Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans

Andrew Stotz 00:03
Andrew, hello, risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was head of Research at Buckingham wealth partners. You can learn more about his story on episode 645, Larry stands out because he bridges both the academic research world and practical investing world. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And that chapter is chapter 18, Black Swans and fat tails. Larry, take it away. Yeah,

Larry Swedroe 00:36
the term Black Swans was a very common expression in the 1500s because nobody thought there was anything other than white swan. So a black swan was thought to be an impossible event, until 1697 when people were exploring the world. Eventually, they went into Australia, found that there is such a thing as a Black Swan, and then it became known more as something that's highly unlikely, right? And that term became popularized in finance in 2001 when Nicholas Taylor published his book called black swans. And the point of his book was to show that stock returns really have big fat tails. Their distribution of returns are not normally distributed, and fat tails means that unlikely, what people think are unlikely events are really much more likely than people think likely, meaning what might be in a normal distribution, but a a distribution with what's called crypto excess kurtosis, it's going to have big fat tails, and that means the probability of that unlikely event is probably higher than you think. And the academic research on this has been very clear. It's been known for a long time. I think it was in the 60s. Ken gene Fauci wrote a paper showing that, you know, stock returns were not normally distributed. And if anyone doubted that, just think, in the last 24 years, we've had three big quote, Black Swans, things that you would think might happen once a century, maybe. And we've had three, right, the events of 911, 2008 the great financial crisis, and, of course, COVID, right? So we've had three of them, and there's been some good research. I think we've talked about some of this before, but a good example of this is that if you take stock returns, and if you in the last 100 years, you cut out the best one month a year, not each year the best month, but just take out 100 months that were the best returns, right? That's clearly a fat tail that's 1% of the distribution. You would think you wouldn't lose all that much of the returns. But the fact is, you lose 100% of the returns. So that's the good fat tails. And of course, similarly, if you avoid the worst months, then you know your returns become spectacular, and the evidence is very clear that trying to time the market because these are unpredictable events, is the wrong strategy. So the fact that you have fat tails in the data doesn't mean you should try to time the market or engage in active management strategy, because we know the evidence says that doesn't work. What it does mean, very simply put, is your investment strategy, your investment policy, your asset allocation decisions must take into account that these fat tails exist, that there is the risk of extremely large losses. They're unpredictable, and therefore you shouldn't take more risk than you have the ability, willingness and need to take. So just summarize the way to think about it is we know that say typhoons and hurricanes are rare events. They may happen twice a year in some particular location, maybe so the other 99% of plus of the time you're safe, but you don't build a ship to avoid just safe in those. 99% of the time it's got to be able to withstand it. The same thing is true of a home. If you're in a hurricane prone area, you've got to build the home to withstand that. So you are aware of that. Well, the same principle should apply to investors. That does to home builders and ship builders, and you have to have a plan that can withstand those fat tails, because we know they exist.

Andrew Stotz 05:25
You know, I did some work on the Thai market, and I know he also talked about international markets, this Javier Estrada in this research. And he's actually quite prolific. I'm just looking at his research. A

Larry Swedroe 05:40
lot of his papers, very good stuff. Yeah. Sequence taking this, which applies greatly to the sequence risk, because if that Black Swan hits like in the year or so that you retire, your whole portfolio can blow up, even if he gets good returns over the rest of your life, because you're withdrawing and you can't recover, even if the markets do, because you've taken that money out.

Andrew Stotz 06:05
Yeah, and that's his paper called sequence risk. Is it really? Is it really a big deal? Which you put out in 2021 I think is what you're referring to? Yeah, yeah. Now I have a counter argument here, Larry, which you tend to help me, you know, get my thinking right.

Larry Swedroe 06:24
Let's see if we can do that this time. Let's see. So

Andrew Stotz 06:27
I also did this type of study, and I found, and I don't know if he talked about it in that paper, but what I found, too, in addition, was that best days often followed worst days,

Larry Swedroe 06:40
sure, and that makes common sense, doesn't it correct? Because the worst periods what happens? We know that stock prices are much more volatile than corporate earnings, yep. And therefore stock prices often crash because of two things. One, earnings will fall, but then the risk premium investors demand go way up, and it's the risk premium that determines the expected return. So that is why Warren Buffett tells people don't try to time the market. But if you can't resist, what you should do is buy when everyone else is panic selling and sell when everyone else is being exuberant. Yeah. So what should they know?

Andrew Stotz 07:28
So let's take this. He noted that the maximum daily return maximum was 15% up and the minimum was 20 basically 23% down. Yeah,

Larry Swedroe 07:39
that was Black Monday, uh, October of 87

Andrew Stotz 07:43
so, okay, you just put 100 into the market, and it just went down to become 77 let's say, and then the next day it, let's say it doesn't rise back to 100 No,

Larry Swedroe 07:58
it didn't go up. And market kept going down for a bit more. It took two years to get back, I think, to recover the full loss.

Andrew Stotz 08:07
So there's two things that we can think about here. One is, okay, the black swan event that leads to a decline in the market. Well, now it's just you're in a decline in the market. It's not necessarily that, oh my god, there's this black swan event. It's just an awful decline in the market that started with a big loss. But what I saw most of the time was that those bad days, let's say that's the worst day, but let's say many, many bad days are followed with a bounce back. So maybe you learn you go from 100 to 80 and then you're back up to 92 or 95

Larry Swedroe 08:45
and sometimes it goes down again right after that's called the dead cat bounce. Yeah, again,

Andrew Stotz 08:51
again. If you're in a down market and just going down and down, you're being exposed to a down market. And it just happens to have some violent days during it. But most of these worst days that I did, what I saw when I did this research a while ago, was were followed by bounce backs. And therefore, in those cases, does it even matter? You're a long term investor, you went from 100 you went down to 80. Now you're back up at 95 and things continue on. I'm not talking about a case where that was just a sign that, okay, we're going into a down cycle. That's a whole different thing. But when we just think about these black swans, does it really matter to a long term investor? Yeah,

Larry Swedroe 09:33
it certainly does. Because first of all, you don't know that it's going to come back. There's no guarantee. Think about the many rallies we've had in Japan, and it's still 34 years later, a zero return. Now, obviously you did

Andrew Stotz 09:50
that's on top. That's a down cycle,

Larry Swedroe 09:52
but you Yeah, but you don't know that when it's happening right? When two thought, when we had the.com bubble burst and. Then you had 911, there was no guarantee the US would come back. 2008 you know, the US went into a recession, and two months after, or three months after the market bottom in March of Oh, nine. So what do you knew then? Yeah, right. So that's the problem. You don't so here's the let me just finish this. Yeah, try to answer you you don't know, and because you don't know, there are two strategies you have to employ. One, don't take more risks than you can stomach, and you have to be prepared to rebalance the portfolio to take advantage of those drops and buy more when things are down, and so you can't panic and sell, or you don't get that back. So it matters. You may think you're a long term investor, but if your stomach screams, get me out, because emotionally, you can't handle it. Or maybe, like in Oh, eight, there was a economic crisis, and now you get laid off from your job, and you have to sell because you have to put food on the table and make your mortgage payment. So even though you're 28 years old, you thought you had a long horizon, that black swan showed up, and maybe you shouldn't have been taking that much risk, because your economic cycle risk was correlated with your human capital risk. So investor behavior, psychology matter, and then the sequence risk matters. I would argue anyone who's 65 in normal health is a long term investor, because if you're a 65 year old couple in normal health, the second to die life expectancy is 25 years. Now you've got sequence risk to deal with, so the other part of the strategy should be, not only don't take more risk than you can stomach or need to take, but then you should what I call hyper diversified, so you don't have all your risk in economically risky assets like the stock market, so you can have a more balanced portfolio owning things like just for example, reinsurance, which has no correlation to stocks and bonds, because so that helps you stay the course, because your whole portfolio isn't collapsing, long, short portfolios, trend following strategies or other examples. Trend following in particular, tends to underperform most of the time, because most of the time the market's going up and it lags. But when you get an extended bear market, it gets short and stays short, so it can help you. So that's the other lesson, not only don't take more risks than your stomach will let you take, but also diversify and not concentrate your entire portfolio, and that can even include what people think are safe bonds, because you could have the stock market crash at the same time, interest rates are going through the roof. Just think of what happened to the people. Say, in Greece, in 2010 11, when they had that crisis, interest went through the roof. Their stocks crashed. Not good.

Andrew Stotz 13:18
I still don't get it. Let me, let me go through my thinking, and then I want to hear your feedback to help me improve. So first of all, I agree with the diversification concept that you talked about, and you've talked about alternatives and like so let's just say that that that I simulate through a Monte Carlo simulation or any other way, and I adjust my, my my diversification, so that it, it does lower my return a little bit, but it reduces my, my drawdowns and my downside. And I'm happy with that. So I'm sitting on, let's say, let's say, in my case, 10% what would be considered maybe counter cyclical or low correlation assets in my portfolio, that's 90% tied to equity. Let's say I'm a 30 year old and you know, so I've chopped off a portion of my downside, and I've sacrificed a little bit of my upside, but I'm okay with that. That's the balance that I want to set for the long term. So now a one of these worst days comes, and let's say that there's two potential outcomes here. One is, it's a worst day that was like the flash crash and it bounces back, which is, I would argue, is probably 70% maybe. But then the second option is that, okay? It's the sign we're going into a down cycle. And who knows how long that could last. It could last 30 years. It could last three years. So what? What should I. Do on that day when the market goes down 15% let's say, or let's just say, the market goes down 10% My thinking is, do nothing. I've set my portfolio. I've set my strategy.

Larry Swedroe 15:11
If you set your strategy right, that means you anticipated that those days would happen and you should do nothing. The question is, did you set your strategy right? Did you take into account the intellectual capital? If you were a construction worker, I would say you should never be 90% equities, because there's a you get in a 2008 or an other serious recessions, like in 73 four or in the 80s, we, you know, early 80s, we had a similar one, when the Fed drove interest rates up to 20% those kind of things kill certain industries. So if you're going to get laid off, you may think you got 20 but you may be forced to sell because you can't put food on the table otherwise. So I agree with you completely, if you have taken those things into account and built a portfolio that can withstand the black swans and your stomach won't force you to sell, psychologically or economic events won't force you to sell, either. That's the key, I agree completely. And in fact, what I tend to do is sin a little so I'm going to be a little more aggressive than yours. Your point, which is, after big crashes, I know expected returns are much higher, because all risk assets have what are called self healing mechanisms. When you get a down market, it's not only because earnings are down and they may not even be down at all, like in the flash crash. It's because PE ratios also collapse, and that means the discount rate at which earnings are discounted has gone way up, so my expected return has to be much higher. So where I maybe was 50% equities, just to pick a number and I was comfortable I was able to take and willing to take, say, 60% equities, but I didn't need it, because I only needed a lower return to meet my goal. So I decided on 50. But now the expected returns are so much higher, I might be willing to say, gee, if I could live with the 60 still now I might decide so typically, after severe crashes in returns over long periods. So for reinsurance, for example, went through three really bad years from 18 to 20 the expected return went from about 8% up to 33% 70% of the money left the asset class, and in particular, fund I was in, and I doubled down because I could take that risk, and now the expected return was much higher, so I was willing to put in because the risk had actually gone down, because the deductibles had gone down, the underwriting standards had gone up, so I had a much higher expected return with much less risk. So I said, Okay, now I'm willing to add a little bit more, because valuations matter. You should, all else equal, be willing to take more equity risk when the equity risk premium is larger.

Andrew Stotz 18:40
So let's go back to this guy that's suitable. A 9010 ratio is suitable for him, and he's 30 years old, and then he lives stable

Larry Swedroe 18:51
job. Yep, right. He's an accountant for a big firm, and he almost certainly, he's, in fact, a son in law of the managing partner, and he's not getting fired,

Andrew Stotz 19:03
yep. So it's suitable. Then all of a sudden he reads, you know, Black Swan, or he, you know, goes through, and he gets scared. And then an advisor tells him, you need to prepare for black swans. You know, they're going to happen and you can't. There's nothing you can do about it. They're going to happen. And you know, even in your conclusion, you said, don't take more risks than the ability, willingness or need to take, and never treat the unlikely as impossible or likely as certain. He reads that, he listens and thinks, yeah, I need to prepare for black swans. So how does he do it? He increases that ratio from 10% of, let's say, uncorrelated assets, and he says, I'm going to hold a certain amount of cash. I'm going to hold a certain amount of things that just don't move, or if I can find anything that's counter, I'm going to buy that, and I'm going to be 60% Equity now and 40% other things that are tied to other cycles, and now I've protected myself from when the black swan event and the market goes down by 10% in a day, I'm only going to go down by 7% or 6% or 5% so he has protected himself against these black swan events, but he also likely has reduced his long his terminal value and his long term return certainly

Larry Swedroe 20:26
had. So his mistake was not expecting the black swans in the first place, because so he underestimated his stomach acid test, and he failed it, and he was going to panic and sell everything, but the advisor hopefully convinced them. You know, let's just lower your equity. It's better than panic selling, because you'll never know when to get back in. There is never a clear sign that says it's safe to invest in the stock market.

Andrew Stotz 20:56
So is it correct to say that the main thing we're, we're we're working around, is whether this person is going to panic sell their whole equity portion of their portfolio on a terrible day. That's what

Larry Swedroe 21:14
are some significant portion of it. And here's the thing, no investment advisor should ever allow an investor to invest just because they took some risk tolerance questionnaire? My opinion, they're garbage. They don't tell much of anything. What you have to do is show them real life history and say, Okay, it's January 119, 73 and you have a million bucks, and we put it in the market, and two years later, your million dollars is now 500,000 and I tell you, we need to rebalance and buy more equities. Would you do it? And if the answer is no, then you're taking too much risk.

Andrew Stotz 22:03
Yeah, I have a strong opinion about those risk surveys and having worked in different banks, and that is, they work very well at reducing risk. Larry, yeah, it's just the risk of the institution, not the Exactly.

Larry Swedroe 22:20
Yeah, they're required now, under SEC rules, you're required to give them some form. It's a scam. Yeah, and we know they don't work. It's, it's

Andrew Stotz 22:33
the exact, it's, it's captured banks, captured regulators working with big banks. You know, it's just a that's a whole nother story. Yeah, you it's

Larry Swedroe 22:43
really the advisor's job is to show financial history, show what happens in the worst case scenarios when you're running Monte Carlo, show them the worst case scenarios, which include fat tails. Okay, when we ran Monte Carlos at Buckingham in 2008 it included what happened. It was in the bottom 5% so all our clients knew that that could happen, or it could have even been worse. You know now that doesn't mean 100% of them told us the truth and said they could stay the cost, but a very, very high percentage did, and if you found out that they were guilty of maybe the most common human mistake which we discussed, which is people are just overconfident of all their skills, not just the ability to take investment risk. Well,

Andrew Stotz 23:35
a good advisor understands that, and then they also make an adjustment for the answers that that clients make to adjust for the common behavioral mistakes that you know. So, yeah, sounds like you took care of a lot of clients and helped them reduce their risk in a proper way that didn't really destroy their long term returns.

Larry Swedroe 23:56
Well, the biggest thing that I think that helped people is I drew for every client I spoke with a curve called the utility of wealth curve. So you might hold up a little graph there, Andrew, that shows, you know, the axes like this, and a curve that looks like this, right? If you could show something to the audience, we can, yeah, hold on. Do that? Describe that for them, what it shows is that more wealth is always better than less, right? We always are happy to have more wealth, but your margin utility of wealth is a steep curve up and then flattens out like it's sort of, you're looking at the back of an elephant, right? And that's what it looks at. So let's take that point where it goes flat. Andrew, yeah, and let's put say, just to pick a number, 5 million. Yeah. I think if most people think that at 5 million bucks, and we're going. To withdraw general rule 65 is a 4% so you could get 400,000 a year, sorry, 200,000 a year on 5 million, and you're getting maybe 50,000 a year in the US and Social Security, some number like that, got a quarter million bucks. You can't be happy living on a quarter million bucks, I suggest something's wrong, right? So you have no need to take more risk. Now, what this is showing is the utility of wealth. It never goes flat line. This should always go slightly up, made an absolutely straight line. It should be a decline, yeah, more like that. That's and so what this shows is, when you have start out with very little and the next dollar, you know, if you take an extreme case of a homeless person, you give them 100 bucks, you greatly improve their life. Spend the night in a decent shelter, put a cup, get them a couple of meals, 100 bucks to the $5 million investor, means nothing. It's not going to change anything. So the first million is worth far more on utility than the second. The second is worth far less than the first, the third, etc, by the time you're at in this example, 5 million more is good, but it doesn't change your life in any meaningful way, right? And therefore you have no need to take risks. So you should be dampening your equity exposures and exposure to other risks. Generally, I tell people your job is to figure out separating needs from wants, nice to haves. Make sure all your needs are covered. Make sure, if you got the money, some of your wants are covered. You don't want to die with millions of bucks you didn't get to enjoy, you know, the things you wanted. But once you have those things that really make you happy, like, Hey, I'd like to take two trips around, you know, go somewhere in the world every year, on a nice tour, like I do with a company called tau, right? So if I had to cut back to one, it's not the end of the world. And if I took four, I wouldn't make me twice as happy. I'd be happier, but not that much more. So once you reach that point, you might say, and I tell people, you probably shouldn't take unless you have other objectives, like leaving it's important to you to leave a large sum of money to charity or your children, whatever. Unless that's a high priority, you probably shouldn't have one less than 20% equity. And the reason is there are periods when stocks do well and other assets do poorly, especially bonds, and there are but you probably don't need to have more than, say, 30% because you've got enough. And there are other assets you could include in a portfolio that will allow you to safely withdraw that 4% so that's the key. A lot of people have told me, Larry you and greatly improve the quality of my life. Because when all the bear markets in oh one starting 2000 oh two happen in 2008 and 2020 when they happen, we were able to sleep well through it. We never panicked, where lots of our friends had difficulty. Some of them had to work much longer than they expected. Some of them lost a large part of their wealth and then panicked and sold and then never got back in because they're afraid of loss. So it was the fact that they were able to enjoy their life safely and achieve their goals that really changed things for them.

Andrew Stotz 28:51
Well, lots of great advice there. And once you realize what your number is like. In this case, you said 5 million as an example, then it also helps you think, Well, how do I get there? You know, how do I get there safely and quickly? And one of the things that I like to do is separate the concept of creating wealth and growing well. And for most people, they're creating wealth every single month through the difference between their salary and what their, you know, their expenses. And business owners create wealth by generating profit every month. And ultimately, the question is, you know, how can I crank up my wealth creation machine so that my contributions get me to that 5 million faster? Because if you go into the stock market thinking that's where I'm going to create my wealth, you're really in for trouble.

Larry Swedroe 29:40
It certainly could be. You may get lucky, like if you start out in the US in 1980 and you got a 20 year horizon, you live through the best period ever the stocks, like 19% per annum, right. On the other hand, if it was 1990 in Japan, you got 34 years and no returns and no. Buddy knows which one of those things will happen in the US over the next 20 years.

Andrew Stotz 30:04
Yeah, it happened with my mom. And in this case, when my father passed away about eight years ago, almost nine my I brought my mom to Thailand, and, you know, I looked at her portfolio and we talked about it, my sister is taking care of it in the US. And we have an advisor there who's been taking care of my parents for a long time. And basically, we stayed aggressive with that portfolio. We didn't move to the point where we had to go, you know, to a really low equity allocation, because my sister and I also are in pretty good condition to support her in case something was to happen and she had the ability to take more risk, yeah, and so we saw it more as a family wealth, rather than mom's individual wealth. To to you know that we had the risk

Larry Swedroe 30:51
part of Thailand, which cut our living expenses right down, I'm sure. Yeah. Now

Andrew Stotz 30:55
what we the bet that we had to make, too, was that we couldn't get reimbursement for medical Yeah, so we had the

Larry Swedroe 31:02
medical care is a lot cheaper, I'll bet, in Thailand, than it is in the US.

Andrew Stotz 31:06
It's incredible. I mean, us is the most expensive in the world, and it's out of control. In the US here, it's not expensive to pay cash. And also, you know, we had to make some assumptions. You know that hopefully, well, I think in mom, mom's case, we had a discussion that was that we're not going to prolong life. That's not what she wants in her health care directive, anyway, so we made that decision. Well, it just so happens that the stock market did pretty well over the last eight years, and so even though we draw drew down a lot to cover the expenses over eight years, we still are in pretty good shape, so it just the luck of the draw. A lot of times.

Larry Swedroe 31:44
That's the one thing I'd caution careful. First of all, it sounds like based on what you told me, You did all the right things, the strategy was right because you thought through all these issues about ability, willingness and need to take risks, took into account these factors about medical care and other things, but the outcome didn't have to be that way. What if the market had crashed right after those eight years? So you don't want to make the mistake we call engaging and resulting, which is judging the quality of decision by the outcome. My opinion your decision was exactly the right one, and you put the odds in your favor and the left tail didn't show up. The odds are it won't, but it can, and does happen. It's why we buy insurance, by the way, knowing the odds are against us making money on that bet.

Andrew Stotz 32:41
Yeah. Yeah. Well, with with insurance, we would be even more comfortable getting aggressive with one portion of the

Larry Swedroe 32:46
Yeah, exactly, exactly, right.

Andrew Stotz 32:49
Well, what a great discussion. Larry. I appreciate it, and some great stuff on on Black Swans and how to think about it. And I think you clarified a lot of things in that chapter, so I want to thank you for that. And the next chapter is, oh, my God, I has, you know, I, I'm supposed to go out and give a presentation on Friday on this so, but for ladies and gentlemen to hear it, we'll, we'll talk about this one. Next chapter, 19, is gold a safe haven asset? Hmm, well, you're going to be interested in the answer that Larry comes up with. So for listeners out there, we want to keep up with all that Larry's doing. Follow him on Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz, sane, I'll see you on the upside. You.