In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss three chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this eighth episode, they discuss mistake number 13: Do you confuse the familiar with the safe? Mistake number 14: Do you believe you’re playing with the house’s money? And mistake number 15: Do you let friendship influence your choice of investment advisors?
LEARNING: Just because you’re familiar with something doesn’t make it less risky. Diversify globally to get the real benefits of diversification. Your financial advisor is not your friend; it’s a business. Value and protect your investment gains as much as you value and protect the principle.
“We’re all human beings and have made these mistakes. What differentiates smart people from others is that they don’t repeat the same behavior when they learn it’s a mistake. They change it. They become aware of investment biases and overcome them either on their own or with the help of a trusted financial advisor.”
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 eighth episode, they discuss mistake number 13: Do you confuse the familiar with the safe? Mistake number 14: Do you believe you’re playing with the house’s money? And mistake number 15: Do you let friendship influence your choice of investment advisors?
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
Mistake number 13: Do you confuse the familiar with the safe?
People tend to double up on investments they’re familiar with compared to new companies. But according to Larry, knowing about something doesn’t make it safer. When it comes to risk, people think of something they’re familiar with as safer. When they’re less familiar with it, it becomes more uncertain.
People over-allocate to their domestic stock market and underweight international stocks. This bias causes investors to be overconfident and take too much risk by concentrating on assets they’re most familiar with.
To avoid this bias, the guiding principle is that just because you’re familiar with something doesn’t make it less risky. Diversify globally to get the real benefits of diversification.
Mistake number 14: Do you believe you’re playing with the house’s money?
To explain this mistake, Larry uses the story of the man in the green bathrobe. In the story, a newlywed couple goes to Las Vegas on their honeymoon. Being intelligent, they set aside $1,000 as their gambling money for their week in Las Vegas.
Unfortunately, by the end of the second night, they’d blown the entire $1,000. At the end of that night, the husband was getting ready to go to bed when he saw a little shiny object on the dresser. He picked it up, and it was a $5 chip. The man saw this as a sign to go to a roulette wheel and use that chip. So he quietly left the room and took a cab to the nearest local casino.
The man put the $5 chip on the number 17 because that was the number on the chip. At 35 to-one odds, he won. He played again and won. The man won about five times and now had $6.1 million.
A huge crowd had gathered around the table to watch the man play again. The roulette dealer spun the wheel, and it looked like it would drop on 17. Then it fell over the next number. The man lost all his winnings. Because he was in such a hurry when he left his room, the man was still wearing the hotel’s green bathrobe—in which he had to walk back to his hotel and explain to his wife what’s happened. He tried to sneak in, but his wife was awake. He told her that he’d gone to the casino. She asked how it went, and he said he’d lost five bucks.
The man’s problem was thinking that he didn’t lose $6 million because it wasn’t his money but the house’s money. Now, if someone had given him a check for $6 million, there’s no way he would have bet it on the roulette wheel.
When it comes to investing, Larry says that most people are lucky to find stock at low prices. But when the stocks become winners, they don’t see the gains made as their money. So majority never feel the need to protect their profits and end up losing them.
Mistake number 15: Do you let friendship influence your choice of investment advisors?
Many investors will often hire financial advisors who are their friends. Their decision is not based on facts but on emotion. They’ll continue depending on the financial advisor even when their investments perform poorly. They won’t fire them because they’re friends. The truth is that they’re only your friend because they’re making commissions or other fees off of you. Friendships have caused people so much of their fortunes unnecessarily.
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.
Andrew Stotz 00:02
Fellow risk takers this is your worst podcast hosts 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's Larry deeply understands the world of academic research, about investing, especially risk. Today, we're going to discuss the final three chapters of part one of his book investment mistakes even smart investors make and how to avoid them. The first mistake that we're going to cover is mistake number 13. Which is Do you confuse the familiar with the safe? Larry, let's start with that one. Tell us Yeah,
Larry Swedroe 00:54
sure. This is one of my favorites. It's an error that almost everybody makes. And it's one that's hard to avoid, unless you're aware that you're subject to this bias. So there's a great story. When AT and T was broken up into what became known as the baby bells, I think there were like eight or nine regional bells that were created out of that, you would think that everyone would want to own a diversified portfolio of them. And yet, as it turned out, people when they got their shares, if you lived in the Midwest, you sold your South East shares to buy more Midwest, and if you lived in the southeast, you sold the Midwest, provide more of the southeast. Now why would you do that? Right. It's not any better investment because you know about it. And that's really a great example of that. My favorite one to help teach people about this is that if you lived in Rochester, New York, in the 1970s, can you think of two great companies that you would have probably loaded up on? You are familiar with them, because you work for them? You know who they might be?
Andrew Stotz 02:17
Well, I'm thinking of General Electric, when I think of New York, but
Larry Swedroe 02:21
it's Kodak and Polaroid. Got it. They were the two of those nifty 50 stocks, right? And people loaded up on them. And of course, they turned out to be disastrous for investors eventually, as their technology was disrupted. But so that's just one example. And Rod, if you lived in Houston, people loaded up on that. And the problem is, maybe why did they load up on it? Because maybe they were employees of those companies. They were very familiar with or had family members work. I know the company, it's surely safe, cuz I know about knowing about it really doesn't make it any more safe. So my favorite example, I live in St. Louis. Now that company doesn't exist as a standalone company. But I would bet you could guess what company people loaded up on if you live in St. Louis. I'll give you a little hint here. Drinking a kind of beer.
Andrew Stotz 03:28
You know, is it what is Milwaukee is at Anheuser Busch. And as a bush, okay. I don't drink beer. And I haven't been in the US for 30 years. So I'm yeah, that's
Larry Swedroe 03:37
why so. But then, and it doesn't exist anymore. It's now part of an international contract. But people in St. Louis loaded up on that stock. And the other hand now I'm sure this one you'll get right. People in Atlanta, what stock that they load up on? Oh, good cola. Now, is it any safer to on Coca Cola if you live in New York than if you live in St. Louis, as an any safer to own. But if you live in St. Louis, then you live in, but people do it. It makes no sense when diversification is the basic principle. And that takes us to the question of how investors think about risks when they're familiar with something as safer. And when they are less familiar. It becomes more about uncertainty. So what do you think that how does that apply to how investors think about owning domestic versus international assets? And what do you think that leads them to do?
Andrew Stotz 04:42
Well, I think they're terrified of international assets, and they're familiar with the s&p 500. And so they don't, you know, they don't necessarily see the benefit of investing in the others. And they also don't understand the relationship between when one's up the other winds down that type of thing.
Larry Swedroe 05:02
A little diversification. Well, it turns out, there are many studies on this subject. Turns out, it doesn't matter whether you live in France, Japan, Germany, Netherlands, UK, Canada, Australia, you think your country is the safest place to invest, and you tend to think it has the highest returns. Now, we know that both of those things cannot be true logically, because if something is a safer investment, logically, you should think and has lower expected returns, because risk and expected return should be related. So it turns out that everywhere you go in the world, people over allocate to their domestic economies in the stock market and underweight International. So French investors were France is in single digits, as a percentage of a global market cap might have 80% of their assets in French stocks, and US investors tend to have 90% or so of their money in US stocks, and Japanese invested mostly in Japanese. And this is true all over the world. Well, it can't be true that every country is safer and as higher return. So the guiding principle should be to avoid this bias, just because you're familiar with something does not make it less risky. That's a bias that you have. And that causes you to be overconfident and take too much risk by concentrating risks in the assets you have the most familiar with.
Andrew Stotz 06:42
What do you think I hear people sometimes say, well, the US companies have international business. So I'm already exposed to the international economy. Therefore, why should I diversify? It's, you know, I'm already getting returns in relation to those markets.
Larry Swedroe 07:00
Yeah, there is some truth to that statement. Of course, it's mostly true of big companies, much less true of smaller companies, who tend to be more local. So that's number one. So you want that diversification into different between large and small caps, you really need to diversify globally, to get those more local benefits. That's number one. Number two, certainly Ford and General Motors are international global companies. But so our general, you know, so is Toyota. So are the German auto manufacturers, BMW Daimler Benz, they are international as well. And only then gives you some exposure, of course, to the US. But it turns out that Daimler Benz, and Mercedes, this stock returns a much more correlated to the German stock market, even though they may have more than 50% of their sales outside of Germany, and US car manufacturers are much more correlated to US stocks, and Japanese manufacturers are more correlated to Japanese stocks. So you really need to be globally diversified. In order to get the real benefits of diversification.
Andrew Stotz 08:28
One of the places where that provides a challenge, if you're doing individual company analysis is in the world of finance, we use the capital asset pricing model for all of its flaws. And so people say, well, what's the beta of BMW? Should I say, said, look at the share price of BMW relative to the German market? Or should I say, Well, its revenues coming from around the world? And so I'm going to create some sort of index of weighted by the revenue of BMW, and then measure the stock performance relative to the indices, weighted by revenue, or something like that. I don't know if you have any opinion on that? Yeah. Well,
Larry Swedroe 09:12
my first opinion is you shouldn't be spending time doing individual security analysis. The market has already done that for you. So it's likely to prove to be a non productive behavior. Let the active investors engage in those activities and you can become a free rider get the benefits of all their insights, which drive market prices to be highly efficient, meaning the current price is the best estimate of the right price. But because I mentioned that German stocks tend to have higher correlation with German companies, even if they're international. You should look at the German market beta to the German market or do we Ni fi, you know, beta or whatever, that would be better way of looking at it.
Andrew Stotz 10:06
And the other thing is that when you're buying stock, let's say a US investor is buying a stock, they're buying one asset. And when they're buying, let's say, a BMW, they're buying to assets. They're buying the currency that BMW stock is denominated in, and then they're using that currency to buy the BMW stock in that German market. And what do you say for people like, Oh, yes, but there's all kinds of foreign exchange risk. Now, I think I know what you're gonna say, which is a diversified international portfolio is going to have all kinds of exchanges and exchange rate risk is like a zero sum game like it always balances out, or how should an investor Look at that? Well, here's
Larry Swedroe 10:54
a way to think about a Risk Number one is not a four letter word in the sense of meaning it's a bad word, because it does have four letters, but it's not a dirty word, if you will. And the problem is, investors think of risk, often only in the negative sense, rather than the positive sense, which also happens, on average, over the long term currency returns have been zero, basically, but there are periods when the US dollar outperforms, and therefore you're better off Owning dollar assets. And then there are other periods when the dollar underperformed. And that gives a tailwind to international assets. And so it acts as a diversifier owning international assets. And you could hedge the currency risk, but I would tell you not to do it. One, I wouldn't want to spend the money to do the trades. But two, I want that diversification benefit.
Andrew Stotz 11:56
And when when you by the way, that's giving you
Larry Swedroe 11:59
geopolitical benefits, you know, as well,
Andrew Stotz 12:03
right? And when an investor, let's say in the US looks at a foreign fund, it's priced in US dollars. So the investor may say, Well, wait, I don't have any foreign exposure, because I'm buying and selling this. But can you explain that, you know, in this case, it's just a pricing currency, you still have exposure to the underlying currencies? Am I correct in saying that? Yeah, absolutely.
Larry Swedroe 12:30
All they're doing at the end of each day, let's just take, say, an Australian restaurant that only has, you know, the sites in Australia, while their revenue and earnings are going to be in Australian dollars, they, then it's the company values that price, it trades in Aussie dollars on the Australian market. And if you're a US fund owns that the end of the day, they just take the Australian dollar value and then multiply it by the exchange rate to give you what stuff so you are exposed to that. Let me add one other really interesting story about currency risk. Now, the UK pound will and this is I think, a good tale because people are now I'm hearing lots of questions about D dollarization. of the global economy and the Chinese yuan is going to take over some other currency Well, or whatever. So is a lesson from history, that it's sad that investors don't know their history because lots of lessons you can teach. So that prior to the US dollar being the global standard, do you remember which currency was the global you know, world reserve currency?
Excuse me the pound?
Larry Swedroe 13:55
Yeah, the British pound. Now, after World War One, Britain was in trouble financially. And by the end of World War Two, the nation was bankrupt. They tried to hold the pound at its post World War One levels eventually had to devalue. It was like $5 Venture went down to $1. Right. And, you know, it's not trading that much above it today. So the dot the pound is collapse. And since 1955, I did took a look at it when the pound will, you know, eventually develop. British stocks have ADD similar actually, I think even slightly higher returns in dollars than did US stocks. So, you know, there's a good example where the currency went down. But of course, the assets are real assets, their global assets, a lot of the companies are global companies and are generating and maybe the power went down because of inflation, well, then the value of the assets goes up with them. So there's a good example All that I think is really helpful and people should stop worrying, by the way about D dollarization. You know, fact, the fact that the dollar is the global currency actually has some very negative effects on US manufacturers because the dollar gets overvalued and makes it more expensive to produce here. And then you get a hollowing out of the manufacturing sector. Now, it does make allow us to import cheaper on that side. So it depends on where your jobs are. But that's an issue so I wouldn't worry about this all this talk about, you know, you should set the example of the UK is a perfect example about why that should not be the case.
Andrew Stotz 15:50
And just to wrap up Mistake number 13. You reference a book. And I'm showing it on the screen called Why smart people make big money mistakes by Gary Belsky and Thomas Gilovich. And for those listeners who want to learn more about Gary. He's episode 545 on my worst investment ever, you can hear his worst investment. The title of that one is long term patience is the key to success in investing. But yeah, it's a great, great book. So it's interesting to see our representative
Larry Swedroe 16:23
jump in here on this because Gary Belsky is one of the people who really inspired me that book I thought it was great. And it inspired me eventually to write my books on behavioral finance.
Andrew Stotz 16:35
Exciting. Yeah, well, I really enjoyed my conversation with him. Well, that wraps up Mistake number 13. Let's move on to mistake number 14. Do you believe you are playing with the houses money? We're going to talk about bathrobes. I have a feeling.
Larry Swedroe 16:51
Yeah, green bathrobes. It's my personally my favorite story of all time. To you know, someone once told me I may have mentioned this before, that if you tell someone a fact they learn if you tell them the truth, they'll believe. But if you tell them a story, it will live in your heart forever. That's what the great preachers, you know, have always known tell stories, parables, etc. So how do you teach somebody about this issue about the house money. So I had heard this story about the man in the green bathrobe, which is a legend. We don't know if it's true, it's probably has a some truth in it. But it's apocryphal somebody exaggerated this story. So but the story goes like this as a newlywed couple, they go to Las Vegas, on their honeymoon. And being intelligent, they set aside, you know, $1,000 as their gambling for their week in Las Vegas. Unfortunately, by the end of the second night, they have blown the $1,000. And they're not going to spend any more. One, at the end of that night, the husband is getting ready to go to bed and he looks up on his wife has already fallen asleep. And he looks on the dresser and he sees a little shiny object. And he goes over and he sees it's a $5 chip. And he says I write this, this is a sign I've got to go, you know on a roulette wheel, and, you know, and, and use that chip. So he quietly dresses goes down, walks down, you know, takes take tells the cab take me to the local casino near the nearest one. And he goes in and he puts the $5 chip on the number 17 Because that was the number on the chip. And at 35 to one odds, he wins. And he says let it roll. And he wins again. And he's not won like five times. And he's got million $6.1 million. And now a huge crowd is gathered round the table to watch this is one more time. And the you know the roulette dealer rolls spins the wheel, it looks like it's gonna drop on 17 And then it falls over into the next and he's gone and the whole crowd kind of size and everything. And all these got on because he was in such a hurry. He was the hotels green bathroom. And now he's got to walk back to his hotel for a couple of miles and explain what's happened. He knows what. So he gets back to the hotel he tries to sneak in but
Andrew Stotz 19:45
I can picture him walking down the strip in that bathroom
Larry Swedroe 19:49
in that green bathroom. That's why that's a legend. Right? And he walks in and White says What the hell are you doing in your bathroom or where did you go? So that's why I went to the Casino. He said, How did you do? He said, I lost five bucks. You know, the problem is he was thinking about the fact he didn't lose $6 million. It was his money could have walked away. But it was the houses money, not his. Now, if he had had, someone had given him a check for $6 million, there's no way he would have bet that 6 million on the Roulette Wheel. But he differentiated it between what was sort of found money. There are all kinds of stories, there have been studies done on lottery winners, so win big lotteries, and many of them are bankrupt within two or three years. Now, I'm certain that if those people had spent 35 years or 50 years of their careers, earning the living as a plumber, or an engineer or a doctor and earning that money, instead of getting it as a winning in a lottery, they would never be end up bankrupt. But they treat it as the old saying, easy come. Easy go. Right. So what does this have to do with investing? So my one of my favorite stories is a friend of mine, one of the smartest people I know. I actually worked for him twice and followed him from one job to the next. And he had bought Cisco at, like $10 a share. And then it rode up in the 90s, about 80 bucks training and insane prices to sales. Right? And I said to him, I said, you know, you know, I'm glad you made all this money. But why did you sell some said, Why should I sell some? You know, I only paid 10 bucks for it. I asked them Do you own a green bathrobe. If you didn't own the stock, how many shares would you buy me, you know, it had gone from, say 2% of his portfolio to maybe 15%, he would never have put 15% in a single stock. But he did because it was the house. Of course, a few years later, the stock was right back down. And he had lost it all and eventually traded a little below where he bought it and he sold it to take a tax loss. So that's a great example of thinking you're playing with the houses money.
Andrew Stotz 22:34
And either he thought his friend was a genius, or you just was so mad that he never talked to you again.
Larry Swedroe 22:42
We were still friends.
Andrew Stotz 22:45
At the end of mistake number 14, you know, you summarize by talking about this mental accounting. And I think the idea, you know, you talk about having the investment policy statement and the value of that. In addition, you know, we want to use mental accounting, you know, in our favor where we start to set up mental accounts, where we're protecting a portion of our assets and setting up a mental account where we allow ourselves I say, to play with that a little bit, or can you wrap up on this particular mistake talking about the the IPS and mental accounting?
Larry Swedroe 23:23
Yeah, I think it's incredibly important to have a written financial statement that you sign. And that way, you can look back and say I committed to this. And unless something has changed in your life, about say, your ability to take risk, you just inherited $10 million. You don't need to take risks, I don't need to be 70% equities anymore, I could go down to 30%, I should do that. Or you just got a promotion, or you, you know you lost your job on the other side. Now you can take the same risk. And you should change your investment policy statement, whenever any of the assumptions underlying your plan about your ability, willingness, or need to take risks. So you might check your balance sheet every month or once a quarter, see if it's in within those tolerances. If you set a 30% for equities or 5% for an entertainment account, and you now have more than that, then you should stick to it, rebalance and get back down. And that might well hopefully enforce the discipline. And that's really very important role of a financial advisor is to remind the client you sign this document. You told me you want me to enforce it. I'm going to do it. That's my job.
Andrew Stotz 24:51
It reminds me of a friend of mine, my first boss in Thailand. He came to work at a particular brokerage in Thailand and he said I'm gonna bring in foreign money, foreign investors are going to, you know, buy and sell Thai stocks through your brokerage. But I want shares for the upcoming IPO, that the broker was going to list in the stock market. So he was going to bring in, you know, probably 20% of total revenue of that broker. And he said, I want X number of shares, they signed a contract. And he started doing that and building the business, he hired me as an analyst and had others and he had a team, when the eventually the time came that they were going to list the stock in the stock market. They didn't want to give him the shares. And they, there was a dispute. And there, they said to Him, if we knew it was going to go up from five baht to 50, we wouldn't have signed this agreement.
Larry Swedroe 25:49
And it just shows you that that's exactly why you signed the agreement. Exactly. That's the
Andrew Stotz 25:55
only time the agreement matters is at the point of contention. And that's why the signature on the IPS is so good, because at that point of contention, it you know, it's a document that you can really bring up and use.
Larry Swedroe 26:09
That's at Buckingham strategic wealth, my own firm, we require every investor to go through what we call a discovery process where we go into great detail to understand their ability, willingness need to take risks, what are their financial life goals, and then together, we estimate, future returns and come up with an asset allocation that gives them we think the best chance of achieving that goal is we run a Monte Carlo simulation. And then we have them sign that to say, here is the rebalancing table. And when your targets exceed those, either on the downside, we're going to come in and buy which is going to be tough, because you're going to think the world's coming to an end. And when things are going up, we're going to come in and tell you to sell high, which is what logically you want to do. But it's tougher to do because you'll think why are we selling these winners, right? But that's why you have an investment policy statement. That's your financial plan.
Andrew Stotz 27:13
One last thing I want to ask you, given that you just were mentioning this with what you're doing, you know what you guys do at Buckingham, if I was to look at a 20 year old, let's just take a simple example of a 2025 year old who's got a good job making good money. You know, we know that the stock market ultimately is the place that you will get the highest return is not going to come in the bond market, it's going to come ultimately by having exposure to the stock market. So my question to you is, is that isn't the old forget, forget about that person's risk tolerance or anything. Let's just say that the ultimate objective, if the objective is to have the most amount of wealth at the end of the period, the ultimate objective is to say, invest 100% in the stock market contribute regularly over time, never sell and let that grow and don't put bonds in there, you know, you're just destroying, again, taking away the person's risk tolerance or anything like that. Would I be correct in saying that that would be let's say total market exposure, whether that's us or global, is the optimum strategy?
Larry Swedroe 28:25
Well, that's the only one that everyone can do. Right, because all stocks have to be owned by somebody. But there is academic research showing that there are certain traits or characteristics of stocks or kinds of stocks that Warren Buffett has been recommending people buy for 5060 years now that have outperformed the total market. Those characteristics are smaller companies value or cheap stocks, more profitable companies holding everything else equal. So if you have the same PE you want to buy, the company has a higher ROP or higher Roa. quality stocks have outperformed companies that not only have more stable earnings have lower financial leverage there. That's really a behavioral story. But that's the fact. So if you want the highest expected returns on a portfolio, then you would want to create with the New York Times called the Lowry portfolio, which was my portfolio. I took a barbell approach. And the way I built the portfolio, I wanted to own the riskiest equities that had the highest expected returns. And then I could have a lot less beta exposure, because the stocks I own had a much higher expected return than the market. So just for argument's sake, or keep it simple, small value stocks has returned 40 1% a year with the market of return 10. Well, if bonds say returned five, you know, to get 10, I'd have to be 100% stocks, I could be a lot less than 100% stocks. If I put money into small value, I might be able to be 60%, right or 50%, or, you know, whatever the numbers work out exactly. So now I've got different factor exposures out of exposures to the market, if exposure to size, value, maybe momentum and quality. So turns out when you do that, you get about the same return as the market but a lot less tail risk, and your portfolio is likely to be less volatile. And that allows you as the state of course, more as well, I think, because you're less likely to panic itself. The negative of that portfolio, though, is you don't look like the market. And there are long periods like the late 90s. When small value profitable companies underperform the junkie.com stocks. Same thing happened recently, and 60, out really 17 through 20, when the less profitable companies outperformed again. And it's happened again this year, for the first seven months. So you have to be able to ignore what I call the noises of the market, and be disciplined and have that well thought out plan. And understand, I don't care if my portfolio looks like the market. That's not my objective. My objective is to give me the best chance of achieving those goals with the least amount of risk for those investors who are interested in learning more, I wrote a book called reducing the risk of black swans. And that explains all of the evidence and the ideas behind the strategy. And then you could add like I do, and the last five, six years has been financial innovations. I've added other assets that have equity like or even in some cases, higher today, expected returns in stocks, but are actually less risky. But have illiquidity risk, which I don't need, because I don't take more than, you know, a few percent of a year from my portfolio. So things like reinsurance, and life settlements and drug royalties. Today, US stock returns, most people including Vanguard think, because of the high valuations, they might be in the five to 6% range. That's still a lot higher than safe bonds, which are in the three and a half set of four. But there are other assets that are actually uncorrelated and have higher expected returns, I believe, then that leads us equities, maybe not international equities, where valuations are much lower value stocks, where evaluations today are dirt cheap trading, like we're in serious recessions all around the world. Small value stocks are trading at Pease in the seven to eight range when the s&p is trading at, you know, 19 or 20. And growth stocks and trading of like 28.
Andrew Stotz 33:24
Yeah, that's been fascinating to watch. One last question related to this, let's say we've identified either the market portfolio or let's call what you're talking about the optimum portfolio for risk and return, then, does an individual's risk profile matter? I mean, let's just say that somebody's saying, well, this person, I think, is it, they shouldn't be exposed to too much risk. So you got to 25 year olds, you've got the optimum portfolio. And now you tell one of them? Well, because of your risk profile, we don't want to give you full exposure that we want to give you partial exposure to that. And we want to give you exposure more to bonds, because your risk profile, and for you, the other Miss 25 your risk profile is different, and therefore we're gonna give you 100% exposure to that optimum portfolio. And my question is, is does it really matter? I mean, at 25, shouldn't it really just be that our job as an advisors say, this is the optimum and your job is to, you know, we've got to get you to hold on to that and grow the maximum and minimize the risk?
Larry Swedroe 34:36
No, the answer is very clear. You absolutely have to look at the risk tolerance. And the reason is this. You will, in order, let me say it this way. They're the right portfolio is the one you will most likely be able to stick with and also sleep well and enjoy your life because life's to short not to enjoy it, right. And so if the market, it's now in the next 2008, or the next COVID-19, whatever it might be in the markets drop 50 or 60%. And you panic and sell, and it didn't do any good, it was actually a disservice. Because you, you know, your stomach couldn't handle it, the only way you got those great returns is if you stayed the course. Right, that's number one. But number two, consider to 25 year olds, one is a, let's say that they have just gotten their graduate degree. And they are lucky enough to get a professorship at Harvard. And there, so they're teaching there, and the others an automobile mechanic. economy turned south, the Harvard professors still teaching, and the auto mechanic got laid off, and he has to sell his stocks to put food on the table. Now he can't recover when the market does, because he spent the money. One of the worst mistakes that I see. And this is true, I think of the vast majority of actually professional advisors even that I've met with and asked this question, they don't consider the correlation of somebody's labor capital, with the correlation of stocks. So if you have your job is highly correlated to economic cycle risk of stocks, you should not have high exposure to equities, because you might just be forced to sell to put food on the table, or to pay a medical bill. And now you can't recover.
Andrew Stotz 36:53
And that, that's a great, you know, a great example. And what I want to go back to the one that I was mentioning, and let's just now imagine that those 225 year olds are identical. same job, same everything. And let's say that we do a calculation, we say, Okay, at this for this optimum portfolio, you're going to end up with $10 million at the age of 60. And we say for both of you, you, you're going to need $10 million to have the lifestyle that you want to have. And we've now figured out how much you're going to contribute in that optimum portfolio. However, with person, you know, with a high risk person that has a low tolerance for risk, you say, sorry, we're going to reduce your let's say, risky portion of that portfolio and increase the low risk portion of that portfolio, therefore, you're not going to end up with 10 million, you're going to end up with let's say 4 million, because it's going to grow at a much lower pace. And therefore, we've now exposed another risk, which is shortfall risk, because we decided, hey, I need that 10 million at the end of the period. How do you handle that?
Larry Swedroe 38:06
Yeah, well, there's a big problem and how you phrase the question, because you should never tell somebody because we don't know that this portfolio is going to get 10 million. The only right way to do that is to say, there's a distribution of possible outcomes, with a median expected outcome is 10 million, there's a 60% chance it'll be more than 11 and a 40%. Sorry. So the 50%, the median is a 10, there's a 40% chance will be more than 11 to 20% chance will be more than 12. And a 5% chance it could be 15. On the other side of that there's a 40% chance of might only be nine and 30% Chance might only be seven, and a 10% chance of might only be three. Turns out the world looks like Japan for the next 30 years. Are you willing and able to accept those outcomes because any one of them can come true. And then you show the same thing to the other person. Now, their dispersion of outcomes with the 4 million is going to be much tighter around the 4 million and might be, you know, the 50 percentile is 4 million, but the 90th percentile is only five and the 10th percentile is three. So there's not a big gap there. And he says, You know what, I'm gonna sleep while I'm okay at 3 million that'll give me enough to live on. That's a better portfolio. You're really not one of the worst mistakes is that people think of outcomes as deterministic is the word I use rather than probabilistic. And so let me give you one other example that I have actually put in my book. So I know, I have the approval of the person who you know who the story is, I won't disclose the last name. But we work together in my early career before I became an advisor. And I had just left and formed Buckingham, and his name was Philip. And Philip had a risk tolerance that was asymptotically, close to zero. I mean, he worried every day about the world coming to an end stock market would crash. On the other hand, Philip, who at the time was somewhere in his 40s, wanted to retire, he was good at what he did, which was a marketing executive, but he didn't like the pressure of the corporate world, he wanted to go off and be a photographer. So I said to him, here's your choice, we can have a higher equity allocation. And that'll give you a chance in 10 years to retire. And then you can go enjoy your life, or we can have a low equity allocation, so you can sleep well. But now you're gonna have to work in that corporate environment for 20 years instead of maybe five. Well, I said, that's your choice. That's the way you have to think about it. Now, this was in the mid 90s, he made the decision to say, Larry, it's really important to me, that I retire from this job early to get that stress out. And he went with it. And I said, we're gonna put that down that you said this. Luckily, the market took off for him. And then five years later, he quit his job. And we sold most of his equities got a much lower position. And it turned out, but it could have turned out the other way. For him. It was the choice and that's the way you present it is where are your values? What's more important to you? Right? Would you regret more? Choosing the high equity allocation and the rest show up? Or would you regret more choosing, choosing the low equity allocation, and stocks go on and produce fabulous returns, which one is the one that's more regretful and that helps people figure it out.
Andrew Stotz 42:18
So the point that you're making is that you're looking at the distribution or the possibilities of terminal outcomes at the age of 60, for these 25 year olds. And if it's, let's say, the optimum portfolio that we've talked about, it happens to have a lot of volatility and can have great years, it can have bad years, it can have long streaks of good and bad. And in the end, the distribution of what's the possible outcome is a very wide bell curve, with a let's just say, a $10 million, we've calculated out to say, an expected value of 10 million, but we know the possible outcomes are very wide. Whereas for the other portfolio, the ix, the curve is very narrow, it's not going to be a massive winner, and it's not going to be a massive loser. And that expected value, let's say is $4 million. So now we've got these two. So the point that we make to the two people who are equal, they're the same person, but we decide that this one is got the risk tolerance different, and therefore, their expected value is going to be four. And the person who has a higher risk tolerance, their expected value is going to be 10, with the distributions that we've talked about, basically what we have to tell the the person with a disc with the expected value fours, I'm sorry, but you're going to have to live on 4 million. Based upon your personality,
Larry Swedroe 43:43
I would just said one of the No, because that gives you the best chance of achieving it. Because if you choose the riskier portfolio and the markets go down, you're going to panic and sell or you won't be able to enjoy your life, you can't sleep, you maybe end up getting a divorce or
Andrew Stotz 43:59
the option would be you're going to mess it up and you're going to have even less than 4 million by the high risk one. And therefore you're going to end up with 1 million. And that's the only other option. Really, that's it or take this option.
Larry Swedroe 44:13
Now. I would add one other thing, people become overconfident in the sense that they treat the highly unlikely as if it's impossible. When you're looking at that 10 million distribution, and there's a 10% chance you'll end up with two, you have to seriously consider what would I do if it ended up at 2am? I willing to work a lot longer live on that only 2 million portfolio? Is that an acceptable outcome? Don't treat it just because it's unlikely. I'm sure nobody in Japan and 9090 if the years of spectacular double digit returns for you know the prior 20 years, you know way outperformed the US the next 33 years, the Japanese Nikkei index returns 0.2% A year worse than inflation. So you know, those things can happen, the US could be the next Japan, we just don't know or all equities could turn out that way. Because Moscow decides to launch a dirty bomb and sets off a nuclear war. Who knows?
Andrew Stotz 45:29
So So you've, you've highlighted the importance of understanding the distribution of the potential terminal outcomes. And one thing we didn't mention, in the case of the person that ends up with for that person is going to come back to you, Larry and say, but wait a minute, Larry, I came here and we've already determined I need 10 million. Right? That's we've determined that I need 10 million at the 60 mark, then the other option is then you because of your risk tolerance, you're going to be in low risk stuff, that's going to have a narrow distribution of potential terminal outcomes. And therefore, you're going to have to contribute more to your portfolio than the other person on a monthly basis. Would that be the real solution? If it had to get to 10 million?
Larry Swedroe 46:14
Yeah, you could say cut down your lifestyle now save a lot more. That's number one. And two, I would advise him to go out and buy a 10 year supply or Maalox?
Andrew Stotz 46:28
You know, Larry, one of the great things about our series that we've done so far is the friendship that we've made and for all the listeners and viewers who start to join into that friendship. And that brings us to mistake number 15. Do you let friendship influence your choice of investment advisors?
Larry Swedroe 46:46
Yeah, this one is really an amazing story. But I found it to be pretty common, especially people who use stockbrokers that old Tom Nolan calls himself a stockbroker, because it's kind of a dirty word, or any more than now, financial advisors, or some similar wealth manager or some time, but there are many cases there are still stockbrokers. Right? So yeah, this is a true story of a friend, guy who helped me one of the founders of Buckingham, he had a very good friend. And after a few years, he was in the being in the business, this friend came to him. And, you know, said, You know, God, I'm getting these awful returns and stuff, but you know, can you help me out? And he looked at the portfolio, and of course, it was all actively managed funds with high expenses, lots of turnover and churn. And my friend said, Well, you ought to fire that broker, one is not acting in your best interest. This is not what the evidence says, And the guys, but I can't do it. I've been friends with this guy. Since high school, my daughter plays on his he's the coach of the soccer or softball team. I can't do it. And I'm Bert. So what do you want to do? Next year, cons, the friends complaining, again, they meet again, same thing happens a third year, again, horrible returns. Finally, my friend bird tells, I'm not listening anymore, you bring your wife to the next meeting, they go through all the data and bird shows what they could have done just holding a market, like I'm throwing out the tax efficiently, better, all our expenses would be better. And the guy says I just can't fight. And the wife says if you won't tell them, I will. Right. But that's the problem. And a lot of people on fire somebody because he he gets me tickets to the Super Bowl, or, you know, whatever, some golf, the Masters golf event, and I remind them that those are the single most expensive tickets that you got for free, but they're costing you every year, maybe even 10s of 1000s of dollars in last returns and tax inefficiencies. So it's a real problem. People have a hard time, especially if you truly were friends with somebody. But in most cases, they're only friends because they're making commissions off of you or other fees. They're if they're really a friend, they'll still be your friend, after you go into choosing another financial advisor. Right? That then they were never really your friend in the fur. But I can tell you, I've heard that story so many times, and it's caused people so much of their fortunes unnecessarily.
Andrew Stotz 49:32
And that, on that note, I just want to wrap up to say that, you know, this has been great discussion on part one of the book investment mistakes even smart investors make and how to avoid them that there is written. And Part one was about understanding and controlling human behavior is an important determinant of investment performance. And really, we've learned so much about human behavior and how to you know nav against it, I would say and live with it and build stuff around those strengths and weaknesses that we have as humans, so that we can construct portfolios and build our wealth over time, without exposing ourselves to all kinds of mistakes and risks. We've been to 15 mistakes, is there anything that you want to share to wrap up this part one of your book,
Larry Swedroe 50:26
to me, this is we're all human beings, we've all made these mistakes, I probably made almost every one of the mistakes that I described of the seven the seven in the book, because I'm a human being. What differentiates those smart people from others is that when they learn it's a mistake, they don't repeat the same behavior, they change it, they become aware of these biases and find hard to overcome them. And the best way to overcome them really salve a well thought out written plan. And if you can't do it yourself, because you know that that's a behavioral problem you have, then you definitely should seek the advice of a good financial adviser who will act like Clint Eastwood and say, Make my day right.
Andrew Stotz 51:15
And on that note, Larry, I want to thank you for another great discussion about creating, growing and protecting our wealth for listeners out there who want to keep up with all that Larry's doing. You can find him on Twitter, and I'll have his Twitter handle in here, Larry swedroe. But I can say that every almost every day, it seems like you've got another review of another article, another academic research. You also are publishing on your LinkedIn. This is your worse podcast hosts Andrew Stotz saying, I'll see you on the upside.
Connect with Larry Swedroe
- How to Start Building Your Wealth Investing in the Stock Market
- My Worst Investment Ever
- 9 Valuation Mistakes and How to Avoid Them
- Transform Your Business with Dr.Deming’s 14 Points
Andrew’s online programs
- Valuation Master Class
- The Become a Better Investor Community
- How to Start Building Your Wealth Investing in the Stock Market
- Finance Made Ridiculously Simple
- FVMR Investing: Quantamental Investing Across the World
- Become a Great Presenter and Increase Your Influence
- Transform Your Business with Dr. Deming’s 14 Points
- Achieve Your Goals
Connect with Andrew Stotz:
Further reading mentioned
- Larry Swedroe and RC Balaban, Investment Mistakes Even Smart Investors Make and How to Avoid Them
- Philip E. Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?
- Carol Tavris and Elliot Aronson, Mistakes Were Made (But Not by Me): Third Edition: Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts
- Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the Life-Changing Science of Behavioral Economics