Listener Q&A Episode | #22

Episode Summary

Executive Summary: This Q&A episode centers on four common investing mistakes: unrealistic return expectations, U.S.-home-country bias, high fees, and failing to write down a plan. Using blackjack and valuation formulas, Meb argues investors should anchor expected returns to starting yields and valuations, diversify globally toward cheaper markets, and rely on rules-based, low-cost processes to avoid emotional errors.

Main Topics: Unrealistic return expectations (Priority: 5/5): Meb argues investors anchor to recent U.S. bull-market experience and expect too much from stocks, ignoring how starting valuations and dividends shape future returns. Global diversification and home-country bias (Priority: 5/5): He stresses that U.S. investors are overexposed to domestic equities and should allocate much more to foreign markets, especially cheaper countries with better expected returns. Fees, smart beta, and factor investing (Priority: 4/5): The discussion covers shareholder yield as a smart-beta factor, how it overlaps with value/momentum/quality, and why low costs and genuine differentiation matter. The importance of a written investment plan (Priority: 5/5): Meb emphasizes documenting asset-allocation rules, rebalancing triggers, and sell disciplines to prevent emotional, impulsive decisions. Sentiment and contrarian signals (Priority: 4/5): He explains how extreme bullish or bearish sentiment can be useful at valuation extremes, but should be treated carefully and usually alongside other inputs. Defining and managing risk (Priority: 4/5): Risk is framed less as volatility and more as drawdown, anchoring, and the investor’s inability to tolerate large losses psychologically. Small caps, bonds, and implementation realities (Priority: 3/5): Meb discusses why size is a weak standalone factor, why direct bonds vs. bond funds depends on goals and liquidity, and how trading costs shape practical strategy design.

Key Arguments: Expected stock returns should be estimated from dividend yield + earnings growth + valuation change, not recent market momentum. Current U.S. valuation levels imply materially lower future returns than the long-run historical average. Foreign markets often offer better expected returns because they combine higher yields and cheaper valuations. Shareholder yield is a legitimate smart-beta approach because it combines dividends and net buybacks rather than focusing on only one cash-return channel. A written plan and accountability are essential because investors routinely change rules emotionally when markets move. Risk is best understood as drawdown and behaviorally tolerable loss, not just volatility. Sentiment extremes can improve odds, but they are rarely a standalone timing tool. Small cap is not inherently better; valuation and implementability matter more than size alone. Bond ETFs add diversification and convenience, while direct bonds may feel safer but are operationally clunky and less diversified.

Data Points: Historic U.S. stock return: 9.7% - Long-run nominal return used to explain why investors expect roughly 10% annually. Schroders survey sample: 20,000 people - Global survey used to show investors’ return expectations cluster around 10%. Current U.S. dividend yield: ~2% - Used in the return model as the starting yield for U.S. large-cap stocks. Historic U.S. dividend yield: 4.7% - Historical input in the return formula, much higher than current levels. Historic earnings growth: 4.7% - Approximate long-run earnings/dividend growth assumption in the model. Current CAPE ratio (U.S.): ~26-27 - Elevated valuation level for U.S. equities discussed throughout the episode. Historical CAPE ratio: ~17 - Long-run valuation anchor used to estimate mean reversion headwind. Expected U.S. return under no valuation change: 6.7% - Calculated as 2% dividend yield + 4.7% earnings growth with valuations unchanged. Expected U.S. return with mean reversion: ~2.1% - Calculated assuming CAPE reverts from about 26 to 17 over 10 years. Expected U.S. return with milder valuation reversion: ~4.4% - Illustrative scenario where CAPE stays closer to 21 instead of reverting fully. Home-country allocation benchmark: 50% foreign minimum / up to 75% foreign - Meb’s suggested broad global allocation range based on world market cap and GDP weighting. Household equity allocation vs future returns: Inverse correlation - Cited as a historical indicator: when households own more equities, future returns tend to be lower. Bull market length: Third longest ever - Used to explain why recent experience may have inflated return expectations. Potential bull market record: Could become longest by March/April/May (depending on continuation) - Illustrates how unusual the recent U.S. bull market has been. AAII sentiment signal: Near historic lows at the start of the year - Used to support the contrarian view that bearish extremes can precede strong returns. 2015 market return: Basically zero - Used alongside an institutional sentiment survey showing extreme bullishness at the start of 2015. Small-cap trading cost issue: High turnover can kill the premium - Explains why naive small-cap and momentum strategies can be hard to implement in practice. Bond ETF diversification: 50, 100, 5,000 securities - Illustrates how ETFs can provide broad fixed-income exposure versus buying individual bonds.

Pivotal Quotes: "The first step is: why do people center around that number?" — Meb Faber: Explaining why investors expect around 10% stock returns and how anchoring comes from history and recent bull markets. "You don't have to play." — Meb Faber: Using a blackjack analogy to argue investors can and should avoid unattractive expected-return opportunities. "If you don't, then you're kind of just messing around." — Meb Faber: On the necessity of having a written investment plan and accountability to prevent emotional decision-making.

Implications: Listeners should reset return expectations, diversify globally, and adopt written, rules-based, low-cost processes. The episode argues that valuation discipline and behavioral guardrails matter more than trying to forecast short-term market moves.