ETF Expert Corner

Transcript

You can listen to our interview with Ben Carlson by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: Let's go ahead and welcome Ben Carlson to the show. Ben is joining us via phone from Michigan. Again, Ben is an Institutional Investment Portfolio Manager. He pens the very popular blog A Wealth of Common Sense and as we've been discussing, next week he's releasing a new book titled A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. Ben glad to have you with us this morning.

Ben Carlson: Hey Nate, thanks for having me.

Nate Geraci: Well Ben, I thought we would devote the majority of our time this morning to discussing your new book, because really this is sort of your own investment manifesto. This book boils down many of your core investment beliefs into an easy to understand format for everyone, and if I had to summarize your book in a nutshell, it's that you believe investing is simple but not easy. Is that what inspired you to write this book?

Ben Carlson: Yeah. I'd say I have to give credit to Mr. Buffett on that one. I stole that one from him. But it's true, it's what makes it so confusing for so many people is that there are these simple rules that you can follow, and just like following a diet, everyone kind of knows what you should do, but the hard part is actually following through and implementing those things. So that's where a lot of people run into problems.

Nate Geraci: Well you know, I think one of the single biggest reasons why investing isn't easy is because there is so much information available to investors today. Every investor now has news at their fingertips through their cell phones. We have a very robust 24/7 news cycle with the CNBCs of the world. It's interesting, in your book you say, "Anyone with a smartphone today has better mobile phone capabilities than the President of the United States did twenty-five years ago. We have better access to information than the President had fifteen years ago." That's just remarkable when you think about it, but this isn't necessarily a good thing for investors, is it?

Ben Carlson: Right. Because it's so easy to drink from that fire hose every single day, and so the information is worthless if you don't put some context around it. I do think that ignoring the noise is good advice but people have to realize how to do that and what it entails. So I don't think you can completely go on a media diet and not pay attention to anything because in that case then, you're going to probably end up over reacting, so you have to still pay attention to know what's going on. You really have to figure out what those good sources of information are and what is really just entertainment more than anything.

Nate Geraci: Ben, when you think about the information that's out there and you think of the investment industry or the financial services industry, more information is now available. It's also as complex as it's ever been. More information does mean more complexity but do you think the financial services industry also just makes things more complex for investors, sort of intentionally, perhaps as a way to justify fees?

Ben Carlson: Unfortunately, in many ways they do and I think a lot of it is not that there's people that are out to get you, but I think it's just kind of the incentive structure and the way things are set up. It's really unfortunate that, I always say, that a good sales staff usually will trump a good investment staff because those sales people know how to push the buttons and play to those behaviors and emotions that you have. They know that putting this complex product out there, that is over your head and trying to show investors that they have the holy grill, that will take care of everything and make it easy for them, and they just kind of say, "Well, trust me. I can handle this, don't worry about it." People want that comfort even though that holy grill doesn't really exist out there.

Nate Geraci: You mentioned investor emotions, and earlier I walked through the six pieces of advice you set out to cover in your book. I'd like to walk through some of these. You have some great quotes in your book. Let's start with keeping emotions in check, because throughout your book, it seems like emotions and poor investor behavior are sort of an underlying theme. As a matter of fact, you say, "Emotions are the enemy of good investment decisions. " And you say, "Having the correct temperament is far more important than intellect over time." Is this one of those things controlling emotions that sound simple but isn't very easy to do in practice?

Ben Carlson: Right. Because the thing is, you're never going to completely get rid of emotions, it's what makes us human. Sometimes those emotions are a good thing in our decision-making process but especially when dealing with the markets and financial decisions, those emotions are usually a bad thing. It's not necessarily that you want to completely get rid of them because again, that's impossible. We're human, it's human nature. You want to figure out ways to sort of circumvent those emotions and make sure they don't come into your decision-making process kind of at the wrong time, especially at those stressful moments in the market when there's fear or greed is really ramped up. You don't want to be then using your gut instinct to make decisions and probably making the wrong decisions.

Nate Geraci: Can you talk a little bit about over confidence in particular because you talk about how successful people who have a high level of confidence are actually more likely to underperform the market primarily because of this over confidence.

Ben Carlson: It's interesting I think, I worked in the institutional side and I think that's actually probably the biggest mistake that people make in professional investment circles. These people are very well educated. They're all very smart. I think one of the fallacies out there is that these Wall Street people are under-performing because they're not smart, they don't know what they're doing. Actually it's the opposite, everyone is smart for the most part. It's very easy to assume at all times that you're just the smartest person in the room and everyone else must be wrong. When that overconfidence seeps in, it's very easy to trust yourself with complete certainty and just assume that everyone else is wrong.

Nate Geraci: We're visiting with Ben Carlson, author of the book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. Ben, you talk a lot in the book about buy and hold investing, and you offer some nice color around why buy and hold investing is challenging for investors to stick with. One of the main reasons why you say this is the case is because doing something other than buy and hold, it feels good, it gives you the illusion of control, you're doing something, you're not just sitting there. You make the point that if you think about nearly every other aspect of our lives outside of investing, we're always told to work harder and do more and try to get ahead. You believe that it should actually be the opposite when it comes to investing, is that correct?

Ben Carlson: Right. It's kind of difficult for people to understand that actually making fewer decisions is probably a good thing for investors. All the studies show that people who over trade are performing much worse than anyone else in the market. The thing is that what I try to convey in the book is that buy and hold is not necessarily easy because doing nothing is a decision too. You can't just blindly buy and then just sit by and don't do anything, you still have to have a plan in place. Again, I think doing nothing when your plan calls for it, is usually ninety-nine times out of a hundred the right thing to do. People really want that illusion of control to be able to do something because it's comfortable. You want to release the pressure or do something else or follow the herd when things are going bad. It's very comforting when everyone else is selling after a market crash, to just capitulate and sell yourself because you're in good company at that point. Again, the doing nothing part is a lot more difficult than it sounds, but I think for a lot of investors, it's the right thing to do most of the time.

Nate Geraci: It's funny, we got a kick in reading the book, you mention a study from Fidelity where they looked at which of their accounts had done the best. They were trying to figure out the traits of the most successful investors. They found that accounts that were completely forgotten about by their account holders ended up with the best performance. That really speaks to buy and hold, doesn't it?

Ben Carlson: It's amazing isn't it that the people that try to make all of their maneuvers all of the time and make changes end up just having market impact cost and trading cost. A lot of times they have these huge market timing errors and they're buying at the wrong time and they're selling at the wrong time. These people that just let the markets do their thing and let their money compound are actually the best performers at this giant mutual fund company.

Jason Lank: Good morning Ben, this is Jason Lank alongside Nate in the studio. Early on in your book, you made an interesting point, frankly a little hard to swallow, it ran like this, "It's counterintuitive for investors to accept the fact that they could earn above average returns at a lower cost while giving up the opportunity for extraordinary performance at a much higher cost." As an investor, that goes against my psyche, I want extraordinary returns regardless of cost, that's what I want. If I accept that premise that you're making, am I admitting defeat in a sense?

Ben Carlson: It seems like that, and this is another quote that I stole from Benjamin Graham, Buffett's mentor, he said, "To achieve satisfactory returns, it's actually much easier than most people assume, but to achieve those extraordinary returns is much harder than most people assume." Let's assume there is five or ten percent of investors out there that really truly can deliver market beating returns over the long-term on a consistent basis without blowing themselves up and making these huge errors, but the thing is, eighty percent of investors think that they are in that five or ten percent. It gets back to the fact of trying much harder when you're not in that same league as those investors. Trying harder actually makes you perform much worse. Again, accepting those satisfactory returns means you're going to beat the majority of investors out there, so again it is counter intuitive but it's just how we're hard-wired and competitive people, so it's hard to admit that fact.

Nate Geraci: Ben, we need to take a break here but we talk about achieving those satisfactory investment returns. Let's talk about the importance of having an investment plan in place because you say in the book, "An investor without a plan is no investor at all. They're a speculator." In your mind, what does a good investment plan entail?

Ben Carlson: I think that a good investment plan is really just laying out a bunch of if-then statements and just having an overall idea of a system in place and having some goals. I think the biggest problem for most investors is not just the actions that they implement within their portfolio but it's those reactions. Everyone is investing in an uncertain future, but having some rules in place and automating the decisions up front and having that plan in place so you're not trying to make those decisions when things are going really great or things are going bad, and you follow your rules and you set them up ahead of time for, "If the market does this, I will do this." I think just having those good decisions made up front instead of trying to do them on the fly is really important for investors.

Nate Geraci: As you point out in the book, the best investment strategy is one that you can actually follow. The worse investment strategy is one that cannot be followed. Let's take a break and when we come back we will continue our conversation with Ben Carlson. I want to talk investment cost, diversification, we'll also get Ben's thoughts on ETFs. We'll do that right after the break. This is The ETF Store Show on ESPN 1510.

Welcome back to The ETF Store Show, Nate Geraci, Conor Kelly, and Jason Lank in the studio. Our guest today is Ben Carlson, author of the book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. Ben also manages institutional investment portfolios and runs the very popular blog, A Wealth of Common Sense. Ben, let's talk about one of our favorite subjects on this show, which is investment cost, and clearly you believe it's a good idea for investors to minimize investment costs where possible. I want to talk specifically about the cost of actively managed funds and the performance investors get from these funds in return, because you're fairly critical of active funds in your book. Can you explain why that is?

Ben Carlson: I just kind of took an evidence based approach and looked at all the different studies over the years that show active mutual funds. The majority of them under performed simple index funds in their benchmark. I think the distinction these days doesn't have to be any more about active funds versus index funds. I think ETFs are really helping bridge that gap. You don't really want to think about them as much as active versus index, but you want to think more about these high turnovers versus low turnovers because low turnover funds are going to save you impact cost and commissions. Again, you want to think about high cost versus low cost. Again, those active mutual fund managers are not idiots, they're smart people but it's just that there is a huge hurdle that they have to jump over in terms of their cost because the average cost of an actively managed mutual fund is 1.2 percent. Again, they're starting off behind a huge OB to begin with. They have a much higher benchmark to beat because their cost is so high.

One of the things that you can do now is invest in more actively managed funds and ETFs, but at a lower cost. I think the other great thing about ETFs is that a lot of them are systematic so you're looking more for a disciplined approach versus a discretionary approach. You're looking about tax efficiency versus tax inefficiency. Again, I don't think the feature has to necessarily be index versus active. It has to be those things ... You want to look for low turnover, low cost, disciplined, and tax efficient as opposed to index versus active.

Nate Geraci: You mentioned ETFs. Let's talk about ETFs because you say in your book that you believe ETFs are going to take over the investment industry. That's a pretty strong statement, and obviously we agree with you. But, I’d love to hear your thoughts about why you believe this might happen.

Ben Carlson: I think it's already starting to happen a little bit. I think that we just passed three trillion dollars. There's still a ways to go. The mutual funds obviously have a strong hold on things like 401K plans and workplace retirement plans. The ETF structure makes it so much ... It just makes so much sense because of the way the process works so the cost can be lower, the tax efficiency. This is where I really think that if actively managed funds would like to compete with index funds that they should be making their push into these active ETFs. One of the reasons they're not is because the fee structure isn't quite as enticing for them, so they haven't quite yet. I think if that's the way the actively managed funds want to compete, it's through the ETF structure because you have that tax efficiency so if you are a more actively traded fund and you have more portfolio turnover, you're not giving your investor those huge tax bills that you get in the actively managed mutual funds regardless of your gains or loses. I think that the structure of ETF systems and the fact that you can trade them daily, we're really going to see some enormous growth in that area.

Nate Geraci: Ben, for the average investor out there, I think it can be somewhat confusing, you hear the active versus passive debate and indexing. Obviously, mutual funds and ETFs ... Just in general, what are some of the things the everyday investor should do when deciding what type of fund to invest in?

Ben Carlson: I think the biggest thing for investors is to just realize that every position within your portfolio, you should have a reason for it. If it's an asset class or a fund or an individual holding or whatever it is, don't put it in there because it feels like it's the latest fad investment or it feels like it something you need to have. Have a reason for everything in your portfolio. I think that just starting from that line of thinking and probably trying to keep more stuff out of your portfolio than you put into it. I think a good investor will say no, way more times than they'll say yes over their life time. I think that's kind of one of the things about keeping things simple is just realizing a lot of stuff out there, you definitely don't need but always have a reason for every move you make.

Nate Geraci: Again, we're visiting with Ben Carlson, author of the book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. Ben, obviously, one of the things ETFs have done is open up a lot of different investment opportunities for investors. You spend quite a bit of time in the book talking about both asset allocation and diversification. I think you actually devote an entire chapter to asset allocation. Can you explain to our listeners first the difference between these two, and then why they both are so important?

Ben Carlson: I think asset allocation is something that really gets overlooked because it's kind of this really very very long-term strategy and it's not something that you can talk about every day. Everyone wants to know about what's going on with certain stock names or the market. Asset allocation is definitely more important than the investments you choose. Asset allocation is simply how you distribute your funds within your portfolio. Between stocks, bonds, cash, real estate or other investments. It's how you allocate them amongst those different asset classes. Diversification goes hand in hand with asset allocation because the diversification is how you mix those different asset classes. Really what you're looking for there is to offset risk and invest in asset classes and investments that perform differently so that will kind of offset your risk in any single year or cycle or decade. Add another risk control to your portfolio. I think you can't have a good asset allocation without being diversified, so they really go hand in hand.

Nate Geraci: On diversification, you had a great line in the book, you said, "Investors are always going to end up hating something in their portfolio because there are no scenarios where everything is going to be firing on all cylinders." Does this get back to the theme of your book, investing is simple but not easy because it's pretty easy to diversify but not so easy to stick with a diversified portfolio?

Ben Carlson: Right. That's kind of the problem, you're really not diversified enough, I think, if you don't hate something at some point. That doesn't mean you have to see absolute losses, it could be relative. Let's say in 2014, the S&P 500 was up almost fourteen percent, international stock markets were down. If you were invested in a widely diversified portfolio between international U.S. stocks, you felt like an idiot for holding international stocks. Turn it around to 2015, international stocks are far outperforming, U.S. stocks, and you can see how that smooths out over time but in any given year, month, or quarter, you're going to hate a lot of those things in your portfolio. It could be a number of years even, that you don't see the reason for holding a particular asset, which is again, why you want to have a reason for everything and kind of understand what exactly it is that you're holding in your portfolio. Again, like you said, that's one of the reasons that investing is difficult because it's not always going to be easy on you. You're not going to always be able to pick the best performing asset every single year.

Jason Lank: Ben, I want to skip to chapter 2 entitled Negative Knowledge. I found that an interesting chapter title. I'd like you to add some color to what that means, but my take away was that investors should look to avoid making large pitfalls before they move on to what they should actually be doing. In other words, avoiding bad things comes before striving for excellent things. I found that chronological order interesting that most people want a to-do list, they want to take action. Whereas you're saying, perhaps if you just avoid the worse of the worse, everything else will take care of itself to some extent. Is that true?

Ben Carlson: Right. Yes. It's kind of the Charlie Munger, always invert, that's how we solve problems. You want to almost look at it backwards. If you can go ahead and figure out what you don't want to do. It's almost like I’ll take all that bad stuff away, all that's left is the stuff that you need to really focus on. I think that's one of the most difficult things for investors to realize is that they really just need to focus on what they can control. If you can get rid of all that other stuff that is completely useless and outside of your control, it really can save you from a lot of stress and emotional despair when it's kind of pointless because there’s nothing that you can do about it anyway. I really think that negative knowledge is important and one of my other fellow bloggers, Josh Brown, always says that, "A good investor has to be like a bouncer at a club, turning people away left and right." That's the same thing with your investments, you're going to want to say no more than you say yes. If you can learn how to get rid of those unforced errors, I think that's setting a lot of investors on the right path to success.

Jason Lank: Ben, we've got a pretty good baseball team here in Kansas City, we’re in first place. I was trying to think of a way to explain this to my clients and a baseball analogy came to mind and it ran like this, tell me if this is okay. If you're the Babe Ruth of investing, it's okay to swing for the fences and strike out a lot because you're Babe Ruth. If you're not Babe Ruth, maybe you ought to avoid strikeouts rather than swing for the fences. Is that a fair analogy?

Ben Carlson: Yeah. Exactly. Just saying I'm a Tiger's fan so you guys were in the playoffs last year. I'm still a little sore about that. I think that gets back to the diversification point is that ... A good diversified asset allocation, long-term strategy, you're giving up on those home runs and strikeouts and you're going to be getting singles and maybe doubles every once in a while. That's the point with your life savings on the line in your portfolio, you don't want to put strikeouts on as even an option. If you're blowing yourself up all over and over again, you're never going to save any money, you're never going to succeed as an investor. Again, it's just kind of having a little humility and leaving your ego at the door and allowing yourself to give up on those home runs, but also give up on those strikeouts so you're not going to completely go to zero.

Nate Geraci: Again, we're visiting with Ben Carlson, author of the book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. Ben, we have just a few minutes left here and I thought we'd close our conversation today with two other keys to successful investing. These are perhaps extremely boring keys to success but they might also be two of the most important and that's saving enough money and exercising patience. You had a neat little anecdote in the book where you describe an investor, his name is Bob. You explain how Bob saved money diligently but he had very poor market timing. He only bought into the market at big market tops in 1972, 87, 99, and 2007. Once he was invested, he stayed invested. As it turns out, Bob ended up with over a million dollars even though he was saving just a few thousand dollars a year. This was over a forty plus year period, but I thought this perfectly illustrated the importance of saving and staying the course. Bob was patient even though his timing was poor. Once he was invested, he stayed invested and let it grow. Is discipline saving and staying the course two of the greatest equalizers in the market.

Ben Carlson: I would say the best investment that anyone can make is to be a very diligent saver over time. If you're a good saver and you're saving a good chunk of your income and you're putting it into the market on a consistent basis, it's almost impossible for you to not become wealthy someday. I think that's one of the most overlooked aspects of financial planning that people don't really consider. It doesn't matter how great your investment strategy is, if you're not first saving. The example you provided, I just took a look at what would happen if you invested at the worst times in history but you still saved diligently, put your money in and left it there in the financial markets over four or five decades. It's amazing how that compounding can really smooth out those mistakes over time. Obviously, I would never recommend anyone do that because if our friend Bob would have just diligently put his money in once a month, once a quarter, or once a year into the market, he would have done much better, but that does shows what can happen with patience and compounding.

The other example I provided in the book, is that one of the craziest compounding anecdotes I've ever seen is that Warren Buffett had about four billion dollars when he was age sixty. Putting him at the top of the Forbes List or close to it. In more recent years, he's worth close to sixty billion, so do the math, that's about ninety-five percent of his wealth has been created after the age of sixty because he has kept letting that money grow on itself and it really snowballed into an enormous amount, and that's an extreme example with the richest man on the planet but it just shows how letting your money work for you is so important.

Nate Geraci: I'll close with this, you had a quote where you said, "Patience is the greatest equalizer in the markets between the Pros and the Joes." I thought that was perfectly said. Ben, we have to leave it there but if listeners would like to pick up a copy of your new book, where is the best place for them to go and when can they get it?

Ben Carlson: They can find it on Amazon or Barnes and Noble, anywhere that sells books, just search for A Wealth of Common Sense, and it comes out this Monday, June 22.

Nate Geraci: Well Ben, thank you very much for joining us this morning. We certainly appreciate it.

Ben Carlson: Thanks a lot for having me guys.

Nate Geraci: That was Ben Carlson, author of the book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan. I would also highly recommend checking out Ben's blog at A Wealth of Common Sense Dot-com. He has some great investing content at the site. You might also follow Ben on Twitter as well.