Enrich Your Future 37 & 38: The Calendar Is a Crook & Hot Funds Are a Trap

Larry Swedroe 00:00
You know what the definition of a broker is, someone whose objective is to transfer money from your account to his account?

Andrew Stotz 00:07
There you go. And 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. And 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. And we're going to be talking about chapter 37 Sell in May and go away. And chapter 38 chasing spectacular fun performance, Larry, don't go away in May. Take it away.

Larry Swedroe 00:45
Thank you. Good to be back. Andrew, well, this is one of the things you hear every April, right at the end of the month, that there's this advice that investors should sell in May and go away like many of these axioms, bits of advice, they're legends without actual facts or logic even behind them, but there's usually a hint of truth somewhere in them to cause people to believe it. So let's look at the actual evidence. It is true that stocks have performed much better from November through April than they have from May through September. The stocks in the last roughly 100 years, we have data for the annualized premium from November to April was about 10 and a half percent, and the annualized premium from May to October was about 3.8% okay, so stocks got almost 14% from November to April, when T bills were about three and a quarter, and stocks got about 7.1% from May through October, when T bills were a little bit more than three and a quarter, so there's clearly evidence that stocks do much have done much better for whatever the reason, from November through April and hence, maybe people say you should sell in May and go away. But here's the facts, without even considering the taxes you would have to pay, and in the US, you'd be creating all short term gains, equities returned 7.1% per annum from May through October of 20 for the period through 2024 And outperformed T bills, which returned 3.32% by 3.8% now Gee, that seems like a pretty good equity risk premium to me. And so clearly, there's no logic, no facts. And here's what's really stupid in my mind about it. For you to believe in a strategy, there should be some economically logical reason for it to persist, so you could be confident it isn't just some random outcome. Maybe, for example, it could be a few outliers that causes this, like the crash in September of 29 right? We also had the famous crash in October of 87 when the market dropped 23% and then we had March of 2000 when the internet bubble burst, right, and 911 was September event. But here's the thing, in order for you to believe that stocks are going to underperform totally riskless treasury bills in that period, you must logically believe that stocks are less risky than riskless T bills, because the higher risk asset should, in the long term, provide a higher return. And I think there's nobody who would say stocks are less risky and therefore have lower expected returns in that period. So it's just another one of this bit of nonsense that gets repeated. I heard it again this April, and God help the poor fools who listen to it, at least so far as the month of May, had a huge rally so

Andrew Stotz 04:53
far. Yeah, and why? Why is it that you always talk about the stock? Returns in relation to the risk free rate. You know, other people talk about the absolute stock returns. Why is it you always go back to that?

Larry Swedroe 05:08
Yeah, because you should get a risk premium for taking the risk. And so the benchmark for any asset that has risk should always be the T bill rate. And then you can decide, Is there a large enough risk premium for you to justify taking the risk based upon your own individual situation? I will point out that 2022 was a year that seller may really work well, but it was the last time before that was 2011 went a decade of underperforming every year, and yet still it persists. So you're saying there's a chance, yeah, there's all Yeah, and then people claim at work around anyway. Look what I tell people is the thing you don't know about investing is the investment history you don't know.

Andrew Stotz 06:05
Let me ask you one other thing about this, which is that in your discussions, in your book, and other areas, your discussions about factor investing, you say, one of the things that's important about factor investing is that there should be some logical underlying, you know, relationship you know as to what you're saying. And reason I wanted to ask about that, because some people may say, no, no, but I found that relation between the price of butter in Bangladesh and s, p5 100 and it's, it's, it's a lasting relationship and, and let's say that there's something out there. But why is it so important that it makes sense,

Larry Swedroe 06:43
right? Because you have to be careful to not confuse correlation and causation. If you test, for example, a correlation, and there's a standard test you call the T stat, and the standard had been to test for a T stat of at least two that meant there was a 95% chance. You could be confident it was not a random outcome. Still, it was a 5% chance. But that's reasonable odds. Now, when I was going to college and in order to program a computer, going to date myself here, we had to go in and program punch cards, hand it in overnight and pray you got it back a few days later. Right? So the problem, the benefit, if you will, of that is you really had to have done your work created a good hypothesis for why there was a logical explanation. Say, for example, consumer confidence could predict stock markets. Let's say you believe that that would seem to make sense. If people were confident they put money in the market and put prices up, they became less confident. People would go down. And so you would test that, but you wouldn't test butter production in Bangladesh against the US, because there's no logical reason for doing it today with high speed computers and much broader, better databases and how cheap it is to run data. You can just ask chatgpt to run a correlation, and three seconds later, you might get an answer. The problem is, if you tested 20 and it would take you seconds and cost nothing or virtually nothing, you would get one of them would likely be correct, and it would be purely random. If you just ran 20 samples created 20, you might find one, and that's a problem. So economists, or financial economists, have proposed raising the T stat standard to at least three today, which would mean a 1% chance. But still today, I just read a paper on volatility. Is it a good predictor of downside risk? And there are lots of measures of downside risk, maximum drawdown, semi deviation, which is only the downside, and a whole bunch of other things, Value at Risk, etc, and they tested 1500 now, if you test 1500 almost certainly you're going to find randomly, you know, correlations, but it doesn't mean there's a logical correlation. And today, with the access we have to computers and artificial intelligence, it is very easy to torture the data until it confesses.

Andrew Stotz 09:53
Yeah, and that's interesting, because what you're talking about is, in the old days, you had to structure your hypothesis before you started. Tinkering, whereas now we can tinker and then, and then, you know, create a hypothesis. Yeah. And one of the things that reminds me of my, one of my favorite guys in that influenced me a lot in my life is Dr W Edwards Deming of the quality movement. And what he said was, there is no learning without a hypothesis. Yeah, you know, if you don't set a point right that you're predicting, then any outcome will give you information, but it may not give you knowledge.

Larry Swedroe 10:37
Yeah, that's it. That's you. You always have to confuse information. You have to make sure you don't confuse information with value added information. Oh,

Andrew Stotz 10:50
your bar is always so high. Larry, before we go from selling, may you can go away. I started as a stock broker myself in Bangkok, Thailand in 1993 and I was a research analyst, and I work with a guy from London, and his name is Henry Woodruff, and he said, he he said to me that I love the idea of being a stockbroker in Thailand, because when people ask, what do you do? You say, I'm a stockbroker. They want to hear your views on things. He said, But when I was in London, nobody cares about a stock broker's opinion about anything. And that was, that was pretty funny. But also, you know, we buy from my coffee business. We buy machines, coffee espresso machines, from the largest producer in Italy, chimboli, and we always had to get our orders in early because they shut down in August. So over the whole month of August is shut down. And we know that in Europe, you know, in the UK, to some extent they take long, you know, breaks over the summer. So I always thought that selling May and go away was simply people saying, Please don't bother me, because I want to take the summer off. So,

Larry Swedroe 12:00
speaking of stock brokers, my favorite line is stealing from Woody Allen. The definition of a stock broker is someone who's objective it is to transfer money from your account to their account.

Andrew Stotz 12:13
Yeah, unfortunately, that's that. That can be true. All right, let's move on. So that's a good one. What about, uh, chasing chapter 38 chasing spectacular fun performance. What do you want to tell us

Larry Swedroe 12:24
about that? Yeah, so one of the things we've talked frequently about in our discussions is that investors are prone to all kinds of behavioral errors, and one of them is recency bias, so they project recent events into the future as if it's inevitable, and ignore all the historical evidence. Okay? And that's what actually leads to the phenomenon called momentum, which has no logical risk based explanation. It's that people tend to overweight, in some cases, recent data and project it, and that pushes prices up, and it can also cause prices to go down as well. So there was a we know that when a fund has spectacular performance, what is Morningstar? Do they raise their ratings. And we know the studies have shown that when Morningstar raises its ratings, guess what, funds flow to those funds. So performance itself leads to fund flows, and then ratings follow performance, and that leads to fund flows. And that can actually cause momentum because those funds buy the same stocks, okay, but people forget what often causes spectacular performance is valuations going way up. Okay, so it's interesting. Study was done by Morningstar and Jeffrey patak, he conducted a study that looked at all mutual funds that gained over 100% in the calendar year, which is, yeah, that's spectacular. No one would deny that he found 123 of them between 1990 and 2016 so a 27 year period, just 24% of them, or, you know, just 24 of them, not 24% that's about 20% of them, made money at all in the three years Following the big gain, and much worse than the average fund proceeded to lose 17% a year. That's pretty bad, because if you make 100% and then lose 17% every year, you've given back. Maybe a huge chunk of those gains, maybe even all of them. So the doc also found that funds that had lost money in the years before the big gain were far likely to earn a positive return in the years after the big gain than funds that made money in the run up to the big game, he found 18 funds that earn more than 100% in 2020 and all of them were trading extremely expensive, three times the value of the NASDAQ. And we know the one of the certain things, although it doesn't predict short term returns, is valuations do or are the best predictor we have of longer term return. So you don't want to chase funds that had spectacular returns, because valuations have gone way up.

Andrew Stotz 15:58
And does it mean that you should if you happen to be the lucky one that's owning in a fund that has 100% return, should you exit it?

Larry Swedroe 16:09
Well, I would ask the question why you bought the fund in the first place, and what caused the gains, and how are the valuations? So for example, let's say you are an investor in a distress Value Fund coming out of 2000 and, you know, and the market and the spectacular returns and growth stocks in the 90s valued it poorly, and then you get the recession, you know, now, the PES are six, and the stock double in valuation to 12, leaving you about the historical valuation of value stocks. I don't see any reason to panic and sell there. Your basic reason for owning those that fund is you believe in value investing and prices were about their historical average. So why would you sell? Would you cause you to sell evaluations or stretch so that, let's say, historically, value stocks traded at 12 and growth stocks traded at 20. If value stocks had a run and that led to cash flows and value stocks were now trading at 18, and growth was still trading at 20. Well, now maybe I want to get it. Consider getting out or at least rebalancing, reducing my exposure, because the premium isn't likely. Their premiums are regime dependent, dependent on the spread in valuation.

Andrew Stotz 17:44
So the important part about that is that you state your intention, you write your intention in your investment plan, so that when you go into it, you understand what you're expecting. So in fact, in a turnaround fund, you may expect it's going to do poorly for a bunch of years, and then one or two years, it's going to have a huge return, as opposed to getting to the point where you're sitting on a huge return, and you're rewriting history because you never really wrote it, and then you you end up getting caught in this situation where you're coming up with reasons and excuses as to, you know, why am I owning this? Well, because, you know, I saw that there was a big tech boom, and, you know, therefore such and

Larry Swedroe 18:27
such, or fear of missing out another behavioral mistake, yeah, deadly disease.

Andrew Stotz 18:35
Bomo, well, I think that's a great discussion. And ladies and gentlemen, the sad news is you can't take June, July and August off. You got to stay in the market. So Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth. And I'm looking forward to chapter 39 and has just one word as a title, and it's called enough. There's many ways to interpret that one word. And for listeners out there want to keep up with all that Larry's doing, find him on X Twitter at Larry swedroe, as well as LinkedIn, and follow him on sub stack, and you will get a notification in your email every few days of what he's doing. So keep up that great work. And this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.