Enrich Your Future 33: The Market Doesn’t Care How Smart You Are

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. And 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 33 and investors worst enemy, Larry. Take it away. Yeah.

Larry Swedroe 00:35
Thank you, Andrew, good to be back as almost always. Each of my chapters begins with a story to help people understand the difficult concept. And this story begins with my background. As a kid, growing up in New York City, and like most kids who were athletically inclined, I practically had a basketball glued to my hand. I went to school in the morning, ran home, had a glass of milk and some cookies, and then ran back to the afternoon center to play basketball from like 330 to five o'clock. Run home, have dinner, and then run back to play at seven o'clock till 10 at night there. And I was a good enough athlete that I was able to actually make my colleges freshman basketball team, although I spent most of the season collecting splinters on the bench, and it was only a d3 school, so I wasn't saying much at age 25 I moved out to California, where everybody pretty much played tennis. In those days, that was a much more popular sport even than it is today. And because I was a good athlete, I fairly quickly became a competent player. What people would say would be a good weekend player in US rankings, it would be like a three, five player. So I could play with most people and be competitive, but I would often play against people. At the time, I was 35 and a good athlete could run around and stuff, and I was getting beat by 6065 year old men who I was much better athlete then. But of course, they were better tennis players. And this, of course, became very frustrating. And finally, I decided that maybe I ought to learn how to play the game of tennis and what the right strategy was. And I was out on the court with a tennis pro on a vacation, and we were doing drills. And of course, my weaker shot, like for most people, was my backhand, especially in those days, if you use a one hand backhand. And the Pro, and we were rallying, and he hit a ball deep to my backhand, and I cranked up and hit her, and he came to the net, and I hit this beautiful passing shot like, look like Roger Federer, I do, and went right past them, right down the line, landed dead in the corner. And I'm feeling great, and I've got a big smile on my face. And he calls me up to the net and said, Larry, I want you to know that shot is your worst enemy. So what are you talking I just made this great shot. Said, the problem is you're going to remember that you made the shot and try to replicate it. And while I could make it, he said, nine out of 10 times, you'll make it one out of 10 times, and you play what is called, at your level, a loser's game of tennis. What that means is most of the points are lost by somebody hitting a ball wide into the net or long they're not one because you hit a great shot. Obviously, the higher the level you go, the reverse is true. The great tennis player, if you watch a match with Roger Federer against Nadal, if you were lucky enough to see those events, the points were one because somebody just hit a great shot and the other person couldn't quite reach it. There aren't that many errors at that level. So he said the key to winning the losers game of tennis, which is what anybody but say a pro level at a club, you know, would be, is to just get the ball back with a decent amount of pace so someone can't just wind up and hit it deep. Okay, keep the person back and stop trying to hit winning shots. Just try to avoid hit losing shots by hitting some great shot. And I said, Boy, that sounds like good advice. Maybe I could do better against these people who are better tennis players, but I'm clearly the better athlete, and all of a sudden, I was beating people fairly easily who were beating me. So the key to understanding any game is what's the right strategy, and so how does this all relate to investing most? People think the key to investing is identifying the stocks that are going to outperform the market and avoid the ones that are going to underperform. Yet the vast body of evidence says that's playing the losers game. You're much more likely to hit the ball long wider into the net than find the next Google, and the evidence is overwhelming that the vast majority of professionals who have advanced degrees in finance and mathematics have access to the best databases, etc, spend 100% of their time doing this stuff, have huge advantages over individuals. Yet, as we discussed, something on the order of 98% of them failed to outperform in any statistically significant way on a risk adjusted basis, even before taxes. So the right strategy is to avoid the losers game. Don't try to pick individual stocks or time the market, just invest in a disciplined way so you can stay the cost through bear markets, and you will win simply by getting the markets returned. And so that's the winners game. The problem is we are all human beings, and as people who have observed the world of investing, investors are all just like I was on the tennis court, overconfident that I could make that great backhand passing shot. They all think that they could pick the next great stock. 90% of the people of the ass think they can outperform the market when we know that maybe 2% of them do. So the key is to avoid human biases such as overconfidence. Understand what the right strategy is, and it's because the markets are so highly efficient, not perfectly. So markets make mistakes, but it's hard to identify, especially after the cost and I would add the time and effort required to succeed, right and aren't you better off spending that time with your spouse or your children or grandchildren, taking a nice walk around the park or in the beach, reading a book or playing a game With your grandkids, then trying to outperform by picking the next school book. I leave that to your readers. I think that's a rhetorical question.

Andrew Stotz 07:27
Well, I think that also you could say, if you're a young person and your objective is to accumulate wealth, figure out how to add more value at your job. Figure out, you know, you know how to start a business that adds more value. These are great ways to build wealth, you know, over time. I just want to go back to something you've hit on many, many times, and I know we've even talked about it in relation to playing a tennis player versus playing the market, you know, just to help people understand, you know, what's the difference? So, for instance, I can play that great tennis coach that you just talked about, and he could even have a bad day, and I could even win it. Could. I could be a winner, you know, he could have a bad month and all that. But, you know, what I'm playing is one man or one woman, in this case, depending. And what I'm thinking about is, you know, can you just talk about, who are we playing when we're playing with the market? Okay, we had a fun, fun, you know, game match of tennis, and we played this one person. We're playing pickleball, we're playing this one person. But what happens when we're playing the market? Who are we trading with? Yeah.

Larry Swedroe 08:31
So actually, the way to think about it, I believe, is this, the research shows very clearly, and I think it's pretty simple to understand when you play games where you're playing one on one competition, it actually only takes small differences in skill to lead to huge differences as an outcome. As much as you might like to think you could play a tennis pro and maybe even win a game or a match, that's never going to happen. Literally never, right? Okay, because small differences in skill. Roger Federer, for example, one maybe the greatest player of all time, never lost the single first round match in a Grand Slam tournament. Yet he was always playing against one of the best 128 players in the world, always, and he never lost, ever. All right, so one on one, you could play against a very a master chess player, and if that master chess player plays against a grand master, they'll never win. Maybe they'll win one or two out of 100 matches, the odds are tremendously in favor, even with a small skill advantage. However, when you're competing in the market, you're not competing against one on one, you're competing against the collective wisdom of the entire market. Including their PhDs and rocket scientists at Renaissance technology and Citadel and Warren Buffett, and the research shows it's much harder to win that kind of game because of what's called the collective wisdom of the crowd, and that's why it's such a difficult game to win.

Andrew Stotz 10:22
You said small skill advantages can have major differences in outcomes in one

Larry Swedroe 10:27
on one? Yep, all right, so let me use this example hitting a baseball. Maybe the greatest hitter of all time was Babe Ruth or Ted Williams or whatever. Okay that they, however, were playing a game of one on one. Imagine now that they were facing a pitcher who had Sandy Colfax his curveball, Randy Johnson's fastball, call Hubble's screwball. Greg Maddox is control, etc. The best of each one of them, they probably would hit 200 not 350 or whatever their career averages were, and that's what you're competing against when you're playing the game against the market. But investors never think about it that way. You call

Andrew Stotz 11:24
it the collective wisdom of the market. I guess when I was thinking about what you just said on the baseball pitcher, I was thinking the collective skill of the market.

Larry Swedroe 11:32
Yeah, that's right, it is the collective skill in the same way that Roger Federer, as great as he was, as if he was playing a person who had John McEnroe's volleying skills, you know, Andrew Radox, serve, etc, picked the best the best forehand, the best backhand. He would never have won. He couldn't beat him ever, right? And that's the same thing that is true when you're trying to beat the skill of a market, it is a much, much more difficult competitor.

Andrew Stotz 12:10
Is there any other parallel? I mean, clearly this. The parallels that you talked about tennis really help us to, you know, differentiate. Is there any other game that we play in life, that we're playing a collective experience or a collective skill in the market?

Larry Swedroe 12:27
Well, any one on one game shows you that small differences in skill lead to big differences in outcome. The only one that I can think of, generally is the stock market where you're competing there. However, there are all kinds of other markets, foreign currency markets, betting markets. Now, right? We've got betting markets on almost anything like, will the US launch a strike against Iran in the next 90 days? You can bet on that, and very few people have the skill to outperform the market, especially after the trading costs, because the brokers in that trade, or the house Las Vegas, is taking what's called the vigorous maybe 5% so you have to win like 53% of the time, not 51% of the time. The

Andrew Stotz 13:24
vigor ish, I love that word. You've talked about that before,

Larry Swedroe 13:28
good Yiddish word that became an English word.

Andrew Stotz 13:31
Yeah, that's a good one. In the last section on page 210 you talk about the amount of money that the capital market is extracting. You talked about 150 billion. Maybe we can close with that discussion. Yeah.

Larry Swedroe 13:45
So Ken French did a paper on this and show that the average active fund underperforms by a certain amount every year after expenses, not taxes, even. And he then multiplied that number by the amount of money in actively managed mutual funds to come up with that figure. So the average investor in mutual funds that are actively managed is losing that amount of money. Just think about what the average person could do if they had that extra cash. And you know, it would be like a matching grant to their IRA every if they stopped just trying to beat the market and accepting market like returns. Yeah.

Andrew Stotz 14:28
I mean, that was a good chapter to help, help everybody to think about, who are we competing, about against, and how are we trying to compete the

Larry Swedroe 14:38
way I try to end these conversations and giving advice to people is so I ask them. So I'll just ask you, Andrew, you know, think of a stock that you want to buy. You give me the name. I ask you all the reasons why you want to buy it. You've done your research, or at least you think you've done research. Search. And you give me all these reasons, and then I agree with you that, let's assume you're 100% correct. Everything you say is true. And then I ask you, do you think that Warren Buffett, they're rocket scientists and Renaissance technology and Citadel they're unaware. And you know, you think the stock is at 30, but should be 40. If they thought it was worth 31 it would be there, because they've got billions of dollars that they can move the prices and move it there. It's obviously at 30, because they don't think it's worth 31 let alone 40. So what you have to think of is this, 90% of the trading today is done by the big institutions. That means, if you're buying a stock, you have to ask, who's the sucker I'm buying it from, who's selling it to me, 90% of the odds are it's Warren Buffett or Citadel or some other and then you have to ask, who's the sucker at this poker table? Is it me, if you're honest, the odds are highly likely it is, unless you have inside information, and Martha Stewart found out, what happens if you trade on that and get caught?

Andrew Stotz 16:15
Yeah, that could be your worst investment ever if you trade on that inside information. Yeah, I think the good question is, is it? It's not even a question, it's a statement. It's already in the price.

Larry Swedroe 16:27
That's that's real. What you should always assume is that everything you know is either in the price or illegal to trade on.

Andrew Stotz 16:39
And on that note, I want to thank you for another great discussion, and I'm looking forward to the next chapter, chapter 34 where we're going to talk about bear markets, unnecessary evil. And for listeners out there who want to keep up with what Larry's doing, find him on X Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. I.