probabilistic Decision-Making: Investment strategies should be grounded in probabilistic thinking rather than certainty, acknowledging the inherent uncertainties and relying on historical data to inform decisions without overreaching into prescriptive market timing or stock picking.

Paula Pant [110:41]:
"Small cap value has historically outperformed the broader market, but its advantage may be diminishing... The trade-off between simplicity versus complexity is key to making investment decisions... Investment decisions ultimately come down to probability and personal trust."

Final Thoughts:

The "Small Cap Showdown" episode offers a deep dive into the complexities of portfolio diversification, actively managed funds, and the enduring debate between maintaining simplicity versus embracing strategic complexity in investing. Paul Merriman and Dr. Karsten Jeske provide contrasting yet insightful perspectives, underscoring the importance of aligning investment strategies with individual goals, risk tolerance, and the ever-evolving financial landscape.

For listeners seeking to navigate these choices, the episode emphasizes the value of informed decision-making, balanced skepticism, and the recognition that no single strategy holds a guaranteed path to financial success.