Enrich Your Future 16: The Estimated Return Is Not Inevitable

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 swedro, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry is unique because he understands the academic research world, as well as the practical world of investing. And today we're going to discuss a chapter in his book, enrich your future the keys to successful investing. And the chapter is 16. All crystal balls are cloudy. Larry, take it away. Yeah,

Larry Swedroe 00:36
the story, or this chapter, begins, as all my chapters do, with a story that provides an analogy that helps people understand the issue, and then if you understand the analogy in a common subject, you're able to then translate into vessel. What's ironic about this the timing of this chapter will become evident to your listeners, especially those who happen to live or know people who live around Asheville, North Carolina. So in 1977 this spring, the people in a town called Grand Forks, North Dakota became very concerned about the potential risk of flooding in what was called the Red River. Scientists predicted that the river would crest at 49 feet, and given where the flood stage would be, which was a little above that, they felt okay. The problem was, the scientists didn't guess exactly right. The River crested at 54 feet, and there was massive damage. People had to rapidly abandon their homes. Of course, the same thing just happened. We know in Nashville, North Carolina, especially where people living in the mountains don't worry about hurricanes. Typically, when you're central part of the country and up in the mountains. The problem with that line of thinking is some it has to do with investing, is that all forecasts, such as those that deal with estimations of probabilities. The problem is, people tend to think of them, or what I call a deterministic way. Okay, let's say you're a baseball fan. You predict the guy's going to hit 300 Well, the odds are close to zero. He's going to hit exactly 300 the way to think about it is like a bell curve, normal distribution with a median and then the mean might be 300 but there's a 50% chance might hit more than 300 a 50% chance it hit less maybe there's a 30% chance it hit more than 320, and a 30% chance he might hit less than 280, and a 10% chance he has a really bad year, hits less than 250, and a 10% chance to have a great year hitting, say, over 350 Well, the same thing is true with stocks. You get all these analysts, and I laugh when they predict the S, P is going to close at 5913 like, you know the position really is accurate, right? And it's telling you something right the only right way to think about that is that's your median of an estimate, and you should think about the possibility distribution of returns, and when you're looking at longer time frames, the same thing applies. We don't know. There is nobody who can accurately predict where stock returns are going to be, because there are lots of surprises in the future. No one could have predicted, say, a 73, four oil embargo. No one could have predicted the internet bubble and then it bursting where no one could have predicted 911, there are lots of events this year, and then the last year or two, the war in the Ukraine, the war in the Middle East. And nobody knows how those events will turn out. We also have an election. So how do you think about returns? Again? You should think about them, and we've talked about this a bit before, is that distribution and your estimate is only the middle point, and your plan has to be prepared for either the good tail to show up, which is easy to deal with, that usually will allow you to take chips off the table, reduce your risk, because you'll be well ahead of your goal. But if the left tail shows up, you may have to either work longer, plan on saving more, you're going to have to maybe rebalance, and that means, you know, buying stocks at the, you know, at a very difficult time. But the next point that we want to talk about. Gap is this issue of all crystal balls, not only being cloudy, but even if you could see the future in some sense with perfect endgames, the order of returns which you can see can really impact the outcome of your portfolio if you're in the withdrawal stage of that portfolio. So we have a table you can put up that illustrates this point. And the story begins. It's 1973 and we know that stocks have returned 8% in real terms and 10% in nominal returns, and we've had similar results, you know, over the next 50 years, since then, all right, and so say an investor in that time frame says, well, returns were 8% in real terms, I'm going to withdraw in real terms 7% every year from my portfolio, because I know with my perfectly clear crystal ball that we're going to get 7% for the next, you know, 50 years, and I'll be dead by then. But my, you know, if I'm maybe 60 and I retire, I want to live at least 30 years make it to 90, and I have to plan for even longer than that, so I know with certainty I'm going to get 8% real, and I'm only withdrawing seven, which means if I take out, say, 100,000 just to make the math easy, the first year, and inflation is 3% to keep My real spending the same I have to take out 103,000 so now you're clear. You have the only crystal ball that's perfectly clear. And the fact of the matter is that within 10 years, you're bankrupt, as this table shows, because what is called the danger of sequence risk. The problem is, if returns are negative early on, and inflation 10 could be high, which is one reason the returns could be negative, then you're withdrawing large amounts early and when the market eventually recovers, you don't have that money, it's been spent, and you can't recover. And this shows how dangerous sequence risk can be. So what that tells you is the importance of, you know, managing that sequence risk is not taking too much risk early on in the retirement because if you get that negative outcome, you really could have a problem, be forced into cutting back your spending more than you want, or, you know, maybe having to move to a lower cost living area. So

Andrew Stotz 07:58
you're talking about sequence risk, and just for the people that can't see the chart, the table, basically, this table shows two very significant falls in the market. In the first year in this table is 1973 and the market fell by about 15% and then in 1974 it fell by about 27% the rest of the periods, you know, not bad. In fact, if you just look at, you know, you had 75 you had 37% even in 1980 you had 32% so actually, when you look at, if you were to do a simple average of this, it wouldn't be so bad. But it was the point that that 14 and that 15% and that 27% happened right at the beginning of your investing. And for those people that can see it, you'll notice some notes, because just like lots of people out there, when I read Larry's books, I take a lot of notes. And in this case, one thing I highlighted was he was mentioning that from January of 1973 to October of 1974 when the bear market ended, the S P had lost 48% so that's how you started that period of investing. And for those people that are seeing it, you'll see WB on the right hand side. I was just fiddling around and looking at what was Warren Buffett's returns in those years. But the point is, how do we deal with sequence which and I was asked a question recently Larry and somebody said, Should I do dollar cost averaging, or should I do lump sum investing? And I said to them, well, it basically lump sum investing is always going to be better than dollar cost averaging, as long as you know that the initial returns are going to be high and come you know and that ultimately, so you're not dealing with sequence risk, and if you know that, you're at the bottom of the market. But of course, we don't know that, and then that makes it much more difficult to think about lump sum so how do we think about this situation?

Larry Swedroe 09:51
Well, this question was answered 60 plus years ago by Professor Constantinides OF THE. University of Chicago. And the answer is very simple, from a risk that, from a expected return standpoint, you should always invest a lump sum, because stocks always have higher expected returns than, say, safe bonds or Treasury bills. And that means every day you're out of the market, you're sacrificing expected returns. So from a expected return basis, you're always better off. But what you have to be aware of is that sequence risk you know exists, and therefore you shouldn't take more risk than you're willing and able to deal with should the sequence risk comes up and then you should always before you invest, have a plan B. What do I mean by a plan B? So you have a plan, and you don't want to plan on the worst outcome happening, because then you will underspend likely what you could have spent. You don't want to plan on the worst 5% in that left tail, like 1973 four, right? We have one of those every 40 or 50 years, right? We had in 73 four. The next one happened in 2008 really, I was the really bad returns for the market. So, and the one before that was 29 through 33 maybe, right? So they don't happen often, but they can happen. So plan B says, well, Plan A is, I don't want to expect the worst, because then I may be only unable to spend 50,000 a year, when, if I assume more normal markets, I can spend 70,000 a year. Why deprive myself of that? But I have to have what Plan B is to say, if that risk shows up, here's my plan. I will work longer. I will cut out my annual vacation to Europe and drive to, you know, some local beach or something, right? And save that money. I might move to a lower cost of living area. I might downside, but you should write that into your investment policy statement. So you're thinking about that when you're not under the pressure, oh my god, what am I going to do? And then your stomach is going to make bad decisions, right? You're more likely to panic and sell rather than all right? I thought this app, here's what we're going to do. So that's the way to address that, so make sure you don't take more risk than you have in the first place. The other point of, by the way, maybe if you put that slide up again, just for the people who can't listen, I think it'd be helpful. If we took 7% of a Million Dollar Portfolio, you will withdraw 70,000 the first year, but then you have inflation, which was significant. It was 8.8% so we had a now withdraw to keep our spending the same in real terms, 76,000 but your portfolio was now down to 930,000 and then the market dropped another 26% your portfolio is down to 716,000 and because inflation was 12% you had to draw 85,000 and now you're down to 441,000 and by the end of 1982 you're when the market went down. In 81 you're stuck with less than 20,000 then you're supposed to withdraw 160 so in nine years, you went bankrupt because of that sequence risk. Now, if you could have waited it out, you would say, you know, 30 or 20 years old and 73 you would have actually earned that 7% real, and your portfolio would have been fine. But you don't always have that luxury. So the right way to think about these things are in probabilistic terms. So it should be like, you know, I have a 90% chance of being able to, you know, be able to withdraw, let's say, 5% a year for my portfolio. But there's also maybe a 30% probability that I'll have at least a million dollars. But there's also a 20% probability that I'll have nothing at age 90. And then you have to decide, is that distribution probability acceptable to you? And if it isn't, then you should adjust your plan. And

Andrew Stotz 14:56
just to highlight for those people that can't see but for those that. Can see, I'm just going to highlight that. I think what you're saying is that we're getting a double whammy. Number one, we're getting sequence risk in the first two years, and number two, we're also getting massive inflation in those two years. So not only are you losing the value of your investment in the stock market, but you're also using losing your purchasing power, and that double whammy is what's really causing you to have to draw down more and have less correct and

Larry Swedroe 15:29
yeah, and the same thing happened to allow to somewhat lesser degree, in 2000 we didn't have high inflation, but the stock market went down in 2001 and two, same thing happened in 2008 sequence, risk showed up. There was a really bad year, and then it happened again in 2022 when we had a really bad both stocks and bonds got hit, and inflation ran up so and luckily, you know, things turned out a little better, but there's no guarantee that that was going to happen, right? And so the benefit of the Monte Carlo is allows you to look at these distributions, and then it allows you to do scenario analysis, to say, Okay, let's say there's an 80% chance when you put your assumptions in of success if I withdraw 5% of my portfolio every year. But then you can look at, well, what if I cut it to four if I'm willing to do that, and that drives it up to 95% chance? Well, that's a big difference. A 20% risk of failure at 80% versus a 5% risk of failure at 4% now you might decide that, hey, that's worth I'm willing to sacrifice. But what if it moved it from 80 to 81 well, most people say I'm only picking up 1% I might as well spend the extra money. So the Monte Carlo analysis allows you to do that shifting your asset allocation, to see what that does. If I take a little more risk or less risk, if I shift your withdrawal rates a little bit, what does that do? If I save a little bit more now, what does that do? And you play this scenario, and that can really help you make those decisions.

Andrew Stotz 17:26
So Monte Carlo simulations basically construct the normal distribution, or the distribution of outcomes, and

Larry Swedroe 17:34
then with fat tail. So many of them don't, you know. But the point here is this even, and you know, none of us has the clear crystal ball, and we showed you an example, even if you had a long term crystal ball showing a paper, you know, 50 years down the road, and you got the result you wanted, but didn't know what happened occurred in between, even a clear crystal ball would not have helped you unless you got the newspapers in between. Let me give you one other great example, which just happened this month, even with a clear crystal ball. I think it was September 18 that the Fed announced its change in interest rate policy, and they lowered rates. I'm willing to bet every one of your listeners would have bet the yield on the 10 year would have fallen. I think at the time the 10 year was at 375, it's now 404. So if you bought long term bonds at that time, you would have taken a bit of a bath at that point. So that's a good example. And you know, none of us has that clear crystal ball that knows tells us what will happen. So

Andrew Stotz 18:55
let's talk just briefly about the concept of extreme values on that distribution. Larry's written a book called reducing the risk of black swans, where he talks about that. And those are extreme values. You know, are a different factor. But I think what we're talking about right now is understanding that it's a range of outcomes, and it could be even the statistics that you've shown in 73 and to 82 we're not talking about three or four or five standard deviation events. These are, you know, kind of normal outcomes. My question to you is, this is my last part is, it's very possible that from today forward the next few years, we could see strong negative returns possible. You know, some people are predicting that. Let's say we get two years of minus 20 or 30% or something like that. It's also possible that we could face an inflationary period. We certainly printed a lot of money, and so let's just imagine that we're going into. For a moment to do this as an exercise. We're going into a 7374 period, where market's going to be down by a sizable amount, and inflation is going to be up by a sizable amount. And let's now imagine that, yeah, we're not talking about a 20 year old who has, you know, 70 years to compound. We're talking about

Larry Swedroe 20:17
to happen to a 20 year old as long as they don't get unemployed, because prices will be much lower, returns will be higher, yeah, but it's the worst thing that could happen to a 65 year old. Let's

Andrew Stotz 20:32
say that. Let's now say we have a perfect crystal ball. We picked it out. We think we've seen the negative scenario. We think it's going to happen, let's just imagine that we're right, and how would we prepare ourselves for something like that? Now

Larry Swedroe 20:47
the better question related to that is we all agree that that's possible, which means you must build that possibility into your plan, regardless of what you think is going to happen. And we have discussed many times the worst mistake maybe that people make, and certainly it's the most common, is they're overconfident, or their abilities to see what is going to happen. And so you must build that possibility and think always in probabilities. So the way to deal with what is very simply put is uncertainty. We don't have certain future. There's only one way logically to deal with uncertainty, and that's diversify, of course, assets that have unique risks. So you don't have all your assets in the risk that could expose. So for example, if you own a lots of stocks that could get hit and the same time, inflation is a risk to you because you're retired and not working, your wages aren't going to go up with inflation, and you're not the same as that young, tenured professor at you know some university who's not going to get unemployed, right? He's rooting for that bear market, if he's smart, right? So he could buy a lot cheaper your stock, so you should know a lot of long term bonds, because that sequence risk combined with high inflation would kill you or could destroy you. So my belief is you should be all investors. Basically should be hyper diversified, not just owning the traditional 6040 stocks and bonds, because there are periods like you saw 73 four, and a reminder was 2022, when stocks and bonds both can get killed. And I can certainly construct an argument for why that could happen again, because of all the budget deficits that the whole world, all the industrial world is facing, and all this fiscal stimulus that's incurred, so it's possible. So you want to own lots of assets, maybe that don't get hurt by inflation, right? Things like private credit, which is all floating rate debt, but there you want to make sure it's not exposed to a lot of credit risk, so you don't want to own a lot of junk bonds. So I own senior secured and backed by private equity. The fund has an average LTV of about 40% a 20 year history of less than 1% defaults and default losses are less than that, and the fund is currently yielding 11 and a half percent, and it's all floating rate, and correlation is close to zero for stocks, it's non zero. Clearly, if we get a bad recession, the faults would go up, but the you know, so that, but it will go down nowhere near as much as stocks, maybe 10% or 15% as bad as the stock market. I own things like drug royalties, life structured life settlements that you know, basically buy life insurance policies. All right, that's their returns are totally uncorrelated. I invest in drug royalties, reinsurance, none of those things correlate at all with either and in fact, they some of them are inflation protected because their underlying money is sitting in treasury bills or floating rate notes

Andrew Stotz 24:43
in the book you've got on page 269 a list of reinsurance, alternative lending, diversified alternatives, giving some great either funds or ETFs. So yeah,

Larry Swedroe 24:53
50% of my portfolio is there because I'm a big believer in hyper diverse. Vacation. Now, 10 years ago, I will say that I wouldn't have owned any of these funds because the ones that were available were way too expensive, typically two and 20, meaning 2% annual fee and 20% carry, which meant that the providers were taking all of the benefit. Just think about, say, you own a hedge fund that's getting 15% gross returns. You're charging two and 20 the 20% is 3% 2% is five. You got 10. The market got 10, and you've got daily liquid in the market. You're trapped maybe for a decade or longer.

Andrew Stotz 25:44
Somebody gets rich with hedge funds today, right today,

Larry Swedroe 25:48
you can invest in Clifford's fund for roughly 1% and no carry same thing true. You could have invested in private credit through what are called BDCs, or business development corporations, their typical fees are over 4% because of the high fees. And the carry Cliff waters fund, effectively is about one and a quarter percent no carry. So you're able to capture, as I said, that fund is yielding 11 and a half after fees today, when a high yield fund, the Vanguard is yielding something like six or seven and it's got six years of duration risk. So you've got riskier credits, based on the historical data, you've got 5% or so lower returns, but it's a lot cheaper, and maybe only cost 18 basis points. So some people define as people know the price of everything and the value of nothing, focus only on expense rates, which are important, but they shouldn't be the only criteria.

Andrew Stotz 26:59
So for the listeners and viewers out there who already have the book, just go to the back Appendix A And Larry's got the list there. For the people that haven't gotten the book or that are listening, what would you say? What would be one instrument that you think would be worth somebody who hasn't, doesn't have any alternatives, they have stocks and bonds, you know, maybe a little gold or something like that. But they don't have any alternatives. Where would be one that you would say this one's worth investigating?

Larry Swedroe 27:28
Yeah, well, to me, the most logical and easiest for people to understand is reinsurance. We all know that we don't like buying insurance, and the reason is we know we buy it because we need it in case of a catastrophe, but we not only know we're likely transferring a profit to the insurance company, but we're also praying we never collect it, right? We don't want to collect that premium. We don't want a house to burn down. We're happy to lose money. So how about wouldn't it be nice to be on the other side of that trade, where you're collecting the premium now, that means you have to accept the risk. You know, all risk assets have long periods of poor performance, and that's the investors biggest enemy we've talked about recently. But

Andrew Stotz 28:19
the point, the point is, I think the message from what you've talked about sequence risk is that what we really need to do is do everything we can to protect the downside during the bad time, and then you can survive a little bit better. Now you've got three reinsurance once your pioneer, Stone Ridge, high yield and Stone Ridge reinsurance risk premium. Is there one that you would say that an investor should go and start reading the prospectus and understand it well

Larry Swedroe 28:48
if you need and insist on liquidity, which most investors don't need, at least higher net worth individuals, right? And certainly, if your money is in a retirement tax advantage account in the US, you're not likely taking that money out. Even if you're in retirement, you're probably only taking 345, 6% a year, and the fund provides a minimum of 5% liquidity every quarter. So that's 20% you can get out every at a minimum. Which

Andrew Stotz 29:18
one are you talking about

Larry Swedroe 29:19
that? But this there the the S H, r i x, the high yield fund is daily liquid, but because it's daily liquid, you have similar risk, but you're giving up the illiquidity premium that you would get in the other fund, the S R, R i x, and so you have higher expected return. So I would only own the higher yielding, higher expected returning fund, because I don't need liquidity. But if you needed liquidity, you could go with that fund. Now the Pioneer fund is an excellent fund also, and. It owns some of both of them, so you're getting kind of an in between. I think they jump around their mix, but it might be 75% the illiquid and 25% but it too is therefore only quarterly liquidity.

Andrew Stotz 30:17
Well, I think that's a great, great place to stop this interview, and I think we all got to go back and do our research on understanding funds and ETFs related to reinsurance and see as a starting point for one of many different alternative investments that you mentioned.

Larry Swedroe 30:35
Yeah, let me just close with this. It's important so stocks have high expected returns because they're highly risky. We saw that in that chart, 73 four collapse, 2933 collapse, 2000 oh two collapse, oh eight and 2022, right? That's not a reason to avoid stocks, right? It's a reason to own them, because if they didn't collapse somewhat frequently, there'd be no risk. You just have to hold on for a few years, and then the risk premium would go away, because everyone would bid up. So it's actually a good thing that stocks, on occasion, collapse. No one likes it when it happens, except maybe Warren Buffet, who likes to come in and buy cheap right? The same thing is true of reinsurance, the fund that I own, first five years performed virtually identical to what we predicted as the median was up about on average 5% or so over T bills the next three years were terrible. Lost a total of about 30% investors panic. The Fund had 5 billion at the start of that period, 1 billion at the end. Now, 1/3 of the drop, roughly, was caused by assets falling in value. The losses. The other two thirds were naive investors fleeing. Instead, I bought more, because now the expected return was much higher. Because what happens after losses with stocks PES go down and the expected returns go up. With reinsurance, it too has what I call a self healing mechanism. Premiums go up, the deductibles go up, the underwriting standards go up, and therefore the risk is down, and you're getting a much higher expect. The next year, the fund returned 44% now every risk asset, every one of the ones I mentioned list in the book, will go through some period of poor performance that gives you the exact reason why you should hyper diversify. Because if you try to guess which one will do, well, be it stocks or reinsurance or anything else, maybe that's the one that sequence risk shows up just when you're starting and you blow up, so you don't want to concentrate your risk. You want to diversify it. And there's no reason to think that the stock market goes down and that's going to cause hurricanes and earthquakes and vice versa, right? So

Andrew Stotz 33:16
the question that I have on that is when the reinsurance funds had their bad years. Were those uncorrelated with the equity market, or were they highly correlated at that moment? Uncorrelated

Larry Swedroe 33:28
because earthquakes and hurricanes don't cause bear markets. Well, think about it, stocks go down about 1/3 of the years. Reinsurance funds go down. Let's say it's not this bad, but let's say it's 1/3 of the years. So what are the odds they'll both go down at the same time, one in nine so that means once every nine years it's going to happen, but eight out of nine years it's not going to happen, right? And what are the odds that they'll reinsurance will go down two years in a row? Well, 1/3 times, 1/3 is one night, right? So, but that means you should expect, you know, once every nine years, you're going to get two bad years in a row, but once every 27 years, you might expect three bad years in a row and that, but it showed up. It can happen. The same thing can happen with stocks.

Andrew Stotz 34:28
And for the listeners out there, it's not so I mean, everything that we're talking about are risky assets, which means that they're gonna have periods where they go down. But what we're talking about when we talk about trying to prevent having this double whammy of your overall portfolio going down and also experiencing inflation and not having a lot of time left for your you know you're not going to be able to regenerate if you're 60 or 70 or something like that. The idea is, if the assets are uncorrelated or low correlation. So then that means that, generally, they're going to go down at different times. So when the market does go down, if you can find an uncorrelated or low correlation asset, what you can see is that if that correlation exists at that time, that you're going to preserve the value of your portfolio a little bit. Of course, you're going to give away some of the equity upside, you know, in the overall long term, but that when we get to this point later in life, and we have to be very careful about sequence risk and light, that diversification really has some value.

Larry Swedroe 35:33
Yeah, the way to think about it is, stocks go up, but they go up like this. When you add uncorrelated assets, your line looks more like this, right? And you ask any 65 year old, or anyone there retirement, and they get to the same endpoint, which would you rather experience?

Andrew Stotz 35:51
He said, That looks like my heartbeat. That's the one I want. I don't want that one that's highly volatile. You

Larry Swedroe 35:57
want the one that's looking like a good EKG, not a bad one.

Andrew Stotz 36:01
Well, we got to get you onto your next activity. So I want to thank you for another great discussion, and really a great one about sequence risk and thinking about that, as well as sequence risk combined with inflation, that double whammy. Not saying that it will happen. But you know, this is something that we have to put into our thinking. Larry also talked about the Monte Carlo and using Monte Carlo analysis as a way to force yourself really, to look at the distribution and understand what the changes of different factors mean for not only the average portfolio outcome, but also the wide range of portfolio outcomes. So really a great discussion, and I look forward to the next chapter, which, wait a minute. Hold on, ladies and gentlemen, the next chapter. You know, it's a short one, but there's a lot in there. It starts out with Harry Markowitz quote. This is chapter 17. There's only one way to see things, rightly so. For listeners out there, we want to keep up with what Larry's doing. Just follow him on Twitter at Larry swedro, and you'll see his latest work, which some of the latest stuff. I mean, I, I forward all of your latest stuff to my team to look at and think about. I like the one where you talked about the different economic environments and returns a couple of weeks ago. And also you can find Larry on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.