Paula Pant (3:53)

Forward to learning why, we look forward to digging into all of that research, all of the arguments in favor of this approach. Dr. Jeska, please share with us. And I don't want to be reductive about your position, but you do track a bit more with the VTSAX and chill approach.

Dr. Carsten Jeska (4:13)

Right? And we should stress here. So we are actually not very far apart in our views. I think we both prefer equity investments, especially for young people. Don't stress out too much about volatility. Don't have the fear of stepping into the stock market. You have such a long Runway, you might as well be 100% equities. And you know what, if you shuffle around those hundred percent equities, if you do a little bit more small cap value or you are just in the fancy tech stocks or you do the broad index, I'm not going to try to talk you out. Either way, whatever makes you comfortable getting into the stock market, you should do it. The reason why I wrote my blog post last year was that people in the small cap value community I think are overselling their product. And I'm just saying that over the last 18, 19 years a small cap value has underperformed even though in the 80 years before that it had an absolutely spectacular performance. To me, this is just a head scratcher. How is it possible that you have such a long and also statistically significant outperformance for such a long time and then suddenly everything fizzles? I don't have the perfect answer to that. Again, it's a real head scratcher. So the two possibilities are what we observed as outperformance that was some sort of an alpha, that was some kind of a secret trick that if you knew it, you could harvest it. And I think a lot of people did harvest it before it was actually written up as an academic paper. Every active management mutual fund was doing some variation of this. People that figured that out better, they had Better results and the people that didn't know it had poor results. And you could argue that, well, maybe this alpha source has fizzled and now we're back to normal. Here's another thing I'm saying. I'm not saying that small cap value will underperform forever. I'm just saying that it's going forward. My best guess is that everybody will roughly perform in line with the overall market. I could probably concede that there might be a little bit of a risk premium for smaller cap stocks. So I could see that there's a small gain. And this is not an alpha, this is basically a beta, right? This is a market exposure and a risk exposure and an economic risk exposure. We could probably haggle about that. But I think that the times of outperformance that are in the order of magnitude of something like 2, 3, 4, 4% of extra return per year from small cap value, that's probably gone. And it's gone because everybody has figured it out. And in an efficient market, you're not going to get something for free. The other option could be, of course, that this is actually a market risk where you get paid to take on this additional risk. But even that hasn't really materialized so well because for example, in 2022, small cap value stocks did actually quite well in that bear market. So it doesn't really look like this is an economic risk premium that you are taking on because that was the old story that basically small cap values have more macroeconomic exposure. Small cap stocks are more exposed to that macro risk because they have less secure financing. You go to a bank and you Google, you can get a loan. If you have some small cap stocks in the Russell 2000, you probably have a harder time. And the same thing with value stocks. Value stocks are more of the brick and mortar companies that rely on macroeconomic performance. Whereas growth stocks can grow on their own without macroeconomic growth because they innovate and then they also take away business from other corporations and then also from mom and pop shops. When Walmart takes over the retail business or Amazon takes over the book business, that's how some of these growth companies can grow. So traditionally there was more exposure to macroeconomic risk from in value stocks. And maybe this has also gone away. Maybe now the growth stocks have more growth exposure and this is why they, or at least it's now even and we no longer have this difference. So it's neither an alpha or beta story. So I'm wondering where is the outperformance coming from going forward? We can look backwards, but I'm interested in going forward. Where is the outperformance coming from? I don't see it. And that's why I would like to have hedged beds. I want to have everything. I want to have VTA X or I have the fidelity equivalent of that that has large small value and growth. And I'm probably going to be wrong one way. But if I'm wrong, I'm only half wrong. And have right and I'll have average performance. I prefer that.

Paul Merriman (9:01)

Boy, it was hard for me to stay quiet. Look, I mean Carsten said it all when he said it's not about the past, it's about the future. And when we talk about the future, the reality is, I must admit I don't know anything. I know that I'm well intentioned and I would like things to work out the way that I talk. But I don't know. But here's what I do know. I do know that from 1970 to 1979, large cap growth companies did not do well. Small cap value did do well from 2000 to 2009, those 10 years, small cap value did better than the S&P 500 in all but one year. All but one year. And the small cap value compounded at 10 and the S P 500 compounded at a minus one. Now yes, in the 80s and the 90s, those were wonderful times for growth. But it's not like small cap value wasn't doing anything. It just wasn't making as much. Well, as a matter of fact, if we only look at the 80s and the 90s, it turns out. I'm sorry, let's go back to 1975. The S&P 500 for 25 years compounds at over 17% while small cap value 22. So it's not like it was doing terribly, but people didn't know about it. Carson is right. Most people didn't know about small cap value until the last 10 or 15 years when it didn't do as well. Unfortunately. But the bottom line is, is that over a long period of time, if you want to hedge your bets, there are no two asset classes any better to put together than large cap blend, the S&P 500 or the total market index and small cap value. Because most of the time small cap value does better. But it's almost a 50 50, which means when one is doing well, more than likely the other isn't. Which is exactly what we want if we're going to be rebalancing the portfolio. So from everything That I see there is absolutely no evidence that it's not going to have a premium. Now, having said that, from 2000 to today, the S&P 500 has compounded at about 8.8, while the small cap value, the one that started in 2000 by DFA, has compounded at over 10%. That's not a huge advantage, but it's not unusual for them to come kind of closer together and then to spread apart again. So it will not surprise me if over the next 10 years, small cap value is doing better and The S&P 500 is reverting to the mean. I mean, we don't know that that's always going to happen, but historically it has tended to happen. So here are two asset classes that don't do the same thing normally. Sometimes they do, but not always. And that's a great way to combine equity asset classes. Oh, no, I think I've got them on the mat. I'm not sure.

Paula Pant (12:55)

All right, so a couple follow up questions. I've got some follow up questions for both of you. First, I want to outline what the stakes of this are. Because this is not just pocket change. I mean, Paul, you've demonstrated in your research that the difference between VTSAX and Chill versus being closer to the efficient frontier could be the difference of literally millions of dollars in a portfolio over time. So I just want to take a moment to establish the stakes of what we're talking about. It's substantial when it comes to the end game.

Paul Merriman (13:30)

Let me just give you the numbers that I think you're referring to. We have some tables where we start with $1,000 a year investing $83.33 a month starting in 1970 and going through the end of 2024. And if you took the S&P 500 and only 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. Now then, I think the question I want to know is, okay, so he made more money. How much more risk did you take? And here's the part of it that is so I think is amazing. I didn't expect it before we saw the numbers, but if you look at all of the losing years for the S&P 500 during that period of time and all of the losing years of the 5050 strategy, you actually lost less money with the 5050 strategy, partly because they don't Go up and down together. And so combining them kind of modifies the volatility. Now, I don't want to suggest that the standard deviation is lower because it's just a little bit higher, but standard deviation is about the upside as well as the downside. So if you do have an asset class that is more profitable, you could have higher standard deviation. But I contend that if we look at the real risk that we're taking, that that 5050 is no more risky over time than the S&P 500, with one exception. And that one exception is the total collapse of our economy. If we had a total collapse of the economy, I do believe a 5050 would not make as much as the S&P 500.

Dr. Carsten Jeska (15:44)

Okay, so my reply to that, so this was actually one of the reasons why I wrote my blog post in December is because everybody who is marketing Small Cap Valley, they always start their cumulative return lines in 1926. So the danger with starting 1926 and always starting 1926 and you see this cumulative return chart is that I know very few people that started investing in 1926. So I know even fewer people that started investing in small cap value stocks in 1926. Right. Because remember, this whole small cap value flavor was only academically formalized in 19, I believe, 1993 by Fama and French. So I did an exercise, and actually multiple exercises of basically reversing this window exercise. Everything starts in 1926 and then I expand forward. I said, well, why don't I do the opposite, right? I end in 2024 and then look at different starting points when people might have started investing and then look at the investment results of those people. And I did this multiple different ways. So I did this as a buy and hold investment. So imagine somebody started investing in 1946 until 2024 and 1947 until 2024. I don't know anybody who has only a buy and hold investment and didn't do anything to the portfolio along the way. But for academic curiosity, I did that. Yeah. And I found that in order for me 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. Of course, going all the way to 1926, then you find some nice results. Basically all of this outperformance is very front loaded. And then if you mix it with any of the more recent performances, all getting watered down and Then it gets even worse if I look at regular investments. Right. So think of us in the fire community of, or any retiree doing a retirement portfolio, saving regularly into your portfolio and making regular contributions of say, $1,000 a month. You adjust this for inflation and then how far do I have to go back? I have to go back even further. I think there the crossover point was something like in the 1970s, 1977. And the reason for that is sequence of return risk. Right. So if you have good returns early on, small cap value outperformed in the 70s that helped you, but it helped you with a relatively small portfolio size. And then when the portfolio got bigger towards the end, this is when small cap value underperformed. And if you kept your money In S&P 500, you very swiftly made up for those earlier underperformance. All I'm saying is that it's all really nice and well that the small cap value had such a tremendous performance before anybody knew about it. But all of the investors I know today, myself included, and even people much older than me, and certainly people much younger than me, would not have even outperformed with small cap value if they had, instead of doing vtsax or I did the Fidelity equivalence, if they had just swapped their portfolio. Even looking backwards, small cap value is not as impressive as people want to make it. That's just in a nutshell. My blog post from last year.

Paul Merriman (19:23)

Carsten, how can you say that? A 3% difference in return.

Dr. Carsten Jeska (19:29)

Yeah.

Paul Merriman (19:29)

Over a long period time is not significantly important. It certainly is to the person who's investing $1,000 a year or $5,000 a year, which I'm sure a lot of people who, who watch your work, Paula, are investing the 5 to 7, $8,000. I think it's huge. And all we're talking about is diversification. So we make the big deal about having 500 different companies. And unfortunately those 500 companies, when they get into a slide, they slide together. Now, yes, a few will do well, but most will go down together when the market goes down. And we can't guarantee it because it doesn't always happen that when that slide is going on, there are other things. It might be internationals, it might be utilities, it might be emerging markets, it might be small cap value. The reason I pick on small cap value as kind of the other asset class is because it has a much bigger potential impact, potential impact in the future than, for example, somebody who says, I've got half of my money in the US market S&P 500. And half of my money in the international big large cap blend total market index. Kind of a fund. To which I say that's great, except the academics say that having those internationals in your portfolio are not likely to make you more money but will likely modify the volatility. And that's good that we can modify the volatility. But what if they took that same money and they put it in another asset class, small cap value, by the way, it could be large cap value as well if you wanted to. It just would not be as radical a difference, I don't think. But then not only gives you some value in the portfolio, but it gives you some small. So now you have a portfolio that has large growth that's in the S&P 500, large value in the S&P 500, small value and small exposure and more value. I think that's a much more diversified portfolio and maybe, just maybe it's going to produce a better long term rate of return.

Dr. Carsten Jeska (22:08)

Okay, so multiple things I have to address. So first of all, so I pulled a return series from the Farmer French database. It's actually, they have one return series. So it's a small hibm. So small and then high book market value, which is the value because there's one concern, right? When you use the Fama French factors, right? It's for the entire market you do growth versus value and then for the entire market you do small versus big versus what you are doing. This is always what you bring up. There is a particular gain for value. But it's even better for small cap stocks, right? So if you mix the two together, it's actually a stronger effect to have small cap value, to have value within only the small cap stocks. So this is return series they publish and it has an outperformance since 1926 until the end of 2020. That's 3.46% and that's actually in log percent. So it's actually a little bit bigger, which is absolutely spectacular because this includes both the early period and the later period. So going from 1926 to 1993 had a 4.4% outperformance. And then unfortunately so 2006 to 2024 it has an underperformance of 2.2%. And then you mix the two together, this is how you get the 3.46%. So it's absolutely spectacular and absolutely hands down, that is if you look over the entire horizon, it's a statistically significant outperformance. So you can calculate a T statistic for that Right. And you can test a null hypothesis, the mean of this is zero. And while you can reject the hypothesis that the mean is zero. And so absolutely, I totally concede that. But so first of all, again, we can't only look at 1926 until 2024 and then pretend nothing has happened in between. Right? So if you look over shorter horizons and you start Investing, say in 1980, a lot of the outperformance goes away and you have even at 2%, even at 1%. Yeah. You think a 1% outperformance is tremendous, right? Especially over 30, 40, 50 years. You would call it significant in layman's is a significant outperformance in statistical terms. Unfortunately it's not. And the reason for that is if you calculate the difference between small cap value and the overall market, the volatility of the differences, not the volatility of your returns, but the volatility of the return differences is on the order of magnitude of somewhere between 12 to 15% depending on what index you use. Which means that first of all, small cap value itself then has a volatility that's probably somewhere in the 20%, right? 22, 23 to 25%, depending on what exact index you use. So it's much higher than the S&P 500. And then the return increment is extremely high volatility. So we call that a tracking error in finance, by the way. So you have one benchmark index and I say I want to outperform my benchmark index. So the volatility around your benchmark, this is what you call a tracking error. And with such a big tracking error, and you have only say a 1 or 2% outperformance, even over decades, that is not statistically significant, which is actually also good news because the underperformance of, I think I see something like 2.2% over the last 19 years of the small cap value Farmer French index is also not statistically significant. And the reason is even though 2.2% is a big bad underperformance, especially over almost 20 years, it's small relative to that annual volatility. So yes, absolutely, we shouldn't mix up what is significant. So significant obviously is a significant difference, but so statistically a lot of things that look big are still not statistically significant. So that's where my thought process came from.

Paul Merriman (26:16)

But I think we have to realize that when we talk about returns, how people are investing, where they are in their lifetime will make a huge difference. For example, from 1929 to 1938 it was a terrible time for small cap value. If you had invested $1,000, it would be worth I think about 480 by the end of that 10 year period.

Dr. Carsten Jeska (26:47)

Yeah.

Paul Merriman (26:48)

On the other hand, if you were a young investor, and of course who had any money to invest, you might ask. But if they did, and if they had put in $100 a year over that 10 year period, the compound rate of return is 9% a year. So in one case, one investor has lost over half their money. The other person who's dollar cost averaging into the market, which is what young people are doing. This is one of the reasons, if you look at the long term return of small cap value based on dollar cost averaging, and Carsten mentioned this in a way in those early years, if you were dollar cost averaging and picking up all those cheap shares, that's what we want for young people. Because by the time you get through 1927 to 2024, your return on a dollar cost average, $100 a year, your return is about 24 times more in small cap value than the S&P 500. And that is because you were buying small cap value when it was truly down and dirty.

Dr. Carsten Jeska (28:05)

Right. I make this case all the time. For example, my first job out of grad school was in 2000 and I started investing in my 401k basically at the close to the market peak. And then I went through the entire trough of the dot com. And then you recovered again. And I too. Only by 2007 the market had roughly recovered, inflation adjusted where it was in 2000. But I still made money because the market went down and then went up again. And in fact had the market gone down even further and then also recovered, I would have done even better. Because it's got dollar cost averaging. Right. So it's sequence of return risk and it's the sequence of return risk that goes in the favor of the saver if you have a nearby bare market and a market blowup. And the deeper it goes, conditionally it recovers again. Right. It's not for sure, but conditional and recovering, the deeper it goes, the better it is. So I agree with that. That definitely helped small cap value. So if you had dollar cost averaged yourself into the market during some of the worst market episodes, because small cap value had this property where the drawdown is bigger and then the recovery is also bigger. And then on top of that, I think you also had more recovery because you had on average also some outperformance. So I agree with that. So in that sense I think people who are young and who are putting money into their portfolio, they should probably not be scared of slightly higher volatility. If you say that, you know, the s and P500 maybe has 16% volatility and the small cap value stocks have a little bit higher volatility, there might be a 22%. And I would not tell people, well, you should stay away from small cap value because they have higher volatility. I mean, you should not worry about volatility during your accumulation years. You should almost embrace volatility because the more it goes down, the likely it will overreact. Of course, the biggest volatility is, say, Enron, which went down minus 100%. So that's the kind of volatility you don't want, but you want the volatility to be very temporarily, and then you get the mean reversion back into normalcy. So I concede that to you, that definitely as a young investor, if you have an appetite for more volatility, even though I can guarantee you, Paul, the lot of young investors will do the exact opposite of what you propose because they will invest in Tesla and Nvidia and they say the same thing. Oh, we are okay with having high volatility stocks because your volatility in some of these stocks is. We're not talking about going from 15 to 22%. We're going from 15 to 60, 70, 80% volatility. Because these are stocks and first of all, they have a little bit extra beta, and then they have also idiosyncratic volatility. And so they might take your word, but then do the exact opposite of what you want to push them into.

Paul Merriman (31:03)

So may I mention just one last position? When I look at technology and I look at the long term, one of the ways to track technology is as professionals have tried to take advantage of it. One fund that's been around for a long time is the Fidelity Select Technology Fund. And over the last 15 years, it's had a 19% compound rate of return, which is obviously part. You get that in the technology part of the market. But if we go back to 2000 and we look at it in good times and bad, $10,000 grows to about 600,000. On the other hand, in the S&P 500, it's closer to about 700,000. And then if you were in Dimensional Small Cap Value Fund, it would be around 1300. And so I know that looking back over the last 25 years, that people would probably have done better putting their money in a small cap value fund than putting their money in the high flying stocks that were so wonderful the latter part of the 1990s, the last five years of the 1990s, the compound rate of return of the S&P 500 was 28.5%. So those were the golden years and they way outperformed value at that point. But over the long term, which is what I'm concerned about for young people, not the short term. The short term, you buy one stock and you can get phenomenal returns over the short term or terrible returns. I'm looking for a way that young people, and I'm not trying to throw the S&P 500 or total market index out, there are going to be times it's going to feel good to have that in your portfolio. But I truly believe, based on what I know about the past, there are going to be years you are going to say, boy, what a great thing that I had this small cap value as a part of my diversification. So now that's my argument and it's important that I win this argument because I want to try to change the financial future of today's young people. And I don't think they're going to get there with seven great companies.

Dr. Carsten Jeska (33:40)

So my point was, I think I addressed this in my blog post. So strictly speaking, it is not diversification because you are adding an asset that has more risk. We can debate about expected returns, right? Expected returns are very hard to pin down. And very small changes in expected returns can make huge differences in, say, an efficient frontier analysis, for example, or optimal portfolio maximization analysis. But at least on the risk side, if you have a total market index fund, your small cap value is in it already and it's a very small share, obviously, right? I think it's probably on the order of magnitude. I mean, correct me if I'm wrong. If you have a total market fund is 80% large, 20% small, maybe even less than 20% small. And then among the small, it's halfway value and halfway growth. So you might only have somewhere between say 7 and a half and 10% small cap value in your total market index. Now the question is, once you have a total market fund, should you add more small cap value? And if I look at the variance covariance matrices or the correlations and the variances and standard deviations of these underlying components, the more I add to my portfolio as additional small cap value, I get slightly higher volatility that way. So at least if I measure risk as the standard deviation of my portfolio I would actually go in the wrong direction if I add more small cap value. You may argue that, well, maybe standard deviations and variances is not what we should look at. We should maybe look at drawdowns. We should look at say, risk correlations sharp with the macroeconomic growth. Maybe this whole AI thing is all going to go be a bust and then small cap value will shine again. Not because small cap value is so great, but because basically all of the tech bubble will deflate again like it did in the early 2000. But just purely from a mathematical variance covariance perspective, adding more small cap value is unequivocally going to increase your standard deviation. And I went through the derivation of the formulas and I plugged in the actual numbers and it doesn't really matter if you claim that, but my small cap value fund is heavily 21% volatility, not 22% is relatively robust. No matter what small cap value fund you would take there, looking at the correlations and the variances, it doesn't really do much in terms of diversification. This is why I called my blog post Die Worse Ification. And in the middle word is a worse W O R S E. So it actually makes some of your return stats worse. We can talk about return stats and average returns because that's debatable what it will do in the future. But I can almost bet with you that over the next 10 years, if we calculate the volatility as a standard Deviation of an S&P 500 versus say half S&P 500 have a small cap value, your portfolio is going to have a higher standard deviation than mine.

Paul Merriman (36:47)

It will, sure.

Dr. Carsten Jeska (36:48)

Anybody would take that bet and you would probably not want to take that bet. Question is, what kind of diversification are you talking about? What other measures do you look at in terms of risk as a drawdowns, the skewness, cortosis or so Can I suggest this?

Paul Merriman (37:05)

I would like to submit a study that we update every year of all of the portfolios we recommend and it shows their performance and their risk and their Sortino and their Sharpe ratio, all of these kinds of things as ways of measuring risk. I would submit that to you and Karsten, I'm sure you have something very similar. And let the readers take a look and see if they can sort through that and find what's comfortable. I'm going to send it to you, Paula, and if you can use it, that's great. But. But you're the boss.

Paula Pant (37:45)

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Paul Merriman (41:16)

They have low correlation and you'll see that one of the things I'll send you is a quilt chart. Quilt chart shows every year since 1928 how the S&P 500 did and how small cap value did. And on average their difference in return is 15%. That's a lot. I mean that tells me that they are different kinds of equity asset classes. But you will be amazed because it's so colorful. You see that chart, you see one is green and one is red. And it just amazes me how often they are at the opposite ends of the spectrum in terms. In fact, oftentimes one will have a nice gain and the other has a nice loss. So I think it will show very quickly how different they are.

Paula Pant (42:11)

What would you say? There are people who make the argument that value investors in general, not just small cap but value investors, Generally missed the MAG7, value investors are necessarily prioritizing an asset class that is not poised to take advantage of where the economy is headed, which is AI growth, which right now looks as though those gains are increasingly going to be concentrated in the largest companies.

Paul Merriman (42:44)

So the reality is that historically growth stocks don't make more than value stocks in the long run. Now it's a very long run. Maybe. But the idea is when people are buying successful companies, Whether it's the seven or the top 50, whatever it might be, they are paying typically two to three times average PE ratio of the companies that are out of favor. And people need to understand The S&P 500 is a great way to participate in capturing the premium of the best companies. According to Bessembinder out of Arizona State University. I believe he says that some 1 out of 25 companies are what really make the return that we call the 10% of compound rate of return. The other 96% of the companies make about 3%, which is outrageous if you think about it. And the way that you know that you're going to get the best is if you in Essence own all 500 of those big companies. And as a matter of fact, I recently looked at the top companies from 1999 technology companies. And how would I have done if I took the top 10 and the top 15? Well, I didn't do very well. I didn't do very well going to today unless I went to 25, because number 24 was Apple. And if you didn't have Apple in your portfolio from 2000 on, you did not get a very good return. And so this whole thing about chasing growth, it always feels good. When I was a Stockbroker Back in 1966, I was a broker for about two years. And I've normally said after that, after I went straight. But I mean, the bottom line is that you sell things that are on the move. That's what people want to be and give me something where I can make some real money. And by the way, I want to make it quickly too. I don't want to wait for the long term and those kinds of companies. Just as cryptocurrency, bitcoin is of interest to people not because they even know what it is, but because it goes up. And that's what I want. I just want to go up. And so the reality, I think, is to get people to understand that small cap value is a whole different thing from the S&P 500. They have nothing in common because the whole idea of The S&P 500 is you own 500 companies. They would rather not ever change those companies, but every year they take about 20 off and add 20. So it's not like it's a passive investment. So over many years you're going to get a major amount of change in the 500, but the idea is to hold them forever. On the other hand, what is small cap value? You have people at Avantis and Dimensional Funds, our two favorite families of funds in this regard. And what are they doing? They are looking out of a universe of maybe 5,000 or 4,000 or 3,000 companies. They are looking for companies that right now are out of favor right now are relative to other companies selling for less. By some measure they're using now. Some people, like the Russell 2000, they just take them all. I mean, they take all 2,000. Then they got bad companies along with good companies. They don't care. They get them all. The EFA and Avadis tries to in essence, cherry pick, if you will, from the better ones that are in better financial shape. But it doesn't change the fact they're stock pickers. They are buying Low price securities compared to other. And in a year they may not be the same ones. And so is it likely that small will have a premium? Yes. Is it likely that value will have a premium? Yes. If you just bought 100 of these companies and just held them forever, would you make a great return? No. That's the part that we need to understand that small cap value, really, it's a moving target. You could say they're using market timing or stock timing. It really isn't. It isn't in the way that people who are trying to pick the best performing companies, they're just trying to position themselves in companies that at this point are undervalued. Now so does Warren Buffett, but he wants to hold them forever. So he's not going to do them in teeny tiny companies. He's more likely going to do them in larger companies that are the type that you own forever. It's a different animal.

Dr. Carsten Jeska (47:54)

Yeah. So I'm glad you brought up this paper, Bessem Binder. If you hadn't mentioned it, I would have because that is the best case for index investing and very broad index investing. It's very hard as a stock picker to consistently beat the market. And it also explains why some stock pickers has performed terribly because they either by bad luck or lack of skill, they didn't pick the handful of say the, the top 1% or top maybe between 1 and 10% of all stocks that are basically the stocks that are responsible for performing really well. And then the rest is basically just very sclerotic, sideways moving stocks. So that's exactly the reason why I prefer to have a. And you know, which you prefer, whether you want the total market or the S&P 500 blend. That's why I like to have the broad index and not be a stock picker because I would be afraid that I pick the wrong stocks or I might just chase after the flavor of the month from last month. And by the time I jump on the bandwagon, basically the party is over. And then you consistently catch these overvalued stocks. So that's exactly the reason why I prefer to be not a market timer, not a stock picker, just keep it hands off. But what you brought up is this is obviously now the new flavor that the small cap value people say that oh, small cap value the way it used to work up to 2006 no longer works. We have to put some more effort into this. And because the small cap value is done in a relatively mechanical way, fashion, I mean correct me if I'm wrong. But basically what you do is if you want to pick the value stock in one index, you sort them by book to market value. Then you look at the stocks that have a high book value and you look at the stocks that have the low book value. And I don't think you do it by number, but you do it by market cap so that you take the 50% most value looking market cap, you put that into the value portion and then the growth portion goes into the other half. And by the way, in the middle there's going to be some trading back and forth, but that's roughly how the index is constructed. And this is obviously something that is observable, right? It's observable for everybody. You can pull these numbers even on Yahoo Finance or on Google Finance and you can almost replicate this every day with your little Google sheet and update those numbers. So this is not something that should create a lot of alpha. So now we have to have additional thought process. We can't just have value, we have to have value and quality, right? We have to pick the best quality stocks among those value stocks because there's this issue of value traps. So the value trap is a stock that is beaten down, but is also beaten down for a good reason. The book value is still really high because we haven't really written down all of the crummy assets that this company has on the balance sheet. And then right before they go out of business and declare bankruptcy, they look like they are really good value. But obviously that's not the kind of value stock you want to invest in. So you want to have an additional filter and an additional screen to look at the value stocks that are better. And I think this is what the DFA people are doing. This is, this is the AVUV etf, they probably do that too. And I mean I wish them best of luck. But at the end of the day, this is again now an actively managed fund and it comes with higher cost, it comes with some expense ratio, it comes with some cost on running the fund. It also comes with costs that you don't even see inside the expense ratio because it comes with turnover. So these companies that run these funds, they have to sell stocks and then buy stocks. There's going to be a bid ask spread in that. So for example, what you also observe is that this FAMA French index, which is that pure small cap value index, always outperforms the DFA fund a little bit. Even though I think FAMA and French or at least one of Them they're on the board of DFA and you would think that hey, I mean you have this great looking flavor and style fund in your database. Why don't you just replicate that if this one beats your DFA funds? Of course the reason is that well you can't really do this as well as you simulate, right? Because there's always a little bit of a drag from a simulated result to an actual result because there's some trading cost bid ask spreads you can't really trade as quickly as you can do in your simulations potentially. So all I'm saying is that yes, now people are trying to put a little bit more nuance into the small cap value landscape but yeah, it basically now reverts more and more into actively managed funds. I always get a kick out of that when you see people that normally are these Bogle heads minded people and they get very intrigued if you show them these return stats about small cap value. So I thought haven't you learned anything? Hasn't this sunk in? So think about this Boglehead's philosophy. Maybe don't do this active management. It's very hard to keep this up consistently and just do the hands off passive investing over the long term. I would take my bet with the very passive index because it is very hard to overcome these additional costs, the expense ratio, the, the people you have to h hire to do the, the calculations, the trading costs. So yeah, this is why I would still take my bets with the broad index.

Paul Merriman (53:40)

Actually Carsten, think if you look at the Avantis and the DFA ETFs they have very little turnover, okay? Surprisingly little turnover.

Dr. Carsten Jeska (53:51)

That's good.

Paul Merriman (53:52)

And to be fair to those people, the worst the indexes with small cap value is the Russell 2000, right? It has by far the worst performance and they go in annually and do a reconstitution of the fund and make the changes. DFA and Avantis don't wait for an annual reconstitution. They do it when they want based on the mechanical, mechanical, systematic strategies they use. It is not the traditional kind of stock picking that people are trying to buy something that's going to go up a hundred percent. They just have a mechanical way of identifying what something is undervalued. And when it's time to sell they do apply some momentum analysis so that they try to get out at the best price that they can. But it is all in the best interest of the shareholder from everything that I can see. And the fact is DFA has been running one fund since 1993 and another since the beginning of 2000. And they both have fine track records, much better than the S&P 500. And so I think they have shown, in fact, there's a premium. It just isn't the premium. As Carson said, that was achievable when you were only looking at hypothetical results.

Dr. Carsten Jeska (55:26)

Yeah.

Paul Merriman (55:27)

And when you start to trade the actual instruments, there's a tendency the cost and whatnot lower the return.

Dr. Carsten Jeska (55:35)

So the DFA fund is called DFSVX.

Paul Merriman (55:40)

And there's DFF VX and DFSVX.

Dr. Carsten Jeska (55:45)

Yeah, DFSVX. Yeah, that's what I have. So that one has an outperformance of 61 basis points since 1993 and obviously it outperformed very nicely until 2006 and is now dwindling away. So this is basically these two worlds before 2006 and after 2006. So it's a fine outperformance. I mean, I would take 61 basis points. Some people will kill for 61 basis points. But considering that again, that the tracking error is 12.6% every year, remember it.

Paul Merriman (56:19)

Doesn'T go up and down with the market. Yeah, you want that tracking error.

Dr. Carsten Jeska (56:24)

No, in fact, I don't want it. And especially if you want to make the case that this is a significant outperformance. So statistically it's not significant. But if you had been in this fund since 1993 and you made the entire 61 basis points on average, you would have done really well. Also, the one caveat with that is to that fund was not available to just the average Joe investor. You would have to be under the umbrella of a DFA approved money manager. So you would have to pay the AUM fees.

Paul Merriman (56:59)

That's the way it was. It is no longer that way.

Dr. Carsten Jeska (57:02)

That's the way it was. It is no longer that way. But again, so if it didn't do as well once you take into account all of the fees, looking backwards now, question is, will it do as well going forward? If it can offer me 61 basis points, I would have to debate do I want to have this additional volatility over and on top of that S&P 500.

Paul Merriman (57:28)

Do me a favor, Carson, would you please look at DFF V X? Because this is one of the ways in our industry that we confuse people. And I'm not blaming or accusing Carson of this, but DFF vx starts in 2000. So it starts in a bear market.

Dr. Carsten Jeska (57:50)

Okay.

Paul Merriman (57:51)

And small cap valued did fine in that bear market 2000 through 2002. In fact, two of those years it was profitable and it had a smaller loss than the S&P 500 in the third year. So it looked magnificent. But when you look at dffvx, you'll see that the premium through today is much higher. And that's because of where you started. And so the question is, what period of time should we look at? I think, and this is what we do in our study, we look at every decade, we look at decades to see how they hold up one decade at a time. And it is amazing how different one decade can be from the next.

Dr. Carsten Jeska (58:38)

So I don't think there is a fixed rule for that. What time frame you want to look at. I think good practice would be I don't want to compare apples and oranges where I take a fund and I start at the top of a bull market and I do it up to the end of a bear market. So I want to look at over the average market cycle, right? I want to look at say market peak to maybe the next market peak or plus one, plus three, plus two market peaks and how you would performed over that. Or take some kind of an average between the market peak and market trough and look at the next average between market peak and market trough. I don't think there's any fixed time frame that I want to look at. For example, there was one extremely deceiving study where somebody wanted to prove, oh, actually stocks don't outperform bonds very consistently. I wrote a blog post about this last year in February and they did two really nasty data tricks where they expanded the bond returns and stock returns all the way to basically the late 1700s when basically US bonds obviously were an emerging market bond and US stocks were emerging market stocks. That was very high expected returns. And then at the more recent end, they basically compare the bond market and they start at the bottom of the bond bear Market in 1982 and then go all the way until 2019. But they don't include the bear market on the bond market side. So they compare basically the longest bond bull market ever on record. And then they compared how the stock market performed over that same period where you have bull markets and bear markets all mixed together. And even in this absolutely most biased comparison, stocks slightly outperformed the bond market still. But they said, oh, look at, look at this. The stock market doesn't even outperform the bond market very much. But it's because you pick the right start and end point. So I don't want to do any kind of, well I go from this point to this point. You look at some natural points, right? If the fund started at that time, I start at that time. And then basically 2006 is obviously kind of the turning point and it's also kind of the market peak before the global financial crisis. Past 2006, I now have three full cycles, both in terms of the length and also in terms of economic significance. We've had different kind of recessions, right? We had one very deep recession and long recession that was a demand side recession. We had a very short demand side recession which was the pandemic. And then we had something that was, yeah, it was basically like a supply shock again, like an inflationary shock that sank both bonds and stocks. So we had the whole spectrum of different bull and bear markets along the way. So I actually think that the time since 2006 is quite representative. And by the way, I also think that the time since 1993 is quite representative. But even if you run it all the way back to 1993, I think that all of these DF funds now, the outperformance is so small, especially compared to the DFA AUM fee that you potentially had to pay even if you didn't have to pay, seems that it's a really small and compared to a 12% tracking error annualized. So just food for thought.

Paul Merriman (62:00)

And I would just add that if you went back not to 2006 but to 2000, right, you have the luxury of picking up a severe bear market, which is the way the world works from time to time. Then unexpectedly we get another one. But outside of those two bear markets over that 25 year period, the rest of it is pretty doggone good. And so my sense is, I'd rather, in fact in the tables that we work on going back to 1970, the reason we go back to 1970 is because you pick up 73, 74, another bad market. And we think people should be prepared for those kinds of losses because that's the nature of this business and that's what you're going to have to go through to stay the course.

Dr. Carsten Jeska (62:56)

And again, these are obviously all times when people didn't yet know. And this insight was not yet formalized. I want to give you one more example. We all know about the option pricing formula, right? People won the economics Nobel Prize for the option pricing formula. Merton and Scholes. And so Merton and then Black, Scholz, Fischer, Black had passed away already, I think in the early 90s, maybe 92 or 93. The two remaining researchers, Merton and Scholes, won the Nobel Prize for that. And of course they wrote their papers a little bit before then, before these academic papers were published. And these are some of the greatest minds in academia. There were already some hedge funds that knew these formulas and they were using them. They were making money off of that. What's the worst thing that can happen to them? That the academics find out about it, publish the research, it becomes a Nobel Prize winning insight and now everybody's using it and basically their profit opportunity went away. So I'm not going to go back and say that with an option trading strategy I can generate returns like the returns during the best times when the in crowd could trade based on these insights before everybody else knew it. My point is that it's good to go back further and have more data. Having more data is always better. But once you start adding data that may not be relevant for today anymore, we're basically damaging our academic and intellectual study. Just like I said earlier, adding more data before 1900 to expand the return data for bonds and US stocks all the way to the 1790s. I think it's a great historical exercise. It's useful that somebody went to newspapers in some archive and put together some stock index that way. It's fantastic. I mean it's great. If there were a Nobel Prize in history, they should get one. But it's not really that relevant for today's economy and today's bond market and stock market. I'm afraid that some flavor of that is also true with small cap value. We've had the small cap value that probably most people didn't know about it. Even the people that knew about it. It was probably not as easy to implement. Right? Because you couldn't just go to Yahoo. Finance or go to some database and scrape all that data on book value and create these Fama French styles. Even today, the Fama French data, they don't come out in real time. So I have to wait because I use, I utilize the Fama French factors. You can put Fama French factors into my safe withdrawal rate sheet. You can use it as a return series. I have to wait probably about one and a half months for the Fama French numbers to actually come out. If it takes Fama French a month and a half to update their data. What would it take somebody in 1929 to put this together and run an actual small cap value fund that is as good as some of these return data that Fama French are publishing? Maybe even if you had known about it, I would have been hard pressed to generate These kinds of returns going back. I wish you all best of luck, but I have my doubts that these outperformance stats are going to last and can translate into the future.

Paul Merriman (66:11)

So the last five years have not been good for small cap value.

Dr. Carsten Jeska (66:16)

True.

Paul Merriman (66:16)

Okay. And in fact, AVUV for the last five years has made a little more than the S&P 500 and a little bit more than that over the total market index. So I don't know what to make of that, except that if it can hold up that well in a period that small cap value hasn't done well, I think that bodes well for that period of time when these big growth companies come tumbling down. Because that's exactly what happened at the end of the 1990s. They in surveys in 1999 and 2000, people were predicting that for the next 10 years the S&P 500 would compound somewhere between 20 and 30%. Why would they say that? Because the previous five years that had compounded to 28 and a half. And people think linearly. So recency bias comes in. What then happened, as we know is for the next 10 years, the S&P 500 loses 1% a year. And by the way, that's the same negative compound rate of return as from 1929 to 1938. So I think history does in fact have some value to us because we knew it was likely something like that could happen. But during that 10 years that the S&P 500 is doing so poorly, DFFVX is compounding at over 10%. And by the way, AVUV is out producing Dimensionals Small Cap Value ETF since it came out. So either one of them, I think whether you use DFA or Avantis will be absolutely great.

Dr. Carsten Jeska (68:13)

I tend to agree with what you say. So, for example, I look at the CAPE ratio, right? I mean, you look at the Shiller Cape At 36, I have my own CAPE ratio calculations where I do a few adjustments. So I factor in different corporate tax regimes and different dividend payout ratio regimes because that might make a difference in the Cape. And it's still at 31 point something. So it's still extremely elevated even if you make some adjustments. So I 100% agree that valuation not value, but valuation matters for stocks. But boy, valuation can take a long time to happen because you can be wrong longer or the market can be wrong longer than your time horizon as an investor. For example, people pointed out in 1997 S&P 500 is hopelessly overvalued. And if you've gotten out in 2017, kept rallying, could have actually done terrible that way. Or you got in 2017, 17, you sell your stocks, then you go back in in 2000 only to then face the bear market. So yeah, I totally agree that S&P 500 is very richly valued and we might have a drawdown. But also notice what you just said, right? You just said that small cap and value stocks are more protected from an economic drawdown. And I actually agree with that. And by the way, so are international stocks. Maybe they're not going to drop as much because they haven't gone up as much as US stocks. So if there is a total blow up in the US economy in the style of all of this AI optimism was all way, way too much. And obviously I think AI is going to be very impactful. Doesn't mean that the firms that are high flying AI companies today will benefit from it. Might be some other company that will reap all the rewards, right? Just like the dot com crisis, right? Pets.com is out of business, but Amazon and Google are still rolling. And so I agree with that. It's possible that the US economy falters and it falters because of growth stocks, that all of this technology gain that we probably already priced in doesn't materialize. But that means that while growth stocks now should have the return premium because they are now more susceptible to economic risk, right? The reason why small cap value was long held as a, well, you get more average return, but you also have more risk during economic downturns because it started actually during the, as you said, Great Depression. Small cap value stocks did horribly, had a bigger drawdown. Everybody noticed, oh, we need a risk premium to hold small cap value stocks. And boom, there you go, you have an additional return. And so now you tell me you want to have your cake and eat it too, right? So you say that small cap stocks have higher expected returns and on top of that they also have more protection during the economic downturn. So that, that seems to be the land of milk and honey. I mean, I would like that too. I'm just wondering is that economically feasible in a market that is in some way efficient, that would properly price in these economic risks? So I think the good thing is that we will find out over the next 10 years, right? So I think that now growth stocks have more growth exposure. So this is why they have higher expected returns because you have a risk premium. And of course next time we have a bad recession, it will growth stocks will get hammered and value stocks Will do better. The question is when is that blow up? If it's next year, obviously I want to be in value stocks. But since I don't know when it is, maybe I'm going to milk this growth premium a little bit longer and stay away from small cap stocks.

Paul Merriman (72:07)

Or maybe hold a small percentage forever like I do, which I do too, and not worry about when to get in or get out.

Dr. Carsten Jeska (72:17)

That's less than you. So. Yeah, yeah, good point.

Paula Pant (72:21)

But Carsten, on the Forget About Money podcast you said that if you were to buy small cap value, you would wait until the bottom of the next recession and then buy small cap value.

Dr. Carsten Jeska (72:33)

Right? Again, I said that under the premise that this old value stock GDP correlation is still in effect. Because if you claim that small cap value stocks have more economic exposure and we are at the market peak, if you're not already in small cap value, maybe you just sit it out, wait until the next stock market, the next bear market comes around. Then if small cap value stocks drop more during that event. Yeah, maybe then reshuffle from your large cap growth or just from your overall blend, then you go into small cap value because well, they've been beaten down more, so they should also recover nicely. Now this whole story is working again where small cap value stocks demand a macroeconomic premium and this is why their expected return should be higher. There's higher volatility and then also higher beta, higher exposure to economic volatility. But then again, my expectation is that maybe the next bear market is going to be again growth stocks get hammered and people will then wonder why do I get a return premium for small cap stocks if small cap stocks are not that susceptible to economics economic risk? Because it would already be two in a row then, right? 2022. Again, small cap value did okay during that bear market then, but then also didn't recover as nicely as the growth stocks. If we have two in a row like that, I would almost say it's lights out for small cap value. And is it? Now the growth premium has to go to growth stocks.

Paul Merriman (74:07)

So see the tug of war that's going on here I think is buy and hold versus market timing.

Dr. Carsten Jeska (74:15)

Yeah.

Paul Merriman (74:15)

Because I'm advocating particularly for individual investors who want to do it themselves 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. That is all actually pretty simple. But the part that's complex is this decision. Do I just stay the course no matter what, no matter who the president is, no matter what's going on in Israel. No matter what's going on with Powell, I mean, they just are investing and they're expecting the businesses to do well over a long period of time. And I think that that buy and hold strategy is going to work well for most people, but for people who don't have the ability to ignore all of the noise, it's really hard.

Dr. Carsten Jeska (75:08)

Yeah. And on top of that, right, so imagine you have made up your mind that you want to be x percent in small cap value, say 20% in small cap value, 80% in total market. Right? And now you've been sitting on this for a long time and now the weights have diverged and you now have 85% broad and only 15% small cap value. What do you do? Do you sell the other fund and put it into the fund that underperformed? So this is one of the reasons why I think just simplify your life. Just hold one fund and make it the total market fund and take the emotions out. Because I think the average person will then exactly at the wrong time do the reshuffling of the portfolio weights. And I just keep emotions out. Don't run after that momentum trade, but then also don't go against the momentum trade. So I think that for buy and hold investors, I think it's best to just be in the broad market index and take all these headaches out. And when should you go into the other funds? When should you rebalance? When should you just call it quits and say, okay, I've had enough? There are people who have been in small cap value and they've done this for 20 years and they didn't have terrible returns, but they have underperformed the S&P 500. So what do they do? Should they now go back into the S&P 500 only to see that now is the renaissance of small cap value again over the next 10 years. And people beat up themselves over that. So I think just for peace of mind and simplifying my life because, you know, life is complicated already, so just keep that part of the financial life simple. So I like to have the broad index so I don't have to worry about this.

Paul Merriman (76:53)

You know, Carsten, the thing that I think we're overlooking and it's important is that investing is really like a business. And I've been in a lot of businesses in my lifetime and none of them had much to do with each other. They were totally different kinds of businesses, different challenges in the businesses. And I think the same is true with investing that you can start a business of investing. Like my granddaughter, who's 2 years old. We helped her start her business and we put money into an account which eventually is going to blossom into a Roth ira, but it's still going to be the same business. And we put her half in S&P 500 like and half in small cap value. And she will rebalance once she gets into the Roth because there's no tax implication. And so that's an easy thing to do do once a year. That is not a complex business to run. It certainly isn't compared to the other businesses I've been in. And so I think a lot of people have the ability to handle a slightly more complex business than just putting money into the total market index. I love the idea of just doing a target date fund. I don't think they're the greatest thing that was ever invented for people who like to get involved, but for people who don't want to be involved. There's nothing better than a target date fund. But it doesn't mean that some people couldn't do a target date fund and 20% in small cap value. I mean, you can make these little changes to your business that we hope, and this is the path of every business person. What do we do if we're renting a house? Do we paint the house? Do we do something to the yard to make it more appealing? All of those questions are the same in the business of investing, but it is just a business.

Dr. Carsten Jeska (79:03)

Yeah, I don't disagree with that. I'm not saying that the process of logging into your account and clicking rebalance back to 5050 is complicated. I'm just saying that stressing out over, okay, well, one of my funds underperformed. What do I do? When do I rebalance? It's basically the catching a falling knife, right? So should I just let the momentum run or should I rebalance? Should I rebalance once a quarter, once a year? Never. I'm not saying that it's technically difficult, by the way. I'm saying this as somebody. I'm trading options every day at the open and at the close. It's quite complicated. I'm not saying that I don't do small cap value because it's complicated to have two different ETFs in my IRA. I'm just saying that there's some additional bandwidth that I would have to give up when I have to manage something that's beyond the broad market index. So. And you have to stick to it, Right? So I think when you had your discussion with Rick Ferry at some point, Right. So I think he pointed this out where he said that, yeah, of course, eventually everything is going to catch up again and very long term valuation is going to work out and it's going to equalize all sorts of differences. But do you have the patience to do that especially I'm retired now, right. I'm withdrawing from my account. I'm not really liquidating any assets. So I know about sequence of return risk. So I am no longer somebody who is fresh out of college who can afford to have a little bit of underperformance over the first 20 years of their investing life. If I have significant under underperformance over the next 20 years, well, that might make a big difference at the end of my retirement. So I agree it's not physically complicated to have multiple ETFs, not even for a two year old and certainly not for me personally. But I think a lot of people will benefit from just having that simplicity. Have one type of fund and just roll with that. Don't have to stress out about that one fund underperform. What do I do about that? You just get rid of it. Do I just throw in the towel? Do I go in even more and I rebalance?

Paul Merriman (81:21)

It's what Paula does. Seriously. It's about education, right? It's like when I met with Bogle back in 2017 and I asked him, why do you have bonds in a target date fund for a 21 year old? And his answer is, because we want them to know that that's our responsibility. And here you have a little bit of bonds in the portfolio. My position is totally the wrong answer. Asking investors a half of 1% a year, potentially totally the right answer. We just educate them.

Dr. Carsten Jeska (81:55)

You have to have at least 10% diversifying assets. You can't have 100%. I think there's some law that prohibits you from going more than.

Paul Merriman (82:02)

No, I don't think so. Because there are target date funds that don't have any.

Dr. Carsten Jeska (82:07)

It's a fig leaf of diversification. So if it's a fig leaf that.

Paul Merriman (82:12)

Costs half of 1% a year, they.

Dr. Carsten Jeska (82:15)

Started doing the target date funds as basically the default option. If people get defaulted into the 401k plan. Instead of just doing the cash or money market account, they now do the target date fund that is appropriate for that age. And then if somebody loses money and sues the administrator or the company, then they can say, look, we've had 10% bonds and this is what the academic literature recommends. Even though the academic literature Actually, if you have an unconstrained target date fund, you would actually want to borrow money. You would be short bonds, 150% equities minus 50% bonds. If you could do it, if people didn't want to sue you if something goes wrong. Yeah, I agree with you. Yeah, you shouldn't have even 10% bonds as a person fresh out of college or fresh out of grad school. So we are on the same page. I'm just saying we agree just for different reasons. So.

Paul Merriman (83:10)

But the reality is for most investors, and I'm sure, Paula, that in your work you're taking people up to a fork in the road when to rebalance. And it isn't something we should have to rediscover every year. We should have an automatic answer to that. They should know how often to rebalance. They should know that they should have index funds rather than actively managed when they come to that fork in the road. These things are really very simple. The problem is there's so much noise out there trying to get people to do something that truly is not in their best interest and they know it. And our job, I think, is to educate people to what is as best that we can determine in their best interest. The problem is none of us have the ability to see the future and that's what they want us to be able to do and we can't.

Dr. Carsten Jeska (84:03)

I agree with that.

Paula Pant (84:07)

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Dr. Carsten Jeska (85:46)

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Paula Pant (85:50)

Sorry, do we legally have to say that?

Dr. Carsten Jeska (85:53)

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Paula Pant (85:55)

They do feel that good. And they do good too.

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Paula Pant (86:20)

What's interesting to me is that this debate which the overt topic is smallcat but really the themes that have come out here, one is simplicity versus complexity. One is market timing versus buy and hold really. One has also been actively managed funds versus buying an index. And these are all thematically elements of the debate over this particular asset class.

Paul Merriman (86:48)

How much time you need in your study to represent enough.

Paula Pant (86:53)

Right.

Paul Merriman (86:54)

We come from an industry where people will hold up 10 year track records and pretend that that is something that having to do with reality when that 10 year track record has almost nothing to do with the next 10 years.

Dr. Carsten Jeska (87:07)

Mm, yeah.

Paul Merriman (87:10)

Yep, you're right.

Dr. Carsten Jeska (87:11)

Very good.

Paula Pant (87:12)

Right. Paul, we actually got this question from somebody in our audience. Why do you choose 1970 versus say 1968? You mentioned earlier that by choosing 1970 you do get 72, 73, but yeah. Why a round number?

Paul Merriman (87:28)

Well, when we started building the kinds of tables back in about 1995, a lot of people would show the results starting in 1975. And so what that meant was they had much better results than had they told people in essence the truth. There is a period there that you learn a lot about risk. And so we decided to go back to 1970 to pick up 73 and 74. And now of course our tables are at from 1970 to 2024 and the size of the print is very small. So we're struggling with how to present all of our work because we have never figured out, we never expected to be doing this many years of this kind of work and I'm glad we are.

Paula Pant (88:21)

One other point that I want to bring out because I think a lot of people who listen to this are going to be surprised by the component of the conversation where that went into actively managed funds. So most of the people who listen to this are index fund enthusiasts. But with the conversation around DFA and Avantis, the idea largely is that value alone is insufficient. That. Carsten, you talked about the value trap, that if you do look for value, you also have to screen out the junk. How does that square with the Boglehead's philosophy?

Dr. Carsten Jeska (89:01)

No, I mean, first of all, there was no screening out junk between 1926 and 2006 because everything worked apparently sufficiently well to even with the junk stocks that eventually go bankrupt, you can still make money with this value strategy. So basically what people are trying to do now is they're trying to figure out why value has stopped working and basically what are the ways we can fix this. And just like everywhere in finance, you're now doing an active strategy and you basically have to be ahead of what everybody else is doing because this is almost like an arms race because once you start doing this value screening well, somebody else will start doing that value screening before you can do it and already jump into that trade before you can do so. That's the little bit scary part. And this is why I believe, yeah, I mean, obviously if some new flavor has worked over the last five years or at least has worked better than just plain value investing, maybe that additional alpha that we generated through this new flavor will eventually be arbitraged away too. So just like everything else, some new insight comes in is everything in an efficient market will very quickly be priced in. There are basically programs that sift through if a company releases new data and they put out a report, some program reads through this, looks for certain keywords, looks for certain changes and basically within milliseconds you might have trades out based on that information. Anytime somebody tells me, oh, we just have to find new ways to fine tune this, you might milk this for a while, but eventually it will also go away. So I, I would be cautious about this and I hope that at DFA and Avantis that, that people obviously are, are smart enough that they will stay ahead of the game. But absolutely, this is an active management problem now because the flavor small cap value has become so well known. So you have to do something better than everybody else. If you don't, you just fall behind.

Paul Merriman (91:19)

And you know, it may be that we're overlooking that we are coming to conclusions that are not the right conclusions. For example, we had this great performance for large cap growth in 1980 through the end of 99. And so it certainly made growth look like the favorite sun. Then we go into a 10 year period that I mentioned earlier, from 2000 through 2009, that small cap value out produces the S&P 509 out of 10 years. Why didn't we ask? Oh, well, maybe this is the end of the S&P 500, that there's some change in the market. It may be. The only reason that small cap value hasn't been doing so well is the same reason that it did so well in 2000 through 2009. And that is another equity asset class got way out in front of its skis. And then you have this reversion to the mean, whatever that force might be, that for a period of time, small cap value is back on top. And I felt that in my life because it was a part of the way we managed money for our clients and they thought we were brilliant. We weren't brilliant at all. We just had a massively diversified portfolio and we were able to take advantage of it. But now we may simply mean Carson, still going back to 2006, whether it's 2006 or 2009, whatever it might be, it could be simply the fact that now small cap value isn't doing well for a while now. DFA just came out with a report. If I can, I'll send it to you. Basically says that really what's happened is growth has performed at the 90th percentile. That it has done something that is not impossible, but happens from time to time. But then it also sometimes goes down to the 90th or the 10 percentile. Not very often, but it can. And all we're seeing is this yin and yang or whatever we want to call it, and we're jumping to conclusions because humans want to create a picture of the future. We are insistent on making up stories when we have no idea what's going to happen. It doesn't mean, by the way, that our ideas can't make sense. I look at our political situation and the diversity of ideas about how to run a country. Oh my God. I mean, they're two very different views. And yet it's the same thing that goes on in the stock market. In the stock market you get to see it played out over time and you see how wrong. By the way, as you guys know, all of the studies show that the ability of humans to see the future about the stock market is very, very poor. At which point I say, why would we waste any time doing that?

Dr. Carsten Jeska (94:32)

Yeah, obviously we can't forecast it, but there are some very intriguing correlations, Right? I mean, for example, if you look at the CAPE earnings yield versus 10 year future returns and I'm talking about Real returns, pretty strong correlation between this. So in that sense, valuation works over the very long term. It doesn't educate you in any way about the next month or maybe not even the next year. It's a pretty good correlation, at least for the equity market overall. Now, am I going to use this as a market timing scheme? You could, but then again, the mean reversion times are so long that you may be wrong for so many years. And basically clients are going to fire you before you're right. So this is always a huge concern. And so when I worked in the asset management, so we had clients who would be sovereign wealth funds, pension funds, very large endowments. And yeah, I mean, you could underperform maybe for a year, your benchmark, you can underperform two years, you might get some angry phone calls. If you underperform for too many years in a row, they will fire you. And it's a lot faster than, say, the 19 years from 2006 until today where people would have fired you. And so it's something to keep in mind. So for the people who say that, you know that if we look at only since 2006, that this is not enough data to look at in the finance world, this underperformance for 19 years, that's very hard to justify that with just bad luck. So there's something to keep in mind there.

Paul Merriman (96:05)

So, and I think it's normal.

Dr. Carsten Jeska (96:09)

Okay?

Paul Merriman (96:09)

And therein lies a big difference because as somebody said, for 20 years bonds have outperformed stocks. It's happened. And so do we then decide no more stocks because bonds are better? And I don't think we do, no.

Dr. Carsten Jeska (96:27)

And in fact, I can show you, if you look at the window, right, the end point for the bond return when it did really well was when bond yields were say, 1%. Well, they started at 7% or 8% and they go to 1%. You can say with great certainty that the bond yield is not going to go down by 700 basis points from 1%. It had to go up at some point. But absolutely, there are some banks in California that failed not recognizing that bond yields might go up again. And there's some very smart people working there, and they did not recognize that. And the Federal Reserve trying to oversee them, it did not occur to them. But you're right, one asset class can outperform another asset class then if it out. So I would not project it forever. But I would also not say that bonds now have to go all the way back up to 8% yield. I think the 10 year yield was probably somewhere around 6 or 7% in the late 90s. It was double digit in the 1970s. We'll never go back there, I hope. I don't think that I quite see how small cap value will very quickly make up that 19 years. One option of course would be what if there is this complete unraveling of the AI and tech and growth economy? So that might be the trigger for that. But I hope that that will not materialize. But that would be one way how small cap value will catch up again.

Paul Merriman (97:59)

Paula, maybe you can have us back in five years. We can see how we did.

Paula Pant (98:07)

Absolutely. It would be an honor. What else would the two of you debate?

Dr. Carsten Jeska (98:13)

When I listened again to our podcast from before, I think we recorded this in December and it came out in January, Paul was talking about faith, about this is a matter of faith.

Paul Merriman (98:25)

That's right.

Paula Pant (98:26)

That's right, yeah.

Dr. Carsten Jeska (98:27)

Do you remember that discussion?

Paul Merriman (98:29)

I truly believe that, of course.

Dr. Carsten Jeska (98:32)

So I was quite taken aback by that because as you know, this faith, Right. So faith is good, right. So if you go to church or sinner synagogue or wherever you practice, you do faith there. And faith is something where you don't question, you don't look for scientific proof otherwise, because if you did, that would actually undermine your faith. So for example, if you believe in God, a God, my God, your God, if you believe in God and you have faith, I think it would be quite troublesome to now say, I would like to see some scientific proof for the existence of God, because that is the opposite of faith. But I also think that the other way around should also hold that in every other aspect of life, whether it's finance or science, we shouldn't have faith. We should have a healthy portion of basically intellectual curiosity and we should always try to question our assumptions. For example, I question my assumption. I asked myself, well, what would it take for me to become excited about small cap value? And then some examples I gave you. Right. Obviously, if this whole return conundrum reverses again and we now pile up excess returns in small cap value the way we did between 1926 and 2006, I would be on board with small cap value. If we have this macroeconomic susceptibility over the next, say two or three macroeconomic cycles, again, small cap value gets hammered more on the way down, then recovers very nicely. People recognize I need to get a risk premium for small cap value, and you get this risk premium, then I would be on board. And so this is how I question my assumptions. And this is Where I don't want to be a person of faith. I want to be a person of science on this side and basically be a person of faith on Sundays for me, probably Saturdays for you. So I would like to hear your thoughts on what is that faith business about? I didn't capture it in real time back then. Explain that again. Why is this a matter of faith for you?

Paul Merriman (100:47)

My point, Carsten, is simply that we do not know what the future is going to bring and that we gather together some information for somebody. All it takes is the stock went up for a week and got my attention. And I think that's going to be a good place to put money because it's going to keep going up. Other people put money away for 30, 40 years. I once made an investment and did not touch it for 30 years. And I maintain my commitment to that investment with the belief. Now, I didn't know. I can't know. If somebody says that they'll guarantee to give me a 6% interest rate for 10 years if I loan them money, I don't know whether they'll be alive to pay me that back. I believe they will be. And even with the US Government, you could have somebody question the ability of the US Government to fulfill its obligations. We have fate now. Maybe fate, faith is the wrong word. What I worry about, what I really worry about for young people is that they trust the wrong mentor, the wrong teacher, the person who either has very little information about how to be a good investor, or the person that has a conflict of interest. And the good investment really is a good investment for the salesperson, not for the investor. And my belief is my job is to try to be a mentor for a lot of people or to present information that they can build a sense of trust and to stay the course. That is hard. That is hard. And who are the people that are able to do it? The best engineers. I mean, this is what's interesting, is the people who understand numbers the best are the ones who have probably the greatest likelihood of actually staying the course, which implies to me that if we can figure out how to educate people, that they will have a higher probability of staying the course. And as I think I talked about before, we have a program at Western Washington University where every student is going to come out of there with about 30 to 40 hours of financial literacy training. And that's from my view, about the best thing that I can do is help in that effort. But at the end of the day, I call it faith.

Dr. Carsten Jeska (103:38)

Again, I get this complaint all the Time, you know, when I do the safe withdrawal rate analysis and the people say, well, I'm pretending that I can forecast the future. And of course I'm not. This is all about probabilistic statements. We can make probabilistic statements that. I mean, for example, right now we have a cape above 30. It's highly unlikely that we're going to have another run in the stock market the same way we had over the last 10 years. So because for that, the CAPE ratio at that time probably would have to be in the 40s or 50s or even 60s. Probably not going to happen. And now I can't tell you that we're going to have a terrible return either because it could be that earnings are going to catch up enough and they kind of wiggle a model through this, we could have a total blow up. So we can only always talk in terms of distributions and probabilities. And then even then we can say, well, if we make predictions about the future, how much can we rely on past data? How informative is past data? Should we even look at data before we even had a central bank? Should we look at data before or when we had a central bank, but the central bank was operating quite differently from the way they're operating today? Maybe we, we could ignore data, say before Volker, and cross our fingers that that will never happen again. So I have faith, quote, unquote in the past has some information value for the future. I would never say that what we are doing here is forecasting any kind of point forecast. If anything, we can have a point forecast with some huge distribution around it and especially for stock returns. And that's really all we're doing. Nobody has any faith in predicting exactly what's going to happen. But obviously I have some faith, faith in my toolkit and my experience and past data being informative for future data. So yeah, in that sense you have not religious faith, but you have some confidence that that's something that's useful for the future.

Paul Merriman (105:52)

I believe that the future will look like the past. That's what I believe. And the reason I believe that is because like last year the market was up 25%, right? I have the data one year at a time. And in fact our quilt charts show one year at a time going back to 1928. And I can go back and see all sorts of years that the market made about that kind of money. And so I find that it's very likely that we will see 25% gains in the future. We will see 10% gains we will see. Minus 10% said, what I don't have any way to know is the sequence of returns, but the returns will be the same. And to the extent that the sequence of returns might be unfavorable to me, then maybe I should take some steps to protect myself. For example, somebody who started investing in 1975, in hindsight, they didn't have to put much money away to have more than they needed 25 years later. On the other hand, somebody who started in 2000 doesn't have nearly the amount of money they thought they were going to have, probably because they expected to be making 20 to 30% when they didn't. And so maybe what I do is to protect myself is I save more than I might like saving, but I'm protecting myself against the sequence of returns. What I did personally was I worked until I was 70 and I kept saving money. And I only retired when I had several times what I needed to retire because I didn't trust the sequence of returns that I might walk into. And that's the kind of discussion we have to have with ourselves. What do we trust? I don't trust a 10% compound rate of return from the S P 500, but I'm 81 years old. I don't have much longer to trust anything. In fact, my wife and I have enough money and fixed income that will probably never have to touch the stock portion of our portfolio and it will go to charity and children. That's a conversation we have to have with ourself. And I think there's trust and there's faith. But I'd also like to believe that people are making those decisions on good probabilities. You don't believe as strongly as I do, Carsten, about the probability of small cap value adding a premium. That's fine. One of us is going to be right. I suspect it's going to be me. But this business, everybody can step up and place a bet and we all have a tick, just like at the racetrack. And time will tell.

Dr. Carsten Jeska (109:02)

Yep. Nice.

Paul Merriman (109:04)

I love that.

Paula Pant (109:07)

Wow, that was a beautiful mic drop moment. And so Paul Merriman weighing in at 183, representing Mike Tyson in this fight. Dr. Karsten Jeska weighing in at 208, representing Jake Paul in this fight. I think the judges are calling this fight a draw.

Paul Merriman (109:30)

What?

Paula Pant (109:33)

And we're gonna have to have you both on for a rematch.

Paul Merriman (109:37)

Ah, great. I get a chance to get one of those ears. Thank you.

Paula Pant (109:45)

Paula, thank you so much for joining us. And thank you for this wonderful, wonderful Debate not just about small cap, but about the world of investing. All of the themes that came out of this small cap discussion.

Dr. Carsten Jeska (109:57)

Yep. Thank you. Wonderful.

Paula Pant (110:01)

Big thanks to both Paul Merriman and Dr. Carsten Jeska for this celebrity death match. What are three key takeaways that we got from this brawl? Key takeaway number one. Small cap value has historically outperformed the broader market, but but its advantage may be diminishing. Our two gladiators fundamentally disagree on whether small cap value's historical premium will continue. Small cap value has shown impressive returns for many decades, but its performance since 2006 has been underwhelming. And so this debate highlights how even financial experts interpret the same data differently.

Paul Merriman (110:41)

I do know that from 1970 to 1979, large cap growth companies did not do well. Small cap value did do well from 2000 to 2009. Those 10 years, small cap value did better than The S&P 500 in all but one year. All but one year. And the small cap value compounded at 10 and the S&P 500 compounded at a minus 1.

Paula Pant (111:20)

Key takeaway number two. The trade off between simplicity versus complexity is key to making investment decisions. Karsten advocates for keeping your investment strategy simple, while Paul argues that a slightly more complex approach by adding in small cap value could potentially yield significantly better returns. This highlights a fundamental tension in personal finance, which is that simpler approaches reduce stress but might leave money on the table. In other words, the debate is, do you follow the simple path to wealth or do you follow the optimal or efficient path to wealth?

Dr. Carsten Jeska (112:04)

There's some additional bandwidth that I would have to give up when I have to manage something that's beyond the broad market index. And you have to stick to it. Right. So I think when you had your discussion with Rick Ferry at some point, Right. So I think he pointed this out where he said that, yeah, of course, eventually everything is going to catch up again and very long term valuation is going to work out and it's going to equalize all sorts of differences. But do you have the patience to do that?

Paula Pant (112:40)

Finally, key takeaway number three, Investment decisions ultimately come down to probability and personal trust. Both Paul Merriman and Karsten Jeska agree that no one can predict the future with certainty. If there's one thing that we all agree on, it's that no one believes in prognostication. The difference in their views lies in how they interpret past data and what probabilities they assign to future outcomes. And so this reminds us that investing requires making decisions with incomplete information. And living with uncertainty and thinking as professional poker player Annie Duke talks about thinking in bet thinking Probabilistically, I believe.

Paul Merriman (113:24)

That the future will look like the past. That's what I believe. And the reason I believe that is because like last year, the market was up 25%, right? I have the data one year at a time. And in fact our quilt charts show one year at a time going back to 1928. And I can go back and see all sorts of years that the market made about that kind of money. And so I find that it's very likely that we will see 25% gains in the future.

Paula Pant (114:02)

Those are three key takeaways from this battle between two investing philosophies, represented by Paul Merriman and Dr. Karsten Jeska thank you so much for tuning in. I hope you enjoyed this. If you want delicious information, yes, information can be delicious. If you want delicious information delivered sizzling hot and fresh to your inbox head to afford anything.com newsletter where we send deep dives into double I fire that you will not hear anywhere else. It's entirely free and it's@affordanything.com newsletter changing gears we firmly believe that you deserve a raise. Life is more expensive, you work your tail off and we want to make sure you're asking for what you can get. We're committed to teaching you how to do it and we're building out a course that is based around how you can get that next raise. Now, this course is in beta. It's it's still in development and we are opening it up to a second round of beta testers. That opportunity will be available at the end of March, the week of March 24th through 28th. If you join our second beta round, you will get access to this course, including all of its updates, all of its future development, all practice sessions, all peer to peer, everything. You get access to it at a significantly discounted rate. So if you want to access this course for cheaper than you will ever be able to get to it in the future, mark your calendars for March 24th when we will open our doors to the second round of beta. And to make sure that you get that information, go to affordanything.com yournextraise affordanything.com yournextraise thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast and I'll meet you in the next episode.