ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely

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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 fifth episode, they talk about mistake number 7: Do you confuse skill and luck? And mistake number 8: Do you avoid passive investing because you sense a loss of control?

LEARNING: When gauging a fund manager’s performance, consider risk-adjusted performance. If you’re a passive investor and use a systematic strategy, you’re 100% in control.


“You have to accept that you can only control what you can control; you can’t control the unpredictable things that happen.”

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 fifth series, they talk about mistake number 7: Do you confuse skill and luck? And mistake number 8: Do you avoid passive investing because you sense a loss of control?

Mistake number 7: Do you confuse skill and luck?

According to Larry, investors don’t know statistics well enough to differentiate skill from luck. To understand if an outperformer is outperforming because of skill and not luck, look at risk-adjusted performance. So, for example, over the very long term, value stocks have outperformed growth stocks, and small stocks have outperformed large stocks. So somebody who outperforms simply because they owned lots of small and value stocks more than the market isn’t outperforming on a properly adjusted basis. Other factors than size and value, such as momentum, profitability, or quality, can also drive the return. Larry recommends Portfolio Visualizer, a tool that shows how much exposure an active fund has to those factors. It also reveals the alpha or the remaining performance that cannot be explained.

The second thing you need to consider is whether the fund’s assets are growing. If they’ve grown, the odds are pretty good that that outperformance will disappear. The other thing you can look at is the metrics of the stocks they’re holding. If they’re invested in hot stocks and their values have gone up, that’s a sign not to chase the outperformance.

If you want to outperform by picking managers, Larry advises choosing the largest pension plans because they hire great consultants. They also have the best databases and do thousands of interviews yearly, so you can be sure they’ve asked every question you can think of while doing their due diligence. But still, evidence shows their ability to predict future winners doesn’t exist.

Mistake number 8: Do you avoid passive investing because you sense a loss of control?

In active investing, individuals perform stock selection and/or market timing. Passive investing doesn’t involve any of that. It defines its universe and then buys and holds all the securities that meet that definition.

With passive investing, the problem comes in when the markets are experiencing uncertainties like the Ukrainian war, the COVID-19 pandemic, etc. The investor wants to be in control but with an index fund, the markets are in control. So many people consider active management a way of giving them control. They’re either in control of buying individual stocks, choosing the fund manager, and when they go in and out of the market. The problem is all the evidence shows that control costs you money, and you’re more likely to make mistakes and end up underperforming.

Larry also advises investors to understand that when you’re passive and use a systematic strategy, you’re 100% in control. But you have to accept that you can only control what you can; you can’t control the unpredictable things that happen. Make sure your portfolio design doesn’t take more risks than you have the ability, willingness, and need to take. You should also be hyper-diversified to withstand the shocks that happen to every asset class.

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
Hello fellow risk takers this is your worst podcast host Andrew Stotz, from me starts Academy and I'm here with continuing my discussion with Larry's wardrobe, who is head of financial and economic research and bugging him wealth partners. You can learn more about his story in Episode A 645. Larry has a deep understanding of the world of academic research about vesting, and especially risk. Today we're going to discuss a chapter from his book investments stakes even smart investors make and how to avoid them. And today is going to be Mistake number seven, do you confuse skill and luck? And number eight? Do you avoid passive investing? Because you sense a loss of control? Larry, take it away?

Larry Swedroe 00:49
Yeah, so one of the hard things for most people to understand is that when you have a lot of people engaged in an activity, randomly, you would expect a few to win over a very long period. So the example you hear in the world of investing is someone like Bill Miller beats the s&p 500 for some long period 10 or 15 years, and people automatically assume that must be skilled. Statisticians would know that you have to run T stats or t statistics. So look at what are the odds of that was a purely random outcome. So the example I like to give people and the one I use in the book is that if you have a stadium filled with 10,000, participants, and you ask them to flip a coin, and heads wins and tails loses, after the first round, you'd have randomly about 5000 winners, right after two rounds about 2500. And after 10 rounds, you still would have about 10 people, that would be the median expected outcome of few ran, you know, just a Monte Carlo simulation like that, where you're drawing random outcomes, right? You would expect to have 10 Winners now. So then I say, would you put your money on those 10 to be the winners of the next contest to win and flip 10 heads in a row? Or even outperform, you know, 50% more than 50% of the time? And what is purely a random luck game, right? And the answer, of course, is no. So how do you tell in the world of statistics, in the world of investing, when a money manager wins or outperforms 10 years in a row, what you fail, most people fail to consider is there are 10,000 or more mutual funds, more than there are stocks, right? And so randomly, we should expect, you know, several, if not a bunch to outperform even 10 years in a row. So what you have to do is run statistical tests 20 years ago, or actually now 25 When I wrote my first book came out in 1998. At the same time, Charles Ellis was writing his famous book, winning the losers game. And he was explaining that active management where which is the oddest stock picking and or market timing is a loser's game, meaning while it's possible to win, just like it's possible to flip 10 heads in a row. Right? The odds of doing so are so poor, you shouldn't try when he wrote his book. And I wrote my first book, about 20% of active managers were outperforming the market before adjusting for taxes. So get today that number is about 2%. So 2% of money managers today are outperforming on a statistically significant basis, passing a 5% hurdle, meaning 95% probability, it's skill, there's still a 5% chance that it's locked. And that's the problem that investors that they chase returns they look into manager who is 12345 years and has outperform Morningstar then overweights in their star ratings. overweights the more recent performance, and then money we know from studies flows into those five star funds, which are purely random likely in our performance. And because they have done well the stocks there have bought tend to trade at a higher years and they go on to underperform. That's the problem investors don't know statistics well enough to be able to differentiate skill from luck.

Andrew Stotz 05:12
This is a such a great topic. And I want to kind of step back, given your knowledge of this in and help people walk through this a little bit. First of all, okay, so I was on the internet looking at something the other day, and it was a device where you, it has a bunch of beads like 10,000 beads, and you flip it, and it has a name for it, I forgot what it's called. And then the beads fall down randomly through some device that's causing them to be dispersed randomly. And then they fall into these 10 deciles, you know, 10 groups, and it turns in, they always fell curve, yeah, into the bell curve. And so we all can understand or visualize a normal distribution like that. And basically, the first thing that we should understand is that, that there's a normal distribution underlying probably most things in life, as far as outcomes are concerned, we do have sometimes skewed distributions, but for the purposes of this discussion, let's just focus on that normal distribution. So as a result, you have 10,000, mutual funds, you measure their performance over time, you're gonna get a normal distribution, it's not going to be exactly like the mean, average normal distribution, or as you were saying, like the average outcome, but it's going to look pretty close to that. Is it going to look exactly like that? Or are we going to see some more and more at the tails of that, or? That's the first question is just to understand, okay, that's the theoretical normal distribution. And then if we just look at a normal distribution of 20 years of performance of mutual funds, 10,000 or something, are they going to fit almost exactly into that distribution?

Larry Swedroe 06:59
Well, the bell curve will actually be normally distributed. However, it's going to be shifted to the left, because the average active mutual fund underperformed significantly, because of basically, its expenses, their trading costs are too high, they sit on cash, which has lower returns and the stocks they invest in on average. So those are the problems so the entire curve shifts to the left. So do you have numbers in the tails with a few great outperformers and a few horrible performance. The problem is the outperformance are a bit less than expected in the right tail, meaning fewer outperform than randomly expected. That's what fama and French found in their 2010 study, and others have found the same thing. But you will tend to have more on the left tail because of their expenses being so high, and they trade a lot. Now, if you own just a Vanguard Total Stock Market Fund with, you know, almost no turnover, other than acquisitions and, and the listings, and three basis points or you know, whatever of expenses, you're gonna get that normal distribution. Now, the last point I want to make is something we have covered in our previous discussions, which is the average stock distribution is actually skewed to the left. And the reason is, the while the most you could lose is minus 100%. The most you can make is infinite, you know, on Google or Microsoft, you might own you know, hundreds of percent per annum. So a very few stocks. 4% of all US stocks account for all of the excess return over tables. That means the median stock has a return well below the mean, because a few in the tail pull the average is up, which means if you're an investor, you have to ask the question, what are the odds one that you can own those stocks, and then to hold on to them for the entire time. A great recent example just happened. Cathy Woods ot fun, sold all of this shares in in video before January and the stock is up 130%. So that's an example of even if you picked in Nvidia, but now you sold it, because you thought she wrote that the PE was in the 50s. It's too high. Turned out it was too low. Right. So that's a problem for investors, the individual stock distribution is left skewed, which means the importance of diversification is even greater And then it is for a normally distributed. And there it's important anyway.

Andrew Stotz 10:04
And when you talked about the outcome of the fund management, fund the funds, you talked about the fees, and that shifts the average to below what would be the index? Because and trading costs? Yeah. Okay. So let's say all costs, expenses, all in, you're, the average of that group is never going to even equal, it's always going to be less than the average of the outcome of the market. All my friends

Larry Swedroe 10:35
found that to be about 70 basis points. Now, if you take, say $60 trillion of stocks, times 70 basis points, right? You can figure out how expensive it could be. Now, obviously, not everybody is an active man, and you know, fun. But if everyone was, so it's still costing investors billions of dollars a year. Of course, there are a few winners, not many. And the odds are great that they were lucky. But of course, they'll think it was skill, that people who win attributed to their brilliant decisions, and that people fail. What they do is they attributed to bad luck, not their bad decisions. That's human psychology that protects our egos and prevents us from feeling too bad about ourselves.

Andrew Stotz 11:28
Which is very important. And

Larry Swedroe 11:30
that that keeps the suicide rate down.

Andrew Stotz 11:33
Yes, exactly. We don't want that going out of control. Now, let's take that same distribution. And let's remove the average return of the market and say we're no longer looking at that distribution relative to that center point being the average return of the market. If now we change that distribution to be the average, the average of we're looking at the average outcome of those funds. And now we're saying forget about the market for a minute, all we're doing is looking at that normal distribution of the outcome of all of these funds a little bit like your coin flip example. We're watching the behavior of these guys over 1020 30 years. And over a long period of time. What we're going to see is some type of normal distribution. And when we look at the outperformers, what my question is, and I think you can explain it, you mentioned about T statistic, but in a way that can help us to think about how do we understand if an out performer is in that group at the tail, because of skill versus luck.

Larry Swedroe 12:41
Right, so the first thing you have to do is look at risk adjusted performance. So we know for example, over the very long term, value stocks have outperformed growth stocks, and small stocks have outperformed large stocks. So somebody Whap perform simply because they owned lots of small and value stocks more than the market that's not outperformance on a proper adjusted basis. Because you and I can invest in an index fund that owns that amount of tilt to small investment

Andrew Stotz 13:19
before we before you continue. So Okay, excellent point, the problem about looking at only return and making that distribution is we're not considering the volatility that you're exposed to. So let's now return

Larry Swedroe 13:32
different risks or exposures, not just the volatility. But there are different factors, a handful that the academics have uncovered with the main ones being size, value, momentum, and profitability or quality. Okay, that it's the exposure to those factors that really drives the return. If you consider those four factors, we can explain about 98% of all the returns, without looking at the individual stocks, people bought just their exposure to those factors, which means is very little room for active managers to add value. It's that remaining little sliver.

Andrew Stotz 14:12
So that if we make that normal distribution, now risk adjusted return, and then we find this group that's, you know, really is producing a risk adjusted return. That's significantly above the average risk adjusted return. And we know from statistics that there are a certain number of participants that will be there simply because of luck. And there'll be some that are there because of skill is what we're going to do then is test that group relative to the factors and say, Okay, well, you were just this guy was just overweight, a particular factor, and therefore he's in this group, or not because of skill, but because of the overweight of this particular factor that was that worked very well over that period of time.

Larry Swedroe 14:59
Right? That's exactly the first step that every investor should do. Fortunately, there's a wonderful tool made available on our website called portfolio I use it all the time. I've written over the years analysis of probably 20 Fun families to show does Morgan Stanley's mutual funds and value. And what I do is I run horse race against the leading index funds, like Vanguard, and then the leading passive or systematic funds from dimensional fund advisors as a benchmark, and I run the alphas using the regression tool on portfolio visualizer, which shows you how much exposure the active Fund had to those factors. And then says what's the alpha or the remaining performance that cannot be explained? The alpha could be positive or negative. And so that's the first step you want to you want to take. And like you said, you could still be in a right tail. And if it betas statistically significant at a T stat of two, but that still means there was a 5% chance that it was a random outcome, which means if you had 10,000 funds, and you had 50 of them, right in that tail, that's exactly the number you would expect randomly. So it's pretty hard to tell. Now, if they their T stat was four, that's telling you it's pretty likely that there's some skill there. The problem then becomes this. Successful active management contains the seeds of its own destruction. And the reason for that is that when people will see that outperformance morning, psychism, five stars, more sophisticated investors, like your I run portfolio visualizer, and we see the T stat. And then maybe we'll do due diligence and call up and interview and all this stuff. And some consultants recommend them and all of a sudden institutions now a piling in based on that performance. Well, now they've got a lot more dollars to invest, there's only two ways for them to deal with those dollars. One is the key that concentrated exposures. Because you have to look different to outperform right? If you own basically the index, you're gonna get index returns. But if you do that, then your market impact costs go up significantly when you trade. And it becomes almost impossible to outperform. There are many papers written about the diseconomies of scale in active management. So the other alternative is to diversify, then your active share goes down. And now your higher costs get spread over a smaller and smaller amount of a differentiated portfolio. So if you have 50 basis points, say of greater expenses, and it's spread over on the 3% differentiated portfolio, your odds of outperforming you've got to add more than 6% to outperform in the remaining stocks. That kind of alpha is incredibly difficult. One or 2% would be great. So that's the problem. One, it could still be locked, but two you want to look to see is the fun, has our assets growing and if they've grown, the odds are pretty good. That outperformance will disappear. The other thing you can look at is the metrics of their stocks their whole thing. So if the cash flows, you know, are they in the hot stocks and their values have gone up and now you're buying as much higher Pease than they were, that's the curse again of winning. And that would be a sign that you might not want to chase the outperformance it becomes extremely the bottom line is this. The thing I tell people to do is so think about if anyone's likely to outperform by picking managers. I would suggest that should be the largest pension plans around because they hire great consultants, everyone. Goldman Sachs, Ra sai Russell, anybody else you want to name. All of them are have dozens of really smart people with PhDs in statistics and finance. They have X As the best databases, they do 1000s of interviews every year, you can be sure they've asked every question you or I can think of and doing their due diligence. And the evidence shows their ability to predict future winners doesn't exist. Too big studies on mutual endowments and mutual fund outperformance showed that the stocks that these endowment funds that the endowment bought after firing their previous file, went on to underperform. And the ones they fired went on to outperform after they fired them. So they were better off one not paying the consultants. And number two, not trading at all. And then I posed this question to them. And I said to him, Look, you will hire the consultant, or you did it on your own, and you follow the procedure. And if it didn't work, those managers didn't go on to outperform even though they had outperform in the past. So what makes you think that it's what you did in the past didn't work? What are you doing differently? To make convinced you that you won't Fail This time? And the expression I've gotten the hundreds of times I've asked Is Da, you know, no answer. Because there isn't any. That's why we do that. And that's the right, Einstein said, the definition of insanity is doing the same thing over and over again and expecting a different app. So they're doing that mistake, but they don't know what else to do. Right? Yeah, um, there's a couple of hands in the game. But it definitely would need to hire the board of on their investment policy committees, you could just fire them,

Andrew Stotz 21:58
which then brings in all kinds of other issues that we were going to talk about, I'm sure in the future, it reminds me of a particular book, which for some reason, I don't see it on my bookshelf, but it's called the model and I, I'm gonna highlight that. Richard Lawrence, hold on one second, in Richard Lawrence on my podcast was episode 687. And he basically has very good performance, but what he did is he limited the amount of money that people could put into his fund. And he did that, in fact, he did it over time. And he said that in up markets down markets, you know, you can't take out or put in, and that that's helping, you know, that helps out performance. The second thing I wanted to show and I'm sharing my screen,

Larry Swedroe 22:48
go to the factor regression on the factor. Yep.

Andrew Stotz 22:52
So I'm showing on my screen for listeners, there's a tool that Larry had mentioned, I'll have it in the show notes, which is a portfolio visualizer. I've gone to the factor analysis. Yes. Here we are.

Larry Swedroe 23:02
Yep. And if you just all you have to do is type in whatever ticker symbols you want. And then if you go to the fama for French research factors a little lower down, yep, you can type in VTi, I think or right, yes, use the fama French, which will be limited to their factors. Or you could use the AQR factors, which would give you the quality factor. You can add fix the income, you can then set the period you want. And so you can just run one here, let's run VTi. And they put in all you know, Oh, 101 1000. And then and whenever they you want 2000. Now not Oh, 2000 no 205, right, and then the end period, you could put 1231 2022. Okay, just as an example. And you could put three or four at the same time. And then let's run it at the AQR, just change it and, and then go down to a four factor model, set a three, you can run three factor, and we'll just show this. I then include the quality factor, yes. All right, and then run factor analysis. And this will show you now this is an index fund, right? Yep. So you should expect it to underperform by about its expense ratio, and a little bit for trading costs. Well, it's a total market fund, so you should expect it to have a beta of one and zero exposure pretty much to the other factors. And that's what you see. And the annualized alpha is about it, straightened costs. Got it. And now Now if you want let's just show one other

Andrew Stotz 24:59
thing. Okay, should I press

Larry Swedroe 25:03
vi run vi s VX?

Andrew Stotz 25:06

Larry Swedroe 25:10
x x sorry, that's Vanguard small you can just run the same dates. Yeah. Now this fun is going out, by definition have some exposure to small and value. Right. And so let's run it again with the same factors of AQR. four factors, change it to four and include quality. And now let's run the analysis. And there you go. So now you see, you would expect because it owns a lot of small stocks, which tend to have higher than one betas, so it's got a little bit more than one beta, which means when the market goes up, you would expect to outperform just on that basis, Scott's point six loading on the size factor, a point five on value.

Andrew Stotz 26:09
Okay, so six means what does that mean? Point six means

Larry Swedroe 26:12
if the value premium that year, or over that period was, say, 4% 4%, times point six, you'd expect to outperform by 2.4%, purely because of that exposure to value. And the value was minus 2% a year, you would expect to underperform by minus 1.2. That's not bad management, it's just you had exposure to a factor that was negative. And you could see the other exposures, and he had the fun has a little higher than negative alpha, but pretty close to its expense ratio, but you're gonna have a little bit more turnover, and a small value fund than a market fund. So you might have guessed somewhere around minus point three, shows you how accurate the analysis is.

Andrew Stotz 27:07
Why, wow, what a amazing tool, I have to confess I don't, I've never used it. So you've just opened my eyes. And I'll have a link to that, you know, for everybody. And I got some fun things I want to test in that. So I appreciate that a lot. And that's going to help me to isolate and not confuse, skill, and luck.

Larry Swedroe 27:29
And we're also helps us it tells you if you want exposure to the smallest value of factors, you can run. If you ran the same analysis, say on BS VO, which is Bridgeway small value, you would see a higher market beta, you would see a higher size loading, you would see a higher value loading. And it's a little bit more expensive. And then you'll see if it adds value. And if you want it and it could underperform, you would expect it to really have underperformed in 17 1819. And early because value got killed. And small didn't do well, in 2022, which dramatically outperformed not because they're great stock pickers market timers, but small value dramatically outperformed the market. So it's exposure to those factors. So yeah, that's where you can tell that much of the difference between skill and lock, you know, there's, it's basically, you know, not skill with a passive fund, although there's definitely skill in designing fun construction roles, that can make a fun, more efficient in terms of trading costs, taxes and exposure to factors.

Andrew Stotz 28:49
And when I look at a fun I mean, I people asked me that know nothing about the market, they say, Well, what would be where should I start? I, I oftentimes tell them, look at the value, the Vanguard ve T fund, because it just owns every stock, you know, in a passive way. But that's not always

Larry Swedroe 29:05
should be the benchmark your starting point. Right? It's cheap, you can own fidelity and Schwab total market fund for three basis points, it's going to be an ETF, it's going to be incredibly tax efficient. The quote problem with that is you have no exposure to any of the factors by definition. So you have a concentrated portfolio in terms of its exposure to different unique sources of risk. That is a problem when the market does poorly. And so it's you really can get hit hard portfolios that are more diversified across these other factors that have also shown premiums tend to perform better over the long term and have much smaller tail risks.

Andrew Stotz 29:56
And is that there is that in that space of excess owes you to all those factors and diversification across all those factors. Is there like one like the VT Vaughn or like Fidelity has their fund that is total market? Is there one or two that you would say this one is exposed to all those factors pretty well?

Larry Swedroe 30:18
Well, I would rather say there are fun families that provide a whole series of funds. The ones that I use, I recommend, I own personally, my firm recommend ones who use what I call the science of investing or Evidence Based Investing. It's not individual opinions. There's no individual stock selection, no market timing, just intelligent design. Like they're not purely passive, like an index fund. They trade intelligently. That typically never trading almost never traded more than 100 chairs, so you don't get market impact costs. Right. So the fun families, we tend to use our dimensional Avantis Bridgeway. There are other good ones, I would mention Alpha ARCHITEC is a lesser known name but won by really good smart people. BlackRock is another Vanguard has funds that do this, but their Vanguards funds tend to be more index funds, because they're selling to the general public. And there are some negatives of pure indexing, which I've written about, which can be the minimized or eliminated purely by intelligent design. So I don't I use our in our firm, we always use like a Vanguard Total Stock Market Fund for people one a core, and then we'll use the other funds to get us exposure to these factors. We never use Vanguards other funds, because we think there are more efficient ways to do it.

Andrew Stotz 31:58
And that leads us into the final part of today's discussion, which is mistake number eight, do you avoid passive investing because you sense a loss of control? Well, we're talking about active passive, you mentioned about intelligent design and all that. But let's look at that avoiding passive because you sent a loss of control.

Larry Swedroe 32:15
So let's again just for our audience that hasn't listened to the first several episodes define what we mean here passive, because it's thrown around a lot and a lot of people use it differently. To me, I define passive AMI, so let's define active as individuals stock selection and or market timing. Passive doesn't do any of that passive just defines the universe, and then buys and holds all the securities that meet that definition. An index fund, by definition is passive. But Andrew Stotz could create the Andrew Stotz super large cap, 10 stock fund and equal weights, the 10 largest stocks doesn't rebalance daily, it uses when cash flow comes in it rebalances. So it's going to shoot for an equal weighting. But it may never be exactly equal weighting. That's clearly passive, right? No stock pic, but there's no index. So not all index funds are passive, but not all passive funds are indexed. Okay. So that's our definition here. Systematic, no individual stock selection, you just design your construction rules in the most efficient manner to achieve your objective exposure to factors trade patiently, not like an index fund, which trades dumb late whenever this force trading because of, you know, mergers, acquisitions, deletions or additions by the s&p 500. Committee. All right. The problem is this when we're experiencing periods like today, which happens often when everyone's worried about is the government going into the fall? What's gonna happen in the Ukraine, you know, is China gonna invade Taiwan or whatever the you know, there's your problem of the day. You know, we want to be in control and right if we have an index fund, well, now the markets in control. So a lot of people look at active management in the way that they're in control. They're either in control of buying individual stocks, they're in control of choosing the act of manager, they're in control of when they go in and out of the market. The problem is all the evidence says that that control costs you money, you're more likely to make mistakes end up underperforming right. You know, that's what all the overwhelming Body of Evidence suggests. And what you have to accept this or better understand is that when you're passive, and you use systematic strategy, you're 100%. In control, you decide what exposures that you're taking too each of these factors. When you use active managers, you've given up control to some manager who could decide, I don't like these 10 stocks, or this year, I'm going to go into value, and next year into growth, or I'm going to raise 20% Cash, because I think you actually see control over what the academic literature the empirical evidence shows, determines 98% of the performance of your portfolio, which is what factors you're exposed to. The only way to keep control over those are is to be a passive investor. And then you have to accept that you can only control what you can control, you can't control the unpredictable things that happen. And that's the key then is to make sure your portfolio's design doesn't take more risks, than you have the ability, willingness and need to take. And you're what I call hybrid diversify. So you can withstand the shocks that happened to every single asset class, every single one of them, we know goes through long periods of poor performance. So the key is that don't concentrate like a total stock market fund does. Because that factor can underperform for 20 years or more. As we have discussed in the past, I'll give you one great example 69 through all way, both large cap growth stocks and small cap growth stocks, underperform the 20 year treasury, that's 40 years. So if you were concentrated in that type of portfolio, you really had serious problems.

Andrew Stotz 37:04
40 years is unbelievable. And that that's that's a preview

Larry Swedroe 37:08
event stayed the course and reap the benefits from 10 through 23. When those stocks outperformed again.

Andrew Stotz 37:16
Yeah, cuz it would have been near 39. You said I give up.

Larry Swedroe 37:19
Yeah, that's it. That's my play.

Andrew Stotz 37:23
While we've got your brain here for a couple more minutes, I have a question about this, that some are somewhat related. If you have two investors that say Warren Buffett, as an example, is an investor, that's a concentrated investor. So let's take a concentrated investor that owns 20 stocks. And now let's take another person who's also an active investor, but you know, they they're, their risk department tells them no, no, no, you can only 20 stocks, you got to own 150 or 200. To diversify the risk. And now, then, when we benchmark or look at the performance of those two funds, when we when we benchmark and we look at let's say we look at s&p 500 As an example, what we find is that when we calculate the risk adjusted return, the portfolio that has a constant the concentrated portfolios tended gonna be have more volatility than the 100 200 stock portfolio when compared against a 500. Stock, s&p 500. So my question to you is, when we're measuring an investor's performance, should we be benchmarking within a roughly equal number of stocks?

Larry Swedroe 38:31
No, you want to benchmark against the index and then consider, of course, you're going to have fatter tails with an indifferent, right? So you would expect more in the right tail and more in the left tail, you know, a flatter distribution when you have the concentrated portfolio. But the evidence shows that these concentrated portfolios do not outperform investors have been searching for years. Researchers, like active share a concentrated portfolio and would have a high interactive share, there's no evidence that that is successful, at least for mutual funds. So that's a problem and therefore, since they have the same outcomes, on average, but more risky portfolios, then the right solution should be unless you get a higher expected return for taking more risk. You shouldn't do it, and therefore it's irrational to own the more concentrated portfolio.

Andrew Stotz 39:41
And it sounds like based upon that, if you start playing around with benchmarking as a smaller portfolio, you're gonna start losing the fact that you're being exposed to that more risk than let's

Larry Swedroe 39:54
say it this way. We've run the numbers when the I think the best One way to think about this, Andrew is take that concentrated portfolio, and then run a Monte Carlo simulation of given the expected return and volatility. And then say, Put 60% in that portfolio and 40% and a five year treasury and run the same thing with the same expected return. Right, for a total mock Vanguard fund, and you'll find the safe withdrawal rate will be higher for the more diversified portfolio, meaning the failure rate will be higher for the concentrated portfolio. their odds of getting a higher high performing and having a big outperformance so you get a big, you know, bequeath that you could leave to your kids will be more with the concentrated portfolio. So the tails get wider, but most of us care much more about the left tail and the right tail. So the answer is for any logical person, we tend to be risk averse, we should demand a significant risk premium. Make that bet on the concentrator? And the evidence shows is just not there.

Andrew Stotz 41:21
Yeah. Well, Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth. And really, the gold in this one, besides our discussion was, you know, understanding a little bit more about portfolio analyzer. And I think for a lot of people listening and viewing as well as for myself, we're gonna go off and start playing with that if we're not playing with that are ready. So that was great. For the listeners out there who want to keep up with all that Larry is doing. You can find him on Twitter at Larry swedroe Right there. And he's also on LinkedIn where he is sharing all the stuff that he's doing. This is your worst podcast host Andrew Stotz saying, I'll see you and I'll see you Larry also on the upside.


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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.

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