Enrich Your Future 25: Stock Crashes Happen—Be Prepared

Andrew Stotz 00:01
Andrew, hello, risk takers, this is your worst podcast host Andrew Stotz, from A Stotz Academy continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now, Larry stands out because he bridges both the academic research world and practical investing today, we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. Specifically, we are talking about chapter number 25 battles are won before they are fought. Larry, take it away.

Larry Swedroe 00:37
Yeah. So Nobel Prize winning professor, hopefully your listeners know the name gene fama. He was the thesis advisor to Myron Scholes, who was credited with the CAPM and stuff at the university. He studied the historical distribution of stock returns, and here is what he found. He found that the population of price changes if it was strictly normal on any stock, then a standard deviation shift of from the mean of five standard deviations should occur about once every 7000 years. The reality, though, is it occurs about once every three or four years in the US equity markets. So we know the distribution of returns is not normally distributed. There are big fat tails in the distribution, which means that investors should be prepared to, you know, have to live through once every three or four years, on average, a big shock to the markets, right? And so I began this chapter, which I called, as you noted, battles are won before they are fought, telling the story of Sun Tzu, which was an honorific title bestowed on Sun Wu. He lived from 544, to 496, BC, and he's famous for authoring the art of war, an immensely influential ancient Chinese book, a military strategy, which many business leaders have quoted the wisdom from that book. The book has got 13 chapters, each one dedicated to an aspect of military warfare. Now investors I felt could benefit from one great insight, which was he said, every battle is won before it is fought, which is why he told the story of farmers inside. If you know that, we get these massive, you know, hits to the market, five standard deviations in moves. Some good examples would be October 1987 when the market crashed 23% in one day. That's the standard deviation over a full year, about even higher than the standard deviation for equities over a full year, which for the S, p5 100, is about 18% if my memory is served. And then we have the, you know, crashes in 1998 Andrew, you're living in Thailand. So you would remember that period when we had what was called the Asian contagion. Went all around the world. We had crashes. Then we had the.com crash. Then, of course, you also had long term capital crash in around the time the Asian contagion, when their models, you know, forgot that left fat Tails can and do hit and that. And also, importantly, they seem to forgot they were relying on the fact that correlations tended to be relatively low with the strategies they looked at. But they if they looked at the history, which you would think smart guys who had won Nobel Prizes would have done, they would have seen that in crises, all risky assets can tend to see the correlations go towards one, particularly for the types of strategies that hedge funds engage in, because they tend to invest in a lot of risky, illiquid assets, and illiquidity dries up. I mean, liquidity dries up, and those assets all get killed at the same time. So, you know, long term capital was relying on, what does Russian debt markets have to do with Brazilian debt markets, or, you know, high yield bond, or the currency of Thailand have to do with Russian debt? Well, they all went highly Carly. Of course, we had. A, you know, financial crisis of 2008 we have the COVID crisis of 2020 and then we had stocks and bonds both get crushed in 2022 So the lesson here is that the markets don't always look like the last 17 years in the US or the 30 years before 1990 in Japan, where they run way up, and then people get too enthusiastic, your plan should always recognize that there are these big risks in markets, and your financial Plans should take into account that they're going to occur once or twice on average or so a decade, and you have to be able to survive that, both financially but also psychologically, because life's too short not to enjoy it, and even if you don't panic and sell but you're losing sleep because Your portfolio is getting crushed. Well, that's a serious problem, right? So the story here is you have to know your investment history. You have to be prepared for these bad events. No one generally can forecast them with any persistent accuracy, and therefore you need to have not only that plan that's well diversified, that can live through these events, doesn't take more risk than you have the ability, willingness and need to take, and you also have the plan B, because we don't want to have the most conservative portfolio. That would mean you know that we assume the absolute worst is going to happen when likely it doesn't over the long term. But if that left tail shows up and we have to cut spending, what are the steps I'm going to take in order to avoid panic? Selling my portfolio right? Maybe to sell a second home. Plan on working longer. Move to a lower cost living area, move in with your mother, whatever the case might be, or have your mom move in with you. Yes, there's

Andrew Stotz 07:09
a couple of things that I wanted to there's two different directions. The first one I wanted to just highlight that the study is done on the market, as opposed to individual stocks, so that for people that have a portfolio of individual stocks, you could see that that movement is even 10 times worse, and some stocks even go to zero. So you could own that stock at 100 and it goes to zero. Right

Larry Swedroe 07:31
factors to give you some statistics there that roughly the standard deviation of the market is roughly 20. Okay, that's the measure of volatility. The average stock volatility is twice that. And if you buy high volatility stocks, it could be triple or quadruple that, and then you have even more risk when that five standard deviation

Andrew Stotz 07:57
event occurs, yeah. So that's the first thing is to be aware about this volatility, specifically about individual stocks too. Now the other thing that that makes me wonder about I'm just thinking about, is when we do tests in academia and we look at whether this was just a random outcome, and we try to understand, did this portfolio manager, as an example, outperform by by just pure statistics that he that there's going to be a certain number of people that are going to outperform by a certain amount, or we're going to say no, in fact, it can be attributed to something. How does a stream events like that fit into that, you know, that analysis that we're doing of persistence in performance, or something like that, yeah, it's

Larry Swedroe 08:50
one of the reasons why you need to have very long periods of data to really understand markets. I mean, I think Ken French once pointed out that to be 100% certain, or if you will, that there is a value or a market beta premium, you need at least 75 years of data. Most people don't have investment horizons that long. So the best we could do is make the best estimates we have based on the data, and what we can say is this, we know, based upon studies by French, Ken French and Gene farmer, for example, that only about 2% of all active managers are produce statistically significant alphas, once we adjust for risk, that's less than you would randomly expect. So it's hard to say that those people have skill. Is it possible they do Sure, but there's no way for you to tell, and therefore you shouldn't bet you know your portfolio on the likely. Hood that they have skill. And if you know, as a great example, one of the great money managers, at least in that era, he accomplished something that no one had ever done before, a guy named Miller at Legg, Mason, value, trust, I think of my memory served. He'd outperform the s, p, not over a 15 year period, but 15 straight years, yeah, claimed him the greatest money manager, better than Buffett or Lynch. None of them had ever done that. And the rest of his career, he got slaughtered, and he got fired twice, if my memory said, you know, or was relieved of his you know, role as the manager, because the results were so poor. So how do you know? You know, 15 years is not enough. I think most investors would say, surely that can't be locked. How to be skill well, did he just one day, you know, have a brain fought and then lost his mental skills? I don't think so. So then you have to conclude he just happened to get lucky.

Andrew Stotz 11:03
So let's, let's now, um, talk about the other thing that I, I always kind of, I have questions about, and that is now, for a typical investor, particularly in Asia, but let's say around the world that they have their own business. Let's say, and they're generating cash, and they're putting that cash in the bank, and they're pretty satisfied with that. You know, they're like, I got my high risk business there, I generate my cash, and then I put it in the bank, and I get one or 2% but I don't care, I put it in treasuries and I get, you know, whatever. But the point is, it's kind of a barbell strategy. This is my high risk part, and this is my low risk part. But now let's say that that person allocates money into the stock market, and they say, Okay, I'll put, you know, I'll put X percent of that money from the bank into a, you know, a Vanguard Index Fund as an example, knowing that there's going to be a time when the market's going to go down. And, you know, in this case, they have the they have the stomach and the income producing ability of their company that they don't even really need to blend in other types of things to reduce risk, because ultimately, let's say they put in 50% of their money in the market and 50% in cash. When you look at the whole portfolio, it's actually when you look at the volatility of that portfolio, you're not pricing it in your portfolio so much. But you can see when the market collapses by this anomaly, then the cash doesn't go down, and so therefore, it's the ultimate, let's say the perfect diversifier. It just said it doesn't earn that much return. So I like to start with diversification, thinking about cash as a starting point. But now let's imagine that they say, Okay, well, I'm going to buy a bunch of different things someone else is buying. They're building a portfolio. And they say every the correlation was fine, until that crisis, and then the correlation collapsed, or, sorry, the correlation rose, and everything moved together. Well, that was for 15 days, you know, that the market crash, and then it all bounced back, and then those correlations went back to normal. So if you were sleeping, you're in the hospital with a coma for 15 days. All the correlations went perfectly positive, and everything went that way. And then it all bounced back to normal. And then you wake up and you go, see your portfolio. Should you have, you know, should you have diversified in some way to prevent that? Or should you have would have been better if you were woken up right at the point where everything is perfectly correlated. So you gotta do something now. How do we think about that point in time correlation?

Larry Swedroe 13:35
We could probably spend hours on this particular topic. Let's see if we can give a short answer. First of all, I think the most important thing I would point out is here is the evidence. That's very clear from a bunch of studies. They found that the more attention you pay the portfolio, so how often you check its value is inversely correlated to your returns. So the more you check it, the more likely are to do something, and doing something is likely to cause you to make a mistake, because doing nothing, as you point out, over that long term, is likely to prove better. And there's a simple behavioral explanation for why that is true, there are good studies on loss aversion. I'm sure you're familiar with that term. What that tells us that the joy you feel from $1 gain is about half the underside of the pain you feel from $1 loss. Now, make it 1002 1000. It's probably triple. Make it 10, you know 1010 1000, or, you know, up to dollar amounts, or 1,000,002 million, and maybe it's 10 times as bad. So

Andrew Stotz 14:57
loss hurts much more than. Then gain and dollars,

Larry Swedroe 15:02
the bigger the difference. All right, so what does that have to do with the markets? What is the percentage of time stocks go up over annual periods?

Andrew Stotz 15:18
Roughly on average, maybe 70% of time. That's about 70%

Larry Swedroe 15:23
or so. So that's pretty good odds. If you can wait 10 years, it's not certain. What's the odds at an annual periods? It's 70% what is it daily?

Andrew Stotz 15:42
I mean, my first reaction to that is 70% but is it different?

Larry Swedroe 15:47
5050? Yeah, about half the time. Okay,

Andrew Stotz 15:52
so, okay, sorry, let's just clarify, just so we all understand. We're just talking about up versus down. We're not talking about the degree versus Okay, I see what you're saying. Yep, that's

Larry Swedroe 16:01
roughly 50% so think about that over say, a month, you have 20 trading days, on average, 10 will be up and 10 will be down. If we give you one point of joy for each of the good days, you have 10 points of joy and 20 points of pain, you're more likely to make a mistake and sell because you're feeling the pain. So that's a real problem, and why you shouldn't look at short term performance. The other thing I would point out is, while correlations tend to go way up of all risky assets, when we have a crisis, volatility spikes, people look for safety, and they sell anything that's risky. But those tend to be short periods, as you know, but those short periods could last two or three years, not necessarily two or three weeks. Sometimes, as in the case of COVID, they only lasted about a month, and the market rallied and from and the great financial crisis that lasted from about, I think, October of oh seven through March of oh nine, a lot longer and much more painful period. And I saw lots of people panicking then. So the right answer is, should you diversify and own equities? And how much should depend upon your willingness to absorb those periods sleep well, not check your portfolio, not panic and sell? And so this gets to in my books. For those interested, my book on your successful and secure retirement. Also, I wrote a book your only God you'll ever need for the right financial plan. It walks through who should own more equities, who and how much? There's another one talking that talks about that. One doesn't go into specifics, but, and I don't talk about who should own more US stocks, and should own more international stocks, emerging markets, real estate, we ask questions that should be asked, and the question of diversification gets into things like for us, investor, if you're going to panic and sell because emerging markets underperform for a decade, you shouldn't have owned them In the first place, because that's going to happen with certainty at some point in your life, and then there'll be another decade where the US underperforms almost certainly, so that that's not a reason, here's my last comment. There every single asset that's risky is going to go through long periods of poor performance, long periods decades. Sometimes that must be true, or there'd be no risk. All you have to do is wait five years or 10 years. There's no risk long as I'm going to live that long so any 2030, 4050, even 60 year old, can own 100% stocks and just wait it out. That's nonsense. We know that's not true. That's not a reason to avoid an asset. That's a reason we diversify and rebalance. And then we know, as we've talked in our series, that risk assets have self healing mechanisms. When they do poorly, it's mostly because their valuations have gotten cheaper and now their expected returns are higher, but you only earn them if you stay the cost and, even better, rebalance. So

Andrew Stotz 19:32
let's go back to this concept of kind of a moment, just because it hits the news every now and then, all assets are correlated right now, you know, and for me, I feel like it's kind of a waste to even think about that. We're not talking about the fact that sometimes low correlation assets have a period of time where they have a higher level of correlation, which is fine, interrupt

Larry Swedroe 19:59
there. But. This is really important for people to understand what they don't. May not understand about correlation. We look at correlation, say, of stocks and bonds. We're looking at data from 1926 to 1924 that's through 2024 that's 99 years. What we're looking at is the average correlation over the period. There are many long periods, in fact, when stocks and bonds are positively correlated. In fact, on average, it's about point two positive. But we know there are also long periods when it's negatively correlated, right? So you know what you have to be aware of when we talk about correlations, we go through different regimes, and you have to be willing to live through them to get that average correlation likely over that long period.

Andrew Stotz 21:00
So yep, and now let's go back to this event. So what I tell people is, I don't really care about high correlation at a short moment in time. And if you got some advisor that's telling you, oh my god, the correlation between stocks and bonds have now gone so high you need to take some action right now. I think that's just a mistake. I mean, unless you're trading on that correlation going back to normal. And therefore, I just don't really pay a lot attention to the concept of assets being highly correlated for a short period of time of crisis, because otherwise your only thing is okay, guy, if you don't want that, then put more money in cash, because cash is never going to be correlated to the market in that way. And then you just cause your return to go down. So just ride it out and come out the other side of that short period.

Larry Swedroe 22:00
I would agree completely with the point to be just to add, you must be aware that those correlations are regime dependent, and you should be aware if someone tells you stocks and bonds basically have low correlation, as I said, they're something under point two, that's pretty good. Diversify, okay, but you have to be aware there are even some long periods, and we saw it in 2022 when they went highly positively correlated, because we had high inflation, and that killed stocks and it killed bonds. So if you can't take that risk for whatever the reason, or don't want that risk, then you have to shorten your duration of those you could still own bonds, but don't own a 20 year bond. Own a two year bond to cut down that risk, and you could still pick up a premium, typically over cash, pick up some of that term premium, or you could seek other assets, like private credit, for example, a floating rate debt. So, you know, you don't have that inflation risk.

Andrew Stotz 23:08
And there's another thing about correlation that I want to talk to you about, just because I'm not sure if I understand it perfectly. But I was just doing some correlations, looking at some you know, I was looking at something that had a very low volatility, but it had a high correlation to equity. Now let's just imagine, for our sake, that it's 100% correlation between these two assets. But let's just imagine that one of the assets has a volatility or a variation in their return that's 1% positive, 1% negative, whereas stock market has 10% positive, 10% negative, you can say that these two are perfectly correlated. When the stock market goes up by 10% this one goes up by 10% on the 1% Yeah, by one here. So

Larry Swedroe 23:54
here's the definition most people I found. I once asked a group of advisors, okay, who should know better? How you know to define correlation, and not one out of about 100 got it right. They all thought it meant positive correlation, mean when one goes up, the other goes up and negative, mean one goes up and one went down. I even met a money manager who was willing to bet me 100 bucks that that was the definition, and I had to show her mathematically, that's wrong. Okay, here's the definition of correlation. When one asset produces above average returns relative to its average, the other asset also produces above average returns relevant to his their average. So if one is plus 10 and minus 10, the average is zero. Okay, so the average return is zero, but its standard deviation is 10, and in your example, yeah. Something that's plus one and minus one. If, whenever the first one went up 10, the other went up plus one, and when the other went down 10, it went down one. The correlation would not only be positive, it would be positive plus one, perfectly correlated. Now let's assume the other way, when, when stocks went up 10, the other asset went down, one, all the time, and vice versa. That would be perfectly negatively correlated. Okay. Now what we would love to see, if there is such an asset, the ideal asset would be negative correlation and high volatility. Why? Because if your stocks are doing poorly, you want the other asset with its negative correlation not only to do well, but to do super well. And if stocks are doing great Well, the other went down, okay, and but your stocks went way up, okay? And now you can rebalance, and you'll get a big diversification return if you're disciplined. So ideally, in fact, now no one should want to, you know, have this kind of thing happen. But I actually saw an example using turkey over some period where the return to the stock market in Turkey was like minus 3% per annum, but it was you ran a mean variance optimizer, it would have told you to own like 5% of Turkey in your portfolio, because it went like this and this at exactly the right time. Now nobody would if you ask them, would you want to own an asset that lost 3% a year for a decade, they would say no, but hey, look, here's the evidence, right? So what the ideal thing is, you're looking for something with a low or even slightly negative correlation, and hopefully not high volatility, because you're trying to dampen the volatility of the

Andrew Stotz 26:59
equity That's great. Well, excellent discussion. It answers a lot of questions for all of us. I want to thank you again, Larry for this great discussion. And I'm looking forward to chapter number 26 which actually, you know, really is one that everybody needs to understand clearly. And I think there's lots of different misunderstandings too. Dollar cost averaging. For listeners who want to keep up with what Larry is doing, just go to LinkedIn or Twitter and you're going to find him there at Larry swedroe on Twitter and at Larry swedroe on LinkedIn, and he responds. So make sure you leave a comment and talk about it. This is your worst podcast host, Andrews dot saying Larry and to the audience, I'll see you on the upside. You.