ISMS 38: Larry Swedroe – The Self-healing Mechanism of Risk Assets

Andrew Stotz 00:00
Hey, fellow risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and today, I'm continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry deeply understands the world of academic research about investing, and especially risk and asset management, and all of that. And he's recently written a piece called the self healing mechanism of risk assets. And what a great opportunity to learn from the man. So Larry, take it away. Yeah,

Larry Swedroe 00:41
so one of the biggest problems that I have found working with both advisors and investors directly is this kind of biases, which lead to mistakes, which we have talked about in previous episodes, one of them being recency. So recency is a tendency to extrapolate the recent performance of assets, almost ad infinitum into the future as if it's inevitable. And another is a problem of engaging in resulting, which is, as we've talked about, is making the mistake of judging the quality of a decision by the outcome, which is unknown, versus judging it by the quality of the decision making process. And so if you think, for example, that diversification is a prudent strategy, right? Just the use a simple example, maybe you should on stocks and safe bonds, some combination of that, and then stocks go on to far outperform you say what a dummy I was, I bought these bonds. And then of course, you can have period when stocks underperform totally riskless treasury bills for as long as 17 years. So that's a mistake. We know, it's no different than, say, of a young couple, they have children, and they decide to not take out life insurance. And next 10 years, they're lucky enough, nobody dies. And thinking that that was a good decision. From a financial perspective, you cannot judge the quality of the decision by the outcome, because alternative universes to use the stock track term could have easily played out. So you can only judge it by the quality of your decision making. And I We know, for example, I would versification is a proven strategy,

Andrew Stotz 02:46
I would highlight episode 601 were interviewed Annie Duke who's written some books and highlighted the value of what you're talking about resulting. So yeah,

Larry Swedroe 02:55
that's terrific. So the problem it comes about, we know when stocks or any asset class performs very poorly. And so investors then flee the costs of these mistakes that they make, and they fear, the worst outcome, but they fail to understand some basic economic principles, which I use the term that there's a self healing mechanism that's generally in place. So if we think about this, we ask ourselves how to bear markets happen? Well, they happen for two reasons. One is earnings can fall and cause stock prices would fall appropriately. But you get really severe bear markets, when you have the combination of things happening, you get earnings falling, and then the risk premium goes up because we're in a bad recession. Or if there's a war or some geopolitical events, whatever it might be. And people now are willing to pay much lower P E is for the same earnings. And so you get say a 25 or 30% Drop in earnings, but P e is get cut in half, and markets crash. Right. Well, what investors fail to understand for Warren Buffett understood all along and that's what made him a great investor, is that when valuations fall, that's an effect telling you what the cost of capital is to corporations, right? Evaluations of falling the cost of capital is going up, because they have to give away for example, let's say P e is went from 20 to 10. Well, you had to give you only had to give away. For every dollar of earnings. You got 20 bucks for your stock, but now you're only getting 10 And so your cost of capital went way up. But if you're buying the stock, now you only have to pay $10 to get $1 of earnings. That's a 10% return instead of 20 times earnings, which is only a 5% return. So the simple examples I show people is, so there are these three periods when stocks got crushed for a long period of time, most people would never guess that this even happened once I think, but 1929 to 43. T bills outperform stocks, that's 15 years. Now what happened during that period, the cycle, the adjusted P E ratios, what's called the Shiller, k 10, had fallen from 25.3 to less than 11. So now stocks are looking much more attractive, we have this self healing mechanism. And what happened? Well, from 1944 to 65, a much longer 22 year period, stocks return 15% outperform riskless T bills by 13.2%, almost double the historical risk premium. Similarly, what we saw from 66 to 83, that's the longest period in the US that we have where stocks underperform T bills, at least in the modern era, post 1926. And then the cake 10 fell from about 20, all the way down to undertand. And again, that's Warren Buffett's telling people don't try to time the market, but buy when everyone else is panicking and sell when others are getting greedy. And so over the next 16 years, from 1984 through 1999, the s&p returned 18.1% outperform T bills by 12.3%. Well, then, of course that big outperformance works the other way. Of course, what happened is valuations went way up to 44.2. And then the market went down the next 13 years from 2012. Again, the s&p underperforms T bills. But by that time, the cake 10 big cut by more than half down to 21.2, which was less than the average of the last 25 years, a little higher than the historical average. And again, over the next decade or so, the s&p far outperformed. So the way to think about it is falling earnings is bad. But falling valuations is a self healing mechanism. And just as one last example, here, the s&p lost 18.1% in 2022. We have a self healing mechanism that cape 10 went from 38 to about 28. That's still pretty high. And it's a lot better, and stocks went on to have strong returns. Right now those strong returns put the cape 10 up at 33. That's been a period when usually stocks do very poorly. But my last comment is that the one year correlation between the cape 10 or current P E's and stock returns is virtually zero. You cannot use this information to time the market. But it does provide you information about what is likely to happen over the long term. And that means you have to have patience in order to stay the course. So

Andrew Stotz 08:50
is the is the lesson like when you finally get absolutely exhausted, have a terribly performing market after you know, five years, 10 years, it just seems like I give up. That's the time that you should be saying okay, now it's time to add more to my position. Actually,

Larry Swedroe 09:12
I would say it's that's the time you want to rebalance. And get back to your, you know, risk target that you said is what do you think is appropriate based upon your ability, willingness and need to take risk. Now the self healing mechanism doesn't only work between stocks and bonds, it works between value and growth stocks. So a good example of that in the late 90s 95 to 99. As an example, the s&p returned 33.6% per annum the s&p 500 growth index, and dramatically outperformed small value stocks by almost 13% a year. Well, of course, the spread valuations between small value and large growth stocks widened to historic proportions. And the best predictor we have is the relative P E ratios. And of course, over the next eight years small value went out to dramatically outperform, outperform the s&p 500 growth index by 14.3% per annum over the next eight year. But most investors were in there, because they was subject to recency bias, chasing past returns, and engaging in resulting.

Andrew Stotz 10:38
Um, so one of the, I'll tell you a funny story, Larry, that the former Finance Minister of Thailand who is was a finance minister, many years ago, he also was a pioneer in the financial markets here in Thailand, I really have a lot of respect for the guy, he's very smart. So he's been, you know, investing in all that for many, many years. But on Sunday, February 4, he wrote a, an article in Thai stop mug has been terrible for I don't know, 510 years now. And the article was titled, Why I pulled all my investments out of the Thai stock market. And I thought to myself, I thought to myself that I need to write the article in the same newspaper to say, that's the signal that we're at the end of this period. In fact, I think I need to get him on the podcast to debate that and discuss that. But I think the point is, is that when you feel exhaustion, is the point that you may, you know, you may actually make your best, your most profitable decision if you can go against the exhaustion. Yeah, that I

Larry Swedroe 11:46
think the key is that the basic underlying premises of why you made the investment have to remain the same. So for example, if you invested say, in, I'll just make this up in Thailand, because you saw good governance, you know, good democracy, assets had, you know, govern government protection for private property, governments weren't taking over companies and, you know, taking them out of the public domain, and taxes would go way out. If those underlying basic principles are no longer there, you may want to change your view. But if the basic premises for why you made the investment haven't changed, it's just that the risks showed up, well, then you should be in effect, doubling down are rebalancing, because the story just got better, because you're now having to pay a much lower price for the same amount of earnings. So that's what's key.

Andrew Stotz 12:54
And when you talked about PE, you really referenced the concept of risk, do you look at let's say, a P E ratio or that type of thing, do you is that risk? Or how do you look at a P E.

Larry Swedroe 13:07
No, P P e is a measure of the cost of capital, if you will, of a company, a high P E ratio means the company has to give away a lower amount of capital to get a, you know, a give up fewer earnings to get the same amount of capital. And investors are willing to pay a higher P E in two for two reasons. One, the expected growth rate is higher. And number two, it's a safer investment. riskier companies have to have higher risk premiums, higher expected returns to entice investors. So that's what most people don't understand. They think this company is safe, it's got to have great returns no risk and ex ante X expected returns have to be inversely related. So if that's what's if a

Andrew Stotz 14:01
company was trading on 20 times it mean, we could take one divided by 20 and come up with 5%.

Larry Swedroe 14:08
That would be the earnings yield. And historically, whenever we look at the one year, the five year average, or the cape five, or the cape eight or the Cape 10, that's about as good a predictor we have a future of long term returns, and in real terms, so a 20 pe would translated to a 5% earnings yield. And then you would say I would expect to earn 5% In real terms over the long term for stocks. And then you could look at say in the US, we would look at them for say between a 10 year tips and inflation protected security and a 10 year bond, and that today would be roughly 2% And we'd add 2% to the five to get a nominal expected return to stocks of about seven. That's how you would do it.

Andrew Stotz 15:07
Okay, and one one last thing, I think you mentioned that it's if you look at just trying to predict one year's forward performance from the Cape 10, let's say ratio, you know, you're just gonna, you're just getting noise, basically, you're getting randomness and stuff like that. But also, if we look at right now, and look at the situation and look at the PE right now, I mean, it is quite high. What do we derive from that, even though it has had some self healing happen, as you said, what do we derive from that? Well,

Larry Swedroe 15:45
it's gotten reverse after 2320 23. All right, because of the very strong 26%. Here's the important thing. And then I want to come back, because I want to show your audience that this self healing mechanism not only works with stocks, and value versus growth, it works with bonds and credit and it works with insurance, and virtually any risk asset. But the right way to think about this issue, Andrew, is as follows. Actually, hopefully, you can embrace this because I just love I was studying and trying to get my train of thought, Oh, Jesus.

Andrew Stotz 16:33
I know that feeling. We can cut.

Larry Swedroe 16:37
Oh, man, I was trying to remember to add in to get this thing about the other assets. And then I lost.

Andrew Stotz 16:43
Yeah, this will consider this a little break. And I'll tell my editor.

Larry Swedroe 16:50
Oh, yeah. What is it tell you? Okay, yeah. So we'll get started.

Andrew Stotz 16:53
So let's start. Let's start from right now we're going to go back to what does it tell you? Right, what is high PE tell you go,

Larry Swedroe 17:01
what does a high current PE tells you this is a mistake that many investors make. First of all, the current P E, or the K five or 10, all have an explanatory power of about 40%. So what that tells you is that if you have a 20 P E, current or cake 10, the expected real return over the net over the long term, not the next one year is 5%. In real terms, however, what's really important to understand is you have to think about that expected return as the median of a wide potential dispersion of outcomes that are possible. So if you look at the data, it goes something like this, if you have a cape 10 of about, say 17, the historical return to stocks may have been about seven real returns. However, in the best 10 year periods, the real return might have been 13. And in the worst, it might have been plus two. And if you have a P E of 10, that's projecting really high, you know, future returns of 10. But you could still get some years, maybe that are low, like maybe three or 4%. Or you can get some good years where it's 15. And the reason is, you'll have resume changes and risks can either show up causing P 's future B's to collapse, or good news to show up or bubbles and returns can go way up. That's the pot that John Bogle called the speculative return the change in the P E ratio, which can happen because you know, hey, we get a great economic environment. Peace breaks out all over the world. Russia walks away from Ukraine, Hamas surrenders you know, all these kinds of things. Inflation goes away. The Fed declares victory rates come down around the world, and stock prices go up. Now, no one would predict that by looking at the current Pease, but that's a change in regime that's unfor castable. So the key is, high valuations predict low median returns, and the best returns possible become less good. And the worst returns become much worse. low valuations predict higher returns, but you can still get bad returns but not as bad as when the valuations are high. And the best returns are much better than the best returns when valuations are high. One of the things to think about it,

Andrew Stotz 19:57
okay, that's great. And one of the things Someone said to me a long time ago was they said, the Andrew, you said that the stock market's efficient. But you know, if I just look past, you know, a year ago, and I compare it to now, we weren't, you know, the stock market wasn't, it wasn't really forecasting very accurately compared to what happened. I said, Wait a minute, the stock market is ultimately digesting all the information we have at that time. And, and just because when new information comes in, it adjusts for that. So to say that the stock market in the future went down or up very different from what people expected. You're not saying that the markets not efficient, what you're just saying is that new information came, and the market efficiently processed that information and decided to derail or rewrite? Exactly.

Larry Swedroe 20:47
It's the new information that comes out, that's better or worse than expected. But let me give you a good example, to help you if you ever have that discussion about market efficiency. So there is something called The Wisdom of Crowds I'm sure you're familiar with. So wikis work on that, and shows that crowds when they are not heard behaving, right, and influenced by the behavior of the crowd, but individually thinking are generally better forecasters than the experts. Okay. And what here's the data, the Wall Street Journal does a survey of market forecasts every year. And they looked at the I think they look back 23 strategists, and they go back, a recent piece done by an investment firm looked at the last six years to see how they did last year, the average forecast before 2023 was for a plus six. There were only off by 20%. Collectively, no one got it as high as the market actually turned out. And some actually predicted down for the market. The answer is thing is that is normal. The average error from the median forecast over the last six years was no better. In other words, it was at least off by 14% from the actual outcome. That's telling you how efficient the market is. Right? Because if otherwise, everyone would be able to forecast exactly what was going to happen. All these active managers who are geniuses will be able to tell you on the markets, no, they can't. And they can exploit it. They are unable to predict what will happen. And therefore you could argue the markets efficient. And

Andrew Stotz 22:45
I took that down to a stock level for my dissertation a while back and looked at the performance of individual analysts forecasting individual stocks. And I came out with a 25% error rate basically 25% Optimism worldwide. Yeah. So yes, I confirm you were talking about other asset classes and talking about, you know, buying, you know, and you were using the PE for stocks, but you were saying that this also applies to other asset classes. What were you gonna say about that? Yeah,

Larry Swedroe 23:20
so let's deal with corporate credits as a first example that everyone can relate to. So a 208 happens, and you get, you know, big defaults. Right. Now, what's going to happen? When that happens? What do lenders do? They tighten up their lending standards, right? Right. They require, say, if we were going to make a real estate loan to make an example, they may have lent willing to lend 70% of the market value at that time. And after that crisis, maybe they were only willing to lend 40%. So the risk just went way down. And what happens to spreads? Well, the banks are short capital on people are unwilling to lend their nervous bad times, the spreads over riskless treasury bills widened dramatically. So you have much higher expected returns from the wider spreads and the risk is coming down, because the underwriting standards have tightened. And so you get the self healing mechanism. I work in credit. Another great example is the asset class of reinsurance. So, we went through periods in California where we had massive fires never had happened before, like this in metropolitan areas, and of course, premiums Righto way jump through the roof, right? So premiums today are probably at least 60% higher than they were in 2018. Now, on top of that underwriting standards tighten, if you want to be able to buy fire insurance in these areas that are prone to risk, you cannot have a tree within 30 feet of your home, no two trees within 30 feet of each other, and then no brush for another 30 feet. So then what happened on top of that, not only did the underwriting standards increase, okay, but you probably also had to have you know, you know, fire sprays you know, detections if there was a fire in the house, the sprinklers Come on. On top of that the deductibles went way up. So you might have to eat not the first 5000 and expenses, the first 20,000 and expenses. So that also reduce the risks as well. So you got tighter underwriting standards, bigger deductibles means the risks are now lower, and the premiums are up 60%. Last year. By the way, we had the same thing happen with earth star with Hurricane insurance in Florida, after we had a series of years where we had some bad, you know, hurricanes and tornadoes, which led to big losses. Why did we have happened, premiums went through the roof, the deductibles jump, you can't even get insurance now unless your home can, you know, it's got storm shutters that can withstand 140 mile an hour winds. It has to be a concrete or steel reinforced, you know building. And last year, the fund that I use to invest on ridges reinsurance premium after losing money for the previous six years. And it had 5 billion of assets. Before that period started. It was down to 1 billion as investors fleed. Last year the fund returned 44.6%. But most investors were gone because of engaging in recency bias and result. In fact, here's a great example of the CEO of Stone Ridge, a fellow named Roy Stevens white and calculated the return of the fund versus the returns investors in the fund earned. And he found something very common. And we've talked about this before investors dramatically underperform the very funds they invest in, because investors came flying in because the first three years, the fund that had spectacular returns, you know, far outperforming riskless treasuries, and you have totally uncorrelated asset producing, you know, very strong years. So money came flying in, then you had a series of bad years, three losses in a row a good up five, down five, up five. So you lost money, four out of the six, and now is down to 1 billion. And most of the investors weren't there when the fund return 44.6%. So we have the same self healing mechanism. But it only works if you're able to follow Warren Buffett's advice. Okay,

Andrew Stotz 28:38
there's a couple of things I want to visit on this. But before we get into that, in your book, your complete guide to factor based investing in the back of it, you highlight a list of some different instruments that could be you know, use either funds or ETFs to get exposure to some of these different factors. But I didn't see at that time. This, you know, related to, let's say, the insurance or reinsurance stuff. I'm just curious, like, what are some options? Obviously, not advice, but just what are some options for what someone could use as an instrument for them? Well, so

Larry Swedroe 29:13
that bump factor Based Investing dealt with factors there are other asset classes that are on factors. So we covered that in my second edition of reducing the risk of black swans. We didn't include it because a lot of these vehicles were not available. When the first edition came out. We also included in my book your a six, complete guide to a successful and secure retirement. So what you're looking for are assets that meet the same criteria. We established in our Factor Book in the Bergen an AI that is a premium that is persistent over long periods of time, pervasive around the globe and across industries, sectors, countries regions, because we want to make sure it's not a result of data mining. It should be robust to various definitions, if that's appropriate, like value and momentum work for various metrics you can use, there has to be an intuitive reason to believe the premium will persist. Like reinsurance. Insurance companies are in the profit making business, they don't write insurance to lose money. So they're gonna price for where they think the risks are, they know they're not going to make money every year, sometimes the risks show up. But over the long term, they're very likely to come out ahead if they are prudent. So no one likes to buy insurance, you know, you're highly likely to be transferring profits, you do it to cover losses you can't withstand. So why wouldn't you want to be on the other side of that trade and capture the insurance premium where you're not at individually at risk? Right, that's a very logical, intuitive premium. And it has to survive transactions costs. So examples of that, I use a long short factor fun, that goes long, the positive side of a factor so we go long values short growth, long positive momentum, short negative non that momentum, long quality short junk, long carry with high interest rates, in short carry with low interest rates. So there's a fun run by AQR that's called the alternative risk premium strategy. Its symbol is q r p r x, for those that are using taxable accounts, and QSPRX. For those who are in tax advantaged accounts, Stonebridge runs a reinsurance fund. It's Sr. Rix that invests in what are called quoted shares, sharing the risk put on by about 10 of the leading reinsurance in the world. They also have a cat bond fund, which I prefer not to use, because it's more concentrated in US hurricane risk, and you give up the illiquidity premium, you gain your quota share, so the expected return is low. But if you want liquidity, that's a good fun to use. That's another example of that. There's private credit, which gets the benefit of this self healing mechanism. But private credit is illiquid, I use a fun run by Cliff water. It's all floating rate senior secured and sponsored by private equity. So you have them as hopefully backstopping prepared to add equity if things get desperate, because they'll get wiped out. If the creditors come in and take over the company. It's not a guarantee they will, but it can happen. And that's an extra layer of protection. And index that cliff order has of those types of loans, which today have average LTVs of about 40%. So 22 basis points of credit losses. Almost no defaults and 70% recovery rates, and the current yield is 12%. That's a much better yield than you're getting on Vanguards high yield bond fund, which has significantly worse credit experience, but you're getting daily liquidity, but most people don't need liquidity. And there you also taking about seven years or so a duration risk. So those are some examples of funds that you can access that have somewhat low or totally uncorrelated, the risks of stocks and bonds, I have about 40% of my portfolio, and I've been moving that up towards 50 in those assets plus some others. I own a life settlement fund. I'm in a private real estate vehicle as well. In private oil and gas venture as a diversifier in case you get negative supply shocks there as well. So

Andrew Stotz 34:29
And just to wrap it up, reducing the risk of Black Swans is what someone's gonna get when they buy that and read that is understanding first of all, that it's a major risk. And the second one is your strategies for dealing with that.

Larry Swedroe 34:45
Yeah, so what's the biggest thing that people are afraid of? These say black swan events that can happen now? Let's say a war in the Middle East. I wouldn't call that a black swan. That's a white swan. It's a risk we know always there, but we don't know it's going to erupt into a global conflict. All right. But the you know, you have the US budget deficits were at another I recall white swan. I mean, it's certainly possible, the US will fail to pass a budget. And we'll have a shutdown of the government. And we don't know what that to do, right. So what investors, particularly those in retirement, who was subjected to what is called sequence risk, doesn't matter what the long term returns are, if you start to withdraw money, and right away, you get negative returns, you can really have a problem, because you can't recover. Even if the market does, because you are drawing down and those assets are now gone, those assets cannot recover. So if you start, you know, taking assets out in 1966, at the beginning of the worst period, for stocks and bonds we've ever had your typically bankrupt in about nine years, even though returns were great over the last 60 years, starting then. So that's a real problem. I gave that example in my retirement book, in the section on seek. So we want to focus on how can we cut down the tail risks that when they come cause people to panic and sell. And the way you do that is you have to add assets that don't look like stocks and bonds. And then you can't complain when your portfolio doesn't look like the market. Because you did it intentionally. You don't want to engage in resulting, there will be periods when a will underperform like last year, right, because the s&p was the best performer. But in 2022, every one of my alternatives was up some as high as in the 25% range. So that was a year when it didn't work very well. 2008 would have been another, you know, good year. So you have to avoid this and engaging in resulting, and understand why vehicles are in your portfolio in the first place.

Andrew Stotz 37:06
That's a great wrap up. I'm going to just highlight to the listeners and viewers to you know, that your complete guide to factor Based Investing, and also how to reduce the risk of Black Swans are two excellent books. And Larry, I recently bought a Random Walk Down Wall Street because I haven't. I haven't read that since. You know, I originally read it. I'm looking at my original one here, which was

Larry Swedroe 37:30
like the eighth edition or saw its 13th I

Andrew Stotz 37:34
think now it's what it is. But the one I have I bought in 2007. But I I saw excellent reference in there to your complete guide to factor based investing. And I thought that was great. Well, you in there. And then also looking at the one from 2007. He's made some reference to your book, rational investing in irrational time. So that's pretty cool. So I'm really

Larry Swedroe 37:58
proud because Burton Malkiel certainly is one of the giants. And he has written the foreword to several of my books and has written blurbs recommending many of my books, so doesn't get much better than that. Yeah,

Andrew Stotz 38:13
That's the all star list. So that's cool. And I'll have links to those in the show notes. And, Larry, I want to thank you again for another great discussion. Thinking about how we're creating, growing and most importantly, today, we learned a lot about protecting our wealth. And for those out there who want to keep up with Larry, which is not easy to keep up with Larry because he's producing Larry, you can meet him. You can see him at Twitter at Larry swedroe. And also on LinkedIn. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.