ISMS 35: Larry Swedroe – Great Companies Are Not Always High-Return Investments

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Quick take

In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this twelfth series, they discuss mistake number 22: Do You Confuse Great Companies with High-Return Investments? And mistake number 23: Do You Understand How the Price Paid Affects Returns?

LEARNING: Great companies are not always high-return investments. Understand how the price paid affects returns. Rebalance your portfolio regularly.


“Rebalancing forces you to do the opposite of what most people do, which is dumbly chasing returns and ignoring the historical evidence. They ignore the fact that typically, over the longer term, prices tend to revert to some mean.”

Larry Swedroe


In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the 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 two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this twelfth series, they discuss mistake number 22: Do You Confuse Great Companies with High-Return Investments? And mistake number 23: Do You Understand How the Price Paid Affects Returns?

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

Mistake number 22: Do You Confuse Great Companies with High-Return Investments?

According to Larry, if you ask most investors if they’d rather own companies that have had an average return on assets of roughly 9% and a higher growth rate in earnings or companies that have an average return on assets of about 4% and lower earnings growth, 99% of investors would choose the high return and fast growth companies. One of the most persistent and incorrect beliefs among investors is that “growth” stocks have provided (and are expected to provide) higher returns than “value” stocks. But that shows a lack of understanding of how markets work.

Larry says you should buy the safer investment unless the expected return from the worse investment is much higher to compensate for the extra risk because the market is pricing for risk. He reminds investors that just because value companies have lower growth in earnings and lower returns on their assets doesn’t make them bad investments. It just makes them less glamorous and attractive companies.

When you identify a great company, that’s only one bit of the story. Larry says you have to ask yourself, what’s the price you’re paying? What do you know that the market doesn’t know? And suppose the answer is nothing, which it almost certainly is. In that case, the price already reflects all that great information, which means the PE ratio is likely high, meaning the expected return generally will be lower. If you’re going to buy growth stocks or small stocks, make sure that you’re screening out the ones with high investment but low profitability because they’re not burning cash with high investment, and they can turn around.

Mistake number 23: Do You Understand How the Price Paid Affects Returns?

When forecasting investment returns, many individuals make the mistake of simply extrapolating recent returns into the future. Bull markets lead investors to expect higher future returns, and bear markets lead them to expect lower future returns. However, you need to understand the price you pay for an asset impacts future returns.

Larry says the best investment strategy is not to try to time the markets but instead rebalance. When you do well, and the PEs are going up, you’ll put less into equities and more into bonds or even sell some stocks to buy bonds. And when the PEs are low because stocks have done poorly, you’ll put more money into stocks or even sell bonds to buy stocks. Rebalancing will give you an astronomical diversification benefit.

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 00:00
Hey fellow risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and today I'm continuing my discussion with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his episode and his story in Episode 645. Larry deeply understands the world of academic research about investing, especially risk, and today, we're going to discuss two chapters from his book investment mistakes even smart investors make and how to avoid Them. We're gonna be talking about mistake 22. Do you confuse great companies with high return investments? And 23? Do you understand how the price paid affects returns? Larry, take it away. Yeah, well,

Larry Swedroe 00:50
if you ask most investors, would they rather have owned companies that have had average return on assets? Say of roughly 9%? Or would you rather own companies that have that average return on assets a 4%. And those same companies that have had the higher return on assets also had higher growth rate in earnings, much higher than the growth rate in earnings of the companies with a roughly 4%? Return on assets? So which group of stocks asset A, NA, or group A the higher returning on assets and a faster growth in earnings? Or the other group? Do you think like 99% of investors would choose high

Andrew Stotz 01:40
return fast growth?

Larry Swedroe 01:42
Right? And logic is these are the great companies, by definition, right? Because they've had higher return on assets or greater return on capital, they grow their earnings faster, as well. But that makes a fundamental mistake and shows a lack of understanding of how markets work. And the great way to think about it, as we talked about in an earlier episode, is to use an analogy to sports. Because if you think about it that way, it ignores the fact that what you know, everyone else knows. And then it has to already be built into prices. So let's think about let's say you're if you're a soccer fan, so everyone around the world, you know, some international sport now, if Basa alone, as team, one of the best teams, you know, almost every year is playing the St. Louis MSL team, it doesn't take a genius to know they could play 100 times. And Basa literally would virtually be guaranteed to win 100 of those times, right? Think we could, right? But the problem is you can't bet on Barcelona to win, unless one of two things has happened. You might have to give 50 to one odds, or 100 to one odds. Or you might have to spot three goals, or you know, give, you know, or something along those lines, where the goals spread, or the odds actually equalize the risk of betting on either team, right. And that's why we don't know people who get rich betting on sports, because it's often easy to identify the better team. But the point spread or the odds equalize the risk of winning the game. And that's what happens with stocks. So let's help everybody but with an example that I think can be more related to them. So I'll ask you, Andrew, if you had a choice, in this imaginary world, we're going to create that you could buy a brand new office building state of the art. Okay. All right. And you could plop it right on to the most prime piece of real estate, and maybe the hottest city in the country for golf. Let's call it Austin, Texas, may be where a lot of people are moving, brand new building, and you would have to pay $10 million to buy that building. Yeah, oh, the rents are gonna, you know, depress from where they weren't say three years ago, because offense, but, you know, you would still have to pay $10 $10 million for that building. Let's say you could also buy that exact same building in the worst slum in Detroit, where the murder rate is high. But now you might have to also pay 10 million would you buy that building?

Andrew Stotz 04:55
Well, you know, it's interesting because we're getting this announced CES in San Francisco right now, I was just looking at prices of buildings that have absolutely you know, now those aren't new buildings, as you're saying. But generally, you know, so one of the things that you think about is that when investing, we oftentimes get trapped in going for the most sexiest, most kind of well known places, because we think, Oh, it's hot there. But the problem is, am I getting that building in Austin, Texas, 10 years before the peak of the market? Or am I getting that at the peak of the market?

Larry Swedroe 05:34
Right? So in this case, of those to be very specific, you're gonna have to choose, you're going to spend 10 million on either building? Do you want the same building identical? But I think you can guess where the rents will be higher? Do you want to buy the one in the Westin? Or do you want to buy the one in Detroit?

Andrew Stotz 05:53
Ultimately, I want the one that's got the highest rents. Hope, right?

Larry Swedroe 05:57
Because you're paying the same price, right? So that world can exist, where the price of the building is the same as the price in a lesson as the same as the one in Detroit. So let's say you say to me, Hey, Larry, you're my financial analyst, here, you're my advisor, but I'm really this great or meaning you're this great expert on real estate, and you could you're good at projecting real estate revenues. And you say to me, Larry, I think based on the rents today, I'm going to get 50 bucks a square foot on this building. And I think rents are going to increase by x and over the life. And based on that, if I pay 10 million for that building, I get a 10% return. Okay, then you say, Larry, I really think this building in Detroit is a good opportunity. The city's turning around, I think, well, you know, while the rents are only 12 bucks a square foot now, rents are gonna start to go up. And Larry, I could buy the building today for 2 million. Okay, so you flare, what greater return would I get? If I only paid 2 million? And my projections are right. Now, clearly the great property? Is Austin, the weaker one, is there. One is in the true joy. Ah, in this case, Coincidently, they both give you an estimated return of 10%. Neither is guaranteed, of course, we don't know what the future holds even you brilliant real estate analysts. But if those were the numbers, which would you rather buy, given that they both have a 10% expected return? Well, technically,

Andrew Stotz 07:54
I would be, I would choose either one of them if they both had an expected 10% return?

Larry Swedroe 07:58
No, that's not true. Okay.

Andrew Stotz 08:02
And so that's what they mean. That's the technical, right, and not

Larry Swedroe 08:07
the right answer, because that's looking at only the return. What did you miss Andrew, when you thought of the deal when you miss investments, you have to So which they both have the same return? But which one? Would you have a higher confidence that your projection is right? Which one is safer?

Andrew Stotz 08:26
The one with the lower investment amount?

Larry Swedroe 08:28
No, it's the one guy that's all wrong, Larry, that's Yeah, well, it's the one that you have more confidence in the dispersion of outcomes, okay. And it's more likely that the dispersion of outcomes in Austin will be tighter, and the spurt you maybe you get lucky and things turn around. In Detroit, you get a great return. And maybe the city goes bust and you're bankrupt, and we lose it. So when you have the same expected return, you should choose the safer investment. To make it more clear. Let's say you could buy a treasury bond with a 5% yield, or a General Motors bond with a 5% yield, which you're going to buy,

Andrew Stotz 09:16
you're always gonna go with Treasury because the outcome is so much more certain than that. You

Larry Swedroe 09:21
have to look at the risk and the return. Okay. So we're going to buy the safer investment unless the expected return from the worst investment is much higher, to compensate us for the extra risk. So that world that I gave you where the expected return in Austin was 10%. And the expected return in Dallas was a sorry, in Detroit was 10%. That world can't exist. No rational investor would buy the building in Detroit and the say Wait, no rational investor would buy the gym bond, the yield is the same as the government, but you might have to pay 8% or 9%. Before you would take that risk, and the bigger the risk, the higher that risk premium. Okay? And now, let's change it. And now you only have to pay 1 million. And so the rate of return expected but not guaranteed, of course, has gone from 10% to 20%. And the one in Weston, is a gap is 10%. Expected but not guaranteed. Now, which building would you rather buy?

Andrew Stotz 10:38
So now you're getting more interested in the Detroit building?

Larry Swedroe 10:42
You would, but let's say you're a widow living on a pension. And this prompted for

Andrew Stotz 10:48
the possible negative distribution, you know, the negative worst case?

Larry Swedroe 10:53
So there's no right answer, they both are good investments, right. And if you're a risk taker, you might prefer the Detroit building, if you're very conservative, you might prefer the awesome building. And if you're somewhere in between, you might buy a small percentage of each distributing your risk. Okay. So here's the logic coming back to our companies, the companies. And let's help it this way, let's make the Austin building Google and the Detroit building General Motors. Well, you don't want to buy the, you know, you don't know, which is the better buy if the risk adjusted returns assemble. But it must be that the GM company and that GM building has to have a higher expected return. And when you look at the returns of those groups, I gave you the returns to the stocks that had a 9% return on asset and much faster growth of earnings. Those were growth stocks, that had very high P/E on average. So the price you paid to get that return on assets. And the rate and the growth in earnings was very high. And therefore, the returns you earned by owning the stock, were actually quite a bit lower about three and a half percent lower than the returns of the non glamorous companies, because the market is pricing for risk. And that's what people fail to understand. You have to separate the two. Now, the fact that these value companies had lower earnings, lower growth in earnings, lower return on their assets, that didn't make them bad investments. It just made them less glamorous, less attractive companies. But because of that the market price for there risks, creating a risk premium. And for those investors who don't have the discipline to stay the course and build diversified portfolios, because some of them go bankrupt, and others turn around and do real well. And by the way, the same thing is also true of growth stocks, some of them do great, and others become Eastman Kodak or Polaroid or GE and they go bankrupt. So you never want to put all your eggs in one basket. But the point of the story is this, that when you identify a great company, that's only one bit of the story, you have to ask yourself, What's the price you're paying? What do I know that the market doesn't know? And if the answer is nothing, which it almost certainly is, then the price already reflects all that great information, which means likely the P/E ratio is high. And that means the expected return in general has been lower.

Andrew Stotz 14:11
Yeah, and that's, you know, that's such a challenge. Because some people, they see that and then think Well, I'm gonna protect myself by buying these value stocks that are just I'm going to, I'm not going to get messed up on price I'm going to buy at low price so I think I'm getting some benefit from that. But then if you don't diversify that value portfolio, you know, you're gonna get some crap in there that's just gonna fall apart, you're gonna lose a lot. But that brings us to the you know, this concept really is kind of value and growth or let's say value. You know, growth is a little bit different in that it's looking at, you know, earnings growth and all that, but what we're talking about really is returned from dividend and return from the in from the cash flow generated from the business versus return from the price. And so it's a tough one because I know that I've had a guest on that they got burns from buying high price stock, eat, and they thought it was a good company, but it was just expensive timing. And then they shift to Oh, I'm gonna do you know, I'm gonna buy cheap stocks because I'm never gonna get burned on price again, they get flung around.

Larry Swedroe 15:22
Yeah, here's the thing that the research shows, value stocks in general, have outperformed, let's call it three and a half percent a year on average, okay. However, a big chunk of that, or some significant portion of the growth underperformance has come from growth companies that are high investment, which tends to be growth companies, right. But low profitability. Think of all this story stocks, like the battery companies, you know, they came public and raised lots of cash. So they're growing rapidly, but don't have earnings. Right? Right. And lots of small companies are story stocks, and they raise capital and don't have earnings. All right? Well, if you look at the data, small growth stocks, with high investment, and low profitability, over the long term, have underperformed treasury bills. And yet, people love to buy these, what I call lottery stocks, because you do have the chance that they become the next Google or the next Apple or the next Amazon. But the vast majority of them end up you know, disappearing, or getting very poor results. Which means that if you're going to buy a growth stocks, or small stocks, either case, you want to make sure that you're screening out the ones with high investment, but low profitability, right? If they just have low profitability, that may not be too bad, because they're not burning cash with high investment, and maybe they have the ability to turn around. But the evidence also shows that if you buy the highest returns have been to value companies that are more profitable. And so if you screen for those two things, over the long term, that's been the end guest. So can you think of one investor who has tended to buy those kinds of stocks?

Andrew Stotz 17:42
Besides Peter Lynch, maybe Warren Buffett,

Larry Swedroe 17:44
now what growth, Peter Lynch tend to do by mortgage growth, yeah, that were profitable. He avoided the junk by Warren Buffett, you know, as tended to buy cheaper companies that are also profitable, generated cash flow, its actions.

Andrew Stotz 18:01
And so for the typical person who's let's say, they build up a portfolio of a million dollars in, in a passive or very, you know, a very diversified strategy. And they say, look, Larry, I know, I may not be able to beat the market picking stocks, and I'm only going to take 10% of my well, but I just really love analyzing stocks and looking at the numbers, and you know, it feels like I'm going to the racetrack, or whatever. But I want to do it. What would be the advice of where you would tell him? Okay, if you've got to do it, focus in on

Larry Swedroe 18:36
those what I gave you. Yep. Live stocks with relatively low P/E is have relatively high cash flow to the price, have low debt, little leverage. So that reduces the risks as well. I think if you have one single metric you want to look at alone, many are roughly equally good. I think the best one is cash flow to enterprise value.

Andrew Stotz 19:08
All right, that's good. And that's a good little place for some people to start. Now, let's look at mistake 23, which we kind of these mistakes go kind of hand in hand. But that one is do you understand how the price paid affects the return? We've been talking about kind of both of these things, but is there more that you would add there? Yeah. So I

Larry Swedroe 19:26
think the way to think about this way to be most helpful is people look at returns, let's say of stocks from 95 to 99. All right, and what stocks did the best than they were the growth companies, the story stocks, the dot coms, etc. Right? And what people didn't realize is that though they outperform not because their earnings are growing that much faster, but because they prices were going up and up and up. And so recency bias led them to buy more. Right. But if the price is going up faster than the earnings, what does that tell you about the expected future return if you're paying more for the same earnings, and therefore your expected return is now lower. And what's the reverse is true. On the other side, if prices have going down, for whatever reasons, sentiment risk, but the earnings haven't fallen, then the expected return is now higher. Right? The same thing happened by the way to value stocks. Again, in the period from late 16, through late 20, there was a four year period where growth far outperform and everyone was jumping Well, the retail investors on the growth stocks, but none of them I'm willing to bet was looking at the underlying fundamentals. And growth company earnings did not grow faster than expected. They grow faster than value, but not faster than it was already built into the price. So let's just make this up. They'll say, you know, we think growth companies grow at 12% a year and value at five. Well, growth grow at 12. And let's say value with five. But growth stocks went up, you know, doubled and value stocks didn't go up at all. So what happened is the price you're paying for that same growth in earnings went way up. So your future expected returns collapse? Yeah, have to make sure you're evaluating the price you're paying relative to the expected cash flows, because that's going to tell you what the discount rate the market is applying, which is your expected return. So a simple way to look at it. My memory serves here, a study was done a while ago. So the data may be not all inclusive. But if you bought stocks, when the PE was more than 22, you got a 5% return, on average. Now, you still may have a good year, fees were well over 22 and 97, and eight, and nine, because the market had gone way up and those fees were higher. But the next 10 years were off growth stocks over the next 13 years underperform T bills. So but people ignore that, on the other hand value stock PE has remained pretty much unchanged. And so the next 12 years was the biggest outperformance of value in history. And when you buy stocks when the PE is under 10, the return has been something like 16 or 17%. Oh, so does that day matters.

Andrew Stotz 23:04
If let's just imagine that we created a chart that was taking the market PE and breaking it into quintiles. So we've got five different groupings of periods of time when the PE was super high, and periods of time when this Pe was super low. And if we use that as a guide, and let's say that we are doing let's just keep it simple by saying that person is contributing to a passive fund on a monthly basis. And they got a long term plan. And it's very simple. They're not going to change what they're investing in. But they're going to change the amount they're investing based upon what quintile it's in and the only quintiles that let's say maybe matter is the highest most expensive quintile or the lowest, cheapest quintile if they said I'm going to double up my contributions for the time when that when the market is this, this this chart is saying that the market is cheap. And I'm going to cut in half my contributions when it looks like the markets in that expensive quintile Would that work.

Larry Swedroe 24:15
Here's the thing. Let's see if this is how helpful. There's something called the cape 10. The Cape 10 Is the cyclically adjusted price earnings ratio. Okay. And the idea which Warren Buffett is use this. Benjamin Graham talked about this. He didn't call it the K 10. But he argued you should smooth earnings because in an economic boom, earnings will be higher than sustainable, and then a recession there'll be lower than they will be over the long term. So if you take an average Robert Shiller made this famous when he decided on the cake 10 Turns out a few is the case 786 or nine, that makes no difference? The results are identical. And here's the thing, if you break them into deciles, okay, there's a perfect correlation, monotonic increase from when the cake 10 is in the highest decile. So the average is about 33. The real return was under 1%, to stocks. And then it goes up in the next decile to 2.5, then to seven and five and 547887 10, no and 10, six. Okay. So that's telling you, the cheaper it is, the higher the return has been in the long term. But of course, in any one, two or three year period, it's noise. As I told you, 98 and 99, you know, you got great returns, it's the dispersion is still wide. So when prices are low, you can still get bad returns. And when prices are high, you can still get good returns, but the general probability, and the dispersion is moving in the same direction. So at the highest Cape 10, the worst returns are the worst. And the best returns are lower than the best returns in every decile, and the worst returns worse than the worst returns in every desktop. So the curve as prices go down, and you move up the deciles, everything is shifting to the right. But within that there's still a wide dispersion. So let me give you an example of that. So in the 10th decile, the worst return was minus six, and the best return was plus six, not a real return, not just a nominal return. But in the 10. In the best decile when you're buying cheapest, your at the worst return was still plus 4.2. Real and 17. Point 10 was the best. So I would tell you, the best strategy should be don't try to time it. rebalance. Which means when you do well, and the P e's are going up, you're not you're going to put less into equities and more into bonds, you may even sell some stocks to buy bonds. And when the P E. 's are low, because stocks have done poorly, you'll put more money into stocks or even sell bonds to buy stocks. And rebalancing will give you a historically at diversification benefit. So the

Andrew Stotz 27:53
rebalancing would serve the function of trying to make some kind of quintile chart, like I said, or the chart you said,

Larry Swedroe 28:00
forced you to do the opposite of what most people do, which is dumbly chasing returns, and they ignore the historical evidence, they ignore the fact that typically over the longer term prices tend to revert to some mean, returns tend to revert to some mean, we don't know what that mean is exactly, we know what it was in the past. We don't know what the future mean will be. But there is definitely some reversion over time.

Andrew Stotz 28:34
I think that the important message out of this one of the important messages, the concept of dispersion, which you were explaining about, particularly about the building in Detroit, and a building in Austin, and distort dispersion of the potential outcomes. And for the viewers or the listeners out there, you know, if you take your hand, you get and you spread your fingers, you get kind of a fan diagram of many different potential outcomes at the terminal period that you could achieve. And we're going to calculate an average of those. But that does just because we've calculated an average doesn't mean that those other possibilities aren't there. They're very much real.

Larry Swedroe 29:13
Yeah. And that's a problem and investors engaged in resulting. They look at the data and say, Well, that was a good or a bad investment based on what happened, ignoring the fact that you didn't know what was going to happen in other outcomes. We're certainly possible. alternate universes can show up right. Let me give you one other topic before we end here that I think is important related to this. And I just wrote, I think a really important piece on Michael Kitsis. His website, it's It's called the big market delusion and related specifically to electronic vehicles. And this is It's a pattern historically. So what happened, for example, now is people got all excited about EVs, right? And they assume that, you know, Tesla's been a great company. So they buy all the story stocks in this Eevee world, now, all of them can't succeed and become Tesla's and grow earnings that quickly. It's in order for Tesla to justify its very high P E ratio, it has to guard things, I don't know, whatever the number is 30 or 40 or 50% a year, you succeed and only grow earnings 10% a year, investors are going to get killed, because the price is reflecting a much higher, and it is literally impossible for every v Evie company to grow earnings 50% A year or 30, they would become the whole economy of the world in 20, or whatever, right? And the same thing was true in era in the biotech and not every company succeeds is that talking at Green Energy, while you're now seeing a lot of these green companies going bankrupt, because they are over too much capital given chasing and that just aren't the returns. And some of the Evie stocks have already gone backwards. Right. And so you want to avoid getting caught up in the delusion of investing in the story. Maybe it's okay to pick, try to pick the great one company. But the problem is, what if you're wrong? The odds are your quick get wiped out totally. And there's no even guarantee that Tesla will be the winner there. As I said, it may succeed. Right? Or it may not. I mean, right now you have a Chinese saying, I mean, basically they could tomorrow say Tesla, you're done in China, you can't produce there, we're going to just shut you out, nothing could stop. And or they could tell Chinese you can't buy a Tesla, you have to buy a Chinese and we don't know what can happen. And right now, I think Chinese Evie manufacturer is threatening or closing in on Tesla as the largest manufacturer of EVs in the world. So we don't know what's going to happen. I'm not saying don't buy a Tesla, although I wouldn't buy any individual stock for that reason. So my advice is, if you can't resist the temptation, my first advice is given another life. do with your time, like spend more time with your wife or friends or, you know, donate that time to charity do some good, but you know, if that's your personal hobby, you enjoy it, take one or 2% of your money, try to pick stocks which have low relative prices, good cash flow, low operating leverage. So don't get hammered in a recession, low financial leverage as well, in effect, the kinds of stocks that Warren Buffett bought, and you're likely to do reasonably well, in fact, the odds are you will outperform the market because you're buying cheap stocks relative to the market. And that's what has worked historically, over the long term. But I haven't bought an individual stock in 30 years or more. And I used to be a stock market junkie, that guy who wants Louis Rukeyser. Every Friday night, my dad was a junkie, I just learned when I hit a winner, which my first big stock pick me like 13 times what I paid for it. And but that just made me overconfident. In luck, I eventually figured out what the winning strategy is by reading the research. Well,

Andrew Stotz 34:03
I think the articles avoid getting caught up in big market delusions, the case study of electric vehicles. Yeah. And I'll have a link to that for those people that want to read it. I just have one important article everything. Yeah, I really, I want to have one last thing. I just wanted to share a story, Larry, when I was pretty experienced analyst coming down to Thailand, and I went to New York and sat down with some really bright, you know, hedge fund guys, and I'm telling them about the banking sector in Thailand at that time, which is what I was covering. And the guy got kind of caught up on the fact that I was expecting earnings in my model. I'd said earnings growth of I don't know what it was, let's say 7% every year for the next five years. And he said to me, how can it possibly be? You know, next year, it could be this next year, it could be that you know, and so I said to him, I said, Well, I Actually, I have another chart, but I didn't bring it. And I just thought I didn't need to bring it. But I can just draw it right here because he saw a straight line of, let's say, 7% growth each year. And I just said, well, actually, this year, I think it's going to be 9%. And this year, I thought, in the next year, I thought it was going to be 3%. And then by the time I got to the fifth year, I was like, and it's going to be 15, in the fifth year. So I showed each actual item above and below that 5% that I chose. And of course, then he said, How can you possibly predict the fifth year is going to be 15%? Right, which I, you know, I kind of set it up this way. But and then I said, Well, now you got me both ways. First, you're complaining that I was taking a fixed number. And now that I should be forecasting each individual year. Now I've shown you a year. And now you said you're not satisfied with that. But what I tried to did do is that I showed him, I went to each line, each point that I highlighted for each of those years. And I showed him that there was an equal distance between those points, if you summed up the distance between those points and the center point. And then you know what I was trying to show him that just because I'm giving you an average of 7% per year for five years. It doesn't it an average doesn't ignore that there's dispersion, it's coming from dispersion. But sometimes we use an average, to simplify what we're trying to say. And that's how I try to teach my students in my valuation masterclass.

Larry Swedroe 36:40
When I tell people is this, the best estimate we have for future stock returns is to take, let's use the K 10. and invert it. So you get an earnings yield, that's a stuff, it's only got a correlation of about 40% or so. That's because rest shows up. And if risk is more than expected, because we get wars in the Middle East or oil embargoes or, you know, COVID, and then inflation shocks. Well guess what happens? The risk premium goes up and returns a lower, and sometimes we get a perfect world and less rich shows up than expected, right? And then risk premiums go down, and returns go up. Okay. But that's the best estimate we have. So what does that tell us today? Roughly, the K 10. I think it's somewhere around 28, or something like that, which would tell us that the expected real return to stocks is probably my favorite, I'm going to guess three and a half percent in real terms. Okay. Now, if we think inflation is going to be two and a half, well, that tells me I think stocks will get six the mistake people make is the mistake. And the fact that you're in your story, that does not mean stocks are gonna go up goes 6% a year. And the only right way to think about it is that 6% is the median of a very wide dispersion, like I showed you with the cape 10 example, where if you bought stocks, when the cape 10 was about its historical average, over the last, you know, 40 years or so of about 20, the real return average was five, but you needed a wide dispersion to incorporate all the actual outcomes. It was over Remember, these are 10 year periods. Now, the worst return was 9% a year worse than the average of minus 4% A year real negative return over 10 years. And the best return was 18 and a half percent real. More than the average, I'm sorry, eight and a half percent more, or 13 and a half percent in real terms, that's a gap from minus four to plus 13 and a half. That's a 17 and a half percent wide dispersion. And that's what you have to think about. When you make a forecast the stock returns a 6%. It's, it may be you know, you're gonna end up with two and maybe you're gonna end up with 20. And six is only the best guests we have. But you have to build a plan that can live with either of those out.

Andrew Stotz 39:48
Well, we're gonna wrap up there and I think that dispersion, graphic of many, many different paths of outcomes is really a big takeaway for all of us too. Keep that in mind, even when you're talking about average know that there is a dispersion of outcomes. And that's, as Larry has said, when risk shows up.

Larry Swedroe 40:09
Yeah. And by the way, you shorten the Ryzen dispersed gets much wider, right? At any one year, the market may drop 40% And you expected upset. So now the dispersion is much wider.

Andrew Stotz 40:24
Well, that was a great discussion, Larry. And I want to thank you for helping us to create, grow and protect our wealth. For listeners out there who want to keep up with all that Larry is doing. You can find him on Twitter and Larry swedroe And also on LinkedIn. And you're going to find that he is just prolific there. This is your words podcast host Andrew Stotz saying, I'll see you on the upside.


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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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