ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?

Andrew Stotz 00:00
Hey, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, and today, I'm 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 are going to continue our discussion about his book investment mistakes even smart investors make and how to avoid them. And we're going to be talking about Mistake number five, which is, do you let your ego dominate the decision-making process? And Mistake number six, do you allow yourself to be influenced by herd mentality, Larry, take it away.

Larry Swedroe 00:52
Now let's start with the landing your ego dominate your decision making. And this is part of the whole field of behavioral finance, which I find fascinating, so much so that I ended up writing two books on the subject. The first was a rational investing in irrational times, which had 52 mistakes, I thought it was a nice number one for every week of the year. And then, years later, I wrote the new book, investment mistakes, even smart people make that by that time, just several years later, I was up to 77 mistakes. And if I would do it today, it'd be well, probably into the 90s. So we continue to learn about mistakes that people make, because the literature keeps pointing out these errors. So what's interesting about behavioral finance is they meld the two fields taking what they have learned from psychology and human behavior. And logically because we are human beings seems logical, we make mistakes in. In other fields, we would make them with investors. And it turns out to be true. And one of the mistakes is we do let our egos influence our decision making. So what does that have to do with investing? I think it was Nick Johnson, who was the founder of fidelity when John Bogle came out with the first index fund mocked it. And he said, indexing gets your average returns. That's unAmerican, right? No one, we don't want to be average, we want to do better than average, right? Well, of course, by definition, all investors have a market. So if you get average returns, you get market returns. And because of all the expenses involved, if you're active, you spend more money than the people aren't active or passive and just sent market returns, you're going to outperform the average active investor, because in aggregate before expenses, active investors must basically get the same return as passive investors do. The s&p gets temper set, your own s&p 500 fund likely will get almost exactly 10%. That means in aggregate before expenses, active managers will also get 10. But they have a lot more expenses. So they ended up with lower returns. And all of the academic research shows that's exactly what happens. The vast majority of funds underperform that are active and trying to beat the market, either through stock picking or market timing. And there's no persistence beyond the randomly expected. The problem is one investors say, not only do I want to be average, but I'm better than average. I'm gonna happen to me, why not do right, we talked about this in our last podcast, I believe that no matter what you ask people, they all tend to think they're better than average. Tests show that he has people that are better than an average driver 80 to 90% will say yes, well can't be more than 50%. But we tend to think that's the case. But it's not only overconfidence, that's a problem. But our ego wants us to make feel good. So we think we're better than average helps us get through life. But here's the other problem. The ego would much prefer to play a game where it only wins and never loses, versus a game where it can win or lose. So what do I mean by that? Assume you're a passive investor. because you've done all the research, and you say, I'm not going to let my ego get in the way, I don't think I'm likely to beat the market, even the vast majority of professionals fail persistently. You know, the Stiva annual results from s&p typically over 20 year periods 90% Plus fail even before taxes. So you're a smart, you say, I accept average returns, but I'm actually accepting market returns, which means you get better than average returns, right? All right. Now, but if your goal if you choose to be a passive investor, and you choose to invest in the s&p 500, let's say, and it does poorly, you have no one to blame except yourself. You can that you made that decision to invest in the s&p, there's no one to blame. That's a game your ego doesn't like to play. On the other hand, if you choose an act to fund, if the act of fund happens to outperform, you take the credit for your brilliant decision to choose that act of manager. And if it underperforms, what do you do? You fire the manager you go hire the next one blaming this dummy for not outperforming the ego would much rather play a game of I win, but I don't lose, which is what happens if you play active. But with passive there's no one to blame. I think that's part of the reason why investors despite all the overwhelming evidence, still significant numbers about half choose to invest in active funds.

Andrew Stotz 06:46
One of the questions that I have related to this, you know, when I read through the chapter and thought about it is, you know, an argument that's that's a difficult argument to get your head around is, is what we're saying when we talk about this that that hard work, or, you know, talent or skill or focus just doesn't work? You know, it's really hard. It's a little bit like, I mean, we want to attribute success to hard work. We want to attribute success to smart decisions. And does this have no impact.

Larry Swedroe 07:32
It doesn't have no impact, clearly keep people with more skills have a better chance of avoiding all these 77 behavioral mistakes, for example, that we know investors can make simply because they're human beings. The problem is, you have to understand the nature of the game you're playing. I had this conversation with my, one of my earliest bosses that was a really smart guy said, Larry, you telling me that smart people working hard can outperform dumb people. I said, think about that. Let's think about the game of chess. Now you could take somebody who is really smart, and play against me, I'm just the casual chess player. Even if I played though my whole life, I probably couldn't compete against, you know, one of the top players in the world, they would win virtually every match, right? But that's a game of one on one. It's just like think about baseball pitcher against the hitter. One on one. It's a tennis match Roger Federer against your mate, we probably wouldn't win a point and a whole entire match. But when you're in playing the game of investing, you're not competing against one individual. You're competing against the collective wisdom of the entire market, where each person is contributing all of their unique knowledge. And it's the wisdom of the crowds that makes it extremely difficult. James Surowiecki wrote a wonderful book, the wisdom of crowds, in which he showed basically, that in almost every field, the wisdom of the crowds outperforms the very best forecasts. Virtually true in every field. And we see this when it comes to stock picking and market timing, economic forecasts, think about if you would think anyone could get economic forecasts, right. Turn specially interest rates, it would be the Fed because they control it. Yet. The feds own dot plot a year ago predicted that the end of 22 the Fed funds rate would be 1%. They were only off by almost 4% You know, is a real problem here. You think about a baseball player, competing not against, let's say the best pitcher in the game today might pick Garrett Cole from the New York Yankees, because I'm a Yankee fan, but he's certainly one of the better pitchers Max Scherzer. One of them, but let's say you're competing against Garrett Cole. The average hitter in the league hits about 250. But Gary Cole against him the average batter made it to 20. Now Garrett calls got a great fastball right around 100 miles an hour, maybe a very good slider. But his curveball is nowhere near as good as Adam Wainwright's curveball, and his changeup isn't as good as some other pitches. Now, imagine if Garrett Cole had Adam Wainwright's curveball, which is the best in baseball at somebody else's quality, changeup and somebody else's splitter. Now you're competing against the collective wisdom of the market, the batting average might be 150 be a lot tougher. And that's the same thing principle here, you're not competing one on one, we're small differences in skill can lead to large differences in outcome, you're competing against this collective wisdom of the market. And that's something that the evidence shows is very hard to beat. And you have to overcome the expenses of your effort it well, as well. So today, in my book, The Incredible Shrinking alpha, we showed that when I wrote my first book, 20% of active managers were beating appropriate risk adjusted benchmarks before taxes, so maybe half after taxes. By the time I wrote my book, The Incredible Shrinking alpha, and 2015, I think it was published, that number was down to 2%. So 1%, may be after taxes, clearly, you have to have a huge ego to think you're likely to be in that 1%.

Andrew Stotz 12:17
So let me just summarize what you've said about that. Because I think it's an important message. stock market investing is not a one on one game, you're competing against a massive crowd that has accumulated knowledge, but also I would add in has an accumulation of behavioral and emotional actions going on that are very hard to predict. So that's the first thing is that you are playing against me? Well, one of my guests this past week said something great, and I'm gonna remember this always is he said, the market is a predator.

Larry Swedroe 12:56
Does it certainly preys on the mistakes of investors and their egos and their herd behavior.

Andrew Stotz 13:02
Yep. So the market is a predator, it's coming after you. And the other thing that I wrote down when you were talking was that it's not a game of fixed rules. If we look at a game of let's say, chess, or baseball, there's a framework and all of the rules and structure is fixed. But here you have a constantly changing game of not fixed rules. And so when you think about, it's not one on one, and you're competing, it's the collective wisdom and the collective madness of the crowd. Plus, it's not a game that's based upon specific rules, you can say, Oh, I'm gonna buy cheap stocks. Well, sorry, that won't always work. And that the rules are always changing. And that's the reason why you don't want to let your ego get ahead of you and think that you're going to be able to beat it.

Larry Swedroe 13:48
Well, I think, you know, it just struck me You came up, I think, a really interesting point here. Because even in baseball, the game is changing because of information. All of the Saban petitions have figured out, you know, with a lefty is at bat, you should move the shortstop over to the right side of the infield and put the second baseman halfway into the outfield. And because the odds say that left hand the batter is likely to hit the ball in that area. And so what happened is batting averages collapsed. And then the Major League says the game is going to be too boring, and they prevented the shortstop from playing on that side of the field. It's the same thing with investing. It's why Warren Buffett who had, you know, far outperform the market for the first 30 or 40 years of his investment career. But he hasn't been able to outperform for the last roughly 20 years or so, because the market caught up with them and figured out his secret sauce, and you could imitate him all the funds that I invest in from fun families like dimensional Avantis and Bridgeway all buy the exact same types of stocks systematically that Warren Buffett's buys, cheap companies that are profitable tend to have low investment. And more quality. But I

Andrew Stotz 15:17
have to stop you there, Larry. Yeah, now you're starting to sound like you've got a way to I'm not gonna say beat the market, what are you trying to do when you're combining all of those things?

Larry Swedroe 15:32
Alright, I'm gonna try to identify some unique factors that perform differently than the market, and have provided evidence that it of that was persistent over long periods of time, pervasive all around the globe, robust to various definition. So value works, if you use low price to book low price to earnings, low price to cash flow, it's implementable, meaning it survives transactions costs. And there are logical reasons why you think this premium will persist in the future. Warren Buffett told people for 50 years, you buy cheap, profitable companies that are high quality, low leverage low earnings volatility, and he far outperform the market. But today, you can't claim to outperform the market on a risk adjusted basis. Because now we know how to adjust for exposure to those factors.

Andrew Stotz 16:34
So let me just ask on this particular question, is what you're trying to do is reduce the risk component of your portfolio more than the return component when you're combining these different things?

Larry Swedroe 16:51
Well, now you're getting into interesting question about portfolio construction. Let's start off by thinking about things in isolation. I think most people would agree that smaller companies are more risky should have higher expected returns. That doesn't mean it's a free lunch. Right? You took the risk, and especially in bear markets, small companies tend to do much worse. So not a free lunch, it's a risk free. The evidence all over the world is basically you buy smallest stocks that aren't lottery type stocks, that are junk companies that have you know, look, their returns look like a lottery ticket. So they have high P you know, they have high P E ratios, low profitability, spend a lot of money and they tend to go bankrupt. If you screen those out of your small stock index and buy a quality small stock, then you get higher returns. value stocks are they trade at lower p e ratios for a reason market thinks they're risky. But if you buy companies that are lower Pease but are also more tend to be profitable, don't have a lot of leverage, you have gotten higher returns as well. But there's still a risk explanation for those factors being there. So now what you're saying is, I can either out, expect to outperform the market by tilting towards these riskier assets. Or when this is something I explained in my book, reducing the risk of black swans. And let's say you want to build a portfolio, which became known as the Lowry portfolio, and it's only small value stocks, the riskiest stocks, mock it has a volatility or standard deviation of about 20, starkly small value is above 30. So much more volatile, and that's one definite route risk. But you got higher returns by a bow, call it three and a half percent over the last 100 years. So not a free lunch. But so what you could say is, for example, if you want a typical 6040 portfolio with the s&p 500, and say, five year treasuries, you could have got the same returns roughly by running a portfolio that was say 40%, small value. You don't need to own as much equities because the equities you own have much higher expected returns that allows you to own a lot more safe treasuries. And what you get. It turns out when you do that, because these risk factors are different and perform differently at different times. You end up with a smoother ride, much slower tail risk, that's reducing the risk of black swans. I think you end up with a more efficient portfolio, but it's not a free lunch, you're not going to look Like the market, and from 99, through 2000, you did really poorly from 2017 through 20, you did poorly. But most of the time you come out ahead, and that should be your expectation. So you can have a better diversified portfolio, which is likely to reduce your tail risk without lowering your expected returns, you know how to structure it properly. And you can read about that in my book.

Andrew Stotz 20:30
Yeah, and I, I went after our last conversation, I went and got your, the, your complete guide to factor Based Investing, because you, you we started talking about that, and you know, all of your books are really accessible. So I would recommend for anybody listening to get on Amazon, you can get them as Kindle or you can get them as paperback. So I'm going to do that right now. And I've got I'll have more questions on that later. But let me just ask you a wrap up question on this mistake, and then we'll get into the herd mentality. A wrap up question on this is okay, so there was a point in time, Larry, where you acquired this information, you started to really understand these things, you know, and that may have been five years ago, it may have been 20 years ago, but let's just say whenever that period was, until the end of your investing, period, right? Maybe that's another 2030 years, maybe it's a total of 20 years, whatever that number is, where do you end up as far as on a risk adjusted return basis compared to I don't know what would compare that to 6040 the market?

Larry Swedroe 21:33
Well, you have to remember, every individual should have their own unique asset allocation, depending upon your own unique ability, willingness, and need to take risks I wrote about that, in my book, Your complete guide to a successful and secure retirement. So my portfolio has evolved over the years when I was young. I was 100% equities, when I hit, you know, started to earn a lot of income and did well and we sold my first company, I moved from 100% stocks to 60% stocks. Because while I was still young, I didn't need to take as much risk need to hit to try to hit the homerun, I was more concerned about protecting against a really severe bear market. And then I sold my assets grew dramatically as the market went on a tear from the mid 90s, sort of the end of the 99. And at that point, I said, now my assets have grown so much, I don't need hardly any risk. So I moved to about 30% stocks. So now I have a much lower expected return than I did before. But my risk also was down. And my use what I call the margin utility of wealth was much lower. So now okay, somebody could own exactly the same.

Andrew Stotz 23:02
I've asked a bad question. I think,

Larry Swedroe 23:05
sorry, my equities were still under percent small value. But I'm only 30% equities.

Andrew Stotz 23:11
Right, right. I think I've asked the question in a poor way. And maybe I'll just try. One other way of asking is let's just take the average Joe, who's got a 40 year time horizon, you know, from 20, to 60, or whatever. And they follow the traditional way, maybe that's, you know, heading towards a 6040, you know, over time, heavy weighting in equity, and then waiting in bonds. And then the sophisticated Joe, who says, I've learned from Larry's books, and I've learned from all these things, and I've got a little bit more sophisticated way of doing this. What would we expect if we looked at the average, the accumulation of them and some of them are going to make some mistakes? Fine, but let's just say the average Joe versus the average sophisticated, Joe, would they be earning a higher risk adjusted return over the long term?

Larry Swedroe 24:05
Yeah, I think there's no doubt that historical evidence makes that clear. We show that in our complete guide to a successful secure time, and we show it in the book reducing the risk of black swans. Whenever we sit down with our client, we'll show them a typical market like portfolio. So you own maybe a Vanguard Total Stock Market, us fund and a total International, then you might own an intermediate Treasury fund. And then we show him a portfolio that has maybe less equities but more exposure to these other factors than ads in other unique risks, things like reinsurance, private credit, and some other things. And we show that at least based upon the inputs we put into a Monte Carlo based upon the historical evidence, your odds of achieving your goal go away. up, you can withdraw more money at a safe withdrawal rate instead of maybe 3%. From your portfolio, you could draw a four or five that can make a big difference. And, and your left tail risk goes way down. Because you don't have all your eggs, or so many eggs in that one market basket, you own other risks, which may not do poorly, when equities are doing poorly.

Andrew Stotz 25:27
And so would we to sum this up, if we think about what John Bogle talked about, when he talked about just pure passive, just do it follow that is that basically, the advice for the Average Joe that maybe won't know much won't spend time much on it may not have the resources to get access to more sophisticated. And therefore, for the typical person, maybe that type of passively managed situation, as you said, passively managed and tax managed, you say in the book, and then, and then for a little bit more sophisticated, they can improve on that. But it's got to be done in the ways that you're talking about not just trying to make bets on, you know, buying some, you know, cheap stock, and it's going to outperform.

Larry Swedroe 26:13
Yeah, so number one, everything that I'm advocating is all done passively. It's just owning other unique asset classes, other risks. But the key is, is you must understand the nature of those risks, because every single risk asset, no matter what it is, will go through long periods of poor performance, the s&p has had three periods of at least fit for at least 13 years, where it underperformed T bills. This will shock your listeners, but large and small growth stocks, both underperformed long term treasury bonds, which is for a pension plan, the riskless asset for 40 years from 69, through oh eight. So people say well, you should own only equities. While there's a good example, you might hit that 40 year period, and you're in big trouble. But even on things like reinsurance, when it goes through a three year pour period, like it did from 17 through 19, you're you may abandon it, and then you sell out at exactly the wrong time, you own value, and it goes through a four year period from 17 through 20, where it does poorly, you abandon it, because you don't understand it, I think you're more likely to stick with a simple portfolio. Because one, everyone else is also doing poorly and misery loves company. And you at least understand those risks more. So I would advise people only adopt a more quality sophisticated, I'd rather use the word more diversified portfolio, if you're willing to put in the time to be educated about that, understand that every risk asset is going to perform poorly or bad at some time for even a long period, which is why you want to diversify, it's not a reason to run away from risk. So reasons to diversify. So either you have to put in the time, or hire an advisor you trust that has done the work for you, and will help you understand this and help you stay disciplined.

Andrew Stotz 28:27
Great. And I just summarized that into kind of passive or sometimes I call them exposure funds, where they're not trying to outperform in that particular area, they're just giving you exposure to let's say small caps or something like that. So passive funds or passive instruments structured well constructed, like accumulation of different ones, and then sticking with it.

Larry Swedroe 28:55
Exactly. Okay, exactly. Right. Yep.

Andrew Stotz 28:57
So let's just wrap up with Mistake number six about herd mentality, you know, do you allow yourself to be influenced by a herd mentality? And you just, you just highlighted part of this by saying, you know, you're not going to stick with it because it's going to underperform or it's gonna go crazy. And you're going to be you know, emotionally driven. And next thing you know, you're out of what was actually the best long term plan. So tell us about what we know about her mentality and how we you know, avoid this, you know,

Larry Swedroe 29:25
mistake. Yeah, psychologists have known for a long time that we can be influenced by crabs, the behavior of others, we want to, you know, own the same cars as the Joneses for example. Or if you know our neighbors loaded up on Bitcoin and watch the go up. Now you have this fear of missing out as well. That becomes a problem. And while we've known this for centuries, there have been bubbles going back to the 1600s and 1700s in the 1800s, Charles and Rick gay wrote a book about the history of bubbles, called extraordinary Delusions and the Madness of crowds. And even in the night, from the 1900s, we've had probably five big bubbles that burst all around stories, as Robert Shiller Nobel Prize winner would say, there's always a story of new technologies, whether it's the automobile in the 1900, or airplanes, radio and television, or biotech, and then computers, and then the internet. And now artificial intelligence. There's always these Manias, and we get caught up and social media feeds on this spreads it really rapidly. And I think this fear of missing out has become a bigger problem to create this. So it's long been known that we can get influenced by the crowd. And there's a saying, I'm not going to quote it, I'm sure right, but we follow the herd and this madness of crowds very quickly. But it takes us a long time to unwind and realize the insanity of what we're, you know what we're doing. So, you know, whatever is of that moment, that's is the thing that attracts our attention, that shiny new penny, and we want to jump in, join the crowd. And I think this fear of missing out is a big, big part of that. And in

Andrew Stotz 31:41
your book, you highlight the keys to staying disciplined and avoiding becoming irrationally exuberant are having a thorough understanding of how markets work, and know that bubbles eventually burst. Number two is having a well designed roadmap to achieve your financial goals. You talking about that investment policy statement and kind of setting the framework that you're going to be investing under? And then having an understanding of how human behavior can impact investment decisions. And you quote, Anatole, Anatole France is warning if 50 million people say a foolish, foolish thing, it is still a foolish thing.

Larry Swedroe 32:23
Yeah, that's one of my favorite quotes, I'll just read a couple of quotes that I think are worthwhile. Charles Mackay, in the book I cited earlier he said every age has this peculiar folly, some scheme, project or fantasy, into which it plunges spurred on by the love of gain, and then subsidy of excitement, or the force of imitation. And Isaac Newton, who is writing about the investment mania of his day, the South Seas bubbles, he said, I can calculate the motions of heavenly bodies, but not the madness of people.

Andrew Stotz 33:01
And that's a great way to, to wrap this up. And it goes back to the idea that the market is not a framework, that's a structured framework, like the laws of gravity as an example, which don't change. Imagine if the laws of gravity changed, each building that we build would be all of a sudden having a lot of trouble because the law of gravity changed, and it doesn't change. And therefore we have laws in physics as an example. But we do not have laws in finance, because things don't change. We have hypotheses, we have models, we have theories, you know, the capital asset pricing model, the random, you know, such and such theory, you know, we have all of these theories, models, and but we don't have laws. And so this is a great reminder of, you know, and I like what you said that bubbles are built around stories of new technology. And then the last part that you said to that was the quote, where it talked about the necessity for an excitement. Now, he said that went when did he say that? Did you say that recently with all the excitement going on with social media? Or did he say it? At 40s? So it's incredible, almost 200 years ago, people needed excitement just as much probably as they do today.

Larry Swedroe 34:24
as well. That's true.

Andrew Stotz 34:27
Well, I think that I really enjoyed this discussion. And, you know, to think about how all of us are protecting you know, our own wealth and not making the mistake of letting our ego dominate our decision making process, and not making the mistake of letting ourselves be influenced by herd mentality. Larry, I want to thank you again for another great discussion about creating growing and protecting our wealth ultimately, and for listeners out there who want to keep up with all that Larry is doing which it's not easy keeping up with all You're arguing, just go to Larry's Twitter. It's at Larry swedroe Or just go to Larry's LinkedIn, I'll have both links to the both of those in the show notes. But you can just type their name into LinkedIn. And he posts what he's doing there. And he does respond to the questions and other ideas that you that people raise. So thanks for the time.

Larry Swedroe 35:23
You're welcome. And just note that you can see on my Twitter account, I just wrote a piece on recency bias and the case of reinsurance, but it talks about equities and how recency bias, a topic we have touched on in the past can cause people to make big mistakes. So I urge your listeners to you know, check out that article.

Andrew Stotz 35:45
Definitely. There's so much there. Well, this is your worst podcast host Andrew Stotz saying. I'll see you on the upside.