Jonathan and Brad talk to Paul Merriman. The goal is to contrast the "Simple Path to Wealth Approach" with the "Ultimate Buy and Hold Portfolio." Paul is a proponent of the Ultimate Buy and Hold strategy and a legend in this space. The insights Paul provides about this strategy are priceless.

Paul Merriman's Story

Paul started his career as a stockbroker. However, he quickly began to question the fact that he was told by his boss what to sell and when to sell it, and the obvious conflicts of interest. So, he decided to change career paths.

From 1969 to 1983 he did a myriad of things. Eventually, he reached a state of Financial Independence that allowed him to not have to work. At age 40, he was able to choose to work as something that he just loved to do.

Paul chose to start an investment advisory firm, without any money under management. He just started teaching people about their finances. With the help of many people, he was able to build a very successful investment advisory firm. By the time of his second retirement in 2012, the firm had over $1.6 billion under management.

 I am not a financial planner. I am not a security analyst. I am a guy that has been around the investment community now for literally all of my adult life. And I love teaching people how to do this on their own.

Paul started this investment advisory firm without the need for an income. However, Paul freely admits that he is a workaholic, so he really needed to pour his energy into something that he loved doing.

How Paul Built The Firm

His business model for building this company was simple. Paul conducted hundreds of workshops for investors. The goal of the workshop was to teach DIY investors how to do it themselves effectively.

The workshops were several hours long and packed with useful investment information. In many cases, he would be able to teach the attendees enough to build their own investment portfolio without his help. However, at the end of the workshop, he would offer the attendees a free consultation. If at the end of the consultation the client could hire Paul's team to do it for them, if they wanted.

The free consultation worked out for both parties because Paul was retired and did not need to "close the sale" to make a living.

What I liked about it, as a business model, is it eliminated the conflict of interest that you have when the only answer at the end of the sale's pitch is "you have to do business with me." I took the approach "Let me show you how to do it on your own. Now I'm retired and all the work I do, is for people that are doing it on their own."

Basically, Paul would show the DIY investor how they should invest the money in his opinion. The investor could walk away and put that plan into action themselves, or hire Paul's firm to do it for them.

What Did Paul Teach At His Workshops?

The workshops started with teaching the students how to understand the investment process.

We have to figure out who we can trust. If we can figure out the right person or organization or group of people, whatever it might be, that we can trust, then we can move forward to apply that information that they have handed us.

So, where can we look to for information?

• Wall Street: However, they do not have a good reputation for honesty.
• Main Street: Friends and neighbors may offer investment advice but we don't really know how much they know.
• University Street: The academic community is one place that we can trust to provide unbiased information about investing. Paul looks to University Street to build investment strategies.

How To Simplify Investing

Wherever you choose to gather your investment information, it will often seem overwhelming to a beginner. However, it does not have to be.

It's very simple as long as we never have to make more than one decision at a time. [For example] buy and hold versus timing. Load versus no load. Mutual funds versus individual stocks. If we can boil everything down into these simple forks in the road, it's pretty easy to teach people how to be a successful investor.

The process can be broken down pretty easily and once you understand the forks in the road, anyone can handle it.

Forks In The Road

When broken down into simple choices along the way, your path to building the right strategy for you will become easier.

Who Are You?

First, people need to understand who they are, where they are, and where they need to go. And that has, in many ways, very little to do with dealing with all those forks in the road. Because if you don't understand yourself,...the emotional hurdles of investing, those are the things that get us into trouble.

If you do not understand yourself, then the emotional burdens of investing will present roadblocks. Although investing in a diverse portfolio on a budget has never been easier to do, the question is can you buy and hold?

If you cannot buy and hold, then it will be more challenging to be a successful investor. It is important to know that about yourself now. If you know that now, then you can learn ways to work within your risk tolerance. Knowing what risks you are willing to take before you feel compelled to sell your portfolio when the market dips keeps you from making decisions in fear.

If you can find the combination of an investment that can give a decent rate of return within your risk tolerance, then maybe you could turn yourself from a ICSIA (I Can't Stand It Anymore) market timer into a "legitimate buy and holder" who will be able to stay the course.

Once you understand yourself, then it is time to look at the asset classes that could work for you.

Can You Stay The Course?

The challenge for all investors is that everyone comes to the table with different experiences, information, wants, and fears. Paul has worked to teach people that the right thing to do is stay the course, even if it feels terrifying.

He gave the example of an investor that invested $1,000 in small-cap value stock in 1929. By 1938, that investment would have been down to around $400. It could feel like a stroke of bad luck to anyone attempting to retire young. However, if the investor continued to invest $100 a year, over that 10 year period, the portfolio would have ended with $1,600 in 1938. Those were the 10 worst years in market history, but the investor would have been okay.

The goal of this lesson is to teach people to start investing young. Celebrate the bear markets and use that as an opportunity to buy great asset classes at a lower price!

What Asset Classes Should You Consider?

The goal is to get the best assets into your portfolio with the best diversification. The idea is to keep it very simple and follow forks in the road until you've built the best portfolio for you. It is common for investors to want to own good or great companies over a long period of time. But by taking research from University Street, there are other options to building your wealth.

Value Or "Out Of Favor" Companies

For example, over the course of the past 91 years, there is a group of value or "out of favor" companies that people don't want to own. However, the academics have found that the group of companies that are "out of favor" actually have the best returns in the long term. Those returns don't come out of greatness. The better returns come because you took more risk.

Smaller Companies

The academics have also found that smaller companies can carry a higher rate of return but it's because they have more risk. And sometimes there are hidden gems in that category.

When you are young and can afford the risk, you can put together the small and "out of favor" companies to create the most profitable asset class for the long-term. But it is because these are riskier investments. You are taking a chance on greatness.

Overall, Paul wants a portfolio to include small and large companies. Plus, value and growth companies. The key is to find the balance that works best for you.

Terms to Know

When you are exploring your investment portfolio options, these are some good terms to know.

Value: (Out of Favor) Companies that have a relatively high book value (the real net worth of the company) compared to their market price. Think of companies not well known or popular. Many value companies get turned around to have great futures.

Growth: Companies that have a very high price to earnings ratio. These companies are priced at a much higher value than their book value because people want to participate in the future that this company hopes to build. Think of popular companies. Sometimes, these companies can drop in value dramatically.

This is the capitalistic system. When there is an opportunity for people to make money on something, they are going to try to make money and that's what happens to a lot of value companies. They get turned around and have great futures and a lot of those popular growth companies...all of a sudden are not so attractive...because they are priced at such very high prices they can fall like a rock. I'm not saying don't own those great growth companies I want to own the growth. I want to own the value. I want to the large... and I want to own the small.

Active Vs. Passive Management

Active managers are trying to beat the market. If they can't beat the market, then why would we pay them to manage our money. Typically, they look for good stocks at a good pick and attempt to time the market.

A passively managed index fund has hundreds or thousands of companies in its portfolio. These are not trying to beat the market, instead, they are trying to be the market.

Each year, S&P puts out the SPIVA report that tracks the performance of active managers and passive indexes, the benchmark. The bottom line is that most active managers cannot beat the market. Only about 3-7% of managers effectively do better with returns than the market.

So the question is: Do I think that I have the ability to choose an actively managed fund that will beat the benchmark?

Also, if you know that the benchmark would be "enough," then why would you try to beat the market. If you aren't sure what "enough" is, consider reading John Bogles' Enough.

Instead of picking stocks, you could build a portfolio with thousands of stocks that can bring you the market returns. This strategy can also bring an investor peace of mind.

If you own them all, then you don't have to worry about any individual stock. The only thing you have to worry about is how much you are going to lose along the way.

Paul warns that if you follow his advice, you will lose money along the way. It's the only guarantee in investing. The question is how much, for how long, and what to do if you are not able to handle that. Solve those questions and then you have become a competent investor.

Numbers Of The Market

Paul takes us through the history and the numbers of the stock market. Sometimes it has nothing to do with you.

Ah, the worst and the best? That is the right question to ask, because we sell the best. That's wall street, selling the best. And we need to understand the worst [of what can happen].

If you look at the S&P 500 over the last 91 years, the rate of return was 9.7% during a period of time when inflation was about 3%.

However, if you look at every 40 year period, then the average rate of return jumps to 10.9%. The jump in returns is due to the blood bath of the late 1920s and early 1930s. When you remove those numbers, then the market returns are even better. In fact, the very best 40 year period of the S&P 500 had a rate of return of 12.5%. The worst 40 year period had a rate of return of 8.9%.

If you build your portfolio out over 40 years, you may decide to best prepare by assuming that you will be stuck with the lowest historical rate of return. However, you will need to factor in the fluctuations that happen in shorter time frames. Such as the period of 1975 to 1999 when the market rate of return was over 17% and the period of 2000 to 2018 when the market rate of return was less than 6%.

We can do all the right things, believe all the right things, be patient, be disciplined, save lots of money--But the market doesn't hand us the premium we thought we were going to get, which is why I try to teach people--Prepare for the worst, but hope for the best.

In the end, saving more money is the best defense we have to protect against bad luck. Luckily, our community is already working towards increasing our savings rates.

Increase Your Odds Of Success

The biggest hurdle to success is the psychological barriers within our human nature. However, if you can pursue a buy and hold strategy, then you could increase your odds for success in several ways.

The goal is to expand your portfolio beyond the highest quality asset classes such as the S&P 500. Paul is advocating that investors should add some additional asset classes including large growth and value companies, small-cap, international asset classes, and REITs. The beauty is that the volatility of the sum total of this group is about the same as the S&P 500 but the returns can be as much as 2% higher each year. The key is that no single asset class can be more than 10% of your portfolio.

There is NO magic way. The best magic that, I think, people can create is to, upfront, decide what asset classes have a history of success...Better returns [come] from taking more risk. This is not free lunch...all that matters is what the market as a whole does.

Of course, this is not a free lunch! If you buy a diverse set of asset classes in the correct way, then you could reduce the risk and emotional costs that can dissuade investors from staying the course.

Four percent of the companies account for most of the earnings of that famous 10% compound rate of return that we talk about getting from the the stock market...The other 96%, on average, made the same rate of return as treasury bills...about 3% over that same period...If I'm going to try to pick stocks, what happens if I don't get ANY of those 4% and only get those in the other 96%?...If you want to get the market rate of return, own them all because that is going to give you the end result of the whole system.

The market returns seem to be driven by a small set of companies according to a study done by Hendrik Bessembinder at Arizona State University. Only one out of 25 companies made it big and drove the market rate of returns higher. Buying them all is one way to ensure you have these winning companies in your portfolio.

Keep in mind that the stock market is a whole bunch of moving parts, but the fewer moving parts we have, the more likely we are to succeed.

Related: M1 Finance Review: Completely Free Automated Investing

The Ultimate Buy And Hold Strategy

If you know that you can stay the course, then diversifying your investment portfolio for the long-term may be a good idea. However, it likely sounds like a complicated portfolio to build.

The fewer moving parts we have, the more likely we are to succeed. Let our portfolios have 12,000 moving parts, but don't make me deal with 12,000 companies.

Unfortunately, our staple VTSAX fund is not as diversified as it could be according to Paul. If you want to own everything, then you shouldn't limit your portfolio to the top 500 companies.

Instead of letting the S&P 500 drive your portfolio, build a portfolio with more asset classes.

Build a portfolio that is made up of great asset classes, that I've listed before, and give each one equal right and exposure. So it is not cap-weighted, it is asset class weighted.

So, you would still include the S&P 500, but you would not let it drive your returns.

Over the course of your investment building, you could use your new contributions to re-balance the portfolio when needed and to avoid a potentially taxable event.

In an interview on the White Coat Investor, Paul compared this investment strategy to dieting. It can be difficult to stay on track because you have to make the right choice every time you walk into the kitchen...similarly to each time you log into your brokerage account. There was concern that with this extra layer of complexity, you may be less likely to stay the course.

Related: Vanguard Vs Fidelity--Which Company Is Best For You

How To Simplify The Ultimate Buy And Hold Strategy

After a meeting with John Bogle, Merriman decided that the approach might be too complicated for many investors. So he decided to come up with a solution. Merriman was especially focused on investors finding a simple way to maximize the value of the small-cap value. He also explains that Wall Street is about making money, for them... with your money. So be aware of "I'll make you rich!" sales pitches.

One path is to invest in a target date fund that takes care of this rebalancing for you. However, Merriman disagrees with having any bonds in your portfolio at age 20 which is something to consider as research target date funds.

There is a DIY way to include small-cap stocks into your portfolio. Take your age and multiply it by 1.5. Use that number to determine the percentage you should place into a target date fund. The balance of your portfolio will go into a small-cap value fund, or large-cap value fund if you are more conservative. As you age, you will adjust your portfolio to match your retirement plans. As you get closer to retiring, you can move money into "safer" funds.

For example, at age 20, you would have 30% in a target date fund and 70% in small-cap value funds. At age 60, you would end up with 90% in a target date fund and 10% in small-cap value funds. In this way, you've created your own target date fund with more exposure to the productive returns. With this strategy, you still have to accept the risk of the market.

How To Pick The A Target Date Fund

First consider your glide path, which is how much risk you are willing to take now as to when you are older. It also takes into consideration what risk you want to have upon retirement. Every target date fund has a glide path that allows you to see how it will impact at different ages and stages of life. Look for target date funds that are built with index funds because they will give you greater diversification for lower cost.

Remember, the lower the expenses, the better the likely return over the long run.

According to Paul. MorningStar is a good place to start your search. At the bottom of the portfolio page is the glide path. Keep in mind, if you are in your 20's, that bonds might not be in your best interest for rate of return to risk. Vanguard and Black Rock offer different funds for various stages towards retirement.

How To Pick The Right Small-Cap Value Fund

If you want to learn more about finding the right small-cap fund for you, then check out "Best in Class ETFs" by Chris Pedersen.

Look for index funds, low expenses, and great diversification. There are commission-free ETFs at Vanguard.

Many 401K plans have a small-cap blend which includes growth and value funds. IRAs give you more control of the funds included.

Historically, this asset class will produce better returns. However, the market is always changing and the key is to not panic. There will be times when small-cap under-performs large-cap, but if you stay the course it is possible to maximize the potential of your buy and hold strategy.

Listen to Brad and Jonathan's thoughts about this episode here.

How To Connect

The best way to connect with Paul's content is through his website at PaulMerriman.com

You can also email Paul at [email protected]. He tries to answer every question, but he knows that he will not get to them all.

If you are interested in learning more about Paul's approach, then check out his free e-book 101 Investment Decisions Guaranteed to Change Your Financial Future.

The Hot Seat

Favorite Blog: George Sisti's On Course FP

Favorite Article: The Ultimate Buy and Hold Strategy; The Two Funds for Life

Favorite Life Hack: Make a "to-do" list every day with the important items to get done today and 5 items that aren't important to do today but they are easy. Paul makes a new one every day that drives him.

Note! One good option for digital to-do lists is the ToDoist App.

Biggest Financial Mistake: I have always been afraid of a catastrophic event right around the corner. Paul has always gravitated towards the bad news list which led him to be more conservative as an investor than he should have been.

The advice you would give your younger self: Ignore the noise. Read Your Money and Your Brain by Jason Zweig.

Related Articles

• Why Investing Conservatively Is Better
• Podcast Episode: The Stock Series Part 1 with JL Collins
• Podcast Episode: The Stock Series Part 2 with JL Collins

New to FI? Be sure to check out Episode 100: Welcome To The FI Community!