ISMS 36: Larry Swedroe – Two Heads Are Not Better Than One When Investing

Andrew Stotz 00:00
Hey, fellow risk takers, this is your worst podcast hosts Andrew Stotz, from a Stotz Academy, and I'm here today continuing my discussion 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, Larry deeply understands the world of academic research about investing and especially risk. Today we're going to discuss two chapters from his book investment mistakes even smart investors make and how to avoid them. And Mistake number 24 is what we're going to talk about, which is do you believe more heads are better than one and mistake 25? Do you believe active managers will protect you from bear markets? Larry, take it away?

Larry Swedroe 00:48
Yeah, so one of the things I try to teach people is about conventional wisdom when it comes to investing. And conventional wisdom, I think we could define as things that are just so generally accepted that no one questions that, and the reason is they typically apply in most fields. The problem is investing is a very different endeavor than as we discussed, because you're not competing, for example, one on one against someone, you're competing against the collective wisdom of the market. And the conventional wisdom here, why I mentioned that is conventional wisdom always is more heads up better than one, right. And so there's an interesting series of studies that have been done on investment clubs, which is, you know, I think investment clubs really became popular in the 90s, when we had the whole.com era, and you probably remember the Beardstown ladies and stuff, and which

Andrew Stotz 01:57
was that was just a highlight. That was a sensation back in the day. And it was basically communicating to people that hey, you don't have to be a stock market genius. Here's these ladies that don't know much about the market, they do a little reading, they pick their stocks. And as a club, they come up with great ideas. So just for the listeners who haven't experienced that the phenomena of the Beardstown ladies Investment Club, there it is, yeah,

Larry Swedroe 02:23
we'll talk about the group of grandmothers and their fame or later infamy as it turns out. So I think the media all is CNBC became popular and Jim Cramer and, you know, all is banging and clanging and they're all the stuff got people interested, they were trying to make it fun, and get you to trade a lot, of course, so they make money, and they and the media, you know, gets you to pay attention. So they could sell advertising, you know, etc. And getting you to tune in, right. But as always what we do here, we turn to the empirical evidence, and not the investment pornography here in Barron's or corsi and VC. And so there are a group of studies that we can say, and the first one that I want to talk about is by Greg barber and Terrance Oh, Dean, and they have done a whole series on individual investors, showing that individual investors dramatically underperform the market on average. And that's partly because they trade too much. They're overconfident. And you make other kinds of behavioral errors. This study was called too many cooks spoil the profit, the performance of investment clubs, and they looked at data from one brokerage firm over a six year period. And they found that the average club trailed the market by almost 4% a year. And it was even a bit worse when you adjusted for these common factors that we've been talking about on our regular broadcast here of size and value and profitability, quality, momentum, etc. So that was one example. My since you mentioned that we could talk about the story of the Beardstown ladies and we didn't just thing they went on to publish a book and potting their wisdom. And the book had their catchy title of chicks laying nest eggs, how 10 skirts beat the pants off a Wall Street and how you can too. Now they have reported these spectacular results. And, and you know the media picked on up and they sold their books and everything, and then someone decided we ought to do it. In an audit of their actual results, and they found something very interesting, these checks were counting as investment returns their weekly or monthly contributions to the investment fund they had. And when they ran the numbers, they actually had dramatically underperformed the market was so embarrassed that they stopped publishing anything, they underperformed the market over the period of this study, which is about three years by accumulative 16%. So that's one example. But that's not even my favorite one. And then it's hard to underperform over a three year period by 60. You couldn't do it if you try, because the market is too efficient. But my favorite story is about the Mensa Investment Club. It's my favorite story, because for those of you who don't know, the Mensa club, you have to be in the top 2% of IQ to be in there. So if anyone could beat the market, you would think it would be the super geniuses who were members of this club. Well, the Money Magazine sorry, Smart Money Magazine in 2001 wrote an article and reported that while over the 15 year prior years, the s&p have returned 15%. What do you think the Mensa club had done? Andrew? Take a guess.

Andrew Stotz 06:32
15%. But they're geniuses. I mean, come on. They should be outperforming that massively. Theory,

Larry Swedroe 06:42
right. And we know it's hard to underperform toe, right? And when you should accept for expenses. So maybe you would think maybe markets are efficient, they lose by one. Just take a guess where do you think they're, let's say 5%. Now, you're

Andrew Stotz 06:58
no worse than the bay Beardstown. Ladies,

Larry Swedroe 07:00
yeah, they aren't two and a half percent a year. One investor, a guy named Warren Smith had reported that he was an investor for 35 years. And he calculated is original investment of 5300 had turned into 9300 Didn't even double over the 35 years. And investment in the s&p would have produced over 300,000 times as much money. There's examples. More heads or not better than 101

Andrew Stotz 07:41
lesson. And, you know, also, more heads are not better than one is another aspect to when you think about collective decision making, you know, whatever it was that caused this. Sometimes it's hubris, you know, sometimes it's but in, you know, what's interesting is that so many companies and businesses around the world in the fund management space and others take comfort in the idea that they've got a committee or a community group or that it's collective. In fact, Ray Dalio talks about making these kinds of collective decisions, but giving a little bit more weight to some people that you think okay, this person should know more. But should we take any comfort in that when we do that type of decision making process? Yeah,

Larry Swedroe 08:35
your best bet is simply, as we've talked on our previous episodes, just take the collective wisdom of the market, you have to remember that bread barber and Odine study, too many cooks spoiling abroad, found that the average investor underperform by about 4% A year before adjusting for risk and bit worse after, but most of that was probably can't afford that turnover was 65% a year. That's actually a little bit better than the average turnover, barber had found for individuals. And I think they found 75% For the average individual. So you know, but their stock, they their stock picking happened to be even worse. But most of it was accounted for just they're just turnover. And people are just overconfident. In fact, almost every financial adviser that I talked to I know this is my experience, and we kind of chatted about it over the years. It's purely anecdotal. I haven't done a study on it. But if I asked other advisors, what group of individuals as a profession, have the worst investment track record? They make the worst? Take a guess what you think it might be one or fashion?

Andrew Stotz 09:58
Well, one of the things I always say When I worked at a sell side as a sell side analysts at a broker and everybody's talking ideas in the stock market, I was always saying if we track the performance of my colleagues in all of us, I can guarantee you, we're underperforming the market pretty significantly. And we're in the financial industry sitting on top of the market in theory we should be outperforming. So I would say number one financial industry is a huge underperformer when it comes to certainly their personal bets.

Larry Swedroe 10:31
Yeah, that may be true. Again, I don't have any evidence.

Andrew Stotz 10:35
That's the point of talking to you, I have a very, my

Larry Swedroe 10:38
experience is doctors, by far, the worst. And that's because they make the mistake of thinking because they're intelligent, that they know something the market doesn't know. Or they can interpret it better. And so that overconfidence leads to probably too much trading, taking too much risk, and therefore underperforming. And my experience is the people who make the best investors by far. And this is corroborated. When I talk to other advisors, again, purely anecdotal, after they are engineers, because the engineers read the literature. And they understand a this is science, it's math, this is the evidence, and they tend to follow it. Which means once they have read books, like mine, or Bill Bernstein's or others, they say, Okay, I'm gonna be this systematic investor. And I'm just going to accept market returns, taking the risks that are appropriate for me like value, and size and other invest in these factors. And they tend to stay the course rebalanced. And don't panic when something underperforms for three or four or five years, because they understand this likely to be investment noise, and not ending up chasing recent returns. And for

Andrew Stotz 12:03
those doctors out there, they should read this book, the white coat investor, one of them, one of the great books, that's a resource for doctors. And I've just recently had James who wrote this book on podcasts, and it gives some really good thinking for doctors in that case. And that the other one that I would add to that is entrepreneurs, business owners, because yeah, I would agree. These guys, they have all the success in their business, they got a lot of money, they're confident in what they're doing. And then they take that confidence and they stroll into the market. And they it's just, it's a train wreck. And

Larry Swedroe 12:41
then they tend to take concentrated bets, because that's what made them successful. And so that I absolutely agree I would put entrepreneurs, they are often what we call serial millionaires, they make a fortune and they turn, they have a large fortune, they turned it into a small one thing, go out and build a business, again, create a big fortune, and then go invest it and turn it back into a small fortune. I

Andrew Stotz 13:07
have a story in relation to that. And it's a short one that will wrap this one up on and go on to mistake 25. But I was you know, helped an entrepreneur to sell their business and make a lot of money from it. And there was a couple of things. The first one is there, the we use a bank out of Hong Kong to handle the transaction between the buyer and seller and all that. And what happened was the banker showed up when once everything was getting ready to happen, and he's like, I'm gonna, you know, talk to you about managing your money. And he talked to each person involved. And you know, everybody was paid through that bank. So we were a captive audience, but I told that banker, I said, Look, just do me a favor, and he says yes, anything, what do you want? I said, never call me. Never contact me. And he's like, okay, that's clear. And he never contacted me. Now for the other guys that had their accounts and had their profits from the gain of selling their business. Within a very short amount of time, they had lost a substantial amount of the money they had made by listening to this guy who had given them all kinds of products that the bank was selling. And they were losing I mean, as much as 50% of their overall amount. And what makes it even worse was one of the guys, the accountant that did his submitted his taxes, the tax guy that helped him with his taxes, made a mistake. And it ended up that he ended up owing a lot more money. And there was a penalty because of something that wasn't disclosed. It wasn't that he didn't pay, but he had to pay like a million dollar penalty to the IRS. And there was a point of, you know, desperation where I can tell you that guy felt like he'd lost almost everything that he built up. over 20 years, and I can tell you that is a desperate feeling when you have a family and all of that, that it was almost suicidal. So for those entrepreneurs out there, tread carefully when you get out of you know, and read your books,

Larry Swedroe 15:13
that's a classic mistake we talked about one of the worst mistakes investors make is once you have sufficient assets, to enjoy your life, that module till the wealth is close to zero, and you should be taking those chips off the table. So my line is, once you've won the game, say you've got $5 million, and a 4%. Use that as a general rule as a safe harbor withdrawal, you got 5 million bucks, that's 200,000 a year, right? If you can't live on $200,000, yeah, I'm sorry, something is wrong, you could be happy with that. You know, most people can do that. And therefore, just invest very conservatively. diversify your portfolio, make any big bets, and you'll be fine. But so many people don't do that. And they fail to take those chips off the table once they won the game.

Andrew Stotz 16:14
So let's move on to the next mistake. And I'm gonna preface it with the bear markets that I've lived through. The first one was a 1997 crisis in Asia, which was centered here in Bangkok, Thailand. And from when I started working in the stock market, for my fourth month in the stock market, the Thai stock market had peaked at 1789. Many years went by, and it was probably from about five or six years, the market went to a low of 200. So we're talking about a 90% Fall roughly, and the currency also collapse. So if you're a US dollar investor invested in Thailand, you would have had a 95% loss if you had bought at that top, and you had held it to that bottom. So that was my first experience with a crash and our domestic economy collapsed by 11%. In 1998, after that happened, so it was a brutal crash. And then we had 2008, which was another, you know, crash. And also we had 19 Sorry, I missed the.com bubble, because the Asian crisis didn't really hit America that much. But we had the.com Bubble happen and the crash after that. And then we had the 2008. And then we had some of the COVID stuff that's been going on. So these are the concepts of you know, bear markets are pretty brutal. But luckily, now I can tell you, at the time that the Thai market went through this collapse, I knew nothing about markets, I was a beginner, I was just learning. So how could I add any perspective to it? I really couldn't. But now, Larry, I'm experienced, I should be able to protect people from bear markets. So let's talk about mistake 25 Do you believe active managers will protect you from bear markets?

Larry Swedroe 18:02
Well, the first thing we should do is admit that active managers start off with an advantage headed into a bear market, because of passive systematic investor is going to earn the return of the market. They're not getting in and out of the market right. Now, they may have the market had done very well before the bear market, they would have rebalanced the portfolio if they weren't 100% equities, taking some of those chips off the table and selling high. And then when the bear market hits, if they stay disciplined, they get to buy low, and can even outperform the very funds they invest in simply by doing that if they stay the course. But active managers have the ability, this is what they tout, we can get your out before the bear emerges from its hibernation and will get you back in before the bowl and does the arena again. So they can move to cash. That's a clear advantage. The question is what is the empirical evidence say not what they mock it as their skill set? Right? The empirical evidence is found very clearly that active managers on average tend to have the largest cast positions just before bear markets and the smallest cast positions, just as the bull market is getting started. And so they're exactly the opposite. Exactly the opposite of what happened. Here's an example. And 1973 Okay, that was the boom the first big bear market before the ones you mentioned. Mutual Fund reserves, stood at a then almost record low of 4%

Andrew Stotz 20:00
So in other words, they're fully invested at the peak

Larry Swedroe 20:03
basically fully invested in 4%. At the ensuing law, it was 13%. exactly backwards, they could have been sitting with 13% Cash maybe before and all. And then when they hit the bottom, they, you know, they were then be able to buy because they had cash, but not not not the case, you know, and then they would have had a very low 4%. At the low, they were exactly the opposite. Morningstar has done studies and found no evidence of this Vanguard did a study on this issue that they published, and they concluded, it didn't matter whether an active manager was operating in a bear market, a bull market that precedes or follows it, or, of course, longer time cycles, for combination of costs, security, selection, and market timing, proved difficult hurdle to overcome. past success in overcoming these hurdles, provided no evidence of their future abilities to do it, they concluded, we find little evidence to support the purported benefits of active management, during periods of market stress, they have to remember while Vanguard is a big provider of active funds, they're also a big provider, the leading provider of index funds, they're also provider of a large amount of active funds. And there are many, you know that there's no evidence that active managers can protect you from bear markets.

Andrew Stotz 21:52
And it's oftentimes that I've looked at stock charts and market charts and you look back over time, and you go, why didn't I invest? Then? Why wasn't it so obvious, then? And what I oftentimes think about is that the first thing is, this is hindsight bias. Of course, we can't know at that time that we're at the bottom, let's say. But I also think that there are some other factors, and let's just think about an individual investor, for an individual investor to outperform through bear markets, really, what it means is that first, you have to be able to detect that you're going into a bear market. Okay? That's the first thing. Second thing is you've got to have the, the, you've got to know what to do, let's just say that's not too complicated, you just go to cash. And then the third thing is, you've got to do it.

Larry Swedroe 22:43
Now, the hardest part is then getting back in, right, because

Andrew Stotz 22:47
now let's go down to the bottom of the market economy is terrible, the markets terrible, you think you could be losing your job, or you're losing big customers in the company that you own. And the way you feel about your own financial situation has shifted probably a lot. So then the issue of, you know, to understand you're at a bottom or at a bear market bottom. That's step number one, which is hard enough already, then you've got to have the cash to be able to act. And then you got to have the guts to be able to act. And I think if you add all those things up, it's very hard for most people to make I would say that the people who tell the story of how they, you know, bought at the bottom, either are lying there Miss under Mrs. Representing the past? Or if it's truly the case, it was purely by luck. Yeah, well,

Larry Swedroe 23:41
here's a good example to illustrate your point. So let's say you were smart enough to get out before the bear market hit in November, I think of Oh, seven is when it began. Right now. It's March, I think, ninth of 2009 when the market bottomed down, okay. And let's say you now can't foreseen what stock prices will do. But you are so brilliant, you could predict the economy. And what happens the unemployment rate is continuing to go up, reaching 10% By the end of the year, and staying there for a while, the economy goes crashing into recession in the second and third quarters. And so you knowing that, stay out of the market, and it went up like 55% So if you're even if you miss the downside, you then miss the 55% upside. That's the real problem, which is why Peter Lynch says he never even met anyone who was successful timing the market it's just for difficult now I will add this for all listeners. You There is one strategy that over the long term, on average, that has helped investors reduce the risks, not eliminate them of, of getting hit by a severe bear market. And that's using trend following strategies that trend following, they miss the beginnings of bull markets, they get you in later. And they miss the end of bull markets when bear markets come because it takes a while for the signals to turn, depending upon whether using what are called fast signals like that turned in one month, or an intermediate that might turn in three to six months, or whatever the signal is. The problem is this, on average, over the very long term trend following his help, but because most of the time the market is going up, you're going to underperform because you're missing much of those turns because it hasn't gotten you in. And so you could go for a decade, underperforming and then 209 comps, and then it bails you out because it got you out before and you know, not right away. But it kept you away for much of the severity of the market. And eventually within a few months got you back in. But how many people could stay discipline with a strategy for 10 years of dramatically underperforming to be saved by that one short period? Not many can do that. And that's why a real problem. Unless you could stay with that I tell people avoid trend following. But if you can stay with it, then there is evidence that adding some exposure to a trend following has helped reduce the downside risks. So if you're a risk averse investor, it's worth considering a fund that uses that trend following strategy for at least a portion of your portfolio. And

Andrew Stotz 27:12
what if you maybe we'll wrap this one up by just kind of thinking about the type of investor who, who they they, they're not going to get in and out of the market, they want to build kind of an all weather style of portfolio. There, they understand the market is going to crash, you know, they'd prefer not to go down by 50%. You know, it's just brutal. And they're willing to give up some of the upside when it goes up. So they are optimizing for lower volatility that they can bear, let's say, and we're talking about kind of the average person, we're not talking about some extreme example. But what would be a type of asset construction or asset allocation that could be, you know, valuable over a long term?

Larry Swedroe 28:01
Well, my answer is pretty simple. And the only way to help really minimize those risks, and really be safe is to don't take risks. And then you don't get any returns in real terms. And it's hard to reach your goals. So what's the next best thing? The next best thing is the word the term I use this the hyper diversified, meaning own, like Ray Dalio and a lots of different assets that have unique risks. Some of them have nothing to do with what's going on with the economy, the stock market, so things like reinsurance. As you know, 2022 was a horrible year for both stocks and bonds. And reinsurance funds did fine. This year was another really bad year. For bond funds. Again, a little got a little better in the last week or so. And everything except basically large cap growth stocks, pretty much didn't do anything. But reinsurance, the fund I own is up 42%. Now it had other big ideas, and that's okay, I live with them. In fact, I then bought more, because I know when the fun loses money, then the premiums go up, the underwriting standards get tighter and my expected returns go up. So

Andrew Stotz 29:28
this would be considered in under a uncorrelated or low correlated

Larry Swedroe 29:34
asset, totally uncorrelated because there's no reason logically that hurricanes or earthquakes rarely affect stock market unless it's an unbelievably extreme, you know, event like that, you know, an earthquake that caused the Nakashima Tokyo plant. What is that had caused some atomic huge problem and shut the global economy? Something like that. is obviously possible. But you know, the expectation is the vast majority of the time you're going to have uncorrelated assets. There are other long short strategies that are market neutral. AQR, for example, I invest in their long short Fund, which goes, long values, short growth, it goes long, positive momentum, and short negative momentum, stocks, bonds, commodities and currency. And it does it with two other factors. And its correlation with the market is about zero. There are some other things as well, things like drug royalties as well. That life settlements, for example, there are no logical reason for them to be correlated. So there are assets that are also have lower correlation. So for example, private credit, that's floating rate, and also senior secured, and backed by private equity. So it's less risky than far less risky than junk bonds, for example. And it's floating rate. So you don't have the bond risk, either. You have some economic cycle risk, of course, but the fund I invest in, because of very tight covenants low LTVs. And the private equity backers tend to step in, because if the private equity owner or the private lender has declared the fall, they get wiped out. They not always, but often they will step in and provide more equity and allow for restructuring and a chant. That evidence shows that just senior secured losses are about 1% a year. And they're yielding about today, I'll have 11 or 12. Now senior secured backed by private equity, the losses are only about 25 basis points. In 2020. That fun during the COVID crisis dropped 3% in a month, when the economy didn't tank quickly rebounded and ended up for the year. And in 2022, the fund was up unlike bond funds, so it's gonna have some correlation with economic cycle risk, but not a lot. And it actually helps against the risk of inflation because it's all floating rate debt. So you're trading off some more economic cycle risk. That's a US Treasuries don't have, but you get rid of the inflation risk that treasuries have, unless you want tips. So I think it wasn't some example, just hyper diverse, don't only us don't only tie a tie investor and add 50% of his portfolio in US stocks, which is what the market cap roughly or even at that time, maybe it was 60%, now would have been much better off. So same thing US investors should not have, you know, 8090 or 100%. In the US My opinion is they should market cap rate, and that 50 to 60% kind of range. And

Andrew Stotz 33:16
if if an investor owns land, let's just say they own land straight out, we kind of don't count that as part of their investment portfolio because it's something liquid but there's an example of an asset it's not being priced every

Larry Swedroe 33:29
other good asset. That's farmland Timberland, there are even funds that invest don't those things are worth considering. Now you do have to consider the costs and the fees and tax issues. But yeah, those are exactly the kind of things that investors should consider to diversify, more broadly infrastructure funds that invest in toll highways and, you know, gasoline pipelines and stuff. They, you know, they tend to have inflation protections, as well, and what about and they're uncorrelated, at least to some degree.

Andrew Stotz 34:04
And what about, you know, obviously, the big thing we're trying to protect against is a, you know, a crazy loss coming from the equity market. What about a inverse, having an inverse type of fund or ETF? Or is that about

Larry Swedroe 34:21
just just soon as you hear those words, inverse, and then add leveraged through it, run as fast as you can? Why expectation has to be negative returns?

Andrew Stotz 34:32
But let's let me just as positive return, let me let me just push back I do agree, the leveraging of it is kind of not necessary, but let's just say one to one negative return when the market goes up by 10%. Is it gonna go down by 10%?

Larry Swedroe 34:47
Then just don't invest and take that money in and buy a treasury bill and you get 5% All you did is you one did one investment. One is going up while the other is going down? Why do you that's no Return, and I pay expenses on both of those funds. That makes no sense. Now only for a tactician who's trying to time it, you know, fine, you won't you think you're going to be successful, you could predict the bear market fail free, go ahead and buy a triple leveraged inverse fund. And you could check the track record of those funds. Many of them literally go to zero. Because of the leverage. Yeah.

Andrew Stotz 35:29
Well, that's a lot of great wrap up there related to really actionable advice. And so I appreciate that. So I want to thank you, Larry, for another great discussion about creating growing and protecting wealth and for listeners out there who want to keep up with all that Larry's doing, which is a lot. Find him on Twitter at Larry swedroe. And also you can find him on LinkedIn and you'll see all that he's doing and I trust trust me, you're gonna see a lot of stuff. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.