Ep645: Larry Swedroe – Beware of Idiosyncratic Risks

Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community. We know that to win in investing, you must take risk but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives. To join me go to my worst investment ever.com and sign up for my free weekly become a better investor newsletter where I share how to reduce risk, create, grow and protect your well fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy, and I'm here with featured guest, Larry Swedroe. Larry, are you ready to join the mission?

Larry Swedroe 00:40
Absolutely.

Andrew Stotz 00:42
Well, I'm going to introduce you to the audience and such an eminent guy. I want to walk through some of the accomplishments that you've had in the things that you've been doing. Larry is head of financial and economic research at Buckingham wealth partners. Since joining the firm in 1996, Larry has spent his time talent and energy educating investors. On the benefits of Evidence Based Investing with enthusiasm few can match, Larry has was among the first authors to publish a book that explained the science of investing in layman's terms, which was called the only guide to a winning investment strategy you'll ever need. In addition to that book, he has also authored or co authored a total of 18 books. Larry's dedication to helping others has made him a sought after national speaker, and he has made appearances on national television on various outlets. Larry, I can tell you is a prolific writer regularly contributing to multiple outlets, including Alpha architect advisor perspectives, and wealth management. Let's take a moment and tell us about the unique value that you are bringing to this world.

Larry Swedroe 01:51
Oh, I got very lucky in my life. I kind of think about are you where your viewers have ever seen the movie Zelicah with Woody Allen, where this character happens to show up in all kinds of famous events in my life, I just happen to be at the right place at the right time for a bunch of revolutions in finance. So I went to school, I was training to be a security analyst and portfolio manager. When I graduated from Baruch College, I'm proud I was nominated as the most likely to succeed in the field of finance and investing. And now I'm sort of the Antichrist of that whole area of active management, stock banking, I never actually engaged in that. I ended up taking my first job with CBS in the area of international finance in 7375. Just at a time when the Bretton Woods agreement had broken down and exchange rates were now floating all over. Nobody knew how to manage this stuff. And I was hired as an assistant to the assistant treasurer of the company. And I got to learn all about managing the risks of foreign exchange interest rates, of course, we're going all over the place, especially with inflation rising with the oil embargoes and everything. And then two years later, so that was kind of the first revolution I happen to just be in the right place for and the only reason I was there, I couldn't get a job on Wall Street because Wall Street had collapsed 73 for the brokerage commission era was over a fixed Commission's prices collapsed in terms of the Commission's and Wall Street was hiring people with 2030 years experience almost the same price now that you could hire an MBA out of school. So I ended up with that job at CBS. Three years later, Citicorp hired me because in the land of the blind, the one eyed man is king and I had two years of experience of managing risk at CBS. And they work starting a consulting firm to help multinationals manage that risk. So I joined them. And two years later, they sent me out the San Francisco to become a regional treasurer and build up a West Coast presence for the company. And around that time, we got a second revolution, which was the beginning of the first creation of the weapons of mass financial destruction, as Warren Buffett called them these derivatives. So I got involved with actually helping create some of these first derivatives that was simple interest rate ceilings and swaps and foreign exchange swaps and puts in all kinds of derivatives around that. At the time. That was just Citicorp and Salomon Brothers engaged in that area. So I got involved begin in an area just because I happen to be in the right place, sector a revolution Sure. And after eight years of doing that, my boss had left the city coops Treasury area and left to join a city called Pomona, zinc. And he asked me to join in there and I talked to friends, I've been doing this now, managing interest rate, foreign exchange risk, other types of risks like that for a while, it's time to do something new. And he was now in charge of their mortgage business. And this was the beginning of the era of well, Lou, we are an area that created the first private securities other than Fannie Mae and Freddie Mac, backed by residential mortgages. So I got involved with that revolution ventually, a group of us left to form a company called Prudential home mortgage. And I was responsible for managing all of the interest rate risk and the credit risk, and glad to Saudi got out of that business before well, before 2008. I'm proud to say that no one who ever bought any credentials, rated securities ever lost a penny from credit losses, so, but I learned a lot about financial crises. During those times, there were plenty of them, including bunker hunt, about to take down the financial system, we are trying to corral the silver market and I get a call at two in the morning to get my rear end in the office, because we don't know what's going to happen. And, you know, the CFO of Citicorp, you know, need to get in all kinds of crises, including Mexican defaults, and Brazilian

Andrew Stotz 06:34
also the savings and loan crisis in you around the mortgage space.

Larry Swedroe 06:38
Yeah, was one crisis after another in that era, fifth largest bank in the US fail. Most people don't even remember that. Imagine today, if the fifth largest bank were to fail. So that was the third revolution there. And then, years later, we sold that company and friends of mine had started a investment advisory practice. And they were financial planners who could, you know, integrate an investment plan with estate planning, insurance taxes, you know, those kinds of things, but they weren't no investment experience and no experience really managing risk. They were CPAs. So I thought it'd be great, I could join them. And I had, this would be a way for me to teach, I guess, lectured at Stanford and some other places. And I love teaching. So this would be a chance for me to teach, educate, right all about the science of investing that I learned. And it was right after Gene fama and Ken French really revolutionized the way we think about investing. We lived in a single factor cap M world prior to their publication of their paper, the cross section of expected returns. And so that was this new revenue revolution in quality factor based Evidence Based Investing. And then we got other factors that were added several years later momentum with Jagadish and Tippmann, and Rob, and then the publication of paper on that. And then you had Robert Novy Marx writing about profitability, which was expanded the quality. And now there are 600 factors in the zoo of factors. So, you know, I was in the right place at the right time, four different times in my life. And that gave me I think, some very unique perspectives that I had all this experience, living through many crises, and learn how to think properly about the management of risks and economic forecasts when I was at Citicorp, we sold economic and market forecasts, and we can talk about the value of those things if you'd like, and what I learned about them as well. So I, you know, I really have benefited by good luck, which some people say is the residue of hard work and design, but all attributed to luck,

Andrew Stotz 09:06
when you also chose to write it out, you know, not everybody does that. And I know, for myself, anytime I write or teach, it just really helps me to understand the topic more. And that's what I really enjoyed it. I'm curious. If we were to sum up, you know, the core philosophy you have. I mean, I noticed, for instance, you're talking about, you talk about risk a lot. You didn't talk about forex, or interest rates in how to profit from them. You talked about how to manage that risk for them. And I'm just curious if we, if you were to come up with London, or let's say, two or three principles that you really believe in now, after all these years, what would those two or three principles be great

Larry Swedroe 09:54
question for me because I just put together a speech that does exactly what is So that's the first slide, you know of that of that speech, so we can walk through that. So the first principle is that you should believe because the evidence is overwhelming, the markets are not perfectly efficient, even gene Fama, the father of the efficient market hypothesis would acknowledge that, but they're sufficiently efficient, that it makes active management a losing proposition, it doesn't mean you can't win that game. It just means it's like the roulette wheel in Las Vegas, the odds are against you, you can get rich playing the lottery, and you can get rich, taking your IRA account to the Merrill Lynch office. But the odds of you doing that, and being successful are so low, it's not prudent to try, okay should focus on managing risks and not trying to generate alpha or risk adjusted out performance. And that means you should invest in what people generally refer to as index funds. I don't even own any index funds I invest in, I use the common term here is passive. But there's no good definition I think I've created, I'll take credit for it for coming up with the definition based upon gene farmers definition, which was passive investing means no individual stock picking or market timing. My definition takes that to say that, I think the best way to say it is this way, you can invest in three different small value indices in the for US stocks, easily, there are probably more, you have the s&p 500, sorry, s&p 600 value index, you will have the MSCI 1750 small value index, and you have the Russell 2000 value index. Clearly there's some active management going on here in the sense of how you define your eligible universe. But they're all passive in that once they define the universe. There's no individual stocks auction market timing, they systematically implement it. It's transparent how they do it, and it's replicable. So those are my three terms. You define your universe, you then systematically implement in a way that's replicable and transparent, but you can add value over pure indexing because you can trade patiently and not be subjected to high frequency traders front run to you knowing you've got it, you know, to trade because the stock has left or is going to enter the index. So I favor investing in firms or with firms like dimensional Bridgeway AQR, others Alpha architect, there are others that Blackrock that systematically invest in unique sources of risk. But they're not index funds, because index funds have negatives that can be minimized or eliminated. So principle one is invest says if markets are efficient, and invest then in systematic, transparent, rapidly run funds that try to keep their trading costs down with patient trading. If you believe markets are highly efficient, the only logical conclusion you should come to principle two is that all risk assets have to have very similar risk adjusted returns. Once you account for all risks. That doesn't mean Sharpe ratios, because they assume returns are normally distributed, which they're not. You can have fat tails and people care about them. Right. And secondarily, there are other risks besides standard deviation like illiquidity. So if you invest in illiquid assets, you should demand the risk premium. You take credit card debt and you securitize it. And all of a sudden the yields say 3% Lower. Well, that's an illiquidity premium, right. So you should be compensated for taking that. All right. Now, if you believe that all assets that have risks have to have similar risk adjusted returns, once you account for all of the risks, then the only logical conclusion you should draw, I think, is that you should hyper diversify as the term I use, of course, as many unique sources of independent risks that you can identify them meet the criteria that Andy Birkin and I put it in our, your complete guide to factor Based Investing, that there's evidence of a premium and Make sure that wasn't a result of a data mining exercise or at least minimize that risk. What you want to have is evidence that that premium is persistent over a very long periods of time across different economic regimes. So it's not the US in the 50s and 60s, and you got a great environment, right? It has to be pervasive across industry sectors, countries, regions, it should be pervasive, where appropriate, even across asset classes. So for example, buying what's cheap works. Whether you're buying stocks, bonds, commodities, or currencies, is a premium of what's expensive. Momentum works across all kinds of asset classes, it should be robust to various definitions. value, the one fama and French chose was booked to market not because it was the best, but because it had the least turnover, and therefore was more implementable. But that could have been just a fluke of luck, that low book, the market companies have lower returns, and I booked the market companies, right, so why shouldn't PE work or price to cash flow or price to dividends or EBIT dot enterprise value? Well, it guess what turns out, they all work, right, and what works better than any one of them. And this I've learned is true across cite various fields, you're almost always better using an ensemble approach than even the best single metric. So I invest with funds that don't rely on one single metric. So persistent, pervasive, robust, has to survive transactions costs, doesn't do any good if you have a 3% micro cap premium, and it costs you 5% to trade it. And lastly, there has to be intuitive reasons for you to believe that the premium will persist. I prefer risk based reasons because they can't be armed away. A lot of risk, premiums can go up and down. But all except behavioral ones where there are limits to arbitrage that prevent sophisticated investors from correcting Miss pricings. Especially in micro cap stocks, we have high costs, right? And shorting the fears of that, you know, are high because the losses are unlimited. So my portfolio looks much more like the Yale's in the Harvard's of the world where and it's evolved to look more and more like that, over time as vehicles have become available that were only available and very expensive for them if they were available to the public. And two and 20. Hedge funds are even more expensive than that. And that took all the alpha and gave it to the sponsors, so I didn't invest in them, then your head interval fund structure was being introduced. And the fees, while not cheap, are well below the two and 20s of the hedge fund world. So now my portfolio is roughly 25% or so of equities, about 30% a safe, fixed income and the rest are in alternatives, like reinsurance private debt, private real estate, Life Settlements, drug royalties that are totally unique assets. And it was interesting last year, it just happened to be and it was a lucky year when stocks and bonds or at least safe bonds or risky public bonds got slotted. The biggest portion of my portfolio, every single one of the alts was up somewhere up within 20%, which included AQR as long, short multifactor strategy. So prior to years, that didn't work quite as well, because the stock markets did better. But last year proved the worth of having a more diversified portfolio. So those are the core principles, markets efficient, always assets should have similar risk adjusted returns. If you believe that there's no reason to have a 6040 portfolio where 85 to 90% of your risk is concentrated in one single market beta factor. To me that's illogical, it's cheap. It's tax efficient, but should not produce not likely to produce the most efficient results and as certainly as much more tail risk. And I wrote about how to manage that in my book, co authored with my colleague Kevin Grogan, reducing the risk of black swans, which I urge your readers the pick up a copy of if they want to learn how to reduce tail risk.

Andrew Stotz 19:53
And one quick question on that. I'm starting to wonder if we're gonna have time to get to the main question to the podcast because there's So much there. One quick question is for amateurs in as well as you know myself to understand. A question I have is that

20:11
if if risk includes all risks,

Andrew Stotz 20:15
let's say, and forget about, you know, volatility, but we just say risk is a measure of all risks. And each asset class performs at a roughly equal risk adjusted return, which should make sense from a efficient market perspective. And you're smart enough to know you're investing for the long run. So each of those, each of those is going to have its ups and downs and all that. And, and volatility of the portfolio is not as critical for an individual as a fund manager that has to show that it didn't collapse or something but but the volatility not, I'm not worried about being exposed to volatility knowing that over a long period of time, that volatility is probably what's going to bring you the return. Would investing in any one asset, class or instrument not make? Would it make sense just to invest in one? Now? I understand the concept of diversification very well, but my point is, all I'm asking about is this risk adjusted return if risk adjusted return is equal? And we know that all of them are up and down over a long period of time, you're going to be compensated. So 3040 50 years from now, would it have made a difference? If you had been diversified across all those different ones that were all producing the same risk adjusted return? Or just being exposed to one like the market? Wow,

Larry Swedroe 21:46
that so here's a way to think about that. Which ride? Would you prefer to have? One that looks like a roller coaster, or one that looks more smooth,

Andrew Stotz 21:58
can average? And can I ask, Can I let let's take that out of it for a moment. Because I agree. You know, from a behavioral perspective, you could say that people don't want to go on a roller coaster ride. So definitely understand that. But let's just kind of think Rip Van Winkle for a moment, because I'm just trying to understand risk adjusted you what you said about equal risk adjusted return. So

Larry Swedroe 22:20
family ankle. So are two really important issues besides the psychology. You we know from all of the behavioral research, if you have a less bumpy ride, you're more likely to stay with the portfolio and have the discipline to stick with it, which means you get the end result. If you're going in and out and jumping, your end result is going to look entirely different than your theoretical portfolio would have done. So that's really an important point. The second thing you have to understand is that every single risk asset, matter whether it's US stocks, gold, real estate, reinsurance it doesn't matter. They all go through long periods of very poor returns. There are in fact, three periods of at least 13 years, where the s&p underperform totally riskless T bills. That's half of the last 90 years rough right? Now, what if you're a retiree? And then you've got 15 years? Do you want to take the risk? That it could be whatever the asset class you choose? Right? It might be s&p, it might be small value, it might be reinsurance. Why do you want to gamble that the one you choose is the wrong one. Because the right only right way to think about risks is not to think about what the expected return is. But to think about the mean, being the expected return of a very wide distribution of potential outcomes. Now, we don't know what the outcome will be, which is why we run Monte Carlo simulations. And if we build a portfolio of let's say, 10 different asset classes, maybe the mean expected return is 7%. But the bell curve around there if we own 10, asset classes will be tall and narrow, with a worst case might be plus 3%. And the best case plus 10. But if you own any one, the mean might be seven, but the worst case might be minus 10. And the best case plus 20. That's the only right way and I don't know any single investor who would ever choose the wider dispersion of outcomes with a mean is the same. Everyone should logically choose because it's less risky. And therefore the only logical thing to do is to own as many unique ones because By definition, unique ones are uncorrelated. Give a simple example, for us we use for our current clients, will we restrict currently to only publicly available securities. I invested in private ones myself, and we'll probably approve them over time. But right now we're restricting it to those three. So we use a key a key was long, short, multi factor strategy fun. We use storages reinsurance fun. And we use Cliff waters. middle market lending fund, we also use stone ridges alternative lending fund, which has consumer loans. Now, each one of them, let's say has an expected return of 10%. Some of them like reinsurance, the volatility is maybe 10, or 12, the private credit of Cliff waters may be five. And so maybe the average is like eight or something. But when you combine them that correlations are very low, reinsurance is totally uncorrelated to what private credit is going to get, or what long short factors are going to get. And long, short multi factors is uncorrelated with equities and bonds. So it's uncorrelated with reinsurance, though, so they're caught the standard deviation of a portfolio equal weighting those four is about half the average of the individual ones. So why would you choose one, when you can dampen your volatility, which dramatically reduces sequence risk for anyone who's in the withdrawal stage of their portfolio was sequence risk matters a lot. And also, as you get older, we know you're going to almost certainly be less tolerant of risk, because you can't, you don't have your labor capital to replace it. So you want to reduce that drawdown potential, the cost of the sequence risks, you can wait out their markets, and the longer as well, and therefore you want a hyper diversified. That's exactly what the yellows and the Harvard's have been doing for decades, and smooth their returns Napoli. Now you have to be able to deal with tracking variance, you can't care what the s&p is doing, right, that's your trade off. So you have to be willing to look different. If you can't, then the trade off, you own the s&p and you will track everyone else, when they're miserable, you'll be miserable, too. But now you have much more risk. It's not a free lunch to concentrate and get rid of that tracking variance. That's the mistake than all the people who push total market and its simplicity. And its tax efficiency, there is a trade off, you're dramatically increasing your concentration of your risk in one single factor, which greatly increases the tail risk of the portfolio.

Andrew Stotz 28:11
Well, I really enjoy the summaries that you do for alpha architect, and I pretty much you know, love you know that what you're discussing there. So I appreciate you going through that. And I, I think I want to get into the question. And that is your worst investment ever. And we've got a limited amount of time. So I want to try to get to it in an understand what a brilliant man like you. What is your worst investment ever?

Larry Swedroe 28:43
Well, I consider myself intelligent because what differentiates intelligent people from fools is they learn from their mistakes, they don't repeat them. I as I mentioned earlier, I was training to be a security analyst and portfolio manager. My dad was a stock junkie, he got me interested. We would pick stocks together. And I didn't end up doing that. Fortunately, for me, but while I was working at Citicorp and ran there, I was regional treasurer on the West Coast. I was working with a friend of mine and a brokerage firm and he put me on to this company called Jefferson National Bank. This was in the middle 80s. And he said, Larry, this looks like a really good investment. And I happen to believe in the themes that were behind his recommendation. One this was a small regional bank, and the laws were going to change. I was certain in the US to allow consolidation and to build national banks. So there was going to be a trend of purchasing well run small banks at premiums to enable the small the big banks To become national. So that was theme number one, theme. Number two, this was located on the border between the US and Canada and upstate New York, there was a military base there and has a good sound, you know, community, not a lot of risk in businesses and stuff. And NAFTA, I thought was going to pass, and that would build up the trade there. Okay. So I then called a bunch of friends of mine who were in the banking business, I had lots of friends in the business, of course, and ask them who are in the business of lending to other banks? And I asked them, so I'm doing deep due diligence here that the average investor won't have. What do you think of this company? Oh, it's well run, the earnings were good, the bouncing look good. Everything. Now, I could have made a much more intelligent bet, looking at hindsight, which is avoid idiosyncratic risks. And if you want to bet on those themes, just go by there were funds that are a they were trusts of a collection of regional banks to get the themes, but you avoid the idiosyncratic risk, which I now tell people to totally avoid. Right? Well, it turns out that if you had bought that basket of regional stocks, everything I predicted happened, and your returns would have dramatically outperformed the market. But one of those, for me, I bought the one where the President committed fraud, and the company went bankrupt, and I lost 100% of my investment, not quite 100%, I sold out at about an 80% loss, and the government chant and the tax loss. And I, I also avoided the mistake of too many eggs in one basket, I limited myself to 10% of the portfolio. So it wasn't a total disaster. But was was 100,000. Then now think of 35 or so years later, if I put that in the market, and gotten 10% a year, right for 35 years, that money doubles, about every seven years would have doubled four times I'd have 200,408, about 1,000,006, today, something like that. So that it wasn't $100,000 mistake, it was $1,000,006 mistake, it just means my kids are going to inherit a million and a half less. But that was the best lesson I ever learned. I never repeated that mistake. The other mistake I made is, if I could figure that out, everyone else likely could. It was public information. And you shouldn't confuse information with knowledge that allows you to really, even though I got it right, I'm now much more humble about what I think I know versus what the collective wisdom,

Andrew Stotz 33:01
roughly how old were you at that time,

Larry Swedroe 33:04
in my mid 30s.

Andrew Stotz 33:05
And let's think about a mid 30s young man or woman who is facing the same exact situation. They're, they're looking at it, they're finding the themes, they're researching the themes, they think they've got this, you know, a hit, what one piece of advice would you give them?

Larry Swedroe 33:23
The first thing I do when I get this question all the time, almost every day, for the last 30 years from somebody because we're a consultant to hundreds of other advisory firms as a camp, a turnkey asset management provider, so I act as their head of research, etc. So the first thing I said, Okay, tell me what your themes are. And then I'm gonna just tell you, let's say I agree 100% with you. But it's completely irrelevant. It's meaningless, because I asked them, are you the only one who knows these things? Do you think the smart people of Renaissance technology, de Shaw, Warren Buffett, Goldman Sachs, they're unaware of all these things that these are, these are people who are far more research devices, new spend 100% of the time on this while you're some software engineer, and you spend a few hours, if they thought the price was worth much more, it would be there already. It wouldn't be trading at 25. And then sitting there on their hands, watching a trade at 25 when they think it's worth 50. So the most important thing to ask is, unless it's inside information, the only way you can exploit is if you know, Ken interpreted better than the rocket scientists, D Shaw and Citadel and these other hedge funds. And the odds of that if you answer are asymptotically close to zero. And so let me close with this story. Ray Floyd. So when I was a kid, teenager, and I would work part time, so I had money to go on dates. I go with friends of mine to the racetrack a couple of times a year. And they would be betting five and 10 and 20 bucks a race. And to me, that was 100 bucks, and I cheered justice on betting on $2 a race. And on a typical day, I might lose eight or 10 bucks, some days, I'd win 20. But I cheer just as hard betting $2 as they did, betting 20. So if you need excitement from your life by trying to pick stocks and time in the market, take 1% of your portfolio, or you know, just like you go to Las Vegas, you're not hoping expecting to get rich, but you might set aside $1,000 as an entertainment account that you're willing to lose and go play the market. But don't take your IRA account to the Merrill Lynch office because you're more likely to lose it.

Andrew Stotz 36:00
Listeners, there you have it, another story of loss and some wonderful advice to help you keep winning. Remember, I'm on a mission to help 1 million people reduce risk in their lives. And if you've not yet joined that mission, just go to my worst investment ever.com And join the free weekly become a better investor newsletter to reduce risk in your life. As we conclude, Larry, I want to thank you again for joining our mission. And on behalf of AST Arts Academy, I hereby award you alumni status for turning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Larry Swedroe 36:38
Yeah, you know, ignorance is not an excuse for making mistakes, the best thing you could do is get educated. That's why I wrote 18 books that help people avoid the mistakes including a book called investment mistakes, even smart people make it's a lot cheaper to read the book and learn from others mistakes than to make them yourselves. And if you want to, I'd recommend other authors. That too I'd recommend are John Bogle who sadly recently passed away. And my friend William Bernstein. I think there any one of their books will lead you to the same conclusions pretty much that my books have done.

Andrew Stotz 37:17
Fantastic. And we'll have links to all that in the show notes. And that's a wrap on another great story to help us create, grow and protect our wealth fellow risk takers, let's celebrate that today. We added one more person, Larry, in this case to our mission to help 1 million people reduce risk in their lives. This is your worst podcast Hosea Andrew Stotz saying, I'll see you on the upside.