Phil DeMuth Interviewed by Motley Fool's RObert Brokamp

What can a former valedictorian and clinical psychologist teach you about money? Plenty, if that person is Phil DeMuth, Ph.D., a fee-only advisor and Managing Director of Conservative Wealth Management LLC in Los Angeles. He is the co-author, along with actor and economist Ben Stein, of four books about personal finance.

Robert Brokamp: How does a psychologist in Cleveland end up being a financial advisor in Los Angeles?

Phil DeMuth: I have always had some kind of hand in the stock market. My first job at 16 years old was a runner for a brokerage firm on LaSalle Street in Chicago, carrying briefcases full of millions of dollars of securities from one firm to another down the street. I have always had a small portfolio that I managed. Over time, I found myself becoming interested in it to the point that it was more interesting to me than talking to my patients. I found I would say things like, "Well, never mind your sex life, what about your portfolio?" So there was that interest.

I also was a frustrated writer and wanted to try my hand at screenwriting
and for that you had to be in Los Angeles. So I packed my bags and my family moved out to Los Angeles, where I did a little screenwriting and met Ben Stein. Ben's dad [economist Herbert Stein, former Chairman of the President's Council of Economic Advisors] had worked with my brother [President Christopher C. DeMuth] at The American Enterprise Institute. We had lunch and hit it off famously, and I found that Ben shared my obsession with the stock market. After a while, Ben said, "These lunch table conversations are actually pretty interesting. I bet we could write this up in a book." So that led to Yes, You Can Time the Market. That turned out to be quite successful so we kept on writing.

I became an investment advisor to manage my own account using Dimensional Funds, and found that what I was doing was scalable. When the book came out, I put up a website and hung out a shingle and started managing money for other people as well as myself.

Robert Brokamp: Very interesting. Let's start with some retirement-related questions. Let's say someone asks you "What should be my withdrawal rate in retirement?" I know your first answer would be, "It depends." What are some of the factors you consider when helping someone determine a withdrawal rate?

Phil DeMuth: The standard answer, the safe answer would be something in the neighborhood of 4%, and that is just based on looking at what happened to people who started withdrawing in 1929, and asking could they survive for 30 years at that kind of a rate? And they could have.

That seems to be borne out by the different kinds of studies that people have done. The answers all seem to hover in that rough area. So the first thing I would do is figure out if this is a realistic ballpark for the client, and then if it is not, then what kind of plan B could we come up with.

In general, what I would do is use a Monte Carlo simulation, input exactly what the client's portfolio is, and come up with something that looked like it was going to work.

Robert Brokamp: And 4% is generally what you find, or do you find such a wide variety that there is really no general withdrawal rate that you see?

Phil DeMuth: In our book on retirement, we used the "couch potato portfolio" [created by financial journalist Scott Burns] which is half index funds for stocks and half index funds for bonds, then analyzed what kind of withdrawal rates could you make. Based on long-term averages, for most people, a higher withdrawal rate will be possible. You could probably push it up to 5% in many cases.

The question that comes up is, how much do you want to plan for the
worst-case scenario and how much do you want to plan for an average-case scenario? Because most average cases will allow you to take out 6% or even 7%. If we have market returns over the next 30 years like we have had for the last 30 years, everybody is going to be fine. So it is really just a question of how much do you want to bet that everything is going to be just fine, and how concerned are you that maybe everything is not going to be fine, and what kind of a rainy day do you want to plan for?

Robert Brokamp: In Yes, You Can Still Retire Comfortably, you talk a little bit about determining what to sell when you are in retirement, and this is something you and I have emailed about, and I have quoted you on this topic in my newsletter before. So, I have two questions about that. One question is, should people spend the interest and dividends and fund distributions they receive, or should they be reinvesting that money and then sell assets wholesale when they need to take money?

Phil DeMuth: For people in retirement who are taking distributions anyway, I would tend to recommend they take the distribution in the form of cash, not go to the trouble of reinvesting it because I will be paying it out at some point before the end of the year anyway.

Generally, what I think works best is to combine two strategies at
retirement. You take half your portfolio and invest it for long-term capital
appreciation and take half your portfolio and invest it for current income. Because if you do that, what is interesting is that the two sides of those portfolios have a fairly low correlation with each other, so one might do well when another one was doing not so well. So they diversify each other a little bit. If you were to split your portfolio in this way, then you might simply take the coupons and the dividends from the income side and put those in your bank account, but then reinvest the growth side of the portfolio and then just sell that off according to whatever sell formula you wanted to follow.

Robert Brokamp: You have written about using valuation to determine what to sell in retirement. Can you explain?

Phil DeMuth: This goes back to our first book -- Yes, You Can Time the Market -- which it is really a book on how to value the stock market. This looks at very basic market metrics like the price-to-earnings ratio to make some kind of judgment as to whether the market looks relatively cheap or relatively expensive. Right now, this is a very dicey question because both stocks and bonds look to be relatively expensive. But over the course of the next 30 years, the answers will to change.

Robert Brokamp: I should add that your website (www.stein-demuth.com) has a lot of the valuation graphs, although a few of them have unfortunately had to be discontinued due to Barra changing the way they do things. Do you think you will be able to come up with a way to reproduce the price-to-sales charts and the others?

Phil DeMuth: I have not been able to find any kind of link to that data, but it does not concern me. I try to take the big picture, and I think that if you look at price -- price to earnings, price to dividends, and what the stock market earnings look like relative to the bond market yield -- I think that gives you a good sense as to whether the market is expensive. The other metrics just fine tuned that.

Robert Brokamp: To get back to Yes, You Can Time the Market, most people think market timing is impossible.

Phil DeMuth: The title was deliberately provocative. This came out of a discussion with Ben, who said, "If it is really true that you cannot time the market, what follows is that price has no meaning. And yet we know that price has meaning in every possible market. It is the single most important factor. If you go to the grocery store or any kind of a market, price is king. So how could it make sense to say that price has no meaning when you are in one of the most liquid and transparent markets in the world, the stock market?"

We found that if you look at what the price of the stock market is, as
measured by various metrics, compared to where it has been historically, you can make a pretty good judgment about whether the market is cheap or expensive. If you are buying when the market is expensive, that compromises your long-term returns.

So, like with everything else, it is better in general to buy more when
things are cheaper and to buy less when things are expensive. That was the point the book made. The title is a bit equivocal because we are really not talking about some kind of short-term oscillator or some kind of metric that says, "Buy today!" or "No, sell!" tomorrow. It really has nothing to do with that. But it does make the larger point that it is possible to make judgments about whether the market is cheaper or more expensive at any given time.

Robert Brokamp: I was flipping through my copy of the book, and saw next to the phrase "market timing," I had written "price timing." It seems that is what you are getting at.

Phil DeMuth: Yes, exactly.

Robert Brokamp: Also, you don't recommend that investors move all of their money from stocks to bonds, but it is more of determining where you put new money. So you are not moving everything, shifting it around constantly, correct?

Phil DeMuth: Absolutely. Some people have mistaken the book to mean this is a black box or this is a magic formula that tells you what to do. It is really designed for a reasonable investor to be one piece of information, one piece of ammunition in terms of thinking about how he or she wants to allocate his or her portfolio. And so at times when the market looks like it is less expensive, this may be a time to be buying more in the way of stocks. When the market is more expensive, it might be time to lighten up a little bit, but certainly we would advocate, as we do in the book, that people should hold at all times a diversified portfolio, whether stocks look cheap or expensive.

Robert Brokamp: In Yes, You Can Be a Successful Income Investor, you discuss many investments. Let's go through a few and get your quick take on them. Let's start with Treasury Inflation-Protected Securities.

Phil DeMuth: They are probably the safest investment that an investor can hold because they are indexed to the CPI, which is a measure of inflation. We emphasize them especially for retirees because inflation is the great retirement killer. If there is a big bout of inflation, people living off fixed-income portfolios are going to be very badly hurt.

Robert Brokamp: How about their corporate cousins, corporate inflation-linked notes?

Phil DeMuth: They're great, but I would have to know how to buy them. When you are buying notes like that, you have to ask about what kind of a bid-ask spread is there, is it going to be possible for you to buy these efficiently? So while we like the concept a lot, the fact that the market is not that liquid and transparent makes us think that unless you can buy them through the intermediary of some kind of very low-expense, highly diversified mutual fund, it is probably not going to be an efficient way for just the average investor to load up on these securities.

Robert Brokamp: That gets to the difficulty the individual investor has with buying individual bonds or many other types of fixed-income investments, doesn't it?

Phil DeMuth: Absolutely. In other words, the trading costs, the transaction costs, even though they are invisible, are severe. So if an individual investor wants to buy individual securities, they will be fine if they are buying treasury bonds from Treasury Direct (www.treasurydirect.gov), straight from the government, no middle man. They will be OK if they are buying new issues of municipal bonds, typically. But for most corporate bonds and for most municipal bonds, they are not going to be able to get the kind of pricing power that a company like Vanguard, which buys bonds by the billions of dollars, can.

Even though the mutual funds do have internal expense ratios, these are still probably going to be less than what individual investors are paying in the way of spreads. It will give investors a lot more flexibility, too, because if they ever have to sell these bonds for any reason, they will be able to do so with a phone call and they won't have to take a 5% hit on what they thought the bonds were worth.

Robert Brokamp: How about international bonds?

Phil DeMuth: International bonds, again, are great. There is some controversy about them. Right now the emerging-market bonds are like all riskier securities: you are not getting paid a lot in the way of extra yield beyond owning cash in the bank to really take the bonds, so I would not allocate a big percentage of my portfolio to them right now.

In terms of developed-market bonds, the $64 question there is: do you want to have a currency hedge built in? There are some funds that are unhedged, which means that you take on currency fluctuations. There are other funds that are hedged, which means you don't have the currency fluctuation added to the foreign component.

I actually like the currency fluctuation because I think the U.S. dollar is
on a long-term secular downward trend, so I don't mind assuming that risk, but in the short run, I think it is not a risk that you are compensated for.

So I am happy to have investors have some percentage of their portfolios in unhedged foreign bonds. I wouldn't begin to bet the farm on it, but some is fine.

Robert Brokamp: How about leveraged, closed end bond funds?

Phil DeMuth: The big appeal here is the fact that since they use the secret sauce of leverage [investing money they've borrowed], they can jack up a much higher yield than you can get just buying an ordinary bond fund. In fact, when it comes to these closed-end funds, it really doesn't matter what they hold because as long as it is a security that pays some kind of a dividend, by using leverage they can enhance the dividend.

In general, I eschew them and the reason I do is because the leverage tends to increase the volatility more than it does the yield, and the volatility of the portfolio is of also great importance to me. Even though they are not that visible, the risks we assume are important, and they often hit us when we least expect them to. So they are fine for some people, but you have to study them very carefully.

Many of these closed-end funds have distribution policies in place where they will just say, "We promise that we will pay you 7% no matter what" -- which means, in effect, they can be just handing you back your principle in the form of a payout, and maybe you weren't expecting to pay somebody a 2% management fee to hand you your money back to you. So you have to be careful.

Also, the short answer on all closed-end funds is to buy them when they are selling at a discount rather than a premium, and generally the bigger the discount the better. So that is the other key piece of advice with those.

Robert Brokamp: How about high-yield bonds?

PD: Right now, high-yield bonds are paying a very low premium over Treasury bonds, so I don't really see any reason to move out on the credit risk scale in order to capture that extra bit of yield.

Robert Brokamp: What is your take on preferred stocks?

Phil DeMuth: If you have a true preferred stock -- it is not going to be refunded at any point or converted into something else -- it is a like a very long-maturity bond. There would be times to buy them, but when you have an inverted yield curve or a flat yield curve like we have now, there is very little point in buying a bond with a five-year maturity over just having your money in a money market fund, let alone having a bond with a 100-year maturity.

Robert Brokamp: Your take on master limited partnerships (MLPs)?

Phil DeMuth: Master limited partnerships are an act of faith. They have paid off very handsomely in recent years as the price of oil and other natural resources that most of these partnerships hold has shot up. But, if you actually were to take the trouble to read one of the partnership documents, what they basically say is the master partners can do anything they want, and they will give a tip to the shoe shine boy of the limited partner, as they see fit. And so you are taking an enormous leap of faith in the goodness of the hearts of the managers of these partnerships.

It is not the kind of thing that I have been that comfortable getting my
clients involved with. I think if you want to get into them, you would have
to study them pretty closely.

Robert Brokamp: What about real estate investment trusts (REITs)?

Phil DeMuth: REITS are very expensive. I think people are going to be continuing to rent apartments and storage space, and those rents are going to continue to be passed through. So for the income investor, they are going to continue to pay out some stream of earnings that people can live on. For the capital appreciation investor, they are expensive, but they still serve a function as a portfolio diversifier since they have a low correlation to other kinds of assets like stocks and bonds, so there is a place for holding them.

Robert Brokamp: Not all REITs are created equal; different types of REITs have different characteristics. Is there a type of REIT these days that you think is a better bet than others?

Phil DeMuth: Some people do follow the individual REIT sectors like shopping malls, hotels, office space, things like this. I have not gone that route. One interesting way of doing it is looking at REITs like bonds that have a particular maturity. A hotel room is like a bond that has a maturity date of 24 hours. An office lease is typically maybe for three years. So depending on what you think the economy might hold in the future, you can make a bet in terms of whether it is better to go to a longer maturity or a shorter maturity.

I have a different way of looking at REITs now. I used to look to try to
diversify across sectors and try to make heavier weights in sectors that
seem to be more of the "Steady Eddies." I love shopping centers because in good times and bad, people are still going to go to the grocery store or they are still going to have to go to the laundromat and the drug store and all those other stores there. Whereas they might not go into the shopping mall and buy an Armani suit at Neiman Marcus. So I was interested in more of those kinds. Public storage was another kind of a REIT that people tend to use in good times and in bad.

Lately, I look at the dividend yield they have been paying, and compare that to how volatile they have been. I now look at all income investments through that particular prism. I look for the best yield for the least amount of risk along the way. And that is what gets my attention, as well as the stability of that payout, among other things.

Robert Brokamp: So what is the bottom line on REITs? Are they a good risk-adjusted source of income or have they become too volatile recently?

Phil DeMuth: Well, by "volatile" we mean downward volatility. I still would have an exposure to REITs, but I might not have as great an exposure right now as I would have ordinarily, just because they seem to be expensive and going down. I would not take the position that they have sold off now, so we need to double up on our bets. It is important to see what is the overall portfolio looking like, and if you had REITs at a certain percentage and they had grown a lot, I think it would be not a bad time to trim back on them to whatever your original allocation was.

Robert Brokamp: Is there an analysis out there where they look at all these different types of income-producing investments and do a modern portfolio theory-type of analysis, saying these are historical correlations among these types of investments -- perhaps the leveraged closed ends are counter-weighted by some other investments. Can you just throw all these investments into a diversified portfolio where a lot of the risk is evened out?

Phil DeMuth: The next book that will be coming out from Ben and me is a book on portfolio management [Yes, You Can Supercharge Your Portfolio]. There is a chapter on income investing, and this very much takes into account factors like what has the historical yield been of the portfolio, what has the minimum yield been of a particular portfolio, and how can you trade these risks off against each other to sort of optimize your income portfolio.

Interestingly, we feel the way to go is very much the kind of portfolio we
talked about in Yes, You Can Be a Successful Income Investor: perhaps 60% of your portfolio in bonds and 40% in stocks and REITs. If you go much higher than that in terms of emphasizing the stock side of the portfolio, you are really running a growth model.

In general, I have not found that the closed-end funds, the use of leverage, really makes sense in most cases. The added risk is not as sweet as the added return, which is probably just a function of the fact that there are high expense ratios that subtract from the returns, but not from the risks.

The other thing that we found is that we like less the vastly diversified
dividend funds, the kinds that were just coming out from iShares and Power Shares when we wrote the income book. We feel that these funds are over-diversified, which is a funny, strange-sounding concept from a modern portfolio theorist kind of guy. But what we mean is that as you add 30, 50, 100 stocks to your dividend portfolio, the yield is going to start marching down rapidly because there is a finite universe of high-income stocks and REITs to choose from. So the yield gets more and more diluted, and the standard deviation or the variability of the portfolio does not shrink to the same extent.

Our conclusion is that you are better off making some careful, judicious
selections of individual income securities at the higher end of the yield,
but that still have relatively good stability, and then counting on the bond side of the portfolio to really reduce the overall portfolio volatility.

Robert Brokamp: In some cases, you point out that there are some real drawbacks to rebalancing, so what is your take on that?

Phil DeMuth: In the next book we have coming out, we present a little of the data behind the story. What I have found is that if you take a well-diversified, real-world portfolio -- with representative asset classes and so forth -- that rebalancing every year does not really add value. There seems to be an efficient frontier of when to rebalance, and it seems to be about every three years or so, or after your portfolio exceeds a fairly high deviation from its original allocation. So we would rebalance, but not very aggressively. We would take a very minimalist approach.

Robert Brokamp: Larry Swedroe made the point that if people are looking to rebalancing to enhance returns, they are probably looking for the wrong thing. He said that the best argument for rebalancing is that you control your risk profile and you don't let the market control it.

Phil DeMuth: Rebalancing is a strategy for controlling risk. But by controlling the risk, it also tends to lop off the returns. Short-term rebalancing, from my point of view, is really just reshuffling a lot of market noise into your portfolio, while undercutting momentum. There is not a big premium for doing that. By waiting for a longer period of time, you are letting the market really speak more about where the signal is, and then when you rebalance, it is a bit more meaningful.

I think partly, too, rebalancing has become a religion among advisors who feel that by doing this, they are adding value; because at least they are doing something. Some of the original studies were just based on very simple portfolios that were just the S&P 500 and Lehman Aggregate Bond Index and looking at one period where it may have shown some value. But now, even John Bogle has come out against annual rebalancing.

Robert Brokamp: In your Income Investor book, you sounded kind of down on reverse mortgages, then in the Retirement book, it sounds like you changed your view of them. So what do you think of reverse mortgages these days?

Phil DeMuth: We like them more than we used to. The reverse mortgage products have been evolving. The first generations were just outright frauds for bilking seniors. Then seniors became an endangered species with special protected status, so people started looking much harder at these products and trying to protect seniors. The next generation of them has been considerably better. It is not something that I would undertake unless it was a last resort. The caps on the reverse mortgages that you can get that have the blessings of the government are fairly low. If you want to get more money than that, you have to go to the private markets, where the fees become much
higher. It is really nothing to count on unless it is one of your only
remaining choices.

But the products are not as bad as they used to be, and the hope is -- as is the hope with annuities, I would say -- that over time, as the boomers retire and there is a greater need for this, that there will be more players. There will be more competition, and that will drive down the fees. The products will be less cumbersome and more useful than they are right now.

Robert Brokamp: You had mentioned that your opinions on the dividend ETFs have evolved. As an author myself, I know there are always times when you write one thing and then you change your ideas, possibly because you learned more or someone raised fair criticism. Is there anything that sticks out from all your books, things where you have changed your opinion considerably or anything you would write differently if you could go back?

Phil DeMuth: With Yes, You Can Time the Market, I would have emphasized that this is not a market-beating system that we are advocating -- that you just look at the signal and then make a yes/no decision about being in the stocks or bonds.

The demonstrations were simply trying to provide evidence that, yes,
valuation is extremely important when you buy a portfolio, but it was not
intended to be some kind of system, and I don't think that was made clear enough. This is just from the criticism the book has received, that it kept people out of the market during the 1990s or something like that, which was not true, and was not the intention of the argument.

I think that we are less fond, as you said, of the super-highly diversified
income funds. They are still great for investors that don't have the
resources to pick individual stocks. But if you do have the time and the
interest to go a little deeper, I think you will be better rewarded by
picking individual dividend stocks.

When we wrote Yes, You Can Still Retire Comfortably, in order to come up with some system of what kind of investment savings you would need over a lifetime in order to generate distributions you could count on during retirement, we had to lock down a portfolio. We chose the Couch Potato Portfolio -- half stocks and half bonds -- because it seemed to be pretty reasonable, inexpensive to own, easy to implement, and because it seemed to be so much better than what most people were doing anyway.

But in practice, people would be much better off having a far more
aggressive portfolio when they are younger, having 80% or 90% stocks, and then ratchet that down as they got closer to retirement, and then increasing their equity portfolio a bit in later retirement. You have fewer years the portfolio has to shepherd you through, so you can afford to take greater risks later on. By the same token, when you are much younger, you have a lot more time for a portfolio to recover, so you are better off betting more of your assets on stocks than bonds. So a U-shaped portfolio over time -- where you have more stocks earlier and more stocks later and more bonds sort of right around as you hit retirement -- would actually be a more optimal portfolio. At the time, there really wasn't a way of putting that into the formula -- it was just going to make everything too complicated. But in real life, as I plan for retirement, I would invest more along that U-shaped curve than just having a 50-50 stock/bond portfolio from womb to tomb.

Robert Brokamp: Explain how important those first few years of market returns are to a retiree?

Phil DeMuth: The newly-minted retiree is like a newborn baby. He no longer can count on his human capital -- his job -- to add new assets; he is entirely dependent now, not on his mother's breast, but on the breast of the stock market. If you retire in October of 1929 or in March of 2000, just when we get socked with a huge downturn, you are forced to sell them off at distressed prices. Because you are eating your seed corn, you never really have a chance to recover. In retirement, you need a higher bond allocation so that if you do get hit with a loss like this, you could live off the bond side of your portfolio and give your stocks five years, ten years, whatever it takes, to climb back up.

Robert Brokamp: My final question, and it is the one I ask all my guests since I am the retirement guy here at The Motley Fool. Phil, are you ever going to retire?

Phil DeMuth: I have no plans to retire. I will retire when they pry the keyboard from my fingers. I think in general, retirement is over-rated. I think people find meaning in life -- at least, I know I do -- primarily through work. Even when people "retire," they still ought to find some work to do. I am increasingly heartened to find many of the people that I am talking to now, and I hope this is a trend, are making money in business and they are retiring and then they want to give it back. They are sort of following the Bill Gates/Warren Buffett model. As they retire, they want to spend their time or their money doing things, working for charities or non-profit organizations. They are trying to do things to help people and make the world a better place, and that is a trend that I expect to see a lot more of as the baby boomers retire.