Oct. 26, 2022

How to Construct a Diversified Stock Portfolio of Major Index Funds

How to Construct a Diversified Stock Portfolio of Major Index Funds

And some free tools to level up your portfolio.

I’m not an investment professional or licensed financial advisor, but I do have access to free products and portfolios built by licensed investment professionals—and so do you! The perks of living in 2022, right?

This week, we’re breaking down a few big investing topics:

  • the relationship between risk and returns
  • diversification beyond the S&P 500 (and why it’s something you may want to consider, considering it involves securities that aren’t down 25% YTD)
  • the (free) tools you can use to level up your portfolio


I also sat down for a conversation with Trey Lockerbie of The Investor’s Podcast Network (https://www.theinvestorspodcast.com/) to talk about all things “value investing,” Warren Buffett, and why Trey can’t help himself from investing in individual stocks.

To learn more about our sponsor, Vin Social, check out http://vinsocialvip.com/.

Episode transcripts can be found at https://www.podpage.com/money-with-katie-show/.

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Katie: Welcome back to The Money with Katie Show, #RichGirls and Boys. I am your host, Katie Gatti Tassin, and in today's episode, we're gonna talk about a few fundamental theories about investing (fun) and the relationship between risk, returns, and intelligent investing. My guest today is Trey Lockerbie, the host of The Investor’s Podcast, and coincidentally, the CEO and co-founder of a kombucha company called Better Booch that I happen to love and have a few cans of downstairs, so that's fun. He is a self-proclaimed Warren Buffett aficionado. So I'm gonna pepper him with some questions about value investing in a little bit.

But before we do that, let's talk about something crucial in investing and personal finance more broadly: the Big D. Diversification. That's what you thought I was gonna say the Big D was, right? Sexy. Everyone loves diversification. It is a word that we throw around a lot, though I don't know that many of us, myself included, until recently, had a very strong technical understanding of what it means or how to apply it to our portfolios. It's related to the question I hear all the time: “I want to invest, but I don't know what to invest in.” Now, you could always go the robo advisor route and let an algorithm decide for you. I will always, always, always advocate for that if you are not interested or proficient in playing “Equities Build A Bear Workshop” with your stock portfolio in Vanguard or Fidelity. But regardless of whether or not you tap into the convenience of a robo advisor or go rogue in Vanguard's 200-year-old UX/UI, it's wise to understand why you own what you do and confirm that you are not overexposed to any one category, placing a larger than necessary bet on a segment of the market unwittingly. 

So a brief lesson on the purpose of diversification. When we talk about diversification, what we mean is we're trying to buy stocks that are uncorrelated in order to lower our risk, but keep our returns more or less the same. This sentence alone requires approximately three disclaimers. So let me back up. When I say stocks, I'm typically talking about index funds composed of hundreds if not thousands of equities, not individual stocks. When I say uncorrelated, it is worth noting that there's really no such thing anymore, thanks to the globalization of the last few decades. The correlations between different categories have generally been going up, so there's no perfect way to de-risk a portfolio, but any correlation lower than one, meaning perfectly correlated, helps. Lastly, when I say to lower our risk, but keep our returns more or less the same, I'm referring to a paradox of investing, which is that even adding riskier assets to your portfolio can help lower the overall risk of the portfolio, within reason, if the assets within it are not highly correlated to one another.

Okay, do you got all that? I feel like I should be standing in front of a whiteboard with a blazer with, like, elbow patches. The logical intuitive conclusion I would draw here is, “Well, great. That means the more risk I take on, the higher my returns will be.” Not quite. Without diving too deeply into the academic weeds, there is something known as the Capital Asset Pricing Model, abbreviated as CAPM, which is pronounced CAPM in conversation, that basically says there is no risk premium or reward for bearing risks that can be diversified away. In other words, if you could diversify further to eliminate a risk, there's really no reward associated with keeping that risk. The mathematical proof that people way smarter than me developed for this finding is enough to make your eyes water, so we're not gonna go there, but now you'll have a fancy new acronym to throw around at dinner parties and intimidate your husband's friends. Yay! We will be right back after a message from the sponsors of today's episode. 

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Katie: This is a perfect segue for the complicated relationship between risk and return. Is it true that more risk always equals more return? Kind of. It depends on the type of risk that you're taking on. So the only discernible way to get higher long-run returns is to accept what's called systematic risk, greater systematic risk. This is basically an investment professional's fancy way of saying risk associated with being in the market at all, aka volatility. This is the horrifying and titillating roller coaster ride of throwing your life savings into the market, parking your ass in front of a TV that's playing 24/7 CNBC, and then taping your eyes open.

Surely there is some sector or category or company size that could, like, help us get around the risk, right? One that's sure to always perform well? No. The trouble with this, at least as a function of the wisdom of crowds, is that if there were an asset class that is identified as providing better returns in exchange for the risk that you have to take on to get them, the risk premium goes away. This is the paradox, as Ben Felix and Cameron Passmore note on their podcast Rational Reminder a few months ago, about something called “factor investing” that basically attempts this. It tries to use quantifiable characteristics of a firm like size or liquidity to get better returns, and they said factor investing by definition cannot be for everyone, because it relies on a sort of arbitrage that would disappear if everyone did it. We will link that episode in the show notes. 

An easy example of this that I think kind of makes it real is the rental property market. Rental property investing became widely fashionable as of the last decade, really like anything post 2008. And in the beginning, arbitrage opportunities were everywhere. By the way, arbitrage basically just means the ability to buy something in one market and then sell it in another market for a higher price. So in this example, we're talking about acquiring real estate in a buyer's market and then selling it, quote unquote “selling it” in a rental market to renters. Back then you could generate 2% of the property's value in gross operating revenue per year after putting only 3% down. But as people caught on and it kind of became popularized as an asset class, the arbitrage opportunities were slowly snatched up, and the 2% rule quietly became the 1% rule. And recently investors have settled on the 0.5% rule in many areas for the amount of money that you'd expect to make on any given property, and are instead banking in a lot of cases on capital appreciation to make investing in rental properties worthwhile. In 2010, you could literally throw a rock out your window and hit a property that would create immediate cash flow because everything was so cheap. Today, armed with all the tools of the pros, you still might be able to find one or two, but you're gonna struggle a lot more to do so, or you're gonna fight with Tim and Connie next door to do it. 

Functionally, I think this means we should be skeptical of anyone who claims to have the secret sauce. Anyone who is too readily willing to offer up their “beat the market” strategy to the masses or pump any specific asset class or holding. Because if their strategy is sound and it's relying on the one thing that does tend to reliably create overperformance in the market, they probably would not want everyone doing it. Conversely, if an investment requires other people to invest in it to be successful, you don't have an investment, you have a pyramid scheme. The point is believing that any one thing is permanently or holistically better than everything else is a dangerous gamble. And yes, I know frequent listeners of the show or consumers of my content are probably like, “But wait a second, Katie—aren't you always espousing the virtues of small cap value funds in their overperformance?” And you would be right, but also it's not the only thing that I own, and I just happen to think it's a relatively underrated investment in personal finance dogma online and provides nice diversification. That's all. Sue me. I root for the underdog, though I will say that once the small cap value premium was discovered, it has not been as large, and I don't have data on hand to prove that, but anecdotally that's kind of a thing. 

Anyway, diversification is important for what boils down to an economic and philosophical truth. To quote Ken Fisher, the American billionaire investment analyst, to believe a category is permanently and inherently better, you must disavow basic tenets of capitalism, primarily that prices are set by constantly moving forces of supply and demand. Now, if you would like a visual representation of this, I would suggest Googling Callan's Periodic Table of Investment Returns. We will link it in the show notes. Callan is c-a-l-l-a-n. It visualizes which categories have performed best from 2002 to 2021, and it makes a pretty compelling snapshot argument for, well, owning all of it. No one category consistently dominates. I'll read you the names of those in the top spots over the last 20 years and how often they appear. So in 2002 it was global (excluding the US) fixed income. So more colloquially, international bonds, at 22.37% that year. In 2003, 2005, 2007, 2009, and 2017, it was emerging markets, with its highest annualized return of 78.51% in 2009. In 2004, 2006, 2012, and 2014, it was real estate, as measured by the FTSEEPRA developed REIT Index, which includes North American, European, and Asian real estate markets. I say this to distinguish it from, like, a single-family home in Kansas. We are talking about broad-based global REIT indices, not like one primary residence. In 2008 and 2011, it was US fixed income, with the top annualized return in 2011 of 7.84%. Not bad for bonds in the 21st century, right? In 2010, 2013, and yes, even 2020, the winner was small cap equities, as measured by the Russell 2000, with a top return in 2013 of 38.82%. Not bad. 

Let's pause. Have you noticed anything yet? Any asset class category that I haven't mentioned despite covering the top returns of 15 of the last 20 years? What about the S&P 500? The total stock market, the large cap funds? Where are they? Your wait is over. In 2015, 2019, and 2021, large cap funds, as measured by the super niche, indie, little-known S&P 500 (I'm being sarcastic), were the top performers, with the highest return clocking in at 31.49% in 2019. Last but not least, we have, yep, cash. Cash, in the form of a 90-day T-bill. Top performer in 2018 with a whopping 1.87% return. You may have noticed that I failed to mention international equities in my little recounting. Does that mean they're not worthy of our consideration? Not so fast. They had positive returns in 14 of the last 20 years studied, and double digit—yes, greater than 10%—returns in 11 of the last 20 years studied. Call me greedy, but that's not an asset class that screams “forgettable” to me, and I know what you're thinking. “But Katie, if the S&P 500 was the dominant category in only 15% of the last 20 years, why do I hear about it so much? Why do I hear about it the most?” Well, that's a good question. Maybe because we humans love the popular kids, regardless of whether or not their hair is always better…I mean their returns are always superior. There's a reason I consistently compare the S&P 500 to Regina George. And to be fair, some people have an “If it ain't broke, don't fix it” approach. They figure an annualized average 9.9% return will get the job done, and they call it a day. And sure, I would take that over sitting in cash all day long, eight days a week. But this ignores how annualized averages work in real life. Someone holding only the S&P 500 would've lost 37% of their portfolio's value in 2008, only a few years after taking losses of negative 9.1%, negative 11.89%, and negative 22.1% three years in a row during the dotcom bubble crash from 2000 to 2002. That's just painful. The S&P 500 ended the first decade of the 21st century effectively flat. And while we know what happened after that (insert rocket emoji here), if you were a retiree drawing down on your funds during this time, it would've been pretty freaking unnerving. 

So I actually ran it through a portfolio visualizer to get a better understanding for just how unnerving. If you retired in 2000 with a million dollars invested in 75% S&P 500, 25% intermediate-term treasury bonds, so call it your classic 75/25 portfolio, and you withdrew 4% per year for your living expenses, by year 10 in 2010, your portfolio value would be $760,000. That's almost a 25% loss after just one decade of retirement. That spells trouble, because we never wanna deplete our principal balance, aka our starting amount, if we can help it. We need that principal to stay intact because that's what's generating the returns that we're going to live on. So if we lose too much of it early in retirement, it's more likely that we're gonna run out of money. If you were a little more conservative, you went for the 50/50 portfolio of S&P 500 and intermediate-term treasury bonds, you would've slid into 2010 with $960,000. So the presence of those bonds would've mostly preserved your portfolio balance through the lost decade, and you'd have almost the same amount that you started with.

But what if you had diversified beyond only large cap growth equities? What if you had split that 75% stock exposure between large cap growth, emerging markets, US small cap, international stocks, and REITs, with a 15% allocation for each? Well then, the decade wasn't so lost. Your original million dollars would've turned into $1.4 million by 2010, despite your 4% annual drawdowns, despite the dotcom bubble, despite the Great Recession. You were a diversified retiree. You did great. You have 40% more money despite being retired for 10 years. Now, okay, let's be honest. I know that I could sit here, I could cherry-pick data all day long to prove the points I want to, and things are gonna look a little bit different depending on what timelines you use. So for the sake of transparency, let's extend our timeline through 2022 year to date. See how that same retiree would've done across their three pretend portfolios, our 75/25 S&P 500 bonds portfolio withdrawing 4% per year. That person would have $1.68 million today. So they would've gained everything back and then some. Our 50/50 portfolio would have $1.56 million. So when you extend that timeline for that full 22 years, the 75/25 portfolio does take the lead, despite lagging in 2010.

However, our diversified portfolio, with 25% T bonds and 75% equities across those five different categories, was still the winner, with $1.92 million, or about $240,000 more. The diversified portfolio was the only one that almost doubled in value over the 22 years, despite supporting a 4% safe withdrawal rate every single year. Now, what can you do about that? We've already touched on the answer, to some degree, and it's simple: Own all of it, or rather own most of it. Beyond a certain point, more diversification is not going to lower your risk. So it's not necessary to own literally everything, but we can make a strong case for a basket of diversified index exchange traded funds, better known as ETFs, that'll get the job done.

What about the middle ground of actively managed mutual funds that aim to beat the market? Like, should we pay extra for those? Even Ben Graham, the father of fundamental security analysis, said it could no longer be counted on to produce superior investment returns. Warren Buffett—the most legendary investor of all time, I would argue—also admitted that retail investors are better off in an index fund than an actively managed mutual fund. Peter Lynch, the retired superstar manager of the Magellan Fund, agreed. The three wise men are all on the same page. Market indices that index funds or index ETFs, which are like the younger, cheaper, cuter cousins of the index fund tracks are simply so good at pricing and information nearly instantaneously that there's very little advantage to be gained by manually picking mutual funds or stocks in today's environment.

So what is worth owning? In case you have not heard my disclaimer enough, I am not an investment advisor; I'm not a licensed financial professional. This is not financial advice, but my general personal thesis as a retail investor is that anything strong enough to show up on the Callan Periodic table of Returns for the last 20 years is probably worth owning. That hunch has been more or less validated by my dabbling with various robo advisors and smart broker dealers that allow you to build customized expert portfolios based on your risk tolerance. I may not be a registered investment advisor with access to research teams, but these institutions are. So I like to take my cues from them. 

For example, pulling from the ultra aggressive pie offered by brokerage firm M1 Finance with only seven holdings: Vanguard Developed Markets (VEA), Vanguard S&P 500 (VOO), Vanguard’s Small Cap ETF (VB), Vanguard's mid cap ETF (VO), Vanguard's Emerging Markets (VWO), same thing. Vanguard Real Estate ETF (VNQ), Vanguard's Total International Bond ETF (BNDX). Now I know this is a ton of information, by the way. You could go to M1 Finance and get that exact portfolio at their site by creating an account choosing “ultra aggressive allocation,” if you're interested in just easy buttoning it, and that will be the portfolio they give you, though it is subject to change, as the powers that be who build these portfolios may adjust things. The portfolio I just noted here has a five-year return of 46.96%, and a dividend yield of 2.5%. You will notice that that's quite a bit less than had you just held VTI or VOO over the last five years. But to my earlier point, our thesis today is that diversification is to your benefit in the long run. And as we can see from the Callan Periodic Table, large cap growth has outperformed in two of the last five years, but only three of the last 20.

A slightly less aggressive version of the same portfolio introduces Vanguard's intermediate term corporate bond ETF to the mix: VCIT. But you can play around with the different holdings on the M1 Finance site. Now these holdings are gonna be delivered to you in proportions appropriate to your age and investing horizon. So for example, I'm 27—I am not gonna have a 50% bonds portfolio, regardless of what those bonds are. But you know, they should provide ample diversification, and I would venture a guess that diversifying far beyond the scope of the holdings listed likely would offer diminishing returns on that diversification. We'll be right back after a message from the sponsors of today's episode. 

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Katie: Now you've probably noticed we've really only discussed index fund ETFs by this point, and we really haven't touched on the concept of picking your own stocks or trying to find undervalued securities that you can exploit for an outsized gain. As we described in the beginning of this episode, value investing, after all, is by definition trying to find securities that are underpriced relative to their quote unquote “real” intrinsic value. Warren Buffett is probably the most famous value investor of all time. So I wanted to bring one of his acolytes, Trey Lockerbie, onto the show today. So Trey, welcome to The Money with Katie Show. Thank you so much for being here. 

Trey Lockerbie: Katie, thanks for having me. I'm excited to be here.

Katie: Absolutely. So Trey, we have talked a little bit in this episode already about value investing. Can you describe what value investing means to you, to our listeners? Like if you met me on the street and I told you, “Hey, I know nothing about investing in general,” how would you pitch me on this? 

Trey Lockerbie: Value investing is kind of a funny term, and I'll tell you why. So if I answer your question directly, the easiest way I could define it would be something like, you wanna buy a dollar for 50 cents. And it traces back to really Benjamin Graham, who's known as the godfather of value investing. And the way he used to invest is he would find these stocks that were, you know…these are in the '40s, and there wasn't a lot of internet back then, as you can imagine. And the market was fairly inefficient and you'd find these companies that were trading well below their intrinsic value as you just sort of mentioned. The idea was that you buy it at maybe a half off discount to the intrinsic value and you wait for it to appreciate back up to its fair value, and at that point you would sell. So as you mentioned, Warren Buffett was under the tutelage of Ben Graham. Ben Graham was his biggest mentor early on, and Buffett started out doing the exact same thing. But ironically, not a lot of people know this. Buffett would be the first person to tell you that value investing is sort of redundant to him. He's like, I'm not a value investor, I'm just an investor. Right? Because if you think about it, investing is simply laying out money today to make more in the future. And you know, by definition, if you're doing it right, you're getting a good deal at the outset. So it's an interesting term. 

Katie: Okay, that's really interesting. So I guess I didn't realize that in that line of thought, 'cause honestly in my mind I'm like, “Oh, buy and hold. I'm just gonna hold it forever until I, you know, need the money and that will be the event that triggers me selling.” So I'm kind of keyed in on the fact that you said once that appreciates to the what you would consider intrinsic value or fair value, that's when you would make your move and let it go. Is that correct? Did I hear you correctly? 

Trey Lockerbie: Yeah, so what you're touching on there is sort of the evolution of Warren Buffett in a way, because that was Ben Graham's style and what he wrote about in his early books. But Warren Buffett would tell you that I think even today he's sort of 85% Benjamin Graham and 15% Phil Fisher, and Phil Fisher's mentality is that he was very much buy and hold. So that's a little bit where Buffett, you know, at some point came across Phil Fisher, said, “This makes a lot of sense.” You know, we can talk about the further influence from Charlie Munger and how he ended up changing his strategy even more dramatically over time. But he's essentially nowadays very much trying to find something where he is not expecting to sell it anytime soon. Not only for the compounding effect, but the taxes and a number of other reasons. 

Katie: Yeah. You know what, let's go there for a second. With the Charlie Munger piece, how did he influence Buffett and his strategy? 

Trey Lockerbie: Yeah, so Munger had a big influence on Buffett early on, I think primarily in the See’s Candy investment early on, because See’s at the time was not necessarily considered cheap when they bought it, and Charlie was much more in the camp of finding something that would compound and he was willing to pay a good price. So Buffett has this saying nowadays where he says, “Instead of buying a fair business at a wonderful price, I'm gonna buy a wonderful business at a fair price.” And See’s Candy was sort of the first instance of them doing this. And it's proven to be one of the best investments for Berkshire Hathaway over time because it's very low innovation, there's a lot less overhead, and they don't necessarily have to keep iterating and innovating, and it continues to compound and find more and more customers, and has a lot of pricing power. So it's been able to be a very, very high return for Berkshire Hathaway. 

Katie: Fascinating. So the other thing that I noticed you said, and kind of where I wanna take us next, you mentioned this was before the internet, or like, oh well, you know, we're talking about Ben Graham and pre-pocket computer times, and I've heard it said that the arbitrage opportunities left for value investors in the market are slim to none these days because of how quickly new information is priced in, and that any sort of incremental reward that you could possibly gain is mostly going to be discounted through taxes or trading costs, which again are also kind of, you know, nonexistent today in a lot of platforms. And even Buffett himself told his heirs, “Hey, invest this in the S&P 500 index fund and just be done with it.” What do you make of that line of thinking, and how do you kind of conceive of that? 

Trey Lockerbie: Yeah, well there's a lot there. So let's just start off with why you would choose the S&P 500 and maybe why you would choose an individual stock or a smaller portfolio of individual stocks. And I wanna firstly say that I'm a big proponent also of buying the S&P 500. It's not risk-free, right? There's no free lunch, and there's gonna be reasons to discuss, I think, why that is. But if you just think about why you'd be interested in doing something different, it just comes down to math and what you think is enough for you. But essentially over the last hundred years, you could say the S&P 500 returned around 7%, depending on the timeframe and the level of inflation you're adjusting it for. But let's just say 7%, right? So let's say over 20 years, let's just say you invested $100,000, and over 20 years you've put $1,000 in per month. And what would that work out to be if you just had it in the S&P 500 at 7%? It'd be around $900,000. 

So if you wanted to and you wanted to try and find some kind of way to improve that yield, you might look at owning things that you really understand and that are compounding really well and have great management and maybe are undervalued when you bought 'em. And if you did that, you might be able to add a few percentage points to that yield. And just to give you an idea, if it were 10% over 20 years instead of 7%, it would be $1.4 million, so it'd be a half million dollar difference. And if you ticked it up to 12%, it'd be $1.9 million. So it'd be a million dollar difference. So that's kind of the why you might consider, and again, like if 7% is enough for you and what you're starting with and where you're trying to get to and that's enough, like by all means, you know, that's probably the safest bet. And I'm certainly not advising people who don't have the time to kind of really do the diligence on companies and understand what they're buying to do anything different, because most people don't have that time, and I think that's what Buffett's talking about. A lot of people…or they don't even have the interest, right? So I think, I think his kids, to be honest, for the most part, aren't following in his footsteps necessarily in that same way. And you know, that's why he advises as he does. It's much like, you know how Michael Jordan, I think, would advise most people to stay in school, you know? Maybe don't drop out to be in the NBA. 

Katie: Yes. I loved too that, I think when you and I were talking about this last, on your podcast, we were talking about individual stock investing, and you had kind of made some comment on this interest point about like, “I just can't help myself. Like I can't stay away.” And I think that's really important, and I'm glad that you said this around like, hey, if seven percent's good for you, there you go. Like there's no such thing as a free lunch. But that's probably the easiest option. But on the flip side of that, if you are someone that is really interested in doing the due diligence and you really find this stuff fascinating, it might make sense to give it a shot, allocate a certain portion of your portfolio to these things. But I noticed that you made a point of saying, like, it's not risk-free, this is not a free lunch. And I'm curious if you would be willing to expound on that and kind of what makes you say that. 

Trey Lockerbie: Yeah, there's a couple of reasons that stand out to me. One is, if you're just passively investing in the S&P 500, you have to understand a couple of things. One is that it's a market weighted index, and what does that mean? Well, the index is weighted more to the companies that have the biggest market cap, and in this day and age, those are mostly tech companies, right? So you can just think about it like the tech companies make up almost a quarter, if not more, of the S&P’s returns at the moment. And when interest rates go up like they're doing right now, they tend to hit the tech companies first, because they're the more high-flying valuation stocks. And when interest rates go up, valuations typically go down. So to give you an idea of that, the S&P 500 year to date is down around 16% as of today. The Nasdaq, which, you know, a lot of the tech companies where they trade, is down 25%. So they get hit harder, and you often see that affect the S&P 500 more.

So another way to look at that is to say, you're not necessarily buying undervalued companies most of the time with the S&P 500, or if you are, they're making up a smaller portion of the S&P rather than the high-flying tech stocks that tend to trade at much higher multiples. So that's one reason you're not really getting that huge growth rate from the undervalued stocks. And then the other reason is there's really not an issue with the S&P 500 except that human behavior often comes into play, and a lot of people are really bad at buying low and selling high. They tend to do the opposite. And in something like an index where they're panic selling for, you know, say there's a pandemic or there's something else happening, you can think about it a lot like a thousand people running to an exit with one door, you know, so there's not…the market can drop a lot more because there's a…everyone is in this one thing and they're all trying to get out at the exact same time, and that usually tends to this really rapid price depreciation, and there's a lot of liquidity on the way up, and not so much on the way down sometimes.

Katie: That's fascinating. I like that analogy. I also was thinking about this the other day, trying to explain this to somebody, that we were talking about this idea of if you're buying the S&P 500, you're not like getting a deal on Amazon. Like Amazon is already huge. You are, yeah, they're probably gonna be fine, they're gonna do well, but you're not gonna get the same growth that you would've gotten had you bought it in the nineties or you know, 2002 or whatever. I have college football on my mind right now, because it's college football season and I was thinking, it's almost like you're buying Alabama, Clemson, Georgia, and Ohio State for a premium. And like yeah, those teams are probably gonna do well, but on the off chance you have like an Oregon or a Michigan or Notre Dame, like a team that's been good in the past but maybe has not been the top dog recently, that if they come in and just blow everybody out of the water, you have kind of like an up and comer. It's like you're not…you're not getting a deal on Alabama because everyone thinks that Alabama is gonna play well this year, this season…and roll Tide, I went to Alabama. So I feel like I'm maybe a little bit biased in this analogy.

Trey Lockerbie: I would extrapolate that analogy to, you know, what I would use is like the Moneyball approach, right? If you watched that movie, it's a great example of value investing because you've got the Yankees, those are kinda like the high-flying tech stock that are overvalued, and you've got the Oakland Athletics, and you're using your…you're studying and using all these little analytics to build this team that's undervalued, but ultimately does very well. 

Katie: I love that. Wow. Good. I'm glad that we landed that play and we brought that one home. So how do you approach diversification in your own portfolio? How do you think about this approach? And I know that like “S&P 500 and call a day” is very popular in personal finance circles, but I know that that's not really your bag. So I'm curious kind of how you approach it. 

Trey Lockerbie: The way I approach investing, I think first and foremost, is I think about it like buckets, and where I'm gonna put my money and where it's gonna get the most yield. And so that just kind of highlights opportunity costs that you're constantly evaluating. When I go to look at what I'm going to invest, I really follow the Warren Buffett playbook. And that is essentially finding something that he would say is “stable and understandable.” He likes to also describe that as something that's in his “circle of competence.” And that's not to say that you know one thing and that's all you're ever gonna know. He evolves, and you know, you try to find other businesses that you understand. But for example, my day job is running Better Booch. It's a kombucha tea company, it's in beverage. And so I very much understand beverage and I understand CPG and how that whole business model works, and even grocery chains. And I have a natural inclination to stocks that are in that kind of realm because it's in my circle of competence. 

And the next thing would be finding something that's compounding long term or you know, Buffett would say it has a moat. Like if you think about a castle and the water around it, he likes to, I picture companies that have this moat around it and he would call that their competitive advantage. So that's really important, especially over time, because you don't want that business to be constantly disrupted. You gotta find something that is really hard to disrupt. So Google comes to mind, it's one of the most amazing ones. It's got this huge network effect, and for it to be disrupted, it's not impossible, but at this point it's gonna be very hard, you know, if you're starting a search engine, right, to compete. So that's sort of an idea, something that has a really strong competitive advantage. 

The third thing would be something that has great management, and there's a lot of ways to look at great management. Reading their 10-Ks, listening to the investor calls are a pretty easy way to get a feel for the management. If you want to go more quantitative, I like to look at how much debt the company's using and how expensive that debt is, because I interviewed billionaire Tom Gayner once, he's a legendary investor, and he said the same thing, which is if you're a steward for people's capital, you would probably be more mindful about taking on irresponsible debt or not, right? And some businesses are better at that than others. Some businesses have no debt, you know, so sometimes that's at least like a first good starting point to see, is this management managing this correctly? And the interest coverage ratio is probably the best thing to look at, in my opinion, for something like that. 

And then the last thing is we talked about is something that's undervalued, and this is kinda the eye of the beholder mentality, where I could say something that is undervalued and you might say, no, it's totally fair value. And this is where value investing becomes more of an art than a science. There's a lot of calculations and models and things that people, formulas they've come up with that say, hey, it's…the value is this. But even Buffett is not trying to find something that's valued or in his opinion, something that's to the 0.3 decimal point, you know? So he's trying to get a range, you know, and a feel for that. And one thing I love about Buffett is if he can't do that quickly in his own mind, he actually has this folder on his desk that says “Too hard” on it. So if he's looking at something and he’s like, “No, this is too hard for me to understand,” he just throws it into this pile. And that just kind of gives you an idea of how great and folksy he is in real life, and how he approaches this with almost like a sense of humor. 

Katie: “Great and folksy,” I love that. I guess a couple things stick out to me about that, but chiefly the management piece, because I had kind of always wondered…I am familiar with this ethos or this philosophy, and I've worked in some companies in the past where they have terrible reputations externally, but internally, I'm like, the management here is actually pretty good. Like I'm pretty impressed with, like, who's running the show, and others where they're kind of highly thought of, and internally I'm like, this is a shitshow. So I've always kind of wondered, from an investor point of view, how do you get a real, true sense of, like, who's really driving here? And I like that looking at their debt idea. 'Cause I think you're right—it gives you a good quantitative kind of metric or benchmark that you can use that you can't really talk your way out of, or it's not something that you can, you know, make look good on paper, but in reality it's like, kind of is what it is. So I like that one. You know, you had mentioned See's Candy earlier in the interview and I'm curious, is that a concept for you or a company where the moat is almost how simple it is 'cause it's, like, candy? Like, how you gonna disrupt chocolate? Is that kind of how you would think about that? 

Trey Lockerbie: Absolutely. I mean, that and, a lot like…a number of Buffett's biggest performing stocks, it's actually more about the brand. The brand can be the competitive advantage. And for See’s, what's so interesting about this is if I land at an airport where you often see a lot of See’s little kiosks, right? If I land at an airport and I pick up my wife a Hershey bar and I say, “Hey honey, I missed you—here's a Hershey bar.” She might be like, “What is this?” 

Katie: “Didn’t miss me that much, Trey.” 

Trey Lockerbie: Right? Yeah. But if I land and I buy her a box of See’s chocolate, it's like this perceived value effect, right? Where it's like, this is a more premium product, this is, this means more. And so that's what See’s is known for. There's this premium chocolate company and they've been able to hold onto that, and it just really continues to compound because people just continue to believe that it's a very special thing, and it just kind of feeds on itself. 

Katie: Mm. I love it. 

Trey Lockerbie: Literally. Sorry. 

Katie: Okay, now I'm hungry. But that's, that feels like a really great place to end. Trey, thank you so much for being here. I really appreciate it. 

Trey Lockerbie: I appreciate it. Thanks, Katie. 

Katie: Welcome back to Rich Girl Roundup. As a reminder, we will take listener questions every month. I'll put out a call for questions on Instagram, so follow @MoneywithKatie, if you're not already (shameless plug) and we'll pick one that feels interesting and widely applicable. As my standard disclaimer, I am not a licensed financial professional. This is not financial advice, this is just “What would I do if I were in your situation?” And now a message from our sponsors. 

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This week's question is from Paula. “What's the backdoor Roth IRA, and what's the pro rata rule?”

Welcome to the world of tiny violin problems, my friend. There are certainly worse problems to have in the personal finance world. Luckily for you, this one can be circumvented with, like, a little bit of extra legwork. So in 2022, the income limit for investing at all in a Roth IRA is a modified adjusted gross income, or MAGI, which always reminds me of the “We Three Kings” thing, of $144,000 for singles and $214,000 for married filing jointly. But you can't really take those numbers at face value. Keep in mind, there are deductions that apply to your MAGI, like your contributions to your pre-tax retirement accounts. So you'll start phasing out of contribution eligibility at a MAGI of $129,000 and $204,000 respectively. But since Roth dollars are super valuable, people in higher income brackets sometimes still want to leverage them in addition to their pre-tax contributions to things like 401(k)s. 

So what should you do if you fear you're unable to contribute to a Roth IRA because you make too much money? A backdoor Roth IRA. You should be able to pull this off without any tax penalties. But there is one scenario to be aware of that might trigger a tax bill that I'll note at the end: the pro rata rule that you referenced in the question. Clearly you've been doing some reading. In a backdoor Roth IRA, you basically open a Traditional IRA and then you make a non-tax-deductible contribution. In other words, you're using money that you've already paid taxes on, so likely means this is money that's just sitting in your checking or your savings account. Obviously at the outset you're probably like, “Well, what's the point if the main benefit of this account doesn't work for me?” But the ability to convert IRAs from Traditional to Roth is the key here. 

So number one, you're gonna open a Traditional account with your brokerage firm of choice. I like Vanguard, M1 Finance, or Betterment, for example. Then you're gonna open a Roth IRA with the same firm if you don't have one yet. Third, you're gonna fund the Traditional IRA up to the IRA contribution limit: $6,000, going up to $6,500 in 2023. And then you're gonna leave the funds in the money market cash balance. You're not gonna invest them yet. Crucially, you will not claim this as a deduction when you file your taxes. That's the non-deductible part. Number four, you're gonna wait a few days for the cash to settle. Now, from what I've read, converting it too quickly can foul up your plans. So I feel like to be safe, you might want to just wait a week. And then number five, you're gonna convert the cash to a Roth IRA. Now, big brokerage firms know how to do this. If you need help, you can just ask them. There should, though, literally be a button that says “Convert to Roth IRA.” Number six, because the funds are not invested yet, there will be no gains to pay taxes on. You already have a Roth IRA ready and waiting for you from step one. And then last but not least, you're gonna invest in the funds of your choice within the Roth IRA with the money that you just converted. 

So obviously that was a lot of steps. Feel free to consult a CPA, but that should give you a general sense for how this works. Now, when should you, like, almost definitely not try this? If you already have Traditional IRAs lying around like discarded Fiji water bottles, and I'm gonna assume you drink Fiji water because, well, you know. You're going to be subject to this convoluted thing called the IRS pro rata rule, which will result in a tax bill. It's a little complicated. The breakdown between your existing pre- and post-tax dollars in your existing traditional IRAs. Now remember that includes rollover, SEP, anything that has pre-tax money aside from the 401(k)—that's gonna determine the amount of your conversion that is taxable. For example, if you already have $50,000 in a traditional IRA or a rollover IRA, a SEP IRA, again, pretty much any pre-tax funds outside of that 401(k), basically, that you created with deductible pre-tax contributions before you were this high roller, and you add another $6,000 to that amount post-tax, like with the intention of rolling it into a Roth IRA, $6,000 only represents about 10% of your total amount in all of your traditional IRAs.

So that means 10% of your $6,000 conversion to Roth will be tax-free and you'll be taxed on the other 90%, money that you, you guessed it, already paid taxes on since it was non-deductible to begin with. So you'd be paying taxes twice. It's not ideal. 

TL;DR: Depending on how much money you've got in those other IRAs and how much you're trying to roll over, it could create a pretty big tax bill come April. So for that reason, I would really only attempt this again on your own, without the help of a professional, if you do not have a big balance in a traditional rollover or SEP IRA already, and you would just be creating your first one, a fresh one. Or if your balances in those accounts are so low that even a full tax hit would not really be that big of a deal.

All right y'all, that is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from the talented Nick Torres. Sarah Singer is our VP of multimedia, and additional fact checking comes from the lovely Kate Brandt.