Enrich Your Future 17: Take a Portfolio Approach to Your Investments

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 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 the a chapter from his recent book, enrich your future the keys to successful investing. And that chapter is chapter 17. There is only one way to see things rightly. Larry, take it away.

Larry Swedroe 00:36
Yeah. So, as always, we'll begin Andrew with an analogy to help people understand the concept, and one of my favorites is to utilize sports, because many people understand the concept it's related to sports. So one of the players, who's considered one of the greatest players in the National Basketball Association is a fellow named Stephen Nash. Now, if you looked at his career statistics, that are the two that people probably look at the most Steve Nash averaged over his career, which lasted 18 season, he averaged just 14.3 points and just three rebounds a game. Now despite those kind of mediocre statistics. He was named an eight time all star, a two time most valuable player, and is generally considered the greatest point guard of his era. So why is that? Well, he happened to also have over eight assists a game, which is one of the highest in the history of the NBA, but Nash made everyone else around him a better player, and today, when we do more sophisticated analysis with sports, for example, in the National Hockey League, you also see not just goals and assists or saves for the goalie, but for the players on the ice, you see a plus minus score. So a guy may never have many goals or assists, but when he's on the ice, his team outscores the other team, and it's because of his contributions making the other players around them better and being a defensive player as well. So there it's the point being that you should never look at things in isolation, but how it impacts the whole so the expression is, there's only one right way to see things, and that's in the hole. So what does this all have to do with investing? Well, Harry Markowitz, who's the one of the fathers of modern portfolio theory, pointed out that you should never look at the risk and return of an asset in isolation, but you also should consider how its returns and risk co vary with the other assets of the portfolio, okay? And to show that point in the book, I give the example of the 25 year period from 98 through 22 the Vanguard 500 index fund returned 7.53% per annum, and it outperformed their emerging market fund, which returned just 16.14% so it outperformed but almost one and a half percent a year. And you said,

Andrew Stotz 03:34
you said 16, you meant six, right, sorry, I'm sorry about that. So seven and 7.5 and 6.1 roughly, okay, yep, keep going, almost

Larry Swedroe 03:43
one and a half percent difference. And on top of that, the volatility was roughly 16% for the S, p5, 100, and it was almost 23 so why would you ever want to invest in this and include this emerging market fund your portfolio.

Andrew Stotz 04:03
And let me before, before you go into that, let me just, you know, help people visualize that. Here we have a fund with a lower, lower return and a much higher volatility. How could you ever benefit from bringing that into a portfolio that has higher return and lower volatility. It seems impossible that that would have any positive impact on a portfolio. Yeah.

Larry Swedroe 04:32
And if you ask the vast, vast majority of your audience, I bet they would say, if you had the choice, would you include that? The right answer would be, I don't know. I need to see the covariance of the portfolios to see what the correlations are. The correlations are low enough, right? Then you can benefit. Because when the S, p5, 100 dramatically out. Performed, you would buy more to keep your portfolio in balance. Say you wanted to have 10% emerging markets, or 20 or 30% now, instead of 10, you're at eight, or instead of 20, you're at 18. So you would buy more and sell some of the s, p, when it had done really well, and vice versa, right? When the if there was some periods when the emerging market fund did better, which was the case of most of the early part of the first decade of this century, then you would sell some of the emerging markets fund and buy more of the s, p to put you back in 500 Well, it turns out, if you did do a 9010 allocation, I showed that you would have increased your return from seven, five to seven, six, and you would have had the same sharp ratio, so same risk adjusted return, But you would have actually earned a higher return, and it would have even been slightly higher returns, also, if you included a 20 or 30% allocation to the fund. I've even seen examples that was an extreme case in the 90s, when you if you added Turkey to a portfolio of US stocks at a time when Turkey had negative returns, but it was negatively correlated with the s, p, and the volatility was so high that you were selling when it went way up, because The volatility was way high, and then you were buying when it crashed, and you got it cheap, and it would eventually recover, even though it had negative returns for the whole period and dramatically underperform. You would have been ahead. And too many people do a line item analysis and look at each item to see how it's done in the portfolio, instead of considering how the total portfolio did because of its inclusion. And that's really the moral of the tale here.

Andrew Stotz 07:14
Yeah, it's, it's, uh, one of the things that always comes to mind, and I think we're going to cover it in another chapter. Is, you know, what do we do about the fact that in the past, let's just take Turkey as an example, that it behaved, you know, perfectly. It was perfect. You know, great correlation. But then we say, well, okay, is that going to repeat itself in the future. How do you respond to that when someone asks you that question? Yeah,

Larry Swedroe 07:46
well, I wouldn't use that as an example to illustrate the common sense of that. What I would look at is to see if there is common sense about should you expect there to be low correlation, and should you expect there to be risk premiums which would allow you to invest? And that low correlation is there. So it is logical to believe while the correlations of emerging markets and international stocks are going to be positive and maybe even fairly high to the US, because we're all subject to the same, some of the same economic cycle risk, especially when we have global systemic crises like 2008 for example. Or if we had a Persian Gulf War and oil supplies have disrupted, it would be likely that all equities around the globe would be negatively affected. But the fact that the correlations are not perfect, when things calm down, there will be some periods, almost certainly, when emerging markets underperform, and there'll be some periods when they outperform relative to the US, and that's common sense, and that's a good reason to diversify, because you're adding unique sources of risk. And there are other better cases where you see absolutely no correlation with something like reinsurance, because earthquakes and hurricanes don't cause bear markets, and generally, with maybe some possible major exception, earthquakes and hurricanes are not going to cause global bear markets. So there's logic. Even if the data happened to coincidentally for some period showing a high positive correlation, the odds are good that was luck, because there's no logic behind it. So you want to look for the logic of, should you expect low or at least, not extremely high correlation, and any asset that is imperfectly correlated should. Should be at least considered to add in your portfolio if it meets the other criteria that we've talked about, of having a premium that's persistent, pervasive, robust, of various definitions, has logical reasons for you to expect it to continue to persist.

Andrew Stotz 10:16
The last thing, and we're gonna, we're gonna get off this call. But the last thing is, last week, we talked about different funds that are alternative and providing much lower correlation. I did some work on that, and what I was struggling to find was, Can Are there any ETFs, or are they all going to be structured as funds?

Larry Swedroe 10:42
There. The good example of a fund that's available in a mutual fund is aqrs alternative risk premium from that goes long short, four different factors value, what they call defensive, which is buying high quality and shorting low quality momentum. So it goes long stocks, bonds, commodities and currencies that are doing well versus ones that are doing poorly. And the same thing for the carry trade, which is buying and selling stocks or currencies or bonds that have higher yields and shorting the others. So this, it turns out that not only are each of those factors low correlation to stocks and bonds, but they're low correlation to each other. So I mean, it's possible that AQR could turn that into an ETF, although it might be difficult, because they have 500 or 700 positions, making it difficult to replicate in an ETF. But in theory, you could if someone created an ETF of reinsurance risk that would make sense, private floating rate credit might make sense, although that is difficult because they don't have liquidity. That's why that's in interval funds. So there are, most of the assets are likely to be in either private vehicles or interval funds, which often means you're also earning a illiquidity premium, plus you're giving up the ability to trade it daily. And people love liquidity even if they don't need it, and you get rewarded with generally a large illiquidity premium if you're willing and able to take that risk. So

Andrew Stotz 12:40
for those in the audience, just go to black swans chapter eight, and Larry talks more in detail about the AQR style premium alternative fund and what it's doing. And you know the value that it brings.

Larry Swedroe 12:53
Here's an interesting point about that fund, Andrew, that's very important. And again, it shows the low correlation the first four the fund is now in existence. This, I think, is the 11th year, the first five years, it performed just about as you would have expected for the five years were positive returns, it yielded, I think, something like a four to 5% risk premium above t bills, which is what we had estimated it would be. And then the next three years were god awful lost like 30% or maybe a bit more as a drawdown, lots of people fled the fund, never to return, right? And because of the problem we've discussed of recency bias and thinking three years is a long time when any risk asset will go through, at some point, much longer periods than three years of poor performance. So most of the money left the next to me. Five the next four years, including this year, have been spectacular returns, something like 20% a year for the four years and so including 2022 when stocks and bonds both did poorly, and yet, the three years it did poorly, stocks did well. So there's good examples of an asset you should love because it has low correlation. You're buying if you have the discipline after it does poorly when the expected returns are higher, and now you've been selling some taking advantage, especially in 2022 the fund, I think, was up 25% when stocks and bonds got killed, both losing double digits. Unfortunately, most investors were not around because they panicked and sold. Same thing happened with reinsurance for the Stone Ridge reinsurance fund. First four or five years were fine. Next three bad years in a row, people, 80% Of the investor money fled, and then last year, the fund was up 44 and a half percent. I just checked this year, after two bad hurricanes that just hit Florida, back to back, the fund is still up 22% or something like that for the year. But again, most investors aren't there for recency bias, even relativity bias, and they need to and you you should love assets like that, because if they don't have periods of bad performance, then there's no risk, because all you have to do is wait three or four years and the returns will turn around. But we know that can't be true, so you want to that's a reason why you want to diversify, not avoid an asset class. So that prevents you from having all of your money in the asset class that happens to do poorly. Say you're a Japanese investor in 1990 after the most spectacular returns in history for Japan over the previous 25 years or so, right? They were on top of the world. Japan at that point was something like two thirds of the global market cap, and now it's 20% of the market cap or so, and they've had zero return for 34 years, virtually, right? So the same thing could happen in the US. I'm not predicting that, but it's possible. And investors make the mistake of treating the highly unlikely as impossible, and what they think is the highly certain, the highly certain as if it will happen when it may not.

Andrew Stotz 16:46
Well, let's end it on that. Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth, and I'm looking forward to the next chapter. The next chapter is chapter 18, and that is black swans and fat tails makes me think of the Black Swan book,

Larry Swedroe 17:06
yep. Well, thanks for having me. Glad. Hopefully this was helpful, and I'll see you next week.

Andrew Stotz 17:11
Fantastic. This is your worst podcast host, Andrew Stotz, sane. I'll see you on the upside.