Enrich Your Future 31: Risk vs. Uncertainty: The Investor’s Blind Spot

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we're talking about Chapter 31 the uncertainty of investing. Larry, take it away.

Larry Swedroe 00:34
Yeah, thanks. Good to see you again. Andrew, so this is a very interesting topic. It was an economist named Frank Knight, who really kind of brought this to clarity. I think this issue. So Knight tried to describe the difference between risk and uncertainty. And he describes risk as something where you can either know the odds say exactly, like when you throw the dice, or if you're playing at a casino and you're able to count cards, you know, what are the odds of you getting, you know, or going bust, if you're playing 21 or drawing to that inside straight, if you're playing poker, and you know exactly what the odds are. There are other cases where you don't know the odds exactly, but there's a good science in the data that enables you to estimate them with at least a fairly high degree of certainty, like life insurance companies use actuarial tables now they can't be certain of the likelihood of a 65 year old couple that What's the odds of the second to die by the age of 90? But they can make good estimates based upon the available data. And you know now decades of data on the subject, they don't know exactly, because there could be a pandemic which causes lots of people to die early, how could that possibly happen? Or there could be scientific breakthroughs which would be good for them, which causes people to be allowed to live a lot longer, right? But they can make estimates that are fairly accurate. Same thing in the insurance business. Insurance companies, for example, can estimate the odds of a major hurricane hitting, say, Miami Beach, based on now 100 years of data, but they can't know exactly in any one year what the odds are. And the climate is changing, and it's hard to maybe make you know certainty so, but they can make good enough estimates that they believe they can price the risks with some high degree of confidence. Okay, uncertainty is when you have no clue what the odds are okay. So the problem is, most investors tend to think of investing as much more like risk. They look at 100 years of data and they say that there's no period in the US anyway, where you had negative real returns for more than 17 years, there's about a 30% chance of a negative period in any one year. We get a severe bear market about once a decade, and we've only had one great bear market, the Great Depression, where stocks dropped like 90% okay, but the problem is, there's no way to estimate that what the future will look like with that high degree of confidence, because we don't know in 73, four, nobody predicted an oil embargo. For example, we don't know in 2001 the events of 911, or 2008 the great financial crisis that happened. Or in 2020, right, we had COVID striking all World Wars, which wiped out equity markets in several major developed countries around the world. Or, if you were an investor in Russia, which was one of the largest stock markets at the turn of the 20th century, you got wiped out 17 years later. And Egypt was the fifth largest stock market in the world in 1900 and they got wiped out, never to get returns. So investors, when things are especially going well, like in the 80s and 90s, or in the last period since 2008 especially few US investors, they tend to think about investing more. Along the lines of risk, and they tend to forget that there's a lot of uncertainty. And that's a problem because investing is always about uncertainty. You have to recognize that we cannot rely on historical data to tell us that much about the future, and you certainly can't use historical returns to project the future, because today's valuations typically, certainly in the US, are much higher than they were in the past. So you shouldn't extrapolate that. So the right way to think about this as an investor is just like an insurance company. So any smart insurance company would say, Well, I can estimate the odds of major hurricane occurring in Broward County, county in Florida, but I don't want to have 100% of my portfolio betting on that risk not showing up, right? And you can't price it enough as if you know that worst event. Maybe you get three major class, five hurricanes in one year happening, even though it never happened before, right? So what do you do? You diversify that risk, and you don't put all your eggs in that one basket. You have hurricane risks all around the world, the wind risk. You add earthquake risk and event risk, cybersecurity risks, all kinds of other risks, fire insurance, etc. And so you diversify that portfolio to protect against that uncertainty, because we don't know exactly, and investors should really think about it the same way. There's always uncertainty. There's always the risk of that fat left tail showing up, especially if you're subject to sequence risk because you're in retirement or near retirement, and you don't have time for it necessary to recover, because you're withdrawing from that portfolio before the market gets to recover. So that's really the lesson. You really have to think, just like that insurance company, diversify your bets, if you will, and don't be over confident thinking that you know what the odds of some event like Nvidia stock price collapsing, because that has happened to many other companies that were the Nvidias of their day. For example, I could think, as I'm sure you can, there was once a company that dominated the cell phone industry, and Apple took care of them, and somebody may come along and take care of apple one day. We don't know. So that's really the story. Think, make sure you don't think about investing as so much along the lines of risk, but add that degree of uncertainty in your estimates. Be very humble about estimates, and that's why we've talked about this before. I'm a big believer in running Monte Carlo simulations based upon your best estimates of future returns, but we know you reason you run the Monte Carlo and not assume one return number is there is potentially very wide dispersion of outcomes. There may be only a 5% chance that that bad left tail risk occurs like occurred in 2008 but your portfolio, I'd better be able to withstand that when I was in charge of the investment strategy at Buckingham, when 2008 occurred, that occurred in 5% the bottom 5% of all our Monte Carlo simulations. So our clients should have been prepared, and not that they expected it to happen, but they knew it could happen, and their portfolios should have been able to withstand that shock.

Andrew Stotz 09:06
So Larry, I have just made up a famous quote, and I know it's famous with a certain amount of certainty, and that is so before I go to my famous New quote I have just made up. I'm going to just review what you've talked about. So you've talked about risk and risk being known outcomes, known probabilities. I like to think of them as, you know, various outcomes. And you've talked about uncertainty being unknown outcomes, or unknown probability, which we could call them surprises, maybe as an example, right? And you could say, I can't measure it, and maybe nobody can that type of thing. Now let's take an example of a pandemic as an example for someone who knows nothing about virology. You. That a pandemic may seem, you know, impossible to happen, and they may not even think about it. So for them, it would be an uncertainty. But for a virologist, they spend their whole life studying how pandemic spread. They studied every pandemic and how it went. How did it originate, how did it and they understand the decays and the accelerations and all that. So for them, it's really a risk. But for the other person, it could be an uncertainty because they just don't know. Now agree

Larry Swedroe 10:31
with that. Anne, okay, the reason is they can only make maybe even a highly uncertain estimate of the odds of an Ebola event that strikes the world and we can't come up with the cure quick enough before it kills 30% of the population. Okay? There's no way any virologist can put odds on it the way a life insurance company could put the odds on Andrew living to age 90. Okay,

Andrew Stotz 11:01
so let's, let's look at another event. Let's say an enormous eruption of a volcano, right? And I think we had one in Tonga. I believe we had a huge eruption where it can even slow down economic growth. It, you know, throws ashes in the air and all that. Now, for some people, for them, it's completely unknown. They didn't have anything. Whereas there are other people that are geologists, that are tracking movements in the earth, and they have some sort of deeper knowledge on the topic. And for them, they believe it's a risk rather than an uncertainty. But for the other What do you think about that. So

Larry Swedroe 11:41
the way I would answer that is the the earthquake scientists can say something like, there's a one in 10 chance in the next 100 years there'll be an earthquake, but they can't tell you really whether it's going to happen next year, the year after, or whatever, and that's really even their estimate is highly uncertain. Unless we've got they might be able to tell you, after they experience some minor quakes, that the odds of a big quake coming in the next month or year might go way up, because now they have more information, right? This, there's really, I think the best way to think about it is thinking about it when you know the odds exactly like a roll of a dice,

Andrew Stotz 12:33
right? You are ruining my quote. Larry, I thought I was really smart. Here's

Larry Swedroe 12:37
a way to think about it. Maybe that. Maybe this is helpful. I forgot which US Defense Secretary said this. I believe

Andrew Stotz 12:46
Rumsfeld probably about unknowns that

Larry Swedroe 12:49
we know. There are no knowns, unknown unknowns that we can figure out. What you know? We know that Russia could launch a nuclear weapon or North Korea. We nobody knows what the odds of that happening are, but we know that's a risk. Then we have the unknown, unknowns that you can't predict, that some crazy person gets a whole some virus and then goes and pollutes the water supply in New York City and kills 8 million people. There's no way anyone can tell you what those are, right? So that's the thing about investing. There's always the unknown, unknown that can show up. Nasi Nicholas Taleb, you know, famous author, you know, he wrote his book on Black Swans, and he tells the story in 2000 he was, you know, he was working for a big hedge fund, and he was charged with thinking about what things might happen and tail risk. And he writes in his first book, just he happened to say what would happen if a plane crashed into, you know, New York office towers? Well, he thought of it, right. But how many people were hedging that bet in some way? Probably no.

Andrew Stotz 14:14
And one of the things that I wanted to understand about this, let's say we know that these unknown outcomes, can be catastrophic. Yeah. So for instance, Nicholas Taleb, as an example, has I believe, a fund that's like a catastrophic risk fund, where you're paying every year, but then you get a big payoff when that catastrophe happens. Does this uncertainty mean that we should reduce our long term return by a certain amount to protect ourselves against this catastrophic loss?

Larry Swedroe 14:56
I don't think that's necessarily the case. Uh. Directionally, certainly you want to hold some assets that can perform well in those environments, but you can also add assets that have no economic cycle risk. For example, reinsurance has no economic cycle risk if you're investing in litigation, finance or drug royalties, there's no economic cycle risk. You can invest in Long, short factor strategies totally uncorrelated with the returns to stocks and bonds. So there are some strategies that enable you to reduce the risk of the portfolio, because they're not as correlated with the economic cycle risk that we're worried about, right, or hyperinflation, so don't you can own floating rate credits, and today, the private credit fund that I'm investing in, which has historically had less than 1% defaults and 70% recovery rates, and it's yielding 10% today, net. That's more than I think everyone pretty much expects from us. Stock returns going forward, if you look at capital market assumptions that Vanguard or JP Morgan and lots of other people publish, so you don't necessarily have to reduce your expected returns. You might have to take on different risks. In that case, you're taking on illiquidity risk, investing in reinsurance, and takes on different risks, but it's uncorrelated to the risk of Sox, because if we get a pandemic and lots of people die, it doesn't affect the odds of a hurricane or an earthquake occurring. So that's the way. I think investors are best served by understanding that we have these uncertain events and we need to protect that left tail risk. And the way to do that is to diversify your portfolio away from the fact that the typical, and we've talked about this before, the typical 6040, portfolio for us, investor has about 90% of the risk, not 60% of the risk in equities, because equities are much riskier than the state for bonds that people hold. So I'm a big believer in I use the term hyper diversification. You can think of other people have used the words like all weather portfolios that include things like gold and treasuries, you know that tend to perform well in some bear markets, etc, and adding then things like reinsurance and other things like it requires you to look different than the average investor. And don't care what the market's doing, meaning the S, p5, 100, because that's not your objective. You don't want to look like that, because, in my opinion, that takes on way too much systematic risk that you can diversify with.

Andrew Stotz 18:09
So my, my, my, my cute little saying was for a fool, risk may appear as uncertainty.

Larry Swedroe 18:22
Yeah, I don't know. I'm trying to figure out if I can make that work, but yeah, I think my way to think about this is investing always is about uncertainty. It's much less about risk. We can measure risk by looking at things like standard deviations and what's called skewness, or ketosis, the fat tails and how big they are, the distribution of returns, we can look at things like illiquidity and assign some prices to those things, but there's still uncertainty about what the future looks like in terms of events. Nobody knows if Kim Il Young is going to set off a nuclear weapon and start a nuclear war, or if Vladimir Putin will do it right, or the, you know, Iran gets a nuclear weapon. We just don't know,

Andrew Stotz 19:17
um, before we log off. I just wanted to ask a question on another topic. Just to get some perspective, I was reading a research paper recently where they were showing that the out performance that somebody was saying was coming from an ESG portfolio was actually confounded by the fact that once you break it down into profitability and some other factor, I can't remember large, you know, the large, whatever, it didn't really make sense large, because that means there's a premium for small stocks. I've been

Larry Swedroe 19:54
because they were invested in large, profitable companies. And. In that period that you're looking at large has outperformed for the last decade or more. So if they're claiming outperformance in that because of ESG, okay, it may what you have to look at is the factors and say, let's forget ESG. Isolate the factors and then see if the ESG tilt added. Now, what I would say about this, you could get a confounding factor, and this is exactly what happened in the earlier part of the big move to ESG, which occurred around the Paris Accords in 2015 before 2015 there was a trickle of money coming into ESG, sort of like indexing in the 70s and 80s. Okay, and I wrote about this in my book I co authored with Sam Adams. I think it's the best research book on ESG, called your complete guide to, or your essential guide to sustainable investing. And we showed this so all the ESG funds from 2015 to about 2020, were benefiting from massive cash flows into ESG was going from, you know, call it 10, 10 million a month to 5 billion a month. And so that was driving up the valuations of companies. Call them green relative to the brown stocks, or the sin stocks, okay, so you could look at that and say, well, they outperformed, but it was driving up the valuations, which means, what for future expected returns lower right? And that's basically what's happened in the last few years, as those higher returns, higher valuations have led to because the cash flows have stopped, because people, all the research shows fine, if you're willing to sacrifice returns to express your values, go ahead and do it, but the logic is clear. If you invest in ESG, you should expect lower returns for very simple reason, because if people express a preference for owning green stocks and avoiding or boycotting, say, oil companies, you don't change the oil company earnings by divesting of their stocks, you just drive their price down, and That means their future expected returns are higher what most people I'd be willing to bet. Of your listeners don't know, the highest returning asset classes have not been either healthcare or technology. It's been tobacco, alcohol and gambling, all the sin stocks because many people avoid them, and so you get a sin premium that's been known for a long time. There's even been sin funds that have been created. So I'm not saying there's anything wrong if you want to express your values and investing in ESG funds, go ahead, but you should expect low returns. In my opinion, you're better off investing for high returns and and donating those higher expected returns to some ESG cause you believe in, and then you'll get a direct impact there.

Andrew Stotz 23:32
Yeah, in fact, the outcome of this research said we find that the materiality portfolio does not generate alpha after we account for its exposure to profitability and growth factors. So there you go. It's the confounding factors so interesting. Yeah,

Larry Swedroe 23:47
my book cited probably a dozen papers on this subject, all of which came to the same conclusions that the dominant issue is twofold. One, preferences lead to higher valuations and lower expected returns, and to the other factors are what explain those all else equal returns? That's

Andrew Stotz 24:12
your essential guide to sustainable investing, how to live your values and achieve your financial goals with ESG Sri in impact investing by Larry, of course, and Samuel Adams, published in 2022 great reviews on that one. And I haven't read it, but I look forward to it. Well,

Larry Swedroe 24:32
probably cites 100 academic papers on the subjects.

Andrew Stotz 24:36
I'm looking forward to that. Now, before we wrap up, I just want to end with a little story. And this is going to be short, but let me just get my little story up here. Larry, one second. Now, there's a great movie that came out many years ago, and it's called Dumb and Dumber, came out in 1994 and it was Jim Carrey, was the one that you know was you. Phenomenal in that movie. Anyways, what's happening is that his character, Lloyd, Christmas is his name, asks Mary Swanson what the chances are of the true of them ending up together. He's in love, and she's not so in love with him. And so he she replies, not good, and he asks, like, one out of 100 and she replies more, like one out of a million. And he gets all excited, and he looks at her, and he says, So you're telling me there's a chance. So there you go. He believes that there's a chance, and she seems to be saying there is no chance. That's

Larry Swedroe 25:53
what investors really should take. That advice when they build portfolios, be very humble and don't think, oh, there's no chance of this left tail showing up. All forecasters know that you really need to be humble. I was one of the first this is a little amusing tale. When I my one of my first jobs was at Citicorp, giving advice to some of the largest companies in the world are managing interest rate risk, foreign exchange risk, etc. And my mentor told me so Larry, if you have to give a forecast, remember, you can give a number, but never a date, or you can give a date but never a number.

Andrew Stotz 26:40
That's that he is the master. There you go. Perfect. Well, I want to thank you for this great discussion. Lots of interesting stuff, including the tidbit about your book, which I didn't even know you had that book. You just books come out of nowhere with you, Larry crazy, you are incredibly productive, and I look forward to the next section. We are now moving into Part Four of the book, the final part, where we're going to go through and wrap up some final sections, and then we're going to talk about, you know, some portfolio structures that you've talked about in the book. So this next section is called playing the winners game in life. And chapter 32 is what we're going to next the $20 bill. Hmm, just sitting there right on the floor. For listeners out there who want to keep up with all Larry's doing, go to x or Twitter, and you can find him at Larry swedro. And also you can find him on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.