Enrich Your Future Conclusion: Larry’s Timeless Guide to Smarter Investing

Andrew Stotz 00:02
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 head of Research at buckinghamwalt 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. And today, we are wrapping up our series on the book, enrich your future, the keys to successful investing. And specifically we're going to talk about how to put some of this in action, how to think about some frameworks. Are you a conservative? Are you aggressive? What types of frameworks you should be looking at, as well as talking about some instruments. Now, none of what we're going to talk about today is investment advice. It's basically for educational purposes to start thinking about these types of things. So I just want you to use this as a foundational way of kind of thinking about the way you're investing. So Larry, take it away.

Larry Swedroe 01:05
So one of the things that investors have to decide is, do they want to invest in a total market fund, which is a perfectly good weight certainly could be a starting point for discussion, because anything that deviates for that says, To at least some degree, maybe I'm smarter than the market, and I can choose which assets are better. That's one way to think about it, and it's a very low cost, very tax efficient way to do it, however.

Andrew Stotz 01:40
And just to talk about that briefly, when you say total market. Now normally, when we're talking in America, a lot of times when we're talking total market, we're talking about the total US market. So there's total market, as in the total US market, and then there's total global market. Maybe we could just talk briefly about those two steps, because let's just say you absolutely don't have any time, you don't have any knowledge, you don't have any interests, you know, all the stuff that we talk about not that interesting. And therefore, you just need the simplest way. Would it be total US market, total global market. How would you think about those

Larry Swedroe 02:14
two I believe that the right way to think about these things is to start with core principles of investing, and I think that there is just a small handful of them. That's the good news. And the first is you should believe, because the academic evidence, as we have discussed, is overwhelming, that the markets, while not perfectly efficient, they're highly efficient, which means it's very, very difficult to outperform on a risk adjusted basis. Okay, it doesn't mean that there aren't inefficiencies. It doesn't mean that some investors won't outperform. It just means that the odds of your identifying those investors or doing it yourself are so poor you shouldn't try. So if you believe that markets are efficient, then the right way to think about that is the market's price is the best estimate we have of the right price, okay? And that means also, if markets are efficient, that all risk assets right should have similar risk adjusted returns, okay, so one, if markets are efficient, we don't want to engage in individual security selection or market timing, okay? And it means that US stocks have to have the same expected return as Thailand stocks or or emerging markets in general, or

Andrew Stotz 03:55
the same risk adjusted return. Risk adjusted Okay, yep. So

Larry Swedroe 03:59
for example, let's keep it simple. We know that junk bonds should have higher returns than AAA rated corporate bonds. That doesn't make them better investments. It makes them higher expected return, because risk and return should be related once you adjust for risk, and that could be the duration risk or credit risk we talk about bonds, then they should be similar. So let's take an example. If Thai stocks, right, had lower expected returns, as many people think, than US stocks, and if markets are efficient, what would happen? People would sell Thai stocks, driving their valuations down doesn't change the earnings of the Thai companies, so it drives their expected return up, and money would then be flowing into US stocks because they think they. Their higher risk adjusted returns and driving us valuations up, which means expected returns are now lower because you didn't change the earnings until we're in an equilibrium,

Andrew Stotz 05:12
which is exactly what's happened the time Thai stock market has devalued de rated over the last, let's say, five years till we're getting very close to book value. Let's say we're at one to 1.5 times price to book. I was just looking at a company. I went to visit a company yesterday, and they're trading at 0.8 times price to book, whereas you see the US is at four and a half five times price to book for the overall market. So that exact thing you're saying is what's happened, just looking at Thailand versus us,

Larry Swedroe 05:43
should happen over time. Now that doesn't mean the market's always right. Obviously, for the last 1617, years, US stocks have outperformed international stocks, but that's now reversing, and there's no evidence that we know of that people can time flows between stocks. So number one is all risk assets. One, the market is efficient. Number two, all risk assets should have similar risk adjusted returns. So you want to avoid active management, etc, but invest in the assets based upon your ability, willingness and need to take risk. If you're willing to take more risk and have the ability and maybe the need to well, then you can load up on more risky, high expected returning assets. It doesn't mean that they're better assets and means that they have higher expected returns, but not when you adjust for risk. Are they any better? Okay? And then the last thing is, if all risk assets have similar risk, adjust the returns. This makes no sense to concentrate all of your risk in one basket, whether it's US stocks or Thai stocks, if you're live in Thailand and you have a home country bias, or even equities in general, and we've talked about maybe investing in other assets, not just international assets from equities, but Things possibly like reinsurance, infrastructure, funds, private credit, things like that, where you have low ex low correlation to assets. Okay, so, so let's get to your question about us versus International, emerging market. I think the only right way to think about this, at least as a starting point should be. Again, markets are efficient. Today, the US is maybe 65% of the global market cap, so therefore that's a good starting point. And then of the remaining piece, there's a ratio of about three to one between developed and emerging so if you had 35% maybe it's 27 and eight, or something like that, between developed and emerging markets, and you could just buy Vanguard, has a total global market fund where you could buy a total US and a total International and then if you decide that you have either the ability, willingness or need to take risk, or if you decide you're smarter than everybody else, and you think you know us, assets are now way too highly valued, I might use the word sin a Little and not own 65% us. Maybe I'll own 60 or 50, but I wouldn't own 10, right? I don't want to get too far away from the global market cap, because I don't think I'm much smarter than anyone else. It's interesting to point out, by the way, in 1989 Japan was something like 60% of global assets, and it was in a bubble, clearly in hindsight, and now the US is way up there, a much bigger percentage than its share of the world economy, and that's because us valuations have gone way up. So if somebody asked me today, what would your preference be? My own answer is, I'm 50% us and 50% because I think US assets may be, in general, too highly valued in the way Japanese stocks work, too highly

Andrew Stotz 09:36
valued. So 50% us, 50% non US.

Larry Swedroe 09:39
But notice I'm not that different from the rest of

Andrew Stotz 09:43
the world, right? So the rest of the world, right now, if we looked at the VT fund by Vanguard, which owns, let's say, about 10,000 stocks, and there's other ones, whether that's fidelity or Schwab or dimensional or others that have these types of other. Passive funds. But let's just take Vanguard for an example. They've got about 10,000 stocks, and their exposure to the US is about 60 to 65%

Larry Swedroe 10:10
right about the world cap, free float some you know, that's the way, typically, most fund managers do it, not the app, but what's called free float money, you know, shares that are available to be trading.

Andrew Stotz 10:24
Yeah. Okay, so now let's just stay on this topic. So right now, I want to look at kind of three types of people. Let's say someone in their 20s, and let's just say they're a typical person in their 20s. They're they're earning some good money, and there's there's they're spending, they're saving, but you know, they got many years ahead. And then you got someone in their 40s, and let's say that there's 20s and 40s. People want to retire when they're 60, let's say and then you've got someone in their 60s, right? So we've got three different general age groups, and we can say risk profiles, if we consider that they're like the average 20 year old, the average 40 year old and the average 60 year old. Should the, let's just take the global market exposure. Should these people only have global market exposure? Or should they say, I want global market equity exposure, and I should have some sort of fixed income or bond exposure?

Larry Swedroe 11:21
Yeah, so number one, one of the worst mistakes that you'll often see even professional advisers make, which anyone who's read my books on financial planning and retirement knows they they're making the mistake of only looking at one factor, and it's only a part of one factor, which I call the ability to take risk. The ability to take risk depends upon two things. One, your investment horizon. Obviously, if you're 65 or 75 you have a shorter horizon than a 25 year old, so you have less ability to take risk and wait out a bear market, and especially if you're retired, you have less ability to take risk because you're subject to this sequence risk that you can't recover from because you've withdrawn the money.

Andrew Stotz 12:17
And just, just to, just to clarify this, I think when you say the ability to take risk, I think what you really mean is the ability to bear

Larry Swedroe 12:24
risk. To bear risk. Well, the same, you know, same exact thing. Yeah. Okay, so that's number one. But there's a second thing that so many people totally ignore, never even ask. So I'll just ask you, Andrew, to give you a chance to show your audience how smart you are. So you've got two groups of investors, okay, and they're both the same age, okay? And everything about them is equal except their job, okay? So you got a group of investors that are auto mechanics, construction workers and stock brokers, and you got another group that are doctors, 10 years professors at university and government employees not subject to those so which group has more ability to take risk? So,

Andrew Stotz 13:25
but first idea that I had was that the first group seems like they're really exposed to the economic cycles, versus the second group is less exposed to economic cycles. Goes up and down, but doctors are going to get paid, yes. So the result of that is that, first of all, when the economy goes bad, a mechanic or that type of person in that type of job that you've described in the first group is going to be terrified that they're going to lose their job, their income could go down. They could lose their job. They have to switch, get a lower job. And so from that perspective, I would say that they've got some real serious exposure to the economic cycle, and therefore less ability to bear risk.

Larry Swedroe 14:03
That's exactly right. And not only that, it could get much worse for them, because the markets crash and they get laid off, and they have to sell stocks to put food on the table, and then eventually, when the markets recover, they can't, because that money has been spent. So that's one part of the equation that you must consider, but that's only one of a three legged stool, and like any stool, all three legs have to be firmly planted, or you could tip over. So we have the ability to take risk. Second thing is what I call the willingness to take risk, or the stomach acid or sleep well, test right? So some people, if the markets crash, can't sleep and life's too short not to enjoy it, and they're going to worry. So. They shouldn't take a lot of equity risk, and some people just will panic and sell, right? So in the first group, they don't panic and sell, but they worry so much they can't enjoy their life. That group should clearly be taking less equity risk, and the other group, and then you have this need to take risk. And so what I talk to people about is something called the utility of wealth curve. So when you're don't have a lot of money, let's say you're homeless and someone gives you $20 I mean, that's enough for maybe get a shower and, you know, a meal at a, you know, and stuff. And that's makes a huge difference in your life. If you have $10 million and there's a $20 bill on the floor, you might not even stop down to pick it up, because it's not going to change your life in any meaningful way. So what the academic research shows is, once you have a sufficient income, assuming you have your health food on the enough money to put food on the table, you're not worried about paying the rent, those kinds of things you're there is no difference in happiness between people who have more or less this done all these studies on places like Easter Island and New York City and, you know, jungles in Africa and Peru being, you know, the small towns and stuff. And they find this is true, that the utility of wealth curve goes like this. More money early can mean a lot, but once you have a lot, then more money, of course, is better than less, but the incremental value becomes much less. So in the US, a study was done about a decade ago, and it found that that level of happiness where it didn't matter, was about 75,000 So today, let's call it 90,000 now, maybe in New York City, it's 200,000 and in Hope, Arkansas at 60. But there's a level. And if once you have enough, right, it's, you know, yeah, it's nicer to play golf around the golf at Pebble Beach than it is maybe a local, municipal golf course, but you still got a beautiful walk in the sun. Maybe you're playing around the golf with your best friends or your wife. You can have a beautiful day and enjoy it. Pebble Beach is nicer, but it really doesn't change the quality of your life very much. To me, I get the greatest joy of walking around the local park here, around a beautiful lake with my wife reading books or playing a game of Monopoly deal with my grandkids like I did this afternoon. That doesn't cost anything, right? And so what I try to teach wealthy people is, once you have enough, and let's say, in the US fairly wealthy. If you can't be happy on, say, 200,000 a year, something is wrong. Okay, well, you know, if you use a 4% withdrawal rate, multiply then by 25 200,000 5 million, why are you sitting with 50, 6070, 80% equities? It doesn't make a lot of sense, okay, so at least as one starting point is I don't need to take risk. And when I tell people, once you're at that level, I can't see a need to own more than 20 or 30% equities. That greatly reduces your tail risk. And you know, if you miss out on a bull market, who cares? You're going to be happy anyway.

Andrew Stotz 18:46
Okay, so let's tie that into the question I asked you, which was your 20s, 40s, 60s. We now you've talked about three factors to consider, the ability to bear risk, the willingness to bear risk, and the need to bear risk or take risk and now we've got a good understanding of that.

Larry Swedroe 19:04
Let me say this. Add this before you ask your question, because all three legs have to be stable. In general, the answer should be whichever is the lowest number. So if you have a big willingness to take risk and a big ability, but no need, I recommend that that should dominate your answer, okay, but there are mitigating circumstances. I think we may have talked about this in a prior podcast, but I had a friend named Philip was a senior executive, top marketing guy at a company I worked at, and he was the epitome of somebody who couldn't stand risk. I mean, he'd go crazy if the market dropped a few percent, which of course, it could do often on a daily basis throughout a month or a year. It. But he was about at the time, about 45 and he hated working in the pressurized world of corporate Corporation. He wanted to quit and become a photographer, and that was his passion. So I said to Philip, and I wrote this story up in the book, okay? And this was in the early 90s. I said to him, Oh, yeah. I said to him, here's your choice. You can have a low equity allocation, sleep well, and you'll have to stay as an executive in this world, and, but you'll make a lot of money and but you're going to have to work another 20 years to get to your number. Or you could take a lot of equity risk, buy a 20 year supply of Maalox and hope we get a bull market, and then maybe you can de risk later and then quit and whatever. Well, this was early 90s, and the next several years, of course, we had spectacular returns, and he benefited from that, because he made the decision that his life priority was more important and he was going to live with the risk. And he then retired and became a photographer. So sometimes you have to, there's not a free lunch there, but if you have a choice, it's the lowest number that should dominate.

Andrew Stotz 21:31
Okay, so let's go then to the person who's in their 60s, and say they, they do. They don't need to have 100% exposure. Let's say to global equity market is the way that they're going to reduce that exposure through fixed income. The primary way of doing that,

Larry Swedroe 21:52
I would say, No, I would say that again, it comes down to diversifying in a world where all risk assets have similar risk adjusted returns, and here it somewhat depends in the US. We're lucky. We are in the last really, only about the last five, maybe 10 years have seen alternative assets come to market with much lower fees than they used to do you wanted to invest in reassurance or private equity or private credit or private real estate, you were typically paying at least 2% annual fees and 20% carry or share of the profits. Today, those numbers that come way down. So 10 years ago, I didn't own any of these alternatives, and now my portfolio is half because I believe in diversifying those assets, of course, as many as I can. So it may depend upon what you have available to you. And since that book was written, there have now been a few others added to the portfolio. I recently made an investment, for example, in an infrastructure fund run by Hamilton lane, which is a huge company advises on something like a trillion dollars of pension plan assets and infrastructure in this fund happens to be what's called the tender offer fund. Their fees are only 1.4% now that's not cheap relative to index funds, but it's a far call from two and 20 and the expected returns today are in the 10 to 12% range, and the volatility is low single digits, so much lower than equities, and there's very little inflation risk, because they typically have long term contracts that things like dams and roads and utilities or Amazon's got a facility that there's a 15 year contract and it's got escalator clauses with triple net leases. So I now own things like a reinsurance fund. I don't have to pay two and 22 for private credit. I'm paying much less than two and 20 something like effectively about 115 so I'm now able to capture that. So it depends on what's available to you. I think we're much luckier in the US than the investors overseas are, where fees are much higher.

Andrew Stotz 24:39
Yeah, that's for sure, and so it's what you're saying. And I just want to try to get this as simple as possible. Is what you're saying is that fixed income should not be the primary way to reduce risk. It

Larry Swedroe 24:53
depends upon what assets you have as alternatives if you have access to go. The relatively lower cost alternatives, I think the typical investor should have an absolute minimum of 15 to 20% alternatives. Then you might have 30 or 40% inequities, not too much, and then the rest, and you could have in, say, fixed income, if you're a little more aggressive and willing to put in the time to get educated, you might have more like 1/3 in equities, 1/3 and also 1/3 in safe bonds. And if you're more like me, you can look more like the Yale's of the world. And maybe you only have 20% in equities, maybe 50% in or 20 to 30% equities, 50% in these alternatives, and then the remainder, and say, fixed income. Now I think you should never own less than 20% equities, because there are periods when stocks or when do well and bonds do poorly, and so you want to have at least that 20 to 30% but make sure you're globally diversified and use low cost vehicles, okay? And so it's just going to depend on your willingness to deal with a lot of the psychological issues, which we've talked about often, this tracking variance and recency bias, which are the fatal enemies of most investors.

Andrew Stotz 26:27
And when we think about first of all, for international investors, a lot of times, these private these alternative investments, end up being funds that they can't necessarily access as easily as they can ETFs. So that's the reason why, for some people, even though there's lots of different credit private credit instruments available, they are generally funds and harder for, let's say, an international person to buy. And hopefully that will change, but we'll see more of that in ETFs, and I know there are ETFs on them, and so now, basically, one of the questions that I have then, okay, so it always makes me think when I think about asset classes, because in the end, equity is exposure to Companies and fixed income, unless it's government fixed income is exposure to those same companies, but with a different mechanism, a different risk structure, and the like and private credit is maybe exposure to companies, but maybe companies that you wouldn't necessarily get access to, that are smaller or that type of thing. So although it's still exposure to companies, it's, you know, different, and that's different from something like a commodity as an example, that's not necessarily tied to a company. So I want you to help us think about asset class, and just to add in a little more complication, some people will, let's say all the I'm exposed to all these asset classes because I have small cap, I have large cap, I have high quality, I have low quality, I have all of these different stocks. But to me, they're really explaining maybe exposure to factors. They're not explaining exposure to asset class. So how should we think about asset classes?

Larry Swedroe 28:19
Well, so what you want to think about is what types of risks you're exposed to. Forget even the words factors or asset classes. What are the risks? Okay, that you're exposed and what you want to do is diversify across unique sources of risk. So for example, all equities are exposed to economic cycle risk, so they have a market beta, typically on average of one. So you look like the risk of the market. So the market goes up 10% you'd expect to go up 10. If the market goes down 10, you'd expect to lose 10. Now, there are certain stocks that we call high quality, defensive stocks. You might think of them as supermarkets and drugstore chains. You know, high quality companies that have low financial leverage, very stable earnings, they might have a beta of something like point seven or point eight. So much less economic cycle risk. Okay, so when markets are up 10% you might only be up eight because you don't participate as much. But when markets are down 10% you may only be down eight on average. Okay, so these stocks have clearly some unique risk to them, okay? And this happens to be called the quality or profitability factor. We know small cap companies look different than large cap companies. They tend to both. Depends on the. See, you're in to some degree, and your finances be have higher betas than the market. So market goes up 10% small cap stocks may go up 11 and the reverse is true in the downside, just specifically in private credit. We could spend an hour alone on that subject, but credit is has a broad spectrum of risk in it. You could be US government, which has no credit risk, for at least US investors, you have AAA companies which almost have no default risk. I think there's only been one AAA company that's ever defaulted Penn Central Railroad. So it's non zero, but very low. And then you have double A, single a, double B, you know, etcetera, all the way down to high yield bonds. And I yield bonds have much more risk in 2008 when government bonds went up in value, and Triple A bonds also did well. High yield bonds lost 50 or 60% because of their exposure to that and private credit covers that whole spectrum. Could be highly risky, or is a fund that I invest in and run by a firm called Cliff water that only invest in private credit that is senior to all other debt. It is secured by assets, not, you know, paper promises, and it's backed by private equity. So if the private equity firm thinks that the lenders will take over the company and declare a default. They'll get wiped out, or could get wiped out, and so they are more likely to step in. They're not going to throw good money after bad. But the evidence is, if there's a chance and they think they can salvage it, they will and this and the average loan to value is currently about 40% so the historical default losses on this type of loan is 0.25% so I also invest in a little more sophisticated product. It's called the double B tranche of a pro of a clo or collateralized loan, and its yield as the private credit fund I'm in has cranked out about 10 or 11% for the last several years, okay, with very low volatility. Okay, this double B fund is at even higher returns, and in the 20 year history of double BS, there's virtually never been a default loss. But most people aren't aware. They don't it's esoteric, but And very few people play in it. Fact, there's only one fun that even focuses only on that. So there is a big spread available, because there's no supply to that marketplace. So there's a very wide spectrum, and you have to do your homework or work with an advisor who has access to these products and has done their homework. And I would recommend, as we discussed in our last session, ask to see their financial statement if they're invested in those funds they're recommending, and if not, been run, so you really have to do your homework here, or have somebody you can fully trust because they're a fiduciary, puts the money where their mouth is, invests in the same way they're recommending, and is willing to educate you about all of the risks of these investments. So

Andrew Stotz 34:00
for the next thing I'm going to I'm going to preface the next question with a couple little stories. You know. The first story is, if a tree falls in the woods, you know, and we didn't hear it, did it actually fall another in another concept related to this is the tin can portfolio. Some people say, Oh, my uncle just put, you know, his family bought stocks, and they put the shares in a, you know, in a drawer. And 30 years later, he won't, you know, he found them. And he's a multi billionaire, right? Because he didn't look at prices and all that. And Warren Buffett, you know, goes on about that as an example. And then my third thing I would look at is a bank. Now, banks generally trade close to book value. They trade at a premium to book value most of the time, but it's pretty close, and that's because banks are marking their portfolios to market on a pretty regular basis, where they're making an estimate of. Of potential losses, and then setting aside a provision, and that is trying to get somewhat close to market price, and that's why banks tend to not trade it four or five times price to book. Now, when we look at and so therefore, when you buy a bank, you're buying a portfolio of lending. Ultimately, if it's a typical bank, a portfolio of lending that's not priced as daily, let's say, as the market price for assets. But when you look at private credit, to what extent are we just buying things that are not priced often, and we're still exposed to underlying risk, but because we don't see those risk changes, we don't, we don't recognize that in the same way and which, which could be good. I'm not saying it's bad, but I just want to understand this concept of, you know, pricing versus, you know, other risks. Well, just

Larry Swedroe 35:58
one comment for you. I like that story, of course, the guy who found shares of IBM or whatever, okay, but you never hear the story of the guy who looked and found the shares of Polaroid or Enron, right? So that's true. One comment also, banks, on average, may trade around book, but they all they also run other businesses that are growing Asset Management and stuff that you know that is not, you know, an asset per se, it's services provided trust companies and other things. And JP Morgan, for example, I think trades well over two times book today, and there are other banks that trade below book because they're not growing well, and maybe their assets are worried about overvalued. What we do know in general about these illiquid assets is the following. There are plenty of academic papers on this. So private equity as well known to have a lag in their valuations and a fair degree of freedom on how they mark and that leads to stale pricing. And the stale pricing, on average, tends to run between three and six months, depending upon the firm. So that's going to make volatility look a lot lower, because if things go up and down and you know, Mark, you're marking it maybe in the middle of both times, right? So that's a real problem. And however, the private equity fund that I invest in run by Cliff water, the symbol happens to be CPE FX. They actually do where they can a daily mark, and they do that by putting a beta adjustment factor to their portfolio. And let's just, I'm going to make this up. I don't know exactly what it is, but let's say it's point three. So if the market goes up 1% they'll only mark it up one you know, point 3% they also mark daily any new information they get from the hundreds of investments they have. So they invest across, let's say, 300 different investments across maybe 20 private equity providers. So they're partnering with these firms. And each one of them, maybe one of them, does their quarterly marks in January, April, July, etc, and the others do it in February and on, and the other ones doing them on. And they're getting these coming in every month. They're getting some and whatever they get that month, they're marking it immediately, not waiting, so you have much less of a lag there. But you're still going to get a lad on their private credit fund. They're marking it daily with a, again, a beta adjustment to what's happening in the public markets. And there you have a much better read, because you have no duration risk here, because it's all floating rate credit and private credit, almost all of it, and everything this fund does is so you don't have to worry about that not being marked properly. And a recent paper I got a hold of looked at that and found, because of these adjustments, the lag was only about a month. So where private equity may show volatility because of this phony counting, if you will, of only 10 or 12, it's going to be more like 15 or 20, more like equities. But private credit, instead of being two, might be four, and still way below, because. Plus, again, at least the private credit that I'm talking about, senior secured backed by private equity. Low LTV, strong covenants has an incredibly low default rate, and its lag is no more than a month. So again, you really have to do your due diligence, understand the fund, what they're accounting, how they're marking, etc, and that's one of the risks of investing in this space. It's not for amateurs,

Andrew Stotz 40:35
right? Just I just have a file where I keep the price to book of companies and SEC by sector. And just you know, there's two sectors. One is called financials, which is a more all encompassing, versus banks, which is what I was talking about. And banks trading at about 1.3 times price to book globally. And if we look at us right now, the price to book of banks is about, let's say about 1.5 so a little bit better. And JP Morgan's at about 2.5 as you said, you know they're the best. So you know, the best in the industry gets the highest amount.

Larry Swedroe 41:18
We have a lot of earnings coming from services, not assets, correct, Wealth Management, etc,

Andrew Stotz 41:26
yeah, and banks in emerging markets are much more pure lenders, because there's just less of that service industry, you know, income. Okay, so, so the question then becomes, let's go back to a person in their 20s versus a person in their 60s. One of the questions that I have for you is, if you're in your 20s and you've got a good you've got the ability to bear risk, you've got the willingness and you've got you got some need, like, you know you do want to build wealth, is there any point in owning these instruments besides equity,

Larry Swedroe 42:05
yeah, exactly, for example. Today, I'm not saying this is long term, but the expected return to the reinsurance vehicle I invest in is about 20% and the volatility compared to stocks is about half or 60% and it's totally uncorrelated risk, because bear markets don't cause earthquakes or hurricanes and vice versa. So it's the perfect asset. Why people don't own more? I have no clue. It may be because they're scared of climate change, and I tell people, Gene the scientists are Warren Buffett's, you know, general reinsurance. They never heard of climate change, and they haven't built their best estimates. And now could turn out that the risks are greater than they think, but also could turn out to be they're less than they actually think. And the last two years, this fund has returned 92% cumulative. And it's up again this year despite the largest fire in California history, with the largest loss ever done. Okay, so there I you know, if you look at private credit 10 to 10, 11% for the least risky part of that. Well, what's the expected return to us? Stocks today, Vanguard, JP, Morgan, all saying six to seven, and the volatility is four to five times that, at least that of high quality private credit.

Andrew Stotz 43:40
Okay, so for the 20 year old, there's, there's, there's other options. You need access to these vehicles at the appropriate cost. That's

Larry Swedroe 43:50
the problem for foreign investors,

Andrew Stotz 43:53
yeah, but for the 20 year old in the US, basically, what you're saying is that look beyond equity,

Larry Swedroe 43:58
yep. Okay, I don't care if your need to take risk is high and your ability to take risk is high and your need to take risk is high, you should still diversify, because equities can get killed for the next especially us, equities could turn out to be another lost decade as the 30s were as basically 66 to 82 was and the 2000 decade, those were lost decades you got no real return. Basically,

Andrew Stotz 44:34
okay, so one thing that I think people find hard to understand, and I think it was either Yogi Berra or Albert Einstein. Both of them are very smart. He said, in theory, there's no difference between theory and practice. In practice, there is

Larry Swedroe 44:53
yes, but partly because of human behavior. So if you're going to be subject to re. Decency, bias or tracking error, regret you shouldn't own anything but the s and p5 100 or a US total market fund, because there will be periods. I'll give two examples. Reinsurance fund that I just told you made 92% the last two year, calendar years from 17 through 19, I think it lost about 35% and people said, Ah, you know, going on it? I point out that US stocks have gone down a lot more than 35% in any year you they've gone down as much as 90% in the Great Depression. They went down more than that in a weight, right? They went down more than that, or about that much or more than that, actually, in 2000 Oh, two that's a reason to diversify, not have all your rights and what, but not avoid an asset class.

Andrew Stotz 45:58
The question then becomes, it's hard for people to understand the statement that you made, which is that you know that we should have equal risk adjusted return in a, in a in a efficient market, and we have an efficient market. We've talked about that many times. So if let's just take for a moment, that theory was always in practice, and share prices and prices of assets are adjusting constantly, perfectly for their risk level. Does that mean that any asset will do?

Larry Swedroe 46:36
No, we talked about this before, right? That just means, for example, the US expected return. Okay, you could one way to do it is to look at the Cape 10 or the sickly adjusted chiller, and it's close to 40. I'll just round it to 40. And if you invert that to get an earnings yield, you get two and a half percent. If you look at expected inflation, maybe, let's say it's two and a half percent. Look at the Philadelphia Federal Reserve estimate. They publish a quarterly that's like 60 top economists at the leading banks in the country. That gives you a pretty good collective wisdom of the market, so that together is five. Now, does that mean we're going to get five? Of course not. That means there's a 50% chance we think it'll be more than five, and a 50% chance it'll be less than five, and maybe if returns are normally distributed, you might say there's a 40% chance you'll get more than six, and a 40% chance you'll get less than three, and there's a 20% chance you'll get more than eight, and a 20% chance you'll get less than zero, and a 10% chance you'll get more than 10 and a 10% chance, you'll lose 10% a year like, I mean, Japan for 36 years has had a nominal return of less than, I think it's around one and a half percent for the last 36 years. That's nominal. So real returns are probably about zero. Nobody knew that in 1999 right? Well, you have that's why

Andrew Stotz 48:29
hold on for just a second there, because we're, let's say we're in somewhat of a situation now in the US, particularly in a group of stocks, where valuations are very high. And people did know that the Japanese valuations were extremely high. Everybody felt it. Everybody saw it. They enjoyed it for the 10 years prior,

Larry Swedroe 48:46
but they thought the earnings would continue to grow because Japan was dominating the world in electronics and everything else. There was one semiconductor plant left in the US. So high valuations could, in theory, be justified now, I think most economists would have said it was a bubble and it would eventually burst, which it did. But, you know, people were saying the same thing in 85 and they kept, prices kept going up, and they Greenspan said the same thing in the US in 96 and prices went up for three and a half more years almost.

Andrew Stotz 49:22
Well, wouldn't you say that buying something on 40 times PE the risk is extremely high?

Larry Swedroe 49:28
Yeah, yeah. Why is it trading? See, here's the way you have to think about it. Why is it trading at that level? Why, if you assume markets are logical, which are not always perfectly so that means that people expect the earnings growth to be spectacular. So now that can be true of any one company, like Nvidia has been but it cannot be true of every company in the semiconductor space, growing earnings. Is high enough to justify 40 PES because within 10 years, they'd be the whole economy. So we're not saying that the market's rational. We're saying that it's efficiently pricing in what people are expecting. Whether that expectation is right or wrong is another thing, and we have talked about this, that there are what are called limits to arbitrage, which prevents sophisticated investors from correcting over valuation because of the risk of shorting, is unlimited losses. You rarely see markets undervalued, except in panics, maybe for a short term, because that's easily corrected. You could just buy and your losses are limited. So what?

Andrew Stotz 50:44
So, just to wrap up this concept of risk adjusted return, let's go back to theory and imagine that at the moment, let's just say all different alternatives are priced perfectly, and on a risk adjusted return basis. Does that mean that in that case, the only thing that really matters when constructing a portfolio is correlation between these different

Larry Swedroe 51:15
No, I would say this. I would say, you want to find assets with the lowest correlation and good returns are expected, but you have to have confidence in them. So if someone's worried about climate change, and if we have three bad years, they'll fire their advisor and fire the firm, then I would say, don't buy it in the first place. Another example there's a firm called AQR, which runs a style premium fund. So based on the historical evidence, they have some of the best finance people in the world working there, rocket scientists, PhDs, best databases, best trading execution of anybody in the world, probably or at least as good as anybody. And when they do so they go long value, short, growth or short, they go along what's cheap and short what's expensive. They go long things that have high yields. It's called the carry trade. And short things with low carry. Okay, so you might own you Australian dollars assets and short German assets, and earn that carry on average. And they have go long things with positive momentum and go short things with negative momentum. And they go the fourth is they go long quality stocks and short jump. When that fund came out, I think in 2013 or 14, they expected a return of four to 5% above t bills, and that's virtually what it's done, something reasonably close to that. That's amazing, right? That 12 years later, you got pretty much close right to what the returns were. And yet, the first four years or so, it had great returns. Getting very close to that. T bills were about two, so it got seven, totally uncorrelated to anything that's a great asset, right? Volatility, about half of the equity market the next three years have lost about 35% people fled billions, fled the Fund, and the next several years, it earned over 25% a year, and it's up nicely again. Your only way you get the good returns is if you can stay the course and not panic and sell so you have to have a belief and understanding, a willingness to absorb bad periods and what you should think, okay, it's down 35% but I only own five or 10% of it. My portfolio is doing okay, and I hope that there'll be periods like in 2022 that fund was up 25% or something like that, when the S and P was down double digits, and so was US bond funds, right? That's what you want. In fact, someone once said, If there isn't a part of your portfolio that's doing poorly, you're not diversified enough.

Andrew Stotz 54:27
Okay? I think the

Larry Swedroe 54:28
behavior determines outcomes more than assets in some cases. So what I tell people is, there is no one right portfolio. The models in my book are good starting points for you to think about. Maybe, okay, but the right portfolio for you is the one you're most likely to stick with, assuming you didn't take more risk than you had the ability, willingness or need to take.

Andrew Stotz 54:58
Well, um. I think we should probably wrap it up. I mean, we've covered so many things in

Larry Swedroe 55:05
let's cover one more quick thing. Let's do it one you can read about this in my column at sub stack this week, on the virtue of single factor funds, so it invests in value or small cap or quality stocks or integrated funds so dimensional and Avantis, for example, build funds that might be small value, screen out negative momentum and buy high profitability. It. Many people think the best way to do it is just buy the fact that you want. That's the absolutely wrong way to do it. I explained in my paper, why, in my article, why. And a simple explanation might be this, so you have a company that stock is crashing, and now it becomes a value stock, right? The PE is falling. It's gotten cheap, so you're buying it, and over here you own a momentum fund, and it's turned negative momentum, and you're selling it. So you have paid two transactions costs, maybe even realize the gain in a fund, and you end up with exactly the same position because you undid the trade that you did, right? It makes no sense. What the research shows is ensemble funds are much better structures, because what you're doing is avoiding buying something that's cheap but junk, so that's a value fund only, and you didn't screen for value. Or you could own a high quality fund, but it's expensive, too expensive, maybe, so you're better off Owning a fund that screens for both. So it's got maybe second quartile in both, rather than top quartile on one and bottom quartile on the other, and you get better returns, lower draw downs, lower trading costs, more tax efficiency. So you want, instead of owning a small value and a quality fund, own a small value quality fund like Avantis or dimension

Andrew Stotz 57:21
so where the fund manager is bringing together the various factors to then make a final decision on each

Larry Swedroe 57:31
stock. Yeah, of using systematic rules, not their judgment.

Andrew Stotz 57:37
Okay, and okay, so that I, you know, I did, I did read that when you, when you, when you sent it on sub, now that you mentioned it, and I did that, this integrated approach and all that. So, yeah, that's interesting. And that's, it's a good reminder for all of us to keep up on Larry sub stack. But maybe as a, as a wrap up, I'll give the last word to you. You know, what do you want people to take away? We spent a lot of time talking about what you've written about in your book. We've talked about a lot of things outside of that. We've talked about theory, we've talked about practice, we've talked about stories. You know, what would be the last thing you would want people to take away from all of this discussion and what you've written in our talks.

Larry Swedroe 58:21
Yeah, the first thing I would say is, my son in law is really handy. Anything goes wrong in the house, he can somehow fix it. I'm exactly the opposite. I will not try to do anything more than screw in a light bulb or bang a nail to hang a picture, because I will end up creating a problem that will cost twice as much to fix if I hired a Handyman in the first place to fix it. The same thing is true of investors. There are people, maybe, who have all of the skills and all of the behavioral traits needed to do it themselves, I would suggest that that's less than 1% of the population. Based on my 30 years of experience. People are far too over confident of this skills. They don't have the time to do all the research, read the book, all the books that I've written on people like Bill Bernstein and others to get the knowledge, but then to do it right, you have to integrate that into a well thought out estate plan risk management, meaning insurance of all kinds. So I think the vast majority of people are better off finding a an advisor who is truly a fiduciary who fought who makes investment decisions based all only on the empirical evidence, and puts their money where their mouth is and accepts payment only from you, no commissions or anything else, and is willing to show you that their investment. Investing their own money in exactly the same vehicles, although it could be a different asset allocation, because their ability, willingness and need to take risks. Get yourself educated. You don't have to read all, for example, 18 books I've written, but read three or four of them to get that deeper understanding of the basics of finance. You know, education may be expensive, in this case, is pretty cheap. You can go to library, pick up any of my books or buy them on Amazon. But ignorance is much more expensive in investing than education will ever be. Last thing, make sure you build this integrated plan. I'd recommend reading my book, Your complete guide to a successful and secure retirement addressing all kinds of issues, including things like elder abuse, fraud committed against older people, women's issues and stuff, has seven chapters on investing, and the rest upon how to build a life in retirement and make sure you enjoy it. Have that well thought out plan, and make sure one you don't overestimate your ability, willingness or need to take risk, don't own assets that you're not willing to stick with at an absolute minimum of, say, 10 or 15 years and survive and say, Well, I just had bad luck and risk showed up, and I'm going to stick with it, and I'm going to actually have to keep buying more, because my asset allocation is targeted 5% now I'm down to Three. If you aren't willing to do that, then you shouldn't own that asset in the first place. And keep in mind that every single risk asset, including US stocks, goes through very long periods of horrible performance. We've talked about the three periods in the US of at least 13 years where they under perform T bills, and there's no guarantee that the US is in the next Japan, where for 36 years they earned less than a 2% nominal return, which means probably close to zero there. So that's the best advice I could give other than pick up, enrich your future and get a good education on a lot of these issues. Well,

Andrew Stotz 1:02:28
I want to thank you for this discussion, and it's been great to learn from you, but also to get to know you and the way you think about things. It's definitely added a lot of value in my life and in my thinking. So I appreciate that. And in closing out this session, I'm not going to say what I normally say, which is I'm looking forward to the next chapter, but I think we can look forward to some next discussions on interesting topics. And for listeners out there who want to keep up with all that Larry's doing, you can find him on X Twitter at Larry swedrow. Can also find him on LinkedIn, but most importantly, subscribe to his substat, where he is sharing stuff that's fantastic value, as we've just talked about, integrated versus ensemble type of factor investing. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside and.