ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?

Listen on

Apple | Google | Spotify | YouTube | Other

Quick take

In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this third episode, they talk about mistake number three: Do you believe events are more predictable after the fact than before? And mistake number four: Do you extrapolate from small samples and trust your intuition?

LEARNING: Know your investment history. Don’t be subject to confirmation or recency biases.


“The key to long-term success is having a deep understanding of history and not being subject to recency bias.”

Larry Swedroe


In today’s episode, Andrew continues his discussion with Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this third series, they talk about mistake number three: do you believe events are more predictable after the fact than before? And mistake number four: do you extrapolate from small samples and trust your intuition?

Mistake Number 3: Do you believe events are more predictable after the fact than before?

People often believe that events are more predictable before the fact than after. Larry says this is a big investment problem because it leads to overconfidence. After all, investors think they know what the outcome is.

To avoid making this mistake, Larry’s advice is not to act immediately because if you do, you’re likely acting based on irrational fears. You don’t know the investment history and have a confirmation bias. The cure for this bias of believing events are inevitable is to think before the fact when the events are far from certain, let alone inevitable.

Before you invest, Larry says you should keep a diary. Write down what you think will happen and compare it with the results after the fact. This analysis shows that you don’t know the future any better than anyone else. Your crystal ball is just as blurry. So don’t try to make forecasts based on your views because you think events are predictable.

Mistake Number 4: Do you extrapolate from small samples and trust your intuition?

People make investment judgments based on small samples, typically recent ones. For example, growth dramatically outperformed small-value stocks in 1997, 98, and 99 because of the Dotcom bubble.

So people judging by that small sample didn’t look at the long-term historical evidence, showing a 20% chance that growth will outperform small value over any three-year period. At five years, the likelihood drops to 15%. At 20 years, the chances of this happening are between 3% and zero. So there’s always a chance that growth will outperform small value, but the longer the period, the less likely it will happen.

Larry insists that you have to know your investment history. Whenever you see a small sample, look at the long-term data and remember that when investing in risk assets, three years is a very short time, and five years is still a pretty short time. You need much longer periods. The key to successful investing is not intelligence; it’s patience.

Final thoughts from Larry

Know your investment history and keep that diary every time you make a forecast.

Did you miss out on previous mistakes? Check them out:

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.


Read full transcript

Andrew Stotz 00:02
Fellow risk takers this is your words podcast hosts Andrew Stotz, from at Stotz Academy and I'm here today, continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry has a deep understanding of the world of academic research and investing and especially risk. Today we're going to discuss a chapter in his two chapters in his book investment mistakes even smart investors make and how to avoid them. Mistake number three, is the first one we're going to cover which is do you believe events are more predictable after the fact than before? And number four, do you extrapolate from small samples and trust your intuition? Larry, take it away.

Larry Swedroe 00:49
Yeah, let's begin with this issue of people believing in that events are predict more predictable before the fact that then after. And this is a big problem in investing because it leads to us being overconfident. Because we think we know what the outcome is. And we always say I knew it was going to happen, right? So the example I like to use to help with this is there was a famous Superbowl us championship game for the National Football League, where the Seattle Seahawks were needing a touchdown. At the end of the game, they got down to I think it was the three yard line and first and goal. And they had the single best running back in the National Football League, a fellow named Marshawn. Lynch also happen to have a good quarterback named Russell Wilson, everybody was thinking that they're just they've gotten enough time out about them. I think it was a minute or 40 seconds, they could run several plays that have the timeouts. And they would just hand the ball to lynch three times and they would hammer it in on the very first play, they call a pass and it gets intercepted. All of the analysts and people are screaming when this is the dumbest coach's decision ever. And everybody watching was fives. I know what they should have run, right? Well, a group of cyber metocean Cyber mathematicians did the actual analysis, right, and looked at the historical evidence inside, say, the five yard line first and goal, what had happened. And they had found that three times Marshawn Lynch had fumbled the ball. And never in the redzone, even just in that area, that inside the near the goal line had Russell Wilson thrown an interception. So the odds clearly based on the long term historical evidence suggested you tried to pass now. And

Andrew Stotz 03:08
and also just to add, I would expect that the opponent would definitely anticipate that run that that was gonna be anticipated. Yeah,

Larry Swedroe 03:17
they'd be lining up, we've got to stop the run. That's almost certainly coming. Turns out that, you know, one of the defenders made a great play, stepped in front of the receiver intercepted it, and they lose the game. The Cyber mathematician showed that the coaching decision was the absolutely right one, based on the statistics, but people ascertain and then they'll say, I know what they should have run, right. And when they get it wrong, they never recall the events that they got wrong. They only remember the events and they were they say I know it, they never should have done that. Right. So let's the example I use in my book on the investment side is it's 1989. And Japanese stocks have dramatically outperformed US stocks over the last decade. The Japanese real estate, and I suppose in the land under the Imperial Palace was worth more than all the real estate in California. Japanese companies were taking over the world. We have had like one mountain of semiconductor plant left in the US. They were buying up Rockefeller Center and Pebble Beach. And the chairman of Sony appears on the cover of either Forbes a fortune and it's bad job Japan Inc is taking over the next 2030 years the US far outperformed and everyone's think oh, I know it right. Well, nobody pretty much know it. Maybe If I bought we credited ourselves. And when you do that, that leads to overconfidence. So when I talk to people, and they tell me, this is what's going to happen. I said, do yourself a favor, let's let's not act now. Because the evidence says, that's not likely to be the right thing. You're likely acting based upon irrational fears. You don't know their history, you have confirmation bias, you read some article from some crazy lunatic who's writing that the dollar is not going to be the world's reserve currency, because of XY and Z. And you happen to think about those things. So you decide that he's right. And you ignore all the evidence, for example, that the Chinese yuan is 2% A world trade. It's not even a free traded currency. There's no depth of the Chinese market. And there's no way tomorrow it could become or even next decade, that the dollar would lose its status as the world's reserve. There's no other good candidate that really meets that criteria. But your confirmation bias will then jump in. Right. So I tell them, the cure for this bias, of believing facts are like inevitable, you know, events are inevitable, you think, before the fact when they're even far from certain, let alone inevitable. It's the stop to keep a diary. Write down when you're watching a sporting event, whether it's Tiger Woods, will you make that putt from 20 feet? What's the play, the coach should call, you know, it's 10 seconds left? Should you pass it in to the center or have the guys shoot the three point play, write down what you think will happen and compare it with the results after the fact. And that will virtually surely convince you that you don't know the future any better than anyone else, your crystal ball is justice, clarity, and you should stop trying to make forecasts based upon your views because you think events are predictable.

Andrew Stotz 07:13
So this is a you know, the benefit of that taking notes is that you go back and you look at prior decisions where you realized by because you wrote it down, you realize that you are actually wrong. And that's exactly right. Looked back a few times and realized, well, yeah, I guess I wasn't, you know, as right as I thought,

Larry Swedroe 07:35
yeah, there's a related to that. I tell people, whenever they hear a forecast from some guru, the only reason they'll pay attention is because it happens to agree with their preconceived notions. So they're worried about inflation. And they see some commercial, we've seen blitz over the US over the last decade, often of the Federal Reserve printing dollars, and the inflation is going to run away and the dollar is going to collapse and all this stuff. So you know, it plays on their fears. That's exactly what they know they're doing to get you to panic, there's always somebody trying to sell you some product you shouldn't bought. And you have to understand that right. So the way to cure yourself is write down that diary. Write it down every time on other events related to whatever it might be an election result, or, you know, a sporting event, especially right. And the old get to it. So Jason Zweig had a great quote is that when you ever hear a prediction, make sure you ask to see all their prior predictions. But you could be certain pigs and fly before you'll ever get them.

Andrew Stotz 08:52
Yeah, yep. Jason hasn't come on my worst investment ever podcast yet. And I'm trying to get him on. But he'd be a great guest. Yeah. And just to just to take a step back here for the audience. What we're really talking about in this particular chapter is the concept of hindsight bias. And so I went to Wikipedia thinking, Well, is it the trust is the most trusted name in news not really, but you know, it's not bad. So let's see what we can. PTSN says hindsight bias, also known as the I knew it all along phenomenon is the common tendency for people to perceive past events as having been more predictable than they were. People often believe that an event has occurred after an event has occurred, they would have predicted or perhaps even would have known with a high degree of certainty what the outcome of the event would have been before the event occurred. Now hindsight bias may cause distortions of memories of what was known or believed before an event occurred and is a significant source of overconfidence regarding an individual's ability to predict the outcome future But last thing is kind of fun. In America, they call it 2020. Vision, when, when you can see clearly from 20 feet. And so what that turns into is an idiom that for the non native English speakers may not understand 2020 We say hindsight is always 2020, meaning you see things so clearly after you've experienced them. So any thoughts on that? That and how we can?

Larry Swedroe 10:28
That's exactly right. That's the problem. We don't they have actually done psychologists, behavioral finance, people have done studies. And they ask people what their prediction is of an event. And then they ask them after the fact, what their prediction was, did they get it right or wrong? And the amazing data shows far more people said they get it right than actually did get it right. They recall thinking it was sure to happen, but they were wrong. Even people who are shown their actual results, and said here, you've said this, and I know I could not have said that. They argue when they're in their own handwriting, there's the data. That's how powerful this hindsight bias can be. I've read many books on behavioral finance. And there was this one story of this woman literally, she was ready to get in a fight, because she was convinced there was no way that's how powerful our memory our mind works, trying to protect ourselves from feeling stupid. We'd like to feel good, that was smart. But the problem is, it just leads to overconfidence, which leads to taking concentrated risks, not diversify, and trading too much. And men are much worse about those traits than women are. And testosterone effect.

Andrew Stotz 12:00
Yeah, it's also interesting about just history in general, you know, you have two issues in relation to history. The first one is, you know, we as we always say, the winner, the winner, rights rights history. And I remember listening to one of my favorite rap stars in the old days Public Enemy. And they said, history is his story.

Larry Swedroe 12:24
Yeah, that's a good line. Yeah.

Andrew Stotz 12:27
And I thought that was great. But the point is, first, you have people that want to rewrite history, if let's just say that a politician metals in something or a group of politicians, and they actually actually cause a crash, you know, they cause a flood of money going into a particular area, and pushes up prices of everything, and then bubble ensues, and then everything crashes, you think those politicians are going to write the story as Oh, shoot, we cause that? No,

Larry Swedroe 12:53
that's great example of that is the Democratic administration led by Robert Wright's and others, Chuck Schumer, and they fought push policies that led to easy lending and housing, forcing banks to make loans they the typical when I was growing up, you had to put down 30%, you only could get a 70% loan. By the time I got married and had kids, it had to be 80%. By the time of the just before the great financial crisis, some loans, you could even borrow 100% and finance the expense of the mortgage. So we're really borrowing 102 or 3%. And then when they crashed, they said, Oh, no, we didn't have anything to do with that. It was the bank. That wasn't a problem. Yep.

Andrew Stotz 13:41
And how did they do it? They did it through, not through pushing the banks to change their lending standards. They did it through Fannie Mae and Freddie Mac, requiring them to take on the higher level of risky assets, which everybody in the whole world knows that that requires that's going to that's going to bring on additional losses. So what was you mark remarkable about that was that they were able to bring on billions and billions of dollars of losses that eventually, ultimately, the taxpayer has to bear in one way or another, but they could do it in plain sight, but hidden. Yep, exactly. And that

Larry Swedroe 14:19
lasted until trees don't grow to the sky and you're printing a lot of money and keep interest rates suppressed and encourage people to take too much risk and lever up. Eventually, you pay the piper because interest rates have to go up because inflation picks up and then the whole bubble collapse gets exposed. As Warren Buffett said, you know, when the tide goes out, you know who was swimming naked? Yeah.

Andrew Stotz 14:45
And this, this was a great book on that was by I think it was Peter Williamson called Hidden in Plain Sight, where he was on the committee that wrote the history of it. Unfortunately, he was one of the only dissenting voices that said no, it was In banks going crazy, it was the incentive system that was set up. And that's a great book. It also reminds me why I never liked the movie The Big Short, because they never ever talked about any of the incentives behind the scenes by buying the government that were being that were happening that sparked the fire. Of course, once you spark a massive fire, eventually in the top of the bubble or parts of the bubble, you're going to be incentivizing really bad behavior. And so there's definitely a lot of bad behavior to be, you know, cast, you know, but you know, it's a, it's a fascinating one. So my point is that, first you have the problem that you have people that want to write history, you know, as best they can. So that it's his story, as we said, from the Public Enemy scripts, lyrics, but the second thing is that now, even if you have the right history, the correct history of it, it's easy to miss judge it when you look back at how you understood that. So that's a great one, you reference. Gary Belsky here and his book. I think in this chapter, you mentioned about his book of why smart Mary good book, big money, mistakes, excellent book, Gary was a guest. He was on episode 545. And his episode was called long term patience is the key to success in investing. So for those people that want to hear Gary story, because he's also a smart person, and he makes mistakes to narratives.

Larry Swedroe 16:32
But the key to long term success is having a deep understanding of history and not being subjected to recency bias. And the next mistake, we're about to embark on discussing. Yeah. So

Andrew Stotz 16:46
that's interesting, because you've got hindsight bias where you go back and you think you were smart. And then you got recency bias that's pulling you to act, you know, based upon what's coming up. But let's move into Mistake number four, do you extrapolate from small samples? And trust your intuition?

Larry Swedroe 17:04
Yeah, so there's a great experiment, run by some of the leading behavioral finance people. And you're asked to judge the following, should you choose jar a or jar B, and you're told both of them have two thirds of the jar is filled with marbles that are red, and 1/3 is white. Okay, and the first jar from a you're only allowed to pick five. And when the person picked five, he draws four, or 80% of them are red. Second jar, he's told he can pull 30 And he pulls 20 that are read. So two thirds. Remember, you're told that two thirds of the sample is in both cases? Yeah. COVID? Which one? Are you more sure of actually your talk? Um, so in one of the jaws, there's two thirds of them are read. Now, you're asked which jar Are you more confident in choosing? is the one that has two thirds read the Choose the one where you chose 80%? Or you choose the one where it was only 67%?

Andrew Stotz 18:27
I think for most people, it's hard just even understanding those percentages, probably that are doing it. But tell us how it works. Yeah, well, clearly 80%

Larry Swedroe 18:35
is the higher number. And so a lot of people, the majority of people, when they take that test, say I'm more confident that jar a is the one with the two thirds than job D. But anyone who understands statistics knows that you have to do a test of statistical significance. And when you have a very small sample, the T stat may not be significant. A larger sample is much more reliable. So for example, you could flip a coin, and you might flip five heads in a row and think, oh, this coin is bias. But if you flipped it 1000 times, you're going to run across many episodes, where there are five heads or five tails. That's just the odds of that happening. So you have to understand statistics. Now what is that mean? When it comes to investing? People judge by small samples, typically recent ones. So you combine these things. So for example, okay, we saw that from 90 789, roughly those three years and most of it was 98 or 99. Small value stocks dramatically under To perform, it was all the growth market because of bubble. So people judging by that small sample, and recency bias, okay, and the stories of this time is different, didn't look at the long term historical evidence, which said yes, over any three year period, maybe there's maybe a 20% chance that lives growth, and other growth will outperform small value. At five years, maybe it's 15%, at 20 years, it's virtually zero, maybe it's 3%. So there's always a chance that growth would outperform small value, but the longer the period, the less likely, but people trusted their, the fact that this small sample and recency bias and reading the stories, and then maybe confirmation bias, you know, they read stories, this time, it's different quotes can outperform it's a new era, it's dot com, and internet is changing the world, they then make that bet after of course, the fact now they're paying high prices. And therefore you're virtually doomed to get poor returns over the long term, maybe the next year or so it might continue. But eventually, trees don't grow to sky, and high prices predict low future returns. So the problem is here, you have to know your history. Whenever you see a small sample, you want to look at the long term data. Let me give you one other example. We point out in the book from I think it is the 25 year period 6691 month CDs outperformed the s&p Should that be your expectation? Of course not. Right, because one month CDs are totally restless, you have no inflation risk. If you stay within the FDIC limits, you have no credit risk, and risk and expected return must be related. And over the long term, the stock market is probably outperform one month CDs by maybe 7%. But you can have a period forget three years or five, you know, it could be 10 or 25. Japan has underperformed for the last 32 years, 33 years now. But Warren Buffett knows that that is a result of one, Japanese prices were super elevated in 1989. And with Doom to deliver low returns, so he wasn't buying then he wants to buy when everyone else is panic selling. And everyone else has now abandoned Japanese stocks. And they're trading at incredibly low Pease, and he's now saying I'm buying Japanese stocks. But most people aren't doing that, because they want to buy after something has done well. So the key is you really have to know your history, only look at data that's over the very long term. And remember, sweat droves dictum, which is this, when it comes to investing in risk assets, three years is very short time, five years is still a pretty short time. And 10 years is still likely nothing more than noise, you need much longer periods. And the key to successful investing, as Warren Buffett said, it's not intelligence, it's patience. Because investing is simple. It's just not easy, because it's tough to control our behavior, because we're subject to all these mistakes that we're talking about simply because we're human beings. So the biggest value of any investment advisor is one providing the investment history. So you can make an informed decision. And then controlling the investors urge to act when doing nothing other than staying with your well thought out plan anticipates bad periods of bad performance. And it's highly diversified. So you're not concentrated in the one asset class that's doing poorly for, say 10 years. That's where the true value of it advisors.

Andrew Stotz 24:29
So there you go, ladies and gentlemen, if you're a financial advisor, the value is number one, understanding your history and I would say number two is the kind of emotional discipline, you know, we're going to assume that you're going to build a diversified portfolio for your clients. But then it's that emotional stability to be able to help prevent them from doing some panic. I want to highlight episode 62 Jeremy Newsome, one of my guests many years ago, he basically his story was interesting because he was interested in stocks and you He borrowed some money from his father, when he was a young guy. And he invested in a particular stock. And it went up and he made a lot of money. It was exciting. And he sold out or whatever happened to him prop exactly. You got the cash that and you know in Jeremy, we're happy. And then Jeremy got into the idea of silver and he got obsessed with silver as a young guy. And so he was looking at and he eventually convinced his father to give him more money. Father gave him more money. And Jeremy went into silver and silver as Jeremy say, I invested 15 minutes from the peak,

Larry Swedroe 25:36
along with a bunker hunt. Yes,

Andrew Stotz 25:39
exactly. The Hunt brothers when they tried to corner the silver market back in the 80s, or 90s, I can't remember when that was

Larry Swedroe 25:46
80s or late 70s. Right around there, draw silver up to 50 bucks. And then a collapse almost took down the US banking system, by the way, because the major banks were all big lenders. And the Fed had to be called in to try to keep the markets calm, provide liquidity for the big banks. Yeah.

Andrew Stotz 26:07
So anyway, so he convinced his dad that putting the money stopped, the silver started collapsing. But to make matters worse, he had found out something about some derivative instruments on silver. And the end result of his derivative instrument was that he lost 100% of his money in his second trade. And what made this story very remember, memorable is you know, you remember where he got the money, Larry? His father? Yeah, right. And it turns out, his father gave him 100% of his retirement portfolio. Oh, my God. And that is why Jeremy's story is so powerful for the listeners. And for all of us to remember, what they were doing was that they were looking at a small sample size. And that sample size in this case was one, which is the smallest you can dive. And it was one experience of the great experience. And as you said, when I started telling the story, like that's the worst thing that can happen. And so let's talk about sample size for just a moment you mentioned about, you know, three years is too short five years is too short. 10 years is too short. But let's just talk about, you know, I guess the big theme that we want to focus on for this is to help people to realize that it's not so much that we've got to get some large sample, it's that your conclusion is just probably wrong. And if you can start with that and say, well, you're extrapolating a small sample into something big, we call it sometimes in in the logical fallacies, we call it hasty generalization, where you take a specific case, a specific story, my friend lost his job, therefore, the economy is a disaster, that you got to really focus in on the fact that you're likely to try to extrapolate from a small thing that may be visceral, and maybe exciting, and you think you've got it. But you've got to, you know, the next question is kind of what is a reasonable sample size? And I just wanted to ask you this, because you got so much experience with research. And that is like, when, when people are doing, we talked about something statistically significant. We talked about whether the sample size is the right side. And there's a lot of judgment in there. I always thought this statistic was very, very clear. But there is still judgment in there. But from your perspective, what does it mean about statistical significance? Or when something's not significant? And what can people learn about?

Larry Swedroe 28:35
That's a really great question, as they say on Bloomberg all the time, if you've watched Bloomberg, right, so here's the thing you need to know about statistics, right? The standard is typically for statistical significance is a 5% odds of it being a random or lucky outcome. And 95% confident you're right. It's not 100%. Right. So you have to admit, if the T stat is two, that means there's roughly a 95% x i think it's 1.96. But let's call it two, all right now, at one in 100, the T stat is three so you can be more confident, right of that, right. But still, there's the risk that that will be the one in 100 year flood. So one thing you want to think of as an investor, even if you have a T stat of 1%, that father never should have lent that money with that possibility of that kind of loss because there is still a risk that he could get wiped out, and therefore it's okay if you want to make that bet. Take $1 or $2 or one or 2% of your portfolio. out. And like, you might take $1,000, depending upon your net worth to Las Vegas, go to the casino and treat it as luck, you know, an event and you're having a good time. And so I go into the racetrack right? When I was a young kid growing up, when I was in college, I worked hard, I had to get a job after school. So I could go out on dates and, and, you know, and, and so I still enjoy going to the racetrack, maybe three or four times a year with my friends. And I would bet two bucks a race because that was a lot of money in that way, I can never lose more than about 20 bucks, including my entrance fee. And some of my friends, I thought were crazy, they bet five bucks or 10. And if they won, they might that 20 or 30. Were using their winnings. And when the horses were coming down, you know, to the finish line with a screaming, do you think having bet 20 bucks any louder than I was having bet to now we both got the same excitement and fun. So I tell them, if you need excitement in your life from the stock market, Fine, take one or 2% any money played on expect to win, because the only evidence says the odds favor you losing. But if that's how you get enjoyment out of your life, it's entertainment and treated as that. And the other hand, they say sort of tongue in cheek, is that if you need the stock market for excitement in your life, you might want to think about getting another life, I think we're talking and now you know tongue in cheek there. So the key thing here is to understand, if you get a T stat of two, now there's a 5% chance of something being random. They can't be all that confident, you might be willing to allocate some of your money to a strategy, but not all. But here's the thing. What if the research that came up with that T stat actually tried 20 different experiments, using 20 different metrics. And you're just using, you're looking at the outcome of one, you only looking at the one that happened to work when the others fail. Now there's a problem, because that could have been the lucky outcome, right? And nothing works. But that one was random 19 Out of the 20 with very similar things didn't work. So I could so what you want to do, in our book, your complete guide to factor Based Investing, Andy Birkin and I created a list of criteria that you should have or insist on before you make any investment or bet. And that should be that is long evidence of a premium for taking the risks. That evidence is persistent across economic regime. So in good times and bad. It's not just we look at, say that period, say 1981 through 99, when we had 20 years of economic growth and no recessions. And I think you look at period where you have booms and busts. And Did it survive both of those regimes, right? So it's persistent over that, right across regimes. It's pervasive, it's not just in the US, it's not just in some industries or asset classes, it's in the US, and almost every country in the world may be in different regions. So it's pervasive.

Andrew Stotz 33:45
Are there any factors that you guys talk about that would be able to withstand that? Not

Larry Swedroe 33:52
all we get, we list five that do and one that comes close. The third criteria is robustness. So you find that price to book works, maybe that's that random outcome when you want to do other tests to make sure other things that are similar, also mates because what you're doing with price to book is you're buying something that's cheap, and avoiding something that's expensive or shorting it. So why shouldn't price to earnings work? It's really a cost of capital storage, you want to buy companies that have high costs of capital. So you get the high return for providing that gap, price to cash flow price to dividends, price to you know, EBIT, da to enterprise value a lot. There are like 30 different metrics that have been found to work in value that gives you confidence that you are okay. And by the way, the data shows while we're on this subject, whatever the best metric is, it almost never works better than an ensemble metric that uses multiple ones, because they tend to be correlated, but not perfectly so. So you get a diversification benefit through there. So sometimes, let's say price to cash flow work best over the long term. But in some periods P E works better, and some periods price to book more, so you get a smoother ride and avoid the ups and downs. Fourth thing is it has to survive transactions costs, so it's implementable, right. And lastly, they're better the an intuitive reason for you believing that there's a better that premium will persist could be risk based, which I prefer because you can arbitrage risk away, you can trade a premium with lots of capital coming in. But it should never go away. In theory, unless you have a bubble that's totally irrational prices, like peas, and the Nasdaq 100 in March of 2000. That can't be it cannot survive. Or it could be behavioral like momentum, because the tendency is human behavior doesn't change. And there are limits to arbitrage that prevent sophisticated investors from correcting this pricing. There are five criteria or factors that met all of my criteria where market small premium value, profit and quality and quality are similar. And momentum. Love a low volatility can close but we didn't put it in the those unique set, because low volatility only has generated your premium when it's been in the value regime, meaning they're low volatility, and also cheap. So low volatility only predicts future low volatility. So when the markets crash, it will not go down as much. But it only predicts a premium when it's low vol and cheap. When it's expensive, then it still predicts low volatility. But you don't get a risk premium. So it didn't meet quite the 100% of our criteria. So I prefer value investing that screens out the high beta stocks, not high not value, or say just buying low beta, I think you get better results.

Andrew Stotz 37:31
Right. So just to highlight that for everybody, I'll have a link in the show notes to Larry's book, your complete guide to factor based investing the way Smart Money invest today. And I have to admit, I haven't read that one. And I'm gonna buy that right now myself. And I need to go through that. But you also reminded me of one of my prior guests, Kim Van Van Fleet,

Larry Swedroe 37:54
and he has a great research. Yeah,

Andrew Stotz 37:57
I returned from low risk. And what you just described is exactly what he does it he describes in the book or it's similar in the sense that he's first screening for low risk. And he splits the market kind of in half and say, Okay, what's low, not risk, but let's say volatility. And he takes the low volatility portion of the market. And then he says, Okay, which one of these are cheap, and also using dividend so that He's also getting rid of, ultimately companies that aren't producing dividend? Well,

Larry Swedroe 38:32
what he's really doing, I think, is eliminating companies that aren't profitable. Because if you're not profitable, you're not paying a dividend. And those companies tend to perform poorly. He's really getting, I think, a substitute profitability screen. So you want value with profitability. And then if you had low beta, you know, then I think you've got a good strategy. But now you're shrinking your eligible universe a lot into a small number of stocks. So you sacrifice babies on diversification,

Andrew Stotz 39:07
right? Well, we've had such a great discussion, we've covered so many different things. But the key thing for everybody to remember, is to try to avoid mistake number three, by you know, thinking, you know, you don't want to think that, you know, I knew it all along. That's the first thing you want to stop that. And when everybody comes to you, and they say, I knew it, you'd have to think no, they didn't. I didn't know it, you didn't know it. And the second mistake is that, remember not to make hasty generalizations from very specific small sample size things and think that that is going to be predictive of the future. I told you the story of Jeremy Newsome and how he and his father thought that that one first time, as Larry said, that's the worst when your first investment is terrible. So remember about small sample size. Is there anything else you'd add to that before we wrap Yeah, I

Larry Swedroe 40:00
would just say this to give it I'm a big believer in using anecdotes that I think are helpful because people remember stories, not facts. Right? So if you want one story that combines these two mistakes, think of the name Elaine Gaza rally. Do you remember what she was famous for? Addicted literally like right before it happened. She was a money manager at Lehman, if my Shearson Lehman, and she predicted the 87 crash, just before the market crashed, and which was the flash crash? Which was the first class crash, if any? Well, right, Mark, it's because of the insurance schemes that were there that were based upon options, you know, Delta trading stuff so see was then left on their own firm and everything right? No one had asked what Elaine Gaza rallies track record was before that, right and ever, you know, but she was this genius, you have that small sample of one, she went on to have one of the worst track records as a money manager of anybody over the next like decade, failed one place went to another. But you have this recency Vi has the I have this, I knew it. It was predictable. It was certain, right, and you have this small sample. Now all of these biases were just human beings, and we're subjective. So you have to try to rein yourself in. And the way to do that is to know your investment history. And keep that diary every time you make a forecast, whether it's about sports or investing, write it down, and then grade yourself that you get a plus or a minus. And the odds are pretty good, that you'll end up about zero. And it's wonderful for your transaction, Scott, because you made a bet the bookies taking 5% of the money.

Andrew Stotz 42:01
That's a critical part. And for those that want to hear another story about the 1987 flash crash, you can go to Episode 289, where you can listen to Jim O'Shaughnessy, who is the author of what works on Wall Street where he talks another great book, by the way. It's a fantastic book, and he basically talks about having a foot position on the market just before the flash crash. And what did he do? He got out of the position just before the flash crash, he could have made a huge amount of money, but he didn't do it. So there we are a lot of anecdotes, and I'm going to wrap up today and first of all, thank you, Larry, that's such a great and valuable discussion. That's a wrap on another great discussion to help us create, grow and protect our wealth. This is your worst podcast host Andrew Stotz St. I'll see you on the other side.


Connect with Larry Swedroe

Andrew’s books

Andrew’s online programs

Connect with Andrew Stotz:

Further reading mentioned

About the show & host, Andrew Stotz

Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

Leave a Comment